Bank Holding Company Supervision Manual, February 2023

Bank Holding Company

Supervision

Manual

Division of Supervision and Regulation

Prepared by:

Division of Supervision and Regulation

Board of Governors of the Federal Reserve System

Send comments to:

Director, Division of Supervision and Regulation

Board of Governors of the Federal Reserve System

Washington, D.C. 20551

In addition, comments may be sent via the Board’s public website.

General Table of Contents

Bank Holding Company Supervision Manual

This general table of contents lists the major section heads for each part of the manual:

1000 About this Manual, Supervisory Process

2000 Supervisory Policy and Issues

3000 Nonbanking Activities

4000 Financial Analysis

5000 BHC Inspection Program

Sections Title

1000 ABOUT THIS MANUAL, SUPERVISORY PROCESS

1000.0 About this Manual

1020.0 Supervision of Savings and Loan Holding Companies

1040.0 Bank Holding Company Examination and Inspection Authority

1045.0 Supervision of Holding Companies with Less Than $10 Billion

in Total Consolidated Assets

1050.0 Consolidated Supervision of Bank Holding Companies and the Combined

U.S. Operations of Foreign Banking Organizations

1050.1 Guidance for the Consolidated Supervision of Domestic Bank Holding

Companies That Are Large Complex Banking Organizations

1050.2 Consolidated Supervision of Regional Holding Companies

1060.0 Large Financial Institution Rating System

1060.1 Large Financial Institution Rating System: Capital Planning and Positions

1060.2 Supervisory Assessment of Capital Planning and Positions for Category I Firms

1060.3 Supervisory Assessment of Capital Planning and Positions for Category II

or III Firms

1060.20 Liquidity Planning and Positions

1060.30 Supervisory Guidance on Board of Directors’ Effectiveness (Governance

and Controls)

1060.31 Assessment of Risk-Management Processes and Internal Controls of

BHCs Having $100 Billion or More in Total Assets

1062.0 RFI Rating System

1062.1 Supervisory Guidance for Assessing Risk Management at Supervised

Institutions with Total Consolidated Assets Less than $100 Billion

1063.0 Holding Company Ratings Applicability and Inspection Frequency

1065.0 Nondisclosure of Supervisory Ratings and Conﬁdential Supervisory

Information

BHC Supervision Manual February 2023

Page 1

Sections Title

1070.1 Communication of Supervisory Findings

1072.0 Considerations in Assigning and Revising Supervisory Ratings

1075.0 Formal Corrective Actions

1080.0 Federal Reserve System Holding Company Surveillance Program

1080.1 Surveillance Program for Small Holding Companies

2000 SUPERVISORY POLICY AND ISSUES

2000.0 Introduction to Topics for Supervisory Review

2010.0 Supervision of Subsidiaries

2010.1 Funding Policies

2010.2 Loan Administration

2010.3 Investments

2010.4 Consolidated Planning Process

2010.5 Environmental Liability

2010.6 Retail Sales of Nondeposit Investment Products

2010.7 Reserved

2010.8 Sharing of Facilities and Staff by Banking Organizations

2010.9 Required Absences from Sensitive Positions

2010.10 Internal Loan Review

2010.11 Private-Banking Functions and Activities

2010.12 Fees Involving Investments of Fiduciary Assets in Mutual Funds and Potential

Conﬂicts of Interest

2010.13 Establishing Accounts for Foreign Governments Embassies, and Political

Figures

2020.0 Intercompany Transactions

2020.1 Transactions Between Member Banks and Their Afﬁliates—Sections 23A

and 23B of the Federal Reserve Act

2020.2 Loan Participations

2020.3 Sale and Transfer of Assets

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Sections Title

2020.4 Compensating Balances

2020.5 Dividends

2020.6 Management and Service Fees

2020.7 Transfer of Low-Quality Assets

2020.8 Reserved

2020.9 Split-Dollar Life Insurance

2030.0 Grandfather Rights—Retention and Expansion of Nonbank Activities

2040.0 Commitments to the Federal Reserve

2050.0 Extensions of Credit to BHC Ofﬁcials

2060.0 Management Information Systems (General)

2060.05 Policy Statement on the Internal Audit Function and Its Outsourcing

2060.07 Supplemental Policy Statement on the Internal Audit Function and

Its Outsourcing

2060.1 Audit

2060.2 Budget

2060.3 Records and Statements

2060.4 Structure and Reporting

2060.5 Insurance

2065.1 Nonaccrual Loans (Accounting, Reporting, and Disclosure Issues)

2065.2 Maintaining and Documenting the Allowance for Loan and Lease Losses

2065.3 Allowance for Credit Losses

2068.0 Sound Incentive Compensation Policies

2070.0 Taxes—Consolidated Tax Filing

2080.0 Funding—Introduction

2080.05 Bank Holding Company Funding and Liquidity

2080.1 Commercial Paper and Other Short-term Uninsured Debt Obligations

and Securities

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Sections Title

2080.2 Long-Term Debt

2080.3 Equity

2080.4 Retention of Earnings

2080.5 Pension Funding and Employee Stock Option Plans

2080.6 Holding Company Funding from Sweep Accounts

2090.0 Control and Ownership—General

2090.05 Qualiﬁed Family Partnerships

2090.1 Change in Control

2090.2 BHC Formations

2090.3 Treasury Stock Redemptions

2090.4 Policy Statements on Equity Investments in Banks and Bank

Holding Companies

2090.5 Acquisitions of Bank Shares Through Fiduciary Accounts

2090.6 Control Determinants

2090.7 Nonbank Banks

2090.8 Liability of Commonly Controlled Depository Institutions

2091.0−

2092.0

Reserved

2093.0 Control and Ownership—Shareholder Protection Arrangements

2100.0 International Banking Activities

2120.0 Foreign Corrupt Practices Act and Federal Election Campaign Act

2122.0 Internal Credit-Risk Ratings at Large Firms

2124.0 Risk-Focused Safety-and-Soundness Inspections

2124.01–

2124.04

Reserved

2124.05 Consolidated Supervision Framework for Large Financial Institutions

2124.07 Compliance Risk-Management Programs and Oversight at Large Firms

2124.1 Assessment of Information Technology in Risk-Focused Supervision

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Sections Title

2124.2 Reserved

2124.3 Managing Outsourcing Risk

2124.4 Information Security Standards

2124.5 Identity Theft Red Flags and Address Discrepancies

2126.0 Model Risk Management

2126.1 Investment Securities and End-User Derivatives Activities

2126.2 Investing in Securities without Reliance on Ratings of Nationally

Recognized Statistical Rating Organizations

2126.3 Counterparty Credit Risk Management Systems

2126.5 Volcker Rule (Section 13 of the Bank Holding Company Act)

2127.0 Interest-Rate Risk—Risk Management and Internal Controls

2128.0 Structured Notes—Risk Management and Internal Controls

2128.01 Reserved

2128.02 Asset Securitization

2128.03 Credit-Supported and Asset-Backed Commercial Paper

2128.04 Implicit Recourse Provided to Asset Securitizations

2128.05 Securitization Covenants Linked to Supervisory Actions or Thresholds

2128.06 Valuation of Retained Interests and Risk Management of Securitization

Activities

2128.07 Reserved

2128.08 Subprime Lending

2128.09 Elevated-Risk Complex Structured Finance Activities

2129.0 Credit Derivatives—Risk Management and Internal Controls

2129.05 Risk and Capital Management—Secondary-Market Credit Activities

2130.0 Futures, Forward, and Option Contracts

2140.0 Securities Lending

2150.0 Repurchase Transactions

2160.0 Recognition and Control of Exposure to Risk

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Sections Title

2175.0 Sale of Uninsured Annuities

2178.0 Support of Bank-Afﬁliated Investment Funds

2180.0 Securities Activities in Overseas Markets

2187.0 Violations of Federal Reserve Margin Regulations Resulting from

“Free-Riding” Schemes

2220.3 Note Issuance and Revolving Underwriting Credit Facilities

2231.0 Real Estate Appraisals and Evaluations

2240.0 Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans

2241.0 Retail-Credit Classiﬁcation

2250.0 Domestic and Other Reports to Be Submitted to the Federal Reserve

2260.0 Venture Capital

3000 NONBANKING ACTIVITIES

3000.0 Introduction to BHC Nonbanking and FHC Activities

3001.0 Section 2(c) of the BHC Act—Savings Bank Subsidiaries of BHCs Engaging in

Nonbanking Activities

3005.0 Section 2(c)(2)(F) of the BHC Act—Credit Card Bank Exemption from the

Deﬁnition of a Bank

3010.0 Section 4(c)(i) and (ii) of the BHC Act—Exemptions from Prohibitions on

Acquiring Nonbank Interests

3020.0 Section 4(c)(1) of the BHC Act—Investment in Companies Whose Activities

Are Incidental to Banking

3030.0 Section 4(c)(2) and (3) of the BHC Act—Acquisition of DPC Shares, Assets, or

Real Estate

3032.0 Rental of Other Real Estate Owned Residential Property

3040.0 Section 4(c)(4) of the BHC Act—Interests in Nonbanking Organizations

3050.0 Section 4(c)(5) of the BHC Act—Investments Under Section 5136 of the

Revised Statutes

3060.0 Section 4(c)(6) and (7) of the BHC Act—Ownership of Shares in Any Nonbank

Company of 5 Percent or Less

3070.0 Section 4(c)(8) of the BHC Act—Mortgage Banking

3070.3 Nontraditional Mortgages—Associated Risks

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Sections Title

3071.0 Section 4(c)(8) of the BHC Act—Mortgage Banking— Derivative

Commitments to Originate and Sell Mortgage Loans

3072.0 Section 4(c)(8) of the BHC Act—Activities Related to Extending Credit

3072.8 Real Estate Settlement Services

3073.0 Section 4(c)(8) of the BHC Act—Education-Financing Activities

3080.0 Section 4(c)(8) of the BHC Act—Servicing Loans

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

and Collection Activities

3090.0 Section 4(c)(8) of the BHC Act—Receivables

3090.1 Factoring

3090.2 Accounts Receivable Financing

3100.0 Section 4(c)(8) of the BHC Act—Consumer Finance

3104.0 Section 4(c)(8) of the BHC Act—Acquiring Debt in Default

3105.0 Section 4(c)(8) of the BHC Act—Credit Card Authorization and

Lost/Stolen Credit Card Reporting Services

3107.0 Section 4(c)(8) of the BHC Act—Stand-Alone Inventory Inspection Services

3110.0 Section 4(c)(8) of the BHC Act—Industrial Banking

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

3120.0 Section 4(c)(8) of the BHC Act—Trust Services

3130.0 Section 4(c)(8) of the BHC Act—General Financial and Investment Advisory

Activities

3130.1 Investment or Financial Advisers

3130.2 Reserved

3130.3 Advice on Mergers and Similar Corporate Structurings, Capital Structurings,

and Financing Transactions

3130.4 Informational, Statistical Forecasting, and Advisory Services for Transactions

in Foreign Exchange and Swaps, Commodities, and Derivative Instruments

3130.5 Providing Educational Courses and Instructional Materials for Consumers on

Individual Financial Management Matters

3130.6 Tax-Planning and Tax-Preparation Services

3140.0 Section 4(c)(8) of the BHC Act—Leasing Personal or Real Property

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Sections Title

3150.0 Section 4(c)(8) of the BHC Act—Community Welfare Projects

3160.0 Section 4(c)(8) of the BHC Act—EDP Servicing Company

3160.1 EDP Servicing—Network for the Processing and Transmission of Medical

Payment Data

3160.2 Electronic Beneﬁt Transfer, Stored-Value-Card, and Electronic Data

Interchange Services

3160.3 Data Processing Activities: Obtaining Traveler’s Checks and Postage Stamps

Using an ATM Card and Terminal

3160.4 Providing Data Processing for ATM Distribution of Tickets, Gift Certiﬁcates,

Telephone Cards, and Other Documents

3160.5 Engage in Transmitting Money

3165.1 Support Services—Printing and Selling MICR-Encoded Items

3170.0 Section 4(c)(8) of the BHC Act—Insurance Agency Activities of Bank Holding

Companies

3180.0 Section 4(c)(8) of the BHC Act—Insurance Underwriters

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

3200.0 Section 4(c)(8) of the BHC Act—Management Consulting and Counseling

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

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

3210.0 Section 4(c)(8) of the BHC Act—Money Orders, Savings Bonds, and

Traveler’s Checks

3210.1 Payment Instruments

3220.0 Section 4(c)(8) of the BHC Act—Arranging Commercial Real Estate Equity

Financing

3230.0 Section 4(c)(8) of the BHC Act—Agency Transaction Services for Customer

Investments (Securities Brokerage)

3230.05 Securities Brokerage (Board Decisions)

3230.1 Securities Brokerage in Combination with Investment Advisory Services

3230.2 Securities Brokerage with Discretionary Investment Management and

Investment Advisory Services

3230.3 Offering Full Brokerage Services for Bank-Ineligible Securities

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Sections Title

3230.4 Private-Placement and Riskless-Principal Activities

3230.5 Acting as a Municipal Securities Brokers’ Broker

3230.6 Acting as a Conduit in Securities Borrowing and Lending

3240.0 Section 4(c)(8) of the BHC Act—Underwriting and Dealing in

U.S. Obligations, Municipal Securities, and Money Market Instruments

3250.0 Section 4(c)(8) of the BHC Act—Agency Transactional Services

(Futures Commission Merchants and Futures Brokerage)

3251.0 4(c)(8) Agency Transactional Services—FCM Board Orders

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

Customer Investments

3260.0 Section 4(c)(8) of the BHC Act—Investment Transactions as Principal

3270.0 Section 4(c)(8) of the BHC Act—Real Estate and Personal Property Appraising

3320.0 Section 4(c)(8) of the BHC Act—Check-Guaranty and

Check-Veriﬁcation Services

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

3340.0 Section 4(c)(8) of the BHC Act—Operating a Credit Bureau

3500.0 Prohibitions Against Tying Arrangements

3510.0 Sections 4(c)(9) and 2(h) of the BHC Act—Nonbanking Activities of Foreign

Banking Organizations

3520.0 Section 4(c)(10) of the BHC Act—Exemption from Section 4

for BHCs That Are Banks

3530.0 Section 4(c)(11) of the BHC Act—Authorization for BHCs to Reorganize

Share Ownership Held on the Basis of Any Section 4 Exemption

3540.0 Section 4(c)(12) of the BHC Act—Ten-Year Exemption from Section 4 of

the BHC Act

3550.0 Section 4(c)(13) of the BHC Act—International Activities of Bank Holding

Companies

3560.0 Section 4(c)(14) of the BHC Act—Export Trading Companies

3600.0 Permissible Activities by Board Order

3600.1 Operating a “Pool Reserve Plan”

3600.2–

3600.4

Reserved

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Sections Title

3600.5 Engaging in Banking Activities via Foreign Branches

3600.6 Operating a Securities Exchange

3600.7 Acting as a Certiﬁcation Authority for Digital Signatures

3600.8 Private Limited Investment Partnerships

3600.9–

3600.12

Reserved

3600.13 FCM Activities

3600.14–

3600.16

Reserved

3600.17 Insurance Activities

3600.18–

3600.20

Reserved

3600.21 Underwriting and Dealing

3600.22 Reserved

3600.23 Issuance and Sale of Mortgage-Backed Securities Guaranteed by GNMA

3600.24 Sales-Tax Refund Agent and Cashing U.S. Dollar Payroll Checks

3600.25 Providing Government Services

3600.26 Real Estate Settlement through a Permissible Title Insurance Agency

3600.27 Providing Administrative and Certain Other Services to Mutual Funds

3600.28 Developing Broader Marketing Plans and Advertising and Sales Literature for

Mutual Funds

3600.29 Providing Employment Histories to Third Parties

3600.30 Real Estate Title Abstracting

3610.1 Section 4(c)(8) of the BHC Act—Board Staff Legal Interpretation—Financing

Customers’ Commodity Purchase and Forward Sales

3610.2

Section 4(c)(8) of the BHC Act—Board Legal Staff Interpretation—Certain

Volumetric-Production-Payment Transactions Involving Physical Commodities

3700.0 Impermissible Activities

3700.1 Land Investment and Development

3700.2 Insurance Activities

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Sections Title

3700.3 Real Estate Brokerage and Syndication

3700.4 General Management Consulting

3700.5 Property Management

3700.6 Travel Agencies

3700.7 Providing Credit Ratings on Bonds, Preferred Stock, and Commercial Paper

3700.8 Acting as a Specialist in Foreign-Currency Options on a Securities Exchange

3700.9 Design and Assembly of Hardware for Processing or Transmission of Banking

and Economic Data

3700.10 Armored Car Services

3700.11 Computer Output Microﬁlm Service

3700.12 Clearing Securities Options and Other Financial Instruments for the Accounts

of Professional Floor Traders

3900.0 Section 4(k) of the BHC Act—Financial Holding Companies

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

3903.0 Foreign Banks Operating as Financial Holding Companies

3905.0 Permissible Activities for FHCs

3906.0 Disease Management and Mail-Order Pharmacy Activities

3907.0 Merchant Banking

3909.0 Supervisory Guidance on Equity Investment and Merchant Banking Activities

(Section 4(k) of the BHC Act)

3910.0 Acting as a Finder

3912.0 To Acquire, Manage, and Operate Deﬁned Beneﬁt Pension Plans in the

United Kingdom (Section 4(k) of the BHC Act)

3920.0 Limited Physical-Commodity-Trading Activities

3950.0 Insurance Sales Activities and Consumer Protection in Sales of Insurance

3980.0 Establishment of an Intermediate Holding Company

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Sections Title

4000 FINANCIAL ANALYSIS

4000.0 Financial Factors—Introduction

4010.0 Parent Only: Debt-Servicing Capacity—Cash Flow

4010.1 Leverage

4010.2 Liquidity

4020.0 Banks

4020.1 Banks: Capital

4020.2 Banks: Asset Quality

4020.3 Banks: Earnings

4020.4 Banks: Liquidity

4020.5 Banks: Summary Analysis

4020.6–

4020.8

Reserved

4020.9 Supervision Standards for De Novo State Member Banks of Bank Holding

Companies

4030.0 Nonbanks

4030.1 Nonbanks: Credit Extending—Classiﬁcations

4030.2 Nonbanks: Credit Extending—Earnings

4030.3 Nonbanks: Credit Extending—Leverage

4030.4 Nonbanks: Credit Extending—Reserves

4040.0 Nonbanks: Noncredit Extending

4050.0 Nonbanks: Noncredit Extending—Service Charters

4060.0 Consolidated—Earnings

4060.1 Consolidated: Asset Quality

4060.2–

4060.7

Reserved

4060.8 Overview of Asset-Backed Commercial Paper Programs

4060.9 Consolidated Capital Planning Processes—Payment of Dividends, Stock

Redemptions, and Stock Repurchases at Bank Holding Companies

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Sections Title

4061.0–

4065.0

Reserved

4066.0 Consolidated—Funding and Liquidity Risk Management

4067.0–

4089.0

Reserved

4090.0 Country Risk

5000 BHC INSPECTION PROGRAM

5000.0 BHC Inspection Program—General

5010.0 Procedures for Inspection Report Preparation— Inspection Report References

5010.1 General Instructions to FR 1225

5010.2 Cover

5010.3 Page i—Table of Contents

5010.4 Core Page 1—Examiner’s Comments and Matters Requiring Special

Board Attention

5010.5 Core Page 2—Scope of Inspection and Abbreviations

5010.6 Core Page 3—Analysis of Financial Factors

5010.7 Core Page 4—Audit Program

5010.8 Appendix Page 5—Parent Company Comparative Balance Sheet

5010.9 Appendix Page 6—Comparative Statement of Income and Expenses (Parent)

5010.10 Appendix Page 7—Consolidated Classiﬁed and Special Mention Assets

5010.11 Appendix Page 8—Consolidated Comparative Balance Sheet

5010.12 Appendix Page 9—Comparative Consolidated Statement of Income and

Expenses

5010.13 Capital Structure

5010.14 Page—Policies and Supervision

5010.15 Page—Violations

5010.16 Page—Other Matters

5010.17 Page—Classiﬁed Assets and Capital Ratios of Subsidiary Banks

5010.18 Page—Organization Chart

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Page 13

Sections Title

5010.19 Page—History and Structure

5010.20 Page—Investment in and Advances to Subsidiaries

5010.21 Page—Commercial Paper (Parent)

5010.22 Page—Lines of Credit (Parent)

5010.23 Page—Questions on Commercial Paper and Lines of Credit (Parent)

5010.24 Page—Contingent Liabilities and Other Accounts

5010.25 Page—Statement of Changes in Stockholders’ Equity (Parent)

5010.26 Page—Income from Subsidiaries

5010.27 Page—Cash Flow Statement (Parent)

5010.28 Page—Parent Company Liquidity Position

5010.29 Page—Classiﬁed Parent Company and Nonbank Assets

5010.30 Page—Bank Subsidiaries

5010.31 Page—Nonbank Subsidiary

5010.32 Page—Nonbank Subsidiary Financial Statements

5010.33 Page—Fidelity and Other Indemnity Insurance

5010.34 Reserved

5010.35 Page—Other Supervisory Issues

5010.36 Page—Extensions of Credit to BHC Ofﬁcials

5010.37 Page—Interest Rate Sensitivity—Assets and Liabilities

5010.38 Treasury Activities/Capital Markets

5010.39 Reserved

5010.40 Conﬁdential Page A—Principal Ofﬁcers and Directors

5010.41 Conﬁdential Page B— Condition of BHC

5010.42 Conﬁdential Page C—Liquidity and Debt Information

5010.43 Conﬁdential Page D—Administrative and Other Matters

5020.1 Bank Subsidiary (FR 1241)

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Sections Title

5020.2 Other Supervisory Issues (FR 1241)

5030.0 BHC Inspection Report Forms

5040.0 Procedures for “Limited-Scope” Inspection Report Preparation—

General Instructions

5050.0 Procedures for “Targeted” Inspection Report Preparation—General Instructions

5052.0 Targeted MIS Inspection

5060.0 Portions of Bank Holding Company Inspections Conducted in Federal Reserve

Bank Ofﬁce

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BHC Supervision Manual November 2021

Page 15

Bank Holding Company Supervision Manual

Supplement 56—February 2023

This supplement reﬂects decisions of the Board

of Governors, new and revised statutory and

regulatory provisions, supervisory guidance, and

instructions that the Division of Supervision and

Regulation has issued since the publication of

the November 2021 supplement.

Section 1000.0, “About this Manual”

This section was revised to remove a reference

to SR letter 18-5/CA letter 18-7, “Interagency

Statement Clarifying Role of Supervisory Guid-

ance.” The Board codiﬁed the 2018 “Inter-

agency Statement Clarifying the Role of Super-

visory Guidance,” with clarifying changes, as

appendix A to 12 C.F.R. 262, “Statement Clari-

fying the Role of Supervisory Guidance.” The

ﬁnal rule superseded the 2018 statement. See

86 Fed. Reg. 18,173 (April 8, 2021).

Section 1020.0, “Supervision of Savings

and Loan Holding Companies”

This new section contains guidance that was

previously in section 2500.0, “Supervision of

Savings and Loan Holding Companies.” The

material was moved closer to the manual’s other

sections that describe supervisory process guid-

ance. In addition, this section was modiﬁed to

provide an overview of the statutes, regulations,

and guidance that apply to savings and loan

holding companies (SLHCs). The section de-

scribes the supervisory approach for SLHCs,

highlighting that the Federal Reserve employs a

“portfolio approach” to consolidated supervi-

sion for most SLHCs to facilitate greater consis-

tency of supervisory practices and assessments

across comparable organizations. The section

describesthe ratings systems that apply to SLHCs.

The Federal Reserve uses the “RFI/C(D)” rating

system for non-insurance and non-commercial

SLHCs with total consolidated assets less than

$100 billion. The “Large Financial Institution”

or “LFI” rating system is used for all non-

insurance, non-commercial SLHCs with total

consolidated assets of $100 billion or more.

Supervisedinsuranceinstitutionsreceive a unique

rating. See 87 Fed. Reg. 60,160 (October 4,

2022). The section also describes guidance on

qualiﬁed thrift lenders (see SR-17-9, “Supervi-

sory Guidance for Examining Compliance with

the Qualiﬁed Thrift Lender Test”), as well as

covered savings associations (see SR-22-2, “Sta-

tus of Covered Savings Associations and Hold-

ing Companies of Covered Savings Associa-

tions Under Statutes and Regulations

Administered by the Federal Reserve”).

Section 1045.0, “Supervision of Holding

Companies with Less Than $10 Billion in

Total Consolidated Assets”

Previously, this section was called “Supervision

of Holding Companies with Total Consolidated

Assets of $10 Billion or Less.” The section’s

title and content have been revised to reﬂect

minor technical applicability changes. Previ-

ously, the guidance in the section applied to the

supervision of holding companies with $10 bil-

lion or less in total consolidated assets. The

section was revised to reﬂect that the guidance

applies to holding companies supervised by the

Federal Reserve with less than $10 billion in

total consolidated assets. For more information

see SR-13-21, “Inspection Frequency and Scope

Expectations for Bank Holding Companies and

Savings and Loan Holding Companies that are

Community Banking Organizations.”

Section 1060.20, “Liquidity Planning and

Positions (LFI Ratings System)

This new section provides an overview of key

liquidity-related regulations and guidance issu-

ances that apply to ﬁrms that are subject to the

large ﬁnancial institution (LFI) rating system.

This section provides an overview of the “Inter-

agency Policy Statement on Funding and Liquid-

ity Risk Management” (see SR-10-6). The sec-

tion introduces key liquidity-related requirements

in Regulation YY, “Enhanced Prudential Stan-

dards” (12 C.F.R. part 252). Further, the section

describes the liquidity coverage ratio require-

ments and the net stable funding ratio require-

ments in Regulation WW, “Liquidity Risk Mea-

surement Standards” (12 C.F.R. part 249). The

liquidity regulatory requirements in the Com-

plex Institution Liquidity Monitoring Report

(FR 2052a) are summarized. The FR 2052a is

required to be submitted by top-tier BHCs, top-

tier SLHCs, and FBOs subject to Category I, II,

III, or IV standards under the Board’s Regula-

tion YY and Regulation LL. Lastly, the section

BHC Supervision Manual February 2023

Page 1

describestheFederalReserve’ssupervisoryactiv-

ities and approach for assessing liquidity at

LFIs.

Section 1063.0, “Holding Company

Ratings Applicability and Inspection

Frequency”

This section was revised to update the inspec-

tion scope and frequency expectations for super-

vised insurance organizations. A “supervised

insurance organization” is a depository institu-

tion holding company that is an insurance under-

writing company, or that has over 25 percent of

its consolidated assets held by insurance under-

writing subsidiaries or has been otherwise desig-

nated as a supervised insurance organization by

Federal Reserve staff. For more information on

the ratings system that applies to supervised

insurance organizations, see SR-22-8, “Frame-

work for the Supervision of Insurance Organiza-

tions.”

Section 1075.0, “Formal Corrective

Actions”

This new section contains guidance that was

previously in section 2110.0, “Formal Correc-

tive Actions.” The material was moved closer to

the manual’s other sections that describe super-

visory process guidance. The section was re-

vised to include the entities against which the

Federal Reserve has the statutory authority to

take formal enforcement actions. In particular,

the section was revised to indicate which formal

actions apply to SLHCs. Additional information

was added to describe enforcement actions for

Bank Secrecy Act and anti-money laundering

compliance failures, as well as the interagency

coordination activities of federal banking agen-

cies on formal enforcement actions. Clarifying

edits were made to the subsections describing

civil money penalties, prohibited indemniﬁca-

tion payments, and golden parachute payments,

as well as prohibition and removal authority.

The section highlights that the Board does not

issue an enforcement action on the basis of a

“violation” of or “non-compliance” with super-

visory guidance.

Section 2010.6, “Supervision of

Subsidiaries (Retail Sales of Nondeposit

Investment Products)”

Previously, this section was called “Supervision

of Subsidiaries (Financial Institution Subsidiary

Retail Sales of Nondeposit Investment Prod-

ucts).” The section’s title has been revised to

reﬂect the signiﬁcant changes that were made to

the material. This section provides a summary

of the relevant guidance on nondeposit invest-

ment products and directs readers to the key

pieces of guidance, via hyperlinks, that the

Board and other banking agencies have issued

regarding this topic. The inspection objectives

and inspection procedures have been removed.

Relevant examination objectives and procedures

on the retail sales of nondeposit investment

products are in the Commercial Bank Examina-

tion Manual.

Section 2080.6, “Funding (Holding

Company Funding from Sweep

Accounts)”

Previously, this section was called “Funding

(Bank Holding Company Funding from Sweep

Accounts).” The section was renamed to reﬂect

that the guidance in this section applies to

SLHCs as well as bank holding companies

(BHCs). The section was revised to reﬂect the

expanded applicability of the guidance. Further,

the section was revised to better align with the

“Statement Clarifying the Role of Supervisory

Guidance” (see 12 C.F.R. part 262, appendix A).

Unlike a law or regulation, supervisory guid-

ance does not have the force and effect of law,

and the Board does not take enforcement actions

based on supervisory guidance.

Section 2090.2 “Control and Ownership

(BHC Formations)”

This section contains information about the Small

Bank Holding Company and Savings and Loan

Holding Company Policy Statement (12 C.F.R.

part 225, appendix C). Additional information

was added to explain the calculation of equity,

the denominator of the debt-to-equity ratio, as

described in this policy statement. The compo-

nents of total equity capital align with the com-

ponents of equity that are listed in the Parent

Company Only Financial Statements for Small

Holding Companies Report (FR-Y-9SP). Total

equity capital includes perpetual preferred stock

(including related surplus); common stock

Bank Holding Company Supervision Manual Supplement 56—February 2023

BHC Supervision Manual February 2023

Page 2

(including related surplus); retained earnings;

accumulated other comprehensive income; and

all other equity capital components, including

the total carrying value (at cost) of treasury

stock and unearned Employee Stock Ownership

Plan shares.

Section 2110.0, “Formal Corrective

Actions”

The material in this section has been revised and

moved to section 1075.0. As a result, this sec-

tion has been removed from the manual. See the

description above for section 1075.0 for more

information.

Section 2128.02 Asset Securitization (Risk

Management and Internal Controls)

This section was signiﬁcantly revised. Much of

the information that was previously in the sec-

tion was removed because it conveyed outdated

risk-based capital provisions affecting asset se-

curitization, as well as outdated accounting ref-

erences. The section refers readers to the Asset

Securitization section of the Commercial Bank

Examination Manual for more information. The

inspection objectives and inspection procedures

also were removed, as the Securitization Exami-

nation Documentation (ED) module provides

more detailed examination procedures for exam-

iners.

Section 2241.0, “Retail-Credit

Classiﬁcation”

This section was revised to reﬂect that the guid-

ance in this section applies to BHCs as well as

SLHCs. Outdated references were removed from

the section. Minor edits were made to the deﬁni-

tions for the classiﬁcations used for retail credit:

Substandard, Doubtful, and Loss. Edits were

made to these deﬁnitions to ensure they align

with the deﬁnitions that the federal bank regula-

tory agencies utilize for assets adversely classi-

ﬁed for supervisory purposes. Further, edits

were made to better align the guidance in the

manual section with the “Statement Clarifying

the Role of Supervisory Guidance.”

Section 2500.0, “Supervision of Savings

and Loan Holding Companies”

The material in this section has been revised and

moved to section 1020.0. As a result, this

section has been removed from the manual. See

the description above for section 1020.0 for

more information.

Section 3520.0, “Section 4(c)(10) of the

BHC Act (Exemption from Section 4 for

BHCs That Are Banks)”

This section, previously called “Section 4(c)(10)

of the BHC Act (Grandfather Exemption from

Section 4 for BHC’s Which Are Banks)” was

revised to note that at the time of the enactment

of the BHC Act, the exemption described in the

section accommodated only three BHCs and

that these BHCs no longer exist. The section

remains in the manual to provide historical

background information.

Bank Holding Company Supervision Manual Supplement 56—February 2023

BHC Supervision Manual February 2023

Page 3

Bank Holding Company Supervision Manual

Supplement 55—November 2021

This supplement reﬂects decisions of the Board

of Governors, new and revised statutory and

regulatory provisions, supervisory guidance, and

instructions that the Division of Supervision and

Regulation has issued since the publication of

the February 2020 supplement.

Section 1050.2, “Consolidated

Supervision of Regional Holding

Companies”

This section was previously called “Guidance

for the Consolidated Supervision of Regional

Bank Holding Companies.” The section was

revised to note that it applies to domestic bank

holding companies (BHCs) and savings and

loan holding companies (SLHCs) having between

$10 billion and $100 billion in total consoli-

dated assets. Several discussions regarding super-

visory ﬁndings were modiﬁed to align more

closely with the “Statement Clarifying the Role

of Supervisory Guidance” (12 CFR part 262,

appendix A). Further, this section was revised to

include an outline of the report of inspection

that examiners should follow when assigning

holding company rating components and sub-

components at full-scope or roll-up inspections

of BHCs and SLHCs in the regional banking

organization portfolio. The section explains the

timing expectations for examination staff to

complete safety-and-soundness examination and

inspection reports for domestic regional ﬁnan-

cial institutions and the submission of the re-

ports to the institution. Lastly, references to

inactive guidance issuances were updated.

Section 1060.1, “Large Financial

Institution Rating System: Capital

Planning and Positions”

This new section provides an overview of key

capital-related regulations and guidance issu-

ances that apply to ﬁrms that are subject to the

large ﬁnancial institution (LFI) rating system.

The section describes capital stress testing re-

quirements for BHCs and covered SLHCs with

total consolidated assets of $100 billion or more

(Regulation YY and Regulation LL). The sec-

tion also contains an overview of Regulation Q,

which establishes minimum capital require-

ments and overall capital adequacy standards

for Federal Reserve-regulated institutions. A

fuller discussion of Regulation Q is provided in

the “Assessment of Capital Adequacy” section

of the Commercial Bank Examination Manual.

In addition, the section describes the applicabil-

ity and purpose of the capital plan rule (Regula-

tion Y and Regulation LL), which requires an

LFI to develop an annual capital plan that is

approved by its board of directors. This section

contains updated information that was previ-

ously discussed in section 4060.5, “Capital Ad-

equacy (Advanced Approaches)” and sec-

tion 4061.0, “Consolidated Capital (Capital

Planning).”

Section 1060.2, “Supervisory Assessment

of Capital Planning and Positions for

Category I Firms”

This new section contains guidance that was

previously in section 4063.0, “Federal Reserve

Supervisory Assessment of Capital Planning and

Positions for LISCC Firms and Large and Com-

plex Firms.” This material was moved closer to

the other sections in the manual that provide

guidance on the assessment of capital planning

and positions at LFIs. Further, this section was

modiﬁed to cover U.S. BHCs that are subject to

category I standards under the Board’s tailoring

framework. These applicability modiﬁcations

align with the Board’s tailoring rules. See 84

Fed. Reg. 59,032 (November 1, 2019) for more

information. See also SR-15-18, “Federal Reserve

Supervisory Assessment of Capital Planning and

Positions for Firms Subject to Category I Stan-

dards.”

Section 1060.3, “Supervisory Assessment

of Capital Planning and Positions for

Category II or III Firms”

This new section contains guidance that was

previously in section 4065.0, “Federal Reserve

Supervisory Assessment of Capital Planning and

Positions for Large and Noncomplex Firms.”

The material was moved closer to the other

sections in the manual that provide guidance on

the assessment of capital planning and positions

at LFIs. Further, this section was modiﬁed to

cover U.S. BHCs, U.S. intermediate holding

companies of foreign banking organizations,

and covered SLHCs that are subject to cate-

gory II or III standards under the Board’s tailor-

ing framework. These applicability modiﬁca-

BHC Supervision Manual November 2021

Page 1

tions align with the Board’s tailoring rules. See

84 Fed. Reg. 59,032 (November 1, 2019); and

SR-15-19, “Federal Reserve Supervisory Assess-

ment of Capital Planning and Positions for Firms

Subject to Category II or III Standards.”

Section 1060.30, “Supervisory Guidance

on Board of Directors’ Effectiveness

(Governance and Controls)”

This new section is based on SR-21-3/CA-21-1,

“Supervisory Guidance on Board of Directors’

Effectiveness.” The guidance in this section

explains key attributes of effective boards at

BHCs and SLHCs that are LFIs. Speciﬁcally,

this guidance notes that boards of directors at

LFIs should: (1) set clear, aligned and consistent

direction regarding the ﬁrm’s strategy and risk

appetite; (2) direct senior management regard-

ing the board’s information needs; (3) oversee

and hold senior management accountable; (4)

support the independence and stature of inde-

pendent risk management and internal audit;

and (5) maintain a capable board composition

and governance structure. The section also pro-

vides an explanation of supervisory consider-

ations in assessing board effectiveness as part of

the LFI rating system.

Section 1060.31, “Assessment of

Risk-Management Processes and Internal

Controls of BHCs Having $100 Billion or

more in

wSTWF,

reduced NSFR

(70%)

If less than

$50 billion in

wSTWF, no

NSFR

requirement

Liquidity

reporting

(FR 2052a)

Daily T+2

FR 2052a

reporting

Daily T+2

FR 2052a

reporting

If wSTWF

≥ $75b:

Daily T+2

FR 2052a

reporting

If wSTWF

< $75b:

Monthly T+2

FR 2052a

reporting

Monthly T+10

FR 2052a

reporting

Note: Certain requirements for a foreign bank are determined by the risk proﬁle of its intermediate holding

company, whereas other requirements are determined by the risk proﬁle of the ﬁrm’s combined U.S.

operations. Standardized liquidity requirements are determined by the risk proﬁle of the intermediate holding

company and other liquidity requirements are determined by the risk proﬁle of the foreign bank’s combined

U.S. operations. Other foreign banks with limited U.S. presence and global assets of $100 billion ormore

would be subject to certain minimum liquidity risk-management requirements.

Liquidity Planning and Positions 1060.20

BHC Supervision Manual February 2023

Page 15

1060.20.7 SUPERVISORY

CONSIDERATIONS FOR ASSESSING

LIQUIDITY

Through the supervisory process, the Federal

Reserve assesses a ﬁrm’s compliance with liquid-

ity regulations and ability to manage liquidity

risk. The Federal Reserve has issued the “Con-

solidated Supervision Framework for Large

Financial Institutions,” which describes the su-

pervisory framework for the consolidated super-

vision of large U.S. and foreign ﬁnancial institu-

tions.

The consolidated supervision framework for

large ﬁnancial institutions has two primary ob-

jectives: (1) to enhance the resiliency of a ﬁrm

to lower the probability of its failure or an

inability to serve as a ﬁnancial intermediary and

(2) to reduce the effect on the ﬁnancial system

and the broader economy of a ﬁrm’s failure or

material weakness.

The consolidated supervision framework guid-

ance outlines expectations for effective liquidity

planning for large ﬁnancial institutions. To sup-

port effective liquidity planning and adequate

liquidity positions, a ﬁrm should

• maintain strong liquidity positions that not

only comply with regulatory requirements, but

also support the ﬁrm’s ongoing ability to meet

its obligations to creditors and other counter-

parties, as well as continue to serve as a

ﬁnancialintermediarythrough periodsof stress;

• have in place robust internal processes that

enable the ﬁrm to maintain liquidity commen-

surate with its unique risks under normal and

stressful conditions;

• maintain processes that enable the identiﬁca-

tion and measurement of potential risks to

cash ﬂows and other primary determinants of

liquidity positions;

• utilize comprehensive projections of the level

and composition of liquidity resources, sup-

ported by regular stress testing to assess the

potential impact of a broad range of expected

and potentially adverse scenarios;

• maintain sound risk measurement and model-

ing capabilities, supported by comprehensive

data collection and analysis, independent vali-

dation, and effective governance, policies, and

controls;

• establish goals for liquidity positions and re-

ﬂect the potential impact of legal or regula-

tory restrictions on the transfer of liquidity

between legal entities; and

• maintain independent internal audit and other

review functions with appropriate staff exper-

tise, experience, and stature in the organiza-

tion to monitor the adequacy of liquidity risk-

measurement and management processes.

1060.20.7.1 Comprehensive Liquidity

Analysis and Review

The Comprehensive Liquidity Analysis and

Review (CLAR) program is an annual horizon-

tal supervisory program for Large Institution

Supervision Coordinating Committee (LISCC)

ﬁrms subject to Federal Reserve System over-

sight.

The purpose of the CLAR program is to

assess liquidity risk and evaluate each LISCC

ﬁrm’s liquidity position and liquidity risk-

management practices. The CLAR program is

divided into three pillars covering the various

topics for assessing each ﬁrm’s liquidity posi-

tion and liquidity risk-management practices.

• Pillar I evaluates a ﬁrm’s internal liquidity

risk-measurement capabilities and practices.

This assessment includes an evaluation of the

internal stress testing frameworks used to

evaluate a ﬁrm’s liquidity position based on

that ﬁrm’s assumptions.

• Pillar II performs an independent liquidity

risk analysis for each ﬁrm and measures the

liquidity position of a ﬁrm using the Federal

Reserve’s internal metrics and publicly avail-

able models and data. This pillar assesses

whether a ﬁrm has sufﬁcient liquid assets to

match its outﬂows and an adequate funding

structure to decrease the likelihood that dis-

ruptions to its regular funding sources will

affect that ﬁrm’s liquidity position.

27. See SR-12-17/CA-12-14, “Consolidated Supervision

Framework for Large Financial Institutions.”

28. See SR-11-7, “Guidance on Model Risk Man-

agement.”

29. A horizontal examination is a review of a speciﬁc

activity, business line, or risk-management practice across a

group of ﬁrms. Horizontal examinations are conducted to

understand the range of industry practices for a speciﬁc activ-

ity, product, risk-management practice, or control; to ensure

the consistent application of established supervisory expecta-

tions; and to conﬁrm the consistent assignment of ratings. For

more information on the criteria for determining which ﬁrms

are in the LISSC supervisory program, see

SR-20-30, “Finan-

cial Institutions Subject to the LISCC Supervisory Program.”

Liquidity Planning and Positions 1060.20

BHC Supervision Manual February 2023

Page 16

• Pillar III evaluates a ﬁrm’s liquidity risk man-

agement using methods other than internal

stress testing. This component of the program

informs the overall assessment of each ﬁrm’s

risk-management practices. This pillar, in con-

junction with Pillar I, is also responsible for

coordinating the completion of any liquidity

risk reviews necessary for the Supervisory

Assessment of Resolution and Recovery Pre-

paredness.

The results from each pillar contribute to an

assessment that includes each ﬁrm’s ﬁnal liquid-

ity rating and overall liquidity assessment. Super-

visors frequently use these horizontal examina-

tions or reviews on a single topic across several

ﬁrms to identify risks and common trends. Hori-

zontal reviews may be conducted by a central-

ized team of examiners or through a common

scope or work program executed by the dedi-

cated supervisory teams. Unlike the Compre-

hensive Capital Analysis and Review, the LISCC

liquidity program’s assessment does not result

in an objection or non-objection. Rather the

LISCC liquidity program’s assessment results in

supervisory ﬁndings communicated to the ﬁrm,

which may include “matters requiring attention”

and “matters requiring immediate attention,” as

applicable.

1060.20.7.2 Liquidity Reviews at Large

and Foreign Banking Organizations

The Federal Reserve conducts various horizon-

tal reviews to evaluate the adequacy of liquidity

positions and the effectiveness of liquidity risk-

management practices and liquidity stress test-

ing of ﬁrms in the Large and Foreign Banking

Organization (LFBO) supervisory portfolio. Ad-

ditionally, the Federal Reserve completes fo-

cused analysis on ﬁrms’ liquidity positions us-

ing data derived from the FR 2052a and other

reports to supplement the horizontal reviews.

These reviews are tailored to account for differ-

ences in the size, complexity, and risk proﬁle

among ﬁrms.

The Federal Reserve completes an annual

Horizontal Liquidity Review (HLR) for the fol-

lowing large ﬁrms that are not in the LISCC

portfolio:

• domestic ﬁrms with $100 billion or more in

total consolidated assets; and

• foreign banking organizations with $50 bil-

lion or more in total consolidated assets.

Similar to the CLAR program, examiners

complete forward-looking assessments of liquid-

ity risk management and liquidity positions for

ﬁrms in the LFBO portfolio. The HLR assess-

ment evaluates similar liquidity risk topics as

the CLAR pillars. However, the examination

scope and expectations are tailored based on

LFBO ﬁrms’ risk proﬁle, which pose lower

systemic risk than LISCC ﬁrms. The HLR tar-

gets a select number of liquidity risk topics in a

given year.

As discussed in this manual’s section 1060.0,

“Large Financial Institution Rating System,” the

Federal Reserve assigns a liquidity risk manage-

ment and positions component rating to each

LFBO. The liquidity risk management and posi-

tions component rating is not based solely on

the outcome of HLR. The full body of related

supervisory work and monitoring is considered,

including from other regulators, since the previ-

ous ratings communication to a ﬁrm.

1060.20.7.3 Assessment of Liquidity at

Firms Covered by the Large Financial

Institution Ratings System

Given the Federal Reserve’s development of a

supervisory program to enhance resiliency and

address the risks posed by large ﬁnancial institu-

tions, the Federal Reserve developed the Large

Financial Institution (LFI) rating system to bet-

ter assess these ﬁrms. Under the LFI rating

system, examiners assign component ratings for

capital planning and positions, liquidity risk

management and positions, and governance and

controls. Further, examiners assign each rating

into one of the following rating categories:

Broadly MeetsExpectations, Conditionally Meets

Expectations, Deﬁcient-1, and Deﬁcient-2. For

more information on the LFI Rating System see

this manual’s section 1060.0, “Large Financial

Institution Rating System.”

1060.20.7.4 Assessment of Liquidity at

the Depository Institution

The Uniform Financial Institutions Rating Sys-

tem(UFIRS),commonly referredto as the “CAM-

ELS” rating system, establish criteria for rating

a bank or thrift, including bank or thrift subsidi-

aries of holding companies. Under the UFIRS,

each depository institution is assigned a com-

posite rating based on an evaluation and rating

30. See SR-13-13/CA-13-10, “Supervisory Considerations

for the Communication of Supervisory Findings.”

Liquidity Planning and Positions 1060.20

BHC Supervision Manual February 2023

Page 17

of six essential components of its ﬁnancial con-

dition and operations. These component factors

address the adequacy of capital, quality of assets,

capability of management, quality and level of

earnings, adequacy of liquidity, and sensitivity

to market risk. For more information on the

UFIRS, see the

Commercial Bank Examination

Manual

, and “Uniform Financial Institutions

Rating System.”

In evaluating the adequacy of a depository

institution’s liquidity position, consideration is

given to the current level and prospective sources

of liquidity compared to funding needs, as well

as to the adequacy of funds-management prac-

tices relative to the ﬁrm’s size, complexity, and

risk proﬁle. In general, funds management prac-

tices should ensure that a depository 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 ﬁrm 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 fund-

ing sources that may not be available in times of

ﬁnancial stress or adverse changes in market

conditions.

31. See SR-96-38, “Uniform Financial Institutions Rating

System.”

Liquidity Planning and Positions 1060.20

BHC Supervision Manual February 2023

Page 18

Supervisory Guidance on Board of Directors’ Effectiveness

(Governance and Controls) Section 1060.30

1060.30.1 OVERVIEW AND

APPLICABILITY

The Federal Reserve expects the board of direc-

tors (board) of a large ﬁnancial institution (LFI)

to be effective in its oversight of the ﬁrm. The

board plays a critical role in maintaining the

ﬁrm’s safety and soundness and continued ﬁnan-

cial and operational resilience of its consoli-

dated operations. The supervisory assessment of

the board’s effectiveness is one of the elements

within the Governance and Controls component

rating of the LFI rating system. In February

2021, the Federal Reserve issued guidance de-

scribing the key attributes of effective boards at

large domestic bank holding companies and sav-

ings and loan holding companies, and systemi-

cally important nonbank ﬁnancial companies

designated by the Financial Stability Oversight

Council for supervision by the Federal Reserve

(board effectiveness guidance).

The board effectiveness guidance is intended

to promote ﬁrms’ safety and soundness and

compliance with laws and regulations by better

distinguishingsupervisoryexpectations forboards

from those of senior management and refocus-

ing supervisory expectations on boards’ perfor-

mance of their core responsibilities. The Federal

Reserve recognizes that boards can effectively

fulﬁll their core responsibilities in a variety of

ways. As such, the board effectiveness guidance

adopts a principles-based approach to provide

each board with ﬂexibility to determine how to

most effectively fulﬁll its responsibilities. Re-

sponsibilities that are typically the purview of

senior management, including most daily and

operational decisions, are not described in the

board effectiveness guidance.

The board effectiveness guidance applies to

• domestic bank holding companies with total

consolidated assets of $100 billion or more;

• domestic savings and loan holding companies

with total consolidated assets of $100 billion

or more;

and

• systemically important nonbank ﬁnancial com-

panies designated by the Financial Stability

Oversight Council for supervision by the Fed-

eral Reserve.

1060.30.2 KEY ATTRIBUTES OF AN

EFFECTIVE BOARD OF DIRECTORS

The board effectiveness guidance describes the

ﬁve key attributes of an effective board of direc-

tors in overseeing the ﬁrm’s safe and sound

conduct of consolidated operations; compliance

with laws and regulations, including those re-

lated to consumer protection; and ﬁnancial and

operational strength and resilience necessary to

carry out its business activities. The entire board

effectiveness guidance is provided in

SR-21-3/

CA-21-1

, “Supervisory Guidance on Board of

Directors’ Effectiveness.”

1060.30.2.1 Set Clear, Aligned, and

Consistent Direction Regarding the Firm’s

Strategy and Risk Appetite

An effective board oversees the development of,

reviews, approves, and periodically monitors the

ﬁrm’s strategy and risk appetite.

Such a strat-

egy and risk appetite are clear and aligned, and

include a long-term perspective on risks and

rewards that is consistent with the capacity of

the ﬁrm’s risk-management framework. The

alignment of strategy and risk appetite helps the

ﬁrm to maintain sufﬁcient ﬁnancial and opera-

tional strength and resilience for safety and

soundness and to promote compliance with laws

and regulations.

A clear strategy articulates a ﬁrm’s strategic

objectives for its businesses, while helping to

establish and maintain

1. an effective risk-management structure;

2. appropriate processes and resources for strat-

egy implementation, plans, and budgets for

each business line and risk-management or

control function; and

3. an effective risk-management and control

function.

A clear strategy also provides direction to

senior management about how to determine

which business opportunities to pursue consis-

1. The guidance does not apply to U.S. intermediate hold-

ing companies of foreign banking organizations established

pursuant to the Federal Reserve’s Regulation YY.

2. This guidance applies to state regulated insurance com-

panies that are also savings and loan holding companies to the

extent it does not conﬂict with state insurance laws or regula-

tory requirements.

3. “Risk appetite” is deﬁned as the aggregate level and

types of risk the board and senior management are willing to

assume to achieve the ﬁrm’s strategic business objectives,

consistent with applicable capital, liquidity, and other require-

ments and constraints.

BHC Supervision Manual November 2021

Page 1

tent with the ﬁrm’s risk appetite and risk-

management capacity.

A clear risk appetite

• includes sufﬁcient detail to enable the ﬁrm’s

chief risk ofﬁcer (CRO) and its independent

risk-management function to set ﬁrm-wide

risk limits.

• speciﬁes the level and types of risk that the

board is willing to assume, that the board

believes the ﬁrm is capable of managing, and

that allows senior management to establish

risk-management expectations and monitor

risk-taking for the full set of risks.

A ﬁrm’s strategy and risk appetite are aligned

when they are developed, reviewed, and ap-

proved consistent with one another even though

they are not necessarily developed and approved

simultaneously.

An effective board also considers the capacity

of the ﬁrm’s risk-management framework when

overseeing aspects of the ﬁrm’s strategy and

risk appetite. This practice helps to conﬁrm that

strategic plans are commensurate with the ﬁrm’s

ability to identify and manage risks, including

identifying activities that could pose a material

risk to the safety and soundness of the ﬁrm,

threaten the ﬁnancial system, violate the law, or

harm consumers.

For example, if the ﬁrm is considering a new

line of business, a clear strategy explains how

conducting the business would be consistent

with the ﬁrm’s risk appetite and changes that

would need to be made to the ﬁrm’s risk-

management program and its controls to effec-

tively manage different or additional risks posed

by the new business. If the strategy calls for

expansion into a new line of business or a new

jurisdiction, the board evaluates the increased

level of risk. In addition, an effective board

reviews any corresponding risk management or

controls enhancements, including those related

to compliance with U.S. laws, that are necessary

to align with the risk appetite.

The same evalu-

ation is conducted on a regular basis to assess

growth strategies within current businesses and

products.

A ﬁrm’s policies, programs, and plans are

sufﬁciently clear regarding the allocation of

responsibilities to enable the board to evaluate

senior management’s execution of the ﬁrm’s

strategic plan. An effective board reviews and

approves signiﬁcant policies, programs, and plans

based on the ﬁrm’s strategy, risk appetite, risk-

management capacity, and structure. These

include but are not limited to the ﬁrm’s

• capital plan,

• recovery and resolution plans,

• audit plan,

• enterprise-wide risk-management policies,

• liquidity risk-management policies,

• compliance risk-management program,

and

• performance management and compensation

programs.

An effective board might review summarized

forms of policies, programs, and plans, with the

summarized form including sufﬁcient detail and

context for the board to make an informed deci-

sion and to consider consistency with the ﬁrm’s

strategy, risk appetite, and risk-management ca-

pacity.

1060.30.2.2 Direct Senior Management

Regarding the Board’s Information Needs

An effective board directs senior management

to provide directors with information that is

sufﬁcient in scope, detail, and analysis to enable

4. An “independent risk-management function” is respon-

sible for identifying, measuring, aggregating, and reporting

risks in a comprehensive and independent manner. The term

“risk limits” refers to thresholds that constrain risk-taking so

that the level and type of risks assumed remains consistent

with the ﬁrm-wide risk appetite. Internal risk management

sets risk limits in aggregate by concentration and risk type, as

well as at more granular levels as appropriate.

5. U.S. laws include, without limitation, the Bank Secrecy

Act and the Foreign Corrupt Practices Act.

6. 12 CFR 225.8(e)(iii); 12 CFR 252.47(a); SR-15-19,

“Federal Reserve Supervisory Assessment of Capital Plan-

ning and Positions for Firms Subject to Category II or III

Standards;”

SR-15-18, “Federal Reserve Supervisory Assess-

ment of Capital Planning and Positions for Firms Subject to

Category I Standards;” and Federal Reserve paper on Capital

Planning at Large Bank Holding Companies: Supervisory

Expectations and Range of Current Practice (Federal Reserve

Board press release issued on August 19, 2013).

7. 12 CFR part 243;

SR-14-8, “Consolidated Recovery

Planning for Certain Large Domestic Bank Holding Compa-

nies;” and

SR-14-1, “Heightened Supervisory Expectations

for Recovery and Resolution Preparedness for Certain Large

Bank Holding Companies - Supplemental Guidance on Con-

solidated Supervision Framework for Large Financial Institu-

tions (

SR-12-17/CA-12-14).”

SR-13-1/CA-13-1, “Supplemental Policy Statement on

the Internal Audit Function and Its Outsourcing,” and

SR-03-5,

“Amended Interagency Guidance on the Internal Audit Func-

tion and its Outsourcing.”

9. 12 CFR 252.33.

10. 12 CFR 252.34(a).

11.

SR-08-8/CA-08-11, “Compliance Risk Management

Programs and Oversight at Large Banking Organizations with

Complex Compliance Proﬁles.”

Supervisory Guidance on Board of Directors’ Effectiveness 1060.30

BHC Supervision Manual November 2021

Page 2

the board to make sound, well-informed deci-

sions and consider potential risks.

An effective board directs senior management

to provide it with information that is timely,

accurate, and well organized. An effective board

also evaluates the sufﬁciency and quality of

information it receives and directs senior man-

agement to

1. provide more information;

2. address any concerns regarding the volume,

structure, content, or quality of the informa-

tion it receives; or

3. improve relevant ﬁrm processes and prac-

tices for the preparation of such information.

An effective board seeks, outside of regular

board and committeemeetings, information about

the ﬁrm and its activities, emerging and ongoing

risks, personnel, compensation, and other mat-

ters. Such additional inquiries are often con-

ducted through special sessions of the board,

outreach to staff other than the Chief Executive

Ofﬁcer (CEO) and their direct reports, and dis-

cussions with Federal Reserve senior supervi-

sors. Director training is another way directors

may learn more about topics relevant to their

responsibilities and may highlight the need for

further director inquiries.

Directors of an effective board, particularly

the lead independent director or independent

board chair and committee chairs, take an active

role in setting board and committee meeting

agendas. Directors provide input such that the

content, organization, and time allocated to each

topic allow the board and committees to make

sound, well-informed decisions. If the board’s

agenda includes a discussion of growth into a

new business, an effective board typically dis-

cusses the ﬁrm’s risk management and control

capabilities that reﬂect the views of the indepen-

dent risk-management and internal audit func-

tions.

1060.30.2.3 Oversee and Hold Senior

Management Accountable

An effective board oversees and holds senior

management accountable for effectively imple-

menting the ﬁrm’s strategy, consistent with its

risk appetite, while maintaining an effective

risk-management framework and system of in-

ternal controls. An effective board executes

these responsibilities consistent with safety and

soundness and in compliance with laws and

regulations, including those related to consumer

protection, under a range of conditions. An

effective board also oversees and regularly evalu-

ates the performance and compensation of senior

management.

To facilitate accountability, an effective board

engages senior management in a variety of

ways. For instance, at board meetings, engage-

ment is supported by allocating sufﬁcient time

to facilitate a candid discussion and debate of

information while encouraging diverse views.

Directors consider whether and how senior man-

agement’s conclusions and recommendations

align and support the ﬁrm’s strategy and risk

appetite. If weaknesses or gaps are identiﬁed,

the information provided is incomplete, or as

otherwise warranted, directors challenge senior

management’s assessments and recommenda-

tions. Engagement may also take place outside

board and committee meetings.

An effective board engages in robust inquiry

into, among other things,

• drivers, indicators, and trends related to cur-

rent and emerging risks;

• adherence to the board-approved strategy and

risk appetite by relevant lines of business; and

• material or persistent deﬁciencies in risk man-

agement or control practices, whether in pol-

icy or in practice.

An effective board also reviews reports of

internal and external complaints, including

“whistleblower” reports.

An effective board has independent directors

who are sufﬁciently empowered to serve as an

effective check against ﬁrm executives who sit

on the board and against senior management.

For example, if the board has an executive chair,

independent directorsmay be empowered through

the election of a lead independent director with

the authority, among others, to call board meet-

ings with or without the chair present.

A crucial aspect of holding senior manage-

ment accountable is regular board oversight and

evaluation of the performance and compensa-

tion of senior management. An effective board

oversees and evaluates the development and

implementation of performance management and

compensation programs that encourage behav-

iors and business practices consistent with the

ﬁrm’s strategy, risk appetite, and safety and

soundness. This includes promoting compliance

with laws and regulations, including those re-

lated to consumer protection.

In addition, each component of senior man-

agement’s total compensation is informed by

Supervisory Guidance on Board of Directors’ Effectiveness 1060.30

BHC Supervision Manual November 2021

Page 3

the board’s evaluation of the individual’s perfor-

mance against performance objectives. An effec-

tive board approves clear ﬁnancial and nonﬁ-

nancial performance objectives aligned with the

ﬁrm’s strategy and risk appetite for the CEO

and business line executives and nonﬁnancial

performance objectives for the CRO and chief

audit executive. Similar performance objectives

are developed for other members of senior man-

agement. An effective board of directors also

holds senior management accountable for the

implementation of performance management and

compensation programs that promote sound risk

management: compliance with laws and regula-

tions; and internal standards, including for con-

duct. Performance management and compensa-

tion programs, when combined with business

strategies, discourage risk-taking inconsistent

with the ﬁrm’s strategy and safety and sound-

ness, including compliance with laws, regula-

tions, and internal standards, and promote the

ﬁrm’s risk-management goals. Consistent with

safety and soundness, compliance with laws and

regulations, and the ﬁrm’s strategy, an effective

board oversees succession plans for the CEO,

and depending on the size, complexity, and

nature of the ﬁrm, the CRO, chief audit execu-

tive, or other senior management ofﬁcials.

1060.30.2.4 Support the Independence

and Stature of Independent Risk

Management and Internal Audit

An effective board of directors, through its risk

and audit committees, assesses and supports the

stature and independence of the ﬁrm’s indepen-

dent risk-management and internal audit func-

tions. An effective risk committee and an effec-

tive audit committee engage in robust inquiry

into, among other matters,

• the causes and consequences of material or

persistent breaches of the ﬁrm’s risk appetite

and risk limits,

• the timeliness of remediation of material or

persistent internal audit and supervisory ﬁnd-

ings, and

• the appropriateness of the annual audit plan.

An effective risk committee supports the stat-

ure and independence of the independent risk-

management function by:

• communicating directly with the CRO on

material risk-management issues;

• overseeing the appropriateness of independent

risk management function’s budget, stafﬁng,

and systems of internal controls;

• coordinating with the compliance function;

and

• providing the independent risk management

function with direct and unrestricted access to

the risk committee.

After reviewing the risk-management frame-

work relative to the ﬁrm’s structure, risk proﬁle,

complexity, activities, and size, an effective risk

committee effects changes that align with the

ﬁrm’s strategy and risk appetite.

An effective audit committee

• supports the stature and independence of inter-

nal audit by meeting directly with the chief

audit executive regarding the internal audit

function, organizational concerns, and indus-

try concerns.

• supports internal audit’s budget, stafﬁng, and

systems of internal controls relative to the

ﬁrm’s asset size, complexity, and the pace of

technological and other changes.

• reviews the status of actions recommended by

internal audit and external auditors to remedi-

ate and resolve material or persistent deﬁcien-

cies identiﬁed by internal audit, external audit,

and ﬁndings identiﬁed by supervisors.

An effective board monitors the indepen-

dence and stature of independent risk manage-

ment and internal audit and takes action if the

views of these functions are not taken into

12. This may extend beyond requirements to which ﬁrms

may be subject under other statutory and regulatory authori-

ties. For example, the NYSE requires formalized succession

planning for the CEO only. See NYSE Listed Company

Manual, section 303A.09. The CRO and chief audit executive

are named here given the independence of those positions and

the control function each serves.

13. The risk committee is responsible for the ﬁrm’s global

risk-management policies and oversight of the ﬁrm’s global

risk-management framework. 12 CFR 252.33(a). Nonbank

ﬁnancial companies supervised by the Federal Reserve are

required to establish a risk committee pursuant to section 165

of the Dodd-Frank Act. 12 U.S.C. 5365(h)(1). Savings and

loan holding companies subject to this guidance should main-

tain a risk committee that meets the supervisory expectations

discussed herein in order to enhance its safety and soundness.

Also, see SR-13-1/CA-13-1. Firms that are publicly traded are

subject to the audit committee requirements contained in the

U.S. Securities and Exchange Commission’s Rule 10A-3

(“Rule 10A-3”) under the Exchange Act of 1934, in addition

to any requirements imposed by the applicable stock exchange

on which the ﬁrm is listed. See, for example, NYSE Listed

Company Manual, sections 303A.06 and 303A.07, and the

Nasdaq Stock Market Rules, section 5605(c).

14. See, e.g., 12 CFR 252.33(a)(3).

Supervisory Guidance on Board of Directors’ Effectiveness 1060.30

BHC Supervision Manual November 2021

Page 4

account when decisions are made, or if these

functions are unduly inﬂuenced by business

lines.

1060.30.2.5 Maintain a Capable Board

Composition and Governance Structure

An effective board considers whether its compo-

sition, governance structure, and practices sup-

port the ﬁrm’s safety and soundness and the

ability to promote compliance with laws and

regulations based on factors such as the ﬁrm’s

asset size, complexity, scope of operations, risk

proﬁle, and other changes that occur over time.

Reﬂecting these factors, an effective board estab-

lishes a process designed to identify and select

potential director nominees with a mix of skills,

knowledge, experience, and perspectives. This

process takes into account, for example, a poten-

tial nominee’s expertise, availability, integrity,

and potential conﬂicts of interest and considers

a diverse pool of potential nominees, including

women and minorities.

An effective board maintains a governance

structure capable of overseeing senior manage-

ment and addressing issues arising from the

ﬁrm’s size, scope of operations, activities, risk

proﬁle, and resolvability. In addition, an effec-

tive board establishes committees and

management-to-committee reporting lines to sup-

port effective oversight, timely access to infor-

mation, and sound decisionmaking. An effective

board also has the capacity to engage third-party

advisors and consultants, when appropriate, to

supplement the board’s knowledge, expertise,

and experience and support the board in making

sound, well-informed decisions.

An effective board evaluates on an ongoing

basis its strengths and weaknesses, including the

performance of the board committees, particu-

larly the risk, audit, and other key committees.

An effective board adapts its structure and prac-

tices to address identiﬁed weaknesses or deﬁ-

ciencies and as the ﬁrm’s asset size, scope of

operations, risk proﬁle, and other characteristics

change over time.

1060.30.3 SUPERVISORY

CONSIDERATIONS IN ASSESSING

BOARD EFFECTIVENESS

The board effectiveness guidance emphasizes

the key aspects of board responsibilities and

clariﬁes how supervisors assess board oversight.

As the board effectiveness guidance builds on

the principles set forth in the LFI ratings frame-

work, the Federal Reserve uses the board effec-

tiveness guidance to inform its assessment of

the governance and controls for all ﬁrms to

which the guidance applies. In addition to the

board effectiveness guidance, the Federal Reserve

considers applicable statutes, regulations, and

guidance on speciﬁc risks or business activities.

Federal Reserve supervisory staff should base

their assessment of board effectiveness on super-

visory work that may include

• engaging directly with directors in meetings

or other venues on how a board’s structures

and practices reﬂect the key attributes of an

effective board. For example, the Federal

Reserve supervisory staff may inquire as to

how the board achieves the proper alignment

of its strategy with its risk appetite;

• obtaining and reviewing information that the

directors receive, including escalated issues,

board packages, ﬁndings, and internal reports;

• meeting with ﬁrm management and other per-

sonnel;

• evaluating publicly available information as

well as information obtained from examina-

tions conducted by the Federal Reserve or

other federal or state ﬁnancial supervisors that

relate to the expectations for boards;

and

• communicating with directors at ﬁrms with

signiﬁcant supervisory issues outside of board

meetings (including meetings of the audit or

risk committees) on a more frequent basis.

Ratings assigned under the LFI rating system

are communicated by the Federal Reserve to the

ﬁrm, but individual ratings are not disclosed

15. “Final Interagency Policy Statement Establishing Joint

Standards for Assessing the Diversity Policies and Practices

of Entities Regulated by the Agencies,” 80 Fed. Reg. 33,016

(June 10, 2015). The use of the term “minority” is consistent

with the use of such term in this interagency policy statement

and in section 342(g)(3) of the Dodd-Frank Act.

16. In assessing board effectiveness for insurance savings

and loan holding companies, the Federal Reserve tailors its

supervisory expectations based on each ﬁrm’s size, risk pro-

ﬁle, complexity, organizational structure, business model, and

information gathered and assessments obtained from each

ﬁrm’s primary functional state insurance regulators and other

functional regulators. The Federal Reserve relies, to the great-

est extent possible, on the work and examination reports of

state insurance regulators for its assessment of state regulated

insurance companies within an insurance savings and loan

holding companies’ structure.

Supervisory Guidance on Board of Directors’ Effectiveness 1060.30

BHC Supervision Manual November 2021

Page 5

publicly. The Federal Reserve assigns LFI rat-

ings and communicates ratings to large ﬁrms on

an annual basis and more frequently as war-

ranted.

Examiners will not criticize—through the is-

suance of “matters requiring attention” in an

examination report or supervisory letter—a sup-

ervised ﬁnancial institution for, and the Board

will not issue an enforcement action on the basis

of, a “violation” of or “non-compliance” with

supervisory guidance, such as the board effec-

tiveness guidance. However, in some situations,

examiners may provide a written reference to

the board effectiveness guidance in examination

reports or supervisory letters to provide ex-

amples of safe and sound conduct.

17. See 12 CFR part 263, appendix A.

Supervisory Guidance on Board of Directors’ Effectiveness 1060.30

BHC Supervision Manual November 2021

Page 6

Assessment of Risk-Management Processes and Internal Controls of

BHCs Having $100 Billion or More in Total Assets Section 1060.31

1060.31.1 GOVERNANCE AND

CONTROLS RATING AND

APPLICABILITY

As described in section 1060.0, the “Gover-

nance and Controls” component rating of the

Large Financial Institutions (LFI) rating system

reﬂects Federal Reserve supervisory staff’s evalu-

ation of the effectiveness of a ﬁrm’s (1) board of

directors, (2) management of business lines and

independent risk management and controls, and

(3) recovery planning (for domestic Large Insti-

tution Supervision Coordinating Committee ﬁrms

only). This component rating represents the Fed-

eral Reserve’s supervisory assessment of a ﬁrm’s

effectiveness in aligning strategic business objec-

tives with the ﬁrm’s risk appetite and risk-

management capabilities; maintaining effective

and independent risk-management and control

functions, including internal audit; promoting

compliance with laws and regulations, including

those related to consumer protection; and other-

wise providing for the ongoing resiliency of

the ﬁrm.

This section provides guidance for examiners

in the assessment of risk management, pro-

cesses, and internal controls of bank holding

companies that have $100 billion or more in

total assets. The supervisory assessment of a

state member bank’s risk management would be

reﬂected in the management component (M) of

the CAMELS rating framework as well as the

Risk Management rating. For information on

the CAMELS rating framework, refer to the

Federal Reserve’s Commercial Bank Examina-

tion Manual.

Examiners should recognize that the matters

discussed in this section are intended only to

assist an examiner in evaluating a ﬁrm’s risk-

management practices. Therefore, the informa-

tion in this section should not be treated as a

checklist of requirements for an individual orga-

nization. Moreover, while a bank holding com-

pany should be able to assess the major risks of

the consolidated organization, examiners should

expect a holding company that centrally man-

ages the operations and functions of its subsidi-

ary banks to have more-comprehensive, de-

tailed, and developed risk-management systems

than a company that delegates risk management

to relatively autonomous banking subsidiaries.

For more information, see the “Elements of

Risk Management” discussion in

SR-95-51,“Rat-

ing the Adequacy of Risk Management Pro-

cesses and Internal Controls at State Member

Banks and Bank Holding Companies.”

1060.31.2 OVERVIEW

The Federal Reserve places signiﬁcant supervi-

sory emphasis on the importance of a bank

holding company’s sound risk-management pro-

cesses and strong internal controls when evalu-

ating the activities of a supervised ﬁnancial

institution. A bank holding company’s failure to

establish a management structure that ad-

equately identiﬁes, measures, monitors, and con-

trols the risks involved in its various products

and lines of business has long been considered

unsafe and unsound conduct. Serious lapses or

deﬁciencies in a bank holding company’s inter-

nal controls, including inadequate separation of

duties, can constitute an unsafe and unsound

practice and possibly lead to signiﬁcant losses

or otherwise compromise the ﬁnancial integrity

of the institution.

Accordingly, while a bank

holding company’s ﬁnancial performance is an

important indicator of the adequacy of manage-

ment, examiners should give signiﬁcant weight

to the quality of risk-management practices and

internal controls when they evaluate the man-

agement and overall ﬁnancial condition of bank

holding companies. Properly managing risks is

even more important as new technologies, prod-

uct innovation, and the size and speed of ﬁnan-

cial transactions change the nature of banking

markets.

1. Since the issuance of SR-95-51, the Federal Reserve

revised the supervisory ratings frameworks for holding com-

panies. Therefore, refer to this manual’s sections entitled,

“Large Financial Institution Rating System,”

(

SR-19-3/CA-19-2) and “RFI Rating System,” (SR- 19-4/

CA-19-3

) for the supervisory ratings frameworks used for

holding companies. The Risk Management rating, as de-

scribed in SR-95-51, applies to all state member banks,

regardless of their size. For more information on the Risk

Management rating criteria and CAMELS ratings framework,

see the Commercial Bank Examination Manual.

2. If appropriate, the institution should be advised that the

Federal Reserve will initiate supervisory actions if its failure

to separate critical operational duties creates the potential for

serious losses or if material deﬁciencies or situations that

threaten the safe and sound conduct of its activities are not

adequately addressed in a timely manner. Such supervisory

actions may include formal enforcement actions against the

bank or bank holding company, or its responsible ofﬁcers and

directors, or both, and would require the immediate imple-

mentation of all necessary corrective measures.

BHC Supervision Manual November 2021

Page 1

The principles of sound management should

apply to the entire spectrum of risks which

include, but are not limited to, credit, market,

liquidity, operational, legal, and reputational

risk:

• Credit risk arises from the potential that a

borrower or counterparty will fail to perform

on an obligation.

• Market risk is the risk to a ﬁnancial institu-

tion’s condition resulting from adverse move-

ments in market rates or prices, such as inter-

est rates, foreign exchange rates, or equity

prices.

• Liquidity risk is the potential that an institu-

tion will be unable to meet its obligations as

they come due because of an inability to liqui-

date assets or obtain adequate funding (re-

ferred to as “funding liquidity risk”) or that it

cannot easily unwind or offset speciﬁc expo-

sures without signiﬁcantly lowering market

prices because of inadequate market depth or

market disruptions (“market liquidity risk”).

• Operational risk arises from the potential that

inadequate information systems, operational

problems, breaches in internal controls, fraud,

or unforeseen catastrophes will result in unex-

pected losses.

• Legal risk arises from the potential that unen-

forceable contracts, lawsuits, or adverse judge-

ments can disrupt or otherwise negatively

affect the operations or condition of a banking

organization.

• Reputational risk is the potential that nega-

tive publicity regarding an institution’s busi-

ness practices, whether true or not, will cause

a decline in the customer base, costly litiga-

tion, or revenue reductions.

The supervisory assessment of a ﬁrm’s risk-

management process is designed to bring to-

gether and summarize much of the analysis of

and many of the ﬁndings about a bank holding

company’s process for managing and control-

ling risks. This assessment is intended to high-

light and incorporate both the quantitative and

qualitative aspects of an examiner’s review of a

ﬁrm’s overall process for identifying, measur-

ing, monitoring, and controlling risks and to

facilitate appropriate follow-up action.

The overall proﬁtability, asset quality, and

capital adequacy of a bank holding company

should be considered in the examiner’s assess-

ment of management. These indicators can to

some extent be affected, either favorably or

adversely, by factors outside management’s con-

trol. For this reason, examiners’ evaluation of

the risk-management process should be a pri-

mary factor when assessing management at larger

ﬁrms whose activities and structures require

more formal and extensive procedures.

1060.31.3 ELEMENTS OF RISK

MANAGEMENT

When assessing the quality of risk management

at bank holding companies, examiners should

consider the adequacy, effectiveness, and com-

prehensiveness of the key elements of a sound

risk-management system:

1. roles and responsibilities of board of direc-

tors and senior management

2. policies, procedures, and limits

3. risk measurements, risk monitoring, and man-

agement information systems

4. internal controls

1060.31.3.1 Board of Directors and

Senior Management

In assessing the quality of oversight by the

board of directors and senior management, ex-

aminers should consider whether the bank hold-

ing company follows policies and practices such

as those described below:

Board of Directors

1. The board of directors makes appropriate

efforts to remain informed about the risks

inherent in the bank holding company’s ac-

tivities.

2. The board of directors reviews and approves

signiﬁcant policies to limit risks inherent in

the bank holding company’s lending, invest-

ing, trading, trust, ﬁduciary, and other signiﬁ-

cant activities or products.

3. The board of directors or the responsible

committee of the board:

a. reviews and approves risk-exposure limits

to conform with any changes in the bank

holding company’s strategies,

b. addresses new products, and

c. reacts to changes in market conditions.

4. The board of directors holds senior manage-

ment accountable as ﬁnancial markets, risk-

management practices, and the bank holding

company’s activities evolve.

Assessment of Risk-Management Processes and Internal Controls of BHCs 1060.31

BHC Supervision Manual November 2021

Page 2

Senior Management

1. Senior management has identiﬁed and has a

clear understanding and working knowledge

of the types of risks inherent in the bank

holding company’s activities.

2. Senior management is sufﬁciently familiar

with and is using adequate recordkeeping

and reporting systems to measure and moni-

tor the major sources of risk to the organiza-

tion.

3. Senior management ensures that its lines of

business are managed and staffed by person-

nel whose knowledge, experience, and exper-

tise are consistent with the nature and scope

of the bank holding company’s activities.

4. Senior management ensures that the depth of

staff resources is sufﬁcient to operate and

soundly manage the bank holding company’s

activities and that its employees have the

integrity, ethics, and competence that are

consistent with a prudent management phi-

losophy and operating style.

5. Senior management adequately oversees busi-

ness line management who are responsible

for carrying out the institution’s day-to-day

activities and implementing its strategic plan.

6. Senior management is able to respond to

risks that may arise from changes in the

competitive environment or from innova-

tions in markets in which the organization is

active.

7. Before embarking on new activities or intro-

ducing new products, management identiﬁes

and reviews all risks associated with the

activity or product and ensures that the infra-

structure and internal controls necessary to

manage the related risks are in place.

1060.31.3.2 Policies, Procedures, and

Limits

A bank holding company’s board of directors

should set clear, aligned, and consistent direc-

tion regarding the ﬁrm’s strategy and risk appe-

tite. The following guidelines should assist ex-

aminers in evaluating the adequacy of a bank

holding company’s policies, procedures, and

limits:

1. The bank holding company’s policies, proce-

dures, and limits provide for adequate identi-

ﬁcation, measurement, monitoring, and con-

trol of the risks posed by its lending, investing,

trading, ﬁduciary, and other signiﬁcant

activities.

2. The policies, procedures, and limits are con-

sistent with senior management’s experience

level, the organization’s stated goals and

objectives, and its overall ﬁnancial strength.

3. Policies clearly delineate accountability and

lines of management authority across the

organization’s activities.

4. Policies provide for the review of new activi-

ties to ensure that the organization’s infra-

structure is adequate to identify, monitor, and

control risks associated with an activity and

that the control infrastructure is in place

before the activity is initiated.

1060.31.3.3 Risk Monitoring Activities

and Management Information System

As part of its risk monitoring activities and

management information system (MIS), a ﬁrm

should be able to identify and measure all mate-

rial risk exposures. Therefore, a ﬁrm’s MIS

should be able to provide senior management

and board of directors with timely reports on the

ﬁnancial condition, operating performance, and

risk exposure of the consolidated organization.

Further, the MIS should be able to provide regu-

lar and sufﬁciently detailed reports for line man-

agers engaged in the organization’s day-to-day

activities.

In assessing the adequacy of a bank holding

company’s measurement and monitoring of risk

and the adequacy of its MIS, examiners should

consider whether the following conditions exist:

1. The bank holding company’s risk-monitoring

practices and reports address material risks.

2. Key assumptions, data sources, and proce-

dures used in measuring and monitoring risks

are appropriate and adequately documented

and tested for reliability on an ongoing basis.

3. Reports and other forms of communication

are consistent with the bank holding com-

pany’s activities; are structured to monitor

exposures and compliance with internal lim-

its, goals, or objectives; and, as appropriate,

compare actual versus expected performance.

4. Reports to senior management or the board

of directors are accurate and timely and con-

tain sufﬁcient information for decision mak-

ers to identify any adverse trends and to

adequately evaluate the level of a ﬁrm’s risk

exposure.

Assessment of Risk-Management Processes and Internal Controls of BHCs 1060.31

BHC Supervision Manual November 2021

Page 3

1060.31.3.4 Internal Controls

A bank holding company’s internal control struc-

ture is critical to promoting safe-and-sound op-

erations and an effective risk-management sys-

tem. Establishing and maintaining an effective

system of controls, including the enforcement of

ofﬁcial lines of authority and the appropriate

separation of duties—such as trading, custodial,

and back-ofﬁce—is one of management’s more

important responsibilities.

Appropriate segregation of duties is a funda-

mental and essential element of a sound risk-

management and internal control system. Fail-

ure to implement and maintain an adequate

separation of duties can constitute an unsafe and

unsound practice and possibly lead to serious

losses or otherwise compromise a ﬁrm’s ﬁnan-

cial integrity. Serious lapses or deﬁciencies in

internal controls, including inadequate segrega-

tion of duties, may warrant supervisory action,

including formal enforcement action.

When properly structured, an internal control

system promotes effective operations and reli-

able ﬁnancial and regulatory reporting; safe-

guards assets; and promotes compliance with

relevant laws, regulations, and bank holding

company policies. Ideally, internal controls are

tested by an independent internal auditor who

reports directly to either the bank holding com-

pany’s board of directors or a designated board

committee, typically the audit committee. Per-

sonnel who perform these reviews should gener-

ally be independent of the function they are

assigned to review. Given the importance of

appropriate internal controls, the results of au-

dits or reviews, whether conducted by an inter-

nal auditor or other personnel, should be ad-

equately documented, as well as senior

management’s responses to review ﬁndings. In

addition, communication channels should exist

that allow negative or sensitive ﬁndings to be

reported directly to the board of directors or the

relevant board committee.

In evaluating the adequacy of a bank holding

company’s internal controls and audit proce-

dures, examiners should consider the following:

1. The system of internal controls is appropriate

to the type and level of risks posed by the

nature and scope of the organization’s

activities.

2. The bank holding company’s organizational

structure establishes clear lines of authority

and responsibility for monitoring adherence

to policies, procedures, and limits.

3. Reporting lines ensure that control areas are

sufﬁciently independent from the business

lines, and the reporting lines adequately sepa-

rate duties throughout the organization, such

as those duties relating to trading, custodial,

and back-ofﬁce activities.

4. Ofﬁcial organizational structures reﬂect ac-

tual operating practices.

5. Financial, operational, and regulatory reports

are reliable, accurate, and timely. When appli-

cable, policy exceptions are noted and

promptly investigated.

6. Adequate procedures exist for ensuring com-

pliance with applicable laws and regulations.

7. Internal audit or other control review prac-

tices ensure independence and objectivity of

an audit or review.

8. Internal controls and information systems are

adequately tested and reviewed; the cover-

age, procedures, ﬁndings, and responses to

audits and review tests are adequately docu-

mented; identiﬁed material weaknesses are

given appropriate and timely high-level atten-

tion; and management’s actions to address

material weaknesses are objectively veriﬁed

and reviewed.

9. The board of directors or its audit committee

engages in robust inquiry into the effective-

ness of internal audits and other control

review activities.

Assessment of Risk-Management Processes and Internal Controls of BHCs 1060.31

BHC Supervision Manual November 2021

Page 4

RFI Rating System Section 1062.0

1062.0.1 RFI RATING SYSTEM

INTRODUCTION

Since 2004, the Federal Reserve has used the

“RFI/C(D)” rating system (referred to as the

“RFI rating system”) to communicate its super-

visory assessment of bank holding companies

(BHCs) regardless of their asset size, complex-

ity, or systemic importance.

In 2018, the Board

adopted the RFI rating system for non-insurance

and non-commercial savings and loan holding

companies (SLHCs) with less than $100 billion

in total consolidated assets.

At the same time,

the Board also adopted a rating system for

BHCs and non-insurance and non-commercial

savings and loan holding companies with total

consolidated assets of $100 billion or more

(referred to as the “LFI rating system”).

As a

result, the Federal Reserve has two frameworks

for rating holding companies.

1062.0.2 RFI RATING SYSTEM

APPLICABILITY

The RFI rating system generally applies to BHCs

and non-insurance and non-commercial savings

and loan holding companies with less than $100

billion in total consolidated assets. Examination

staff assign and communicate ratings to BHCs

and non-insurance and non-commercial savings

and loan holding companies with total consoli-

dated assets between $10 billion and $100 bil-

lion assets on at least an annual basis, and more

frequently as warranted. However, U.S. interme-

diate holding companies of foreign banking

organizations (FBOs) established under the

Board’s Regulation YY that have $50 billion or

more in total consolidated assets would be sub-

ject to the LFI rating system.

1062.0.3 RFI RATING AND SAVINGS

AND LOAN HOLDING COMPANIES

The Dodd-Frank Wall Street Reform and Con-

sumer Protection Act transferred to the Federal

Reserve the supervisory functions of the Ofﬁce

of Thrift Supervision related to SLHCs and their

nondepository subsidiaries beginning on July 21,

2011. At that time, the Federal Reserve decided

to issue “indicative RFI ratings” to SLHCs until

such time that a rating system was formally

adopted for these companies.

In November 2018, the Federal Reserve ad-

opted a ﬁnal rule to apply the RFI rating system

on a fully implemented basis to SLHCs with

less than $100 billion in total consolidated assets,

excluding SLHCs engaged in signiﬁcant insur-

ance or commercial activities.

Therefore, start-

ing on February 1, 2019, the Federal Reserve

will assign an RFI rating to non-insurance and

non-commercial SLHCs with less than $100

billion in total consolidated assets. Non-

insurance and non-commercial SLHCs face simi-

lar risks and engage largely in the same activi-

ties as BHCs. As such, it is appropriate for the

RFI rating system to apply to non-insurance and

non-commercial SLHCs to ensure that they are

subject to standards and supervisory programs

that are consistent with those that apply to

BHCs. Inspection frequency and scope guid-

ance for non-insurance and non-commercial

SLHCs with $10 billion or less in total consoli-

dated assets are described in

SR letter 13-21,

“Inspection Frequency and Scope Requirements

for Bank Holding Companies and Savings and

Loan Holding Companies with Total Consoli-

dated Assets of $10 Billion or Less.” Further, in

November 2018, the Federal Reserve adopted

the LFI rating system for non-insurance or non-

commercial SLHCs with total consolidated assets

of $100 billion or more.

The Federal Reserve will continue to assign

an indicative RFI rating to SLHCs engaged in

signiﬁcant insurance or commercial activities,

regardless of asset size. The Federal Reserve is

in the process of reviewing whether a modiﬁed

version of the RFI rating system, LFI rating

system, or some other supervisory rating system

is appropriate for these ﬁrms on a permanent

basis.

1. 69 Fed. Reg. 70,444 (December 6, 2004).

2. SLHCs that are excluded from the deﬁnition of “covered

holding company” in section 217.2 of the Board’s Regula-

tion Q receive indicative supervisory ratings. Section 271.2

excludes the following SLHCs: (1) SLHCs that derive 50 per-

cent or more of their total consolidated assets or total rev-

enues from activities that are not ﬁnancial in nature under

section 4(k) of the Bank Holding Company Act of 1956, as

amended (12 USC 1843(k)) (commercial SLHCs), and

(2) SLHCs that are insurance companies or hold 25 percent or

more of their total consolidated assets in subsidiaries that are

insurance companies (insurance SLHCs).

3. See 83 Fed. Reg. 58,724 (November 21, 2018) and 84

Fed. Reg. 4309 (February 15, 2019).

4. 83 Fed. Reg. 56,081 (November 7, 2018).

BHC Supervision Manual February 2019

Page 1

1062.0.4 RFI RATING SYSTEM

The RFI rating system provides an assessment

of certain risk management and ﬁnancial condi-

tion factors that are common to holding compa-

nies,

as well as an assessment of the potential

impact of the parent holding company and its

nondepository subsidiaries (collectively, nonde-

pository entities) on the holding company’s sub-

sidiary depository institutions. Under this sys-

tem, the Federal Reserve endeavors to ensure

that applicable BHCs, including ﬁnancial hold-

ing companies, and non-insurance and non-

commercial SLHCs are evaluated in a compre-

hensive and uniform manner, and that supervisory

attention is appropriately focused on the holding

companies that exhibit ﬁnancial and operational

weaknesses or adverse trends. The RFI rating

system serves as a useful vehicle for identifying

problem or deteriorating holding companies, as

well as for categorizing holding companies with

deﬁciencies in particular areas. Further, the RFI

rating system assists the Federal Reserve in

following safety-and-soundness trends and in

assessing the aggregate strength and soundness

of the ﬁnancial industry.

Each holding company subject to the RFI

rating system is assigned a composite rating (C)

based on an overall evaluation and rating of its

managerial and ﬁnancial condition and an assess-

ment of future potential risk to its subsidiary

depository institution(s).

The main components

of the rating system represent: Risk Manage-

ment (R); Financial Condition (F); and Im-

pact (I) of the nondepository entities on the

subsidiary depository institutions. While the

Federal Reserve expects holding companies to

act as a source of strength to their subsidiary

depository institutions, the Impact rating focuses

on downside risk—that is, on the likelihood of

signiﬁcant negative impact by the nondeposi-

tory entities on the subsidiary depository institu-

tion(s).

A fourth rating, Depository Institu-

tion(s) (D), will generally mirror the primary

regulator’s assessment of the subsidiary deposi-

tory institution(s). Thus, the primary component

and composite ratings are displayed:

R F I / C (D)

In order to provide a consistent framework for

assessing risk management, the R component is

supported by four subcomponents that reﬂect

the effectiveness of the organization’s risk man-

agement and controls. The subcomponents are

Board and Senior Management Oversight; Poli-

cies, Procedures, and Limits; Risk Monitoring

and Management Information Systems (MIS);

and Internal Controls. The F component is also

supported by four subcomponents reﬂecting an

assessment of the quality of the consolidated

organization’s Capital, Asset Quality, Earnings,

and Liquidity.

Composite, component, and subcomponent

ratings are assigned based on a 1 to 5 numeric

scale. A 1 numeric rating indicates the highest

rating, strongest performance and practices, and

least degree of supervisory concern, whereas a

5 numeric rating indicates the lowest rating,

weakest performance, and the highest degree of

supervisory concern.

The sections that follow contain detailed de-

scriptions of the composite, component, and

subcomponent ratings; implementation guidance

by holding company type; and deﬁnitions of the

ratings.

1062.0.5 DESCRIPTION OF THE RFI

RATING SYSTEM ELEMENTS

1062.0.5.1 The Composite (C) Rating

C is the overall composite assessment of the

holding company as reﬂected by consolidated

risk management, consolidated ﬁnancial strength,

and the potential impact of the nondepository

entities on the subsidiary depository institutions.

The composite rating encompasses both a

forward-looking and static assessment of the

consolidated organization, as well as an assess-

ment of the relationship between the depository

and nondepository entities. The C rating is not

derived as a simple numeric average of the R, F,

and I components; rather, it reﬂects examiner

judgment with respect to the relative importance

5. The information in this manual section largely conveys

the information in the original 2004 RFI rating system docu-

ment conveyed in 69 Fed. Reg. 70,444 (December 6, 2004).

However, the information was revised to clarify the applica-

bility of the rating system and to provide current references to

regulations and guidance. The elements of the RFI rating

system and the ratings’ deﬁnitions are unchanged. See

letter 19-4

, “Supervisory Rating System for Holding Compa-

nies with Total Consolidated Assets Less Than $100 billion.”

6. A simpliﬁed version of the rating system that includes

only the R and C components will be applied to noncomplex

holding companies with assets at or below $3 billion. See

SR-13-21 for more information.

7. In 2004, this risk-management rating replaced the risk-

management rating required for bank holding companies by

SR letter 95-51, “Rating the Adequacy of Risk Management

Processes and Internal Controls at State Member Banks and

Bank Holding Companies.”

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 2

of each component to the safe-and-sound opera-

tion of the holding company.

1062.0.5.2 The Risk Management (R)

Component

R represents an evaluation of the ability of the

holding company’s board of directors and senior

management, as appropriate for their respective

positions, to identify, measure, monitor, and

control risk. The R rating underscores the impor-

tance of the control environment, taking into

consideration the complexity of the organization

and the risk inherent in its activities.

The R rating is supported by four subcompo-

nents that are each assigned a separate rating.

The four subcomponents are as follows: (1) Board

and Senior Management Oversight; (2) Policies,

Procedures and Limits; (3) Risk Monitoring and

Management Information Systems; and (4) Inter-

nal Controls. The subcomponents are evaluated

in the context of the risks undertaken by and

inherent in an organization and the overall level

of complexity of the holding company’s opera-

tions. They provide the Federal Reserve System

with a consistent framework for evaluating risk

management and the control environment. More-

over, the subcomponents provide a clear struc-

ture and basis for discussion of the R rating with

holding company management, reﬂect the prin-

ciples in supervisory guidance that are familiar

to examiners, and parallel the existing risk assess-

ment process.

1062.0.5.2.1 Risk Management

Subcomponents

Board and Senior Management Oversight

This subcomponent evaluates the adequacy and

effectiveness of board and senior management’s

understanding and management of risk inherent

in the holding company’s activities, as well as

the general capabilities of management.

It also

includes consideration of management’s ability

to identify, understand, and control the risks

undertaken by the institution, to hire competent

staff, and to respond to changes in the institu-

tion’s risk proﬁle or innovations in the banking

sector.

Policies, Procedures, and Limits

This subcomponent evaluates the adequacy of a

holding company’s policies, procedures, and

limits given the risks inherent in the activities of

the consolidated organization and its stated goals

and objectives. This analysis will include con-

sideration of the adequacy of the institution’s

accounting and risk disclosure policies and pro-

cedures.

Risk Monitoring and Management Information

Systems

This subcomponent assesses the adequacy of a

holding company’s risk measurement and moni-

toring, and the adequacy of its management

reports and information systems. This analysis

will include a review of the assumptions, data,

and procedures used to measure risk and the

consistency of these tools with the level of

complexity of the organization’s activities.

Internal Controls

This subcomponent evaluates the adequacy of a

holding company’s internal controls and inter-

nal audit procedures, including the accuracy of

ﬁnancial reporting and disclosure and the strength

and inﬂuence, within the organization, of the

internal audit team. This analysis will also include

a review of the independence of control areas

from management and the consistency of the

scope coverage of the internal audit team with

the complexity of the organization.

1062.0.5.3 The Financial Condition (F)

Component

F represents an evaluation of the consolidated

organization’s ﬁnancial strength. The F rating

focuses on the ability of the holding company’s

resources to support the level of risk associated

with its activities. The F rating is supported by

four subcomponents: capital (C), asset qual-

ity (A), earnings (E), and liquidity (L). The

CAEL subcomponents can be evaluated along

8. See SR-95-51 and SR letter 16-11, “Supervisory Guid-

ance for Assessing Risk Management at Supervised Institu-

tions with Total Consolidated Assets Less than $50 Billion.”

SR-95-51 and SR-16-11 contain a detailed description of the

four risk-management subcomponents.

9. The board of directors is considered separate from man-

agement.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 3

individual business lines, product lines, or on a

legal entity basis, depending on what is most

appropriate given the structure of the organiza-

tion. The assessment of the CAEL components

should utilize benchmarks and metrics appropri-

ate to the business activity being evaluated.

Examination staff should continue to review

relevant market indicators, such as external debt

ratings, credit spreads, debt and equity prices,

and qualitative rating agency assessments as a

source of information complementary to exami-

nation ﬁndings.

1062.0.5.3.1 Financial Condition

Subcomponents (CAEL)

Capital Adequacy

C reﬂects the adequacy of an organization’s

consolidated capital position, from a regulatory

capital perspective and an economic capital per-

spective, as appropriate to the holding com-

pany.

The evaluation of capital adequacy should

consider the risk inherent in an organization’s

activities and the ability of capital to absorb

unanticipated losses, to provide a base for growth,

and to support the level and composition of the

parent company and subsidiaries’ debt.

Asset Quality

A reﬂects the quality of an organization’s con-

solidated assets. The evaluation should include,

as appropriate, both on-balance sheet and off-

balance sheet exposures, and the level of criti-

cized and nonperforming assets. Forward-

looking indicators of asset quality, such as the

adequacy of underwriting standards, the level of

concentration risk, the adequacy of credit admin-

istration policies and procedures, and the ad-

equacy of management information systems for

credit risk may also inform the Federal Reserve’s

view of asset quality.

Earnings

E reﬂects the quality of consolidated earnings.

The evaluation considers the level, trend, and

sources of earnings, as well as the ability of

earnings to augment capital as necessary, to

provide ongoing support for a holding com-

pany’s activities.

Liquidity

L reﬂects the consolidated organization’s ability

to attract and maintain the sources of funds

necessary to support its operations and meet its

obligations. The funding conditions for each of

the material legal entities in the holding com-

pany structure should be evaluated to determine

if any weaknesses exist that could affect the

funding proﬁle of the consolidated organization.

1062.0.5.4 The Impact (I) Component

Like the other components and subcomponents,

the I component is rated on a ﬁve-point numeri-

cal scale. However, the descriptive deﬁnitions of

the numerical ratings for I are different than

those of the other components and subcompo-

nents. The I ratings are deﬁned as follows:

1—low likelihood of signiﬁcant negative im-

pact;

2—limited likelihood of signiﬁcant negative

impact;

3—moderate likelihood of signiﬁcant nega-

tive impact;

4—considerable likelihood of signiﬁcant nega-

tive impact; and

5—high likelihood of signiﬁcant negative im-

pact.

The I component is an assessment of the poten-

tial impact of the nondepository entities on the

subsidiary depository institution(s). The I assess-

ment will evaluate both the risk-management

practices and ﬁnancial condition of the nonde-

pository entities—an analysis that will borrow

heavily from the analysis conducted for the R

and F components. Nondepository entities will

be evaluated using benchmarks and analysis

appropriate for those businesses. In addition, for

functionally regulated nondepository subsidi-

aries, examination staff will continue to rely, to

the extent possible, on the work of those func-

tional regulators to assess the risk management

practices and ﬁnancial condition of those enti-

ties. In rating the I component, examination

10. The regulatory minimum capital ratios for covered

holding companies subject to the Board’s Regulation Q (12

CFR part 217) are (1) a common equity tier 1 capital ratio of

4.5 percent; (2) a tier 1 capital ratio of 6 percent; (3) a total

capital ratio of 8 percent; (4) a leverage ratio of 4 percent,

and (5) for advanced approaches Board-regulated institutions,

a supplementary leverage ratio of 3 percent.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 4

staff is required to evaluate the degree to which

current or potential issues within the nondeposi-

tory entities present a threat to the safety and

soundness of the subsidiary depository institu-

tion(s).

The I component focuses on the aggregate

impact of the nondepository entities on the sub-

sidiary depository institution(s). In this regard,

the I rating does not include individual subcom-

ponent ratings for the parent company and non-

depository subsidiaries. An I rating is always

assigned for each holding company; however,

nonmaterial nondepository subsidiaries may be

excluded from the I analysis at examiner discre-

tion.

Any risk-management and ﬁnancial issues at

the nondepository entities that potentially im-

pact the safety and soundness of the subsidiary

depository institution(s) should be identiﬁed in

the written comments under the I rating. This

approach is consistent with the Federal Reserve’s

objective not to extend bank-like supervision to

nondepository entities.

The analysis of the parent company for the

purpose of assigning an I rating should empha-

size weaknesses that could directly impact the

risk-management or ﬁnancial condition of the

subsidiary depository institution(s). Similarly,

the analysis of the nondepository subsidiaries

for the purpose of assigning an I rating should

emphasize weaknesses that could negatively

impact the parent company’s relationship with

its subsidiary depository institution(s) and weak-

nesses that could have a direct impact on the

risk-management practices or ﬁnancial condi-

tion of the subsidiary depository institution(s).

The analysis under the I component should con-

sider existing as well as potential issues and

risks that may impact the subsidiary depository

institution(s) now or in the future. Particular

attention should be paid to the following risk-

management and ﬁnancial factors in assigning

the I rating:

1062.0.5.4.1 Risk-Management Factors

• Strategic Considerations: The potential risks

posed to the subsidiary depository institu-

tion(s) by the nondepository entities’ strategic

plans for growth in existing activities and

expansion into new products and services;

• Operational Considerations: The spillover im-

pact on the subsidiary depository institution(s)

from actual losses, a poor control environ-

ment, or an operational loss history in the

nondepository entities;

• Legal and Reputational Considerations: The

spillover effect on the subsidiary depository

institution(s) of complaints and litigation that

name one or more of the nondepository enti-

ties as defendants, or violations of laws or

regulations, especially pertaining to intercom-

pany transactions where the subsidiary deposi-

tory institution(s) is involved; and

• Concentration Considerations: The potential

risks posed to the subsidiary depository insti-

tution(s) by concentrations within the nonde-

pository entities in business lines, geographic

areas, industries, customers, or other factors.

1062.0.5.4.2 Financial Factors

• CapitalDistribution:Thedistributionandtrans-

ferability of capital across the legal entities;

• Intra-Group Exposures: The extent to which

intra-group exposures, including servicing

agreements, have the potential to undermine

the condition of subsidiary depository institu-

tion(s); and

• Parent Company Cash Flow and Leverage:

The extent to which the parent company is

dependent on dividend payments, from both

the nondepository subsidiaries and the subsid-

iary depository institution(s), to service debt

and cover ﬁxed charges. Also, the effect that

these upstreamed cash ﬂows have had, or can

be expected to have, on the ﬁnancial condition

of the holding company’s nondepository sub-

sidiaries and subsidiary depository institu-

tion(s).

1062.0.5.5 The Depository Institution(s)

(D) Component

The (D) component will generally reﬂect the

composite CAMELS rating assigned by the sub-

sidiary depository institution’s primary supervi-

sor. In a multi-depository institution holding

company, the (D) rating will reﬂect a weighted

average of the CAMELS composite ratings of

the individual subsidiary depository institutions,

weighted by both asset size and the relative

importance of each depository institution within

the holding company structure. In this regard,

11. In general,nondepository subsidiariesshould be included

in the I analysis whenever their assets exceed 5 percent of

the holding company’s consolidated capital or $10 million,

whichever is lower.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 5

the CAMELS composite rating for a subsidiary

depository institution that dominates the corpo-

rate culture may ﬁgure more prominently in the

assignment of the (D) rating than would be

dictated by asset size, particularly when prob-

lems exist within that depository institution.

The (D) component conveys important super-

visory information, reﬂecting the primary super-

visor’s assessment of the legal entity. The (D)

component stands outside of the composite rat-

ing although signiﬁcant risk-management and

ﬁnancial condition considerations at the deposi-

tory institution level are incorporated in the

consolidated R and F ratings, which are then

factored into the C rating.

In the process of analyzing the ﬁnancial con-

dition and risk-management programs of the

consolidated organization, a major difference of

opinion regarding the safety and soundness of

the subsidiary depository institution(s) emerges

between the Federal Reserve and the depository

institution’s primary regulator, then the (D) rat-

ing should reﬂect the Federal Reserve’s evalua-

tion.

To highlight the presence of one or more

problem depository institution(s) in a multi-

depository institution holding company whose

depository institution component, based on

weighted averages, might not otherwise reveal

their presence (i.e., depository institution ratings

of 1, 2, or 3), a problem modiﬁer, “P” would be

attached to the depository institution rating (e.g.,

1P, 2P, or 3P). Thus, 2P would indicate that,

while on balance the depository subsidiaries are

rated satisfactory, there exists a problem deposi-

tory institution (composite 4 or 5) among the

subsidiary depository institutions. The problem

identiﬁer is unnecessary when the depository

institution component is rated 4 or 5.

1062.0.6 IMPLEMENTATION OF THE

RFI RATING SYSTEM BY HOLDING

COMPANY TYPE

Since 2004, the Federal Reserve has used the

RFI rating system to communicate its supervi-

sory assessment of BHCs regardless of their

asset size, complexity, or systemic importance.

In 2018, the Board adopted the RFI rating sys-

tem for non-insurance and non-commercial

SLHCs with less than $100 billion in total con-

solidated assets. The scope and frequency of

inspections of holding companies under the RFI

rating system will vary based upon whether a

holding company has been determined to be

“complex” or “noncomplex.”

In addition, the

resources dedicated to the inspection of each

holding company will continue to be deter-

mined by the risk posed by the subsidiary deposi-

tory institution(s) to the federal safety net and

the risk posed by the holding company to the

subsidiary depository institution(s).

1062.0.6.1 Noncomplex Holding

Companies with Assets of $3 Billion

or Less (Shell Holding Companies)

Rating: R and C

Examination staff will assign only an R and C

rating for all noncomplex holding companies

with assets under $3 billion.

The R rating is

the M rating from the subsidiary depository

institution’s CAMELS rating. The C rating is

the subsidiary depository institution’s compos-

ite CAMELS rating.

1062.0.6.2 Noncomplex Holding

Companies with Assets Greater than

$3 Billion

1062.0.6.2.1 One-Depository Institution

Holding Company Rating: RFI/C(D)

For all noncomplex, one-depository institution

holding companies with assets of greater than

$3 billion, examination staff will assign all com-

ponent and subcomponent ratings; however, ex-

amination staff should rely heavily on informa-

tion and analysis contained in the primary

regulator’s report of examination for the subsid-

iary depository institution to assign the R and F

ratings. If examination staff have reviewed the

12. The determination of whether a holding company is

“complex” versus “noncomplex” is made at least annually on

a case-by-case basis taking into account and weighing a

number of considerations, such as: the size and structure of

the holding company; the extent of intercompany transactions

between depository institution subsidiaries and the holding

company or nondepository subsidiaries of the holding com-

pany; the nature and scale of any nondepository activities,

including whether the activities are subject to review by

another regulator and the extent to which the holding com-

pany is conducting Gramm-Leach-Bliley authorized activities

(e.g., insurance, securities, merchant banking); whether risk-

management processes for the holding company are consoli-

dated; and whether the holding company has material debt

outstanding to the public. Size is a less important determinant

of complexity than many of the factors noted above.

13. The federal safety net includes the federal deposit

insurance fund, the payments system, and the Federal Reserve’s

discount window.

14. Refer to SR-13-21.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 6

primary regulator’s examination report and are

comfortable with the analysis and conclusions

contained in that report, then the holding com-

pany ratings should be supported with concise

language that indicates that the conclusions are

based on the analysis of the primary regulator.

No additional analysis will be required.

Please note, however, in cases where the

analysis and conclusions of the primary regula-

tor are insufﬁcient to assign the ratings, the

primary regulator should be contacted to ascer-

tain whether additional analysis and support

may be available. Further, if discussions with

the primary regulator do not provide sufﬁcient

information to assign the ratings, discussions

with holding company management may be

warranted to obtain adequate information to

assign the ratings. In most cases, additional

information or support obtained through these

steps will be sufﬁcient to permit the assignment

of the R and F ratings. To the extent that addi-

tional analysis is deemed necessary, the level of

analysis and resources spent on this assessment

should be in line with the level of risk the

subsidiary depository institution poses to the

federal safety net. In addition, any activities that

involve information gathering with respect to

the subsidiary depository institution should be

coordinated with and, if possible, conducted by,

the primary regulator of that institution.

Examination staff are required to make an

independent assessment in order to assign the

I rating, which provides an evaluation of the

impact of the holding company on the subsidi-

ary depository institution. Analysis for the I rat-

ing in non-complex one-depository institution

holding companies should place particular em-

phasis on issues related to parent company cash

ﬂow and compliance with sections 23A and 23B

of the Federal Reserve Act.

1062.0.6.2.2 Multi-Depository Institution

Holding Company Rating: RFI/C(D)

For all noncomplex holding companies with

assets of greater than $3 billion and more than

one subsidiary depository institution, examina-

tion staff will assign all component and subcom-

ponent ratings of the RFI rating system. Exam-

iners should rely, to the extent possible, on the

work conducted by the primary regulators of the

subsidiary depository institutions to assign the R

and F ratings. However, any risk management

or other important functions conducted by the

nondepository entities of the holding company,

or conducted across legal entity lines, should be

subject to review by Federal Reserve examina-

tion staff. These reviews should be conducted in

coordination with the primary regulator(s). The

assessment for the I rating requires an indepen-

dent assessment by Federal Reserve examina-

tion staff.

1062.0.6.3 Complex Holding Companies

Rating: RFI/C(D)

For complex holding companies, examination

staff will assign all component and subcompo-

nent ratings of the RFI rating system. The rat-

ings analysis should be based on the primary

and functional regulators’ assessment of the

subsidiary entities, as well as on the examiners’

assessment of the consolidated organization as

determined through off-site review and the hold-

ing company inspection process, as appropriate.

The resources needed for the inspection and the

level of support needed for developing a full

rating will depend on the complexity of the

organization, including structure and activities,

and should be commensurate with the level of

risk posed by the subsidiary depository institu-

tion(s) to the federal safety net and the level of

risk posed by the holding company to the sub-

sidiary depository institution(s).

1062.0.6.4 Nontraditional Holding

Companies Rating: RFI/C(D)

Examination staff are required to assign the

full-rating system for nontraditional holding com-

panies.Nontraditionalholding companiesinclude

holding companies in which most or all nonde-

pository entities are regulated by a functional

regulator and in which the subsidiary depository

institution(s) are small in relation to the nonde-

pository entities.

The rating system is not

intended to introduce signiﬁcant additional work

in the rating process for these organizations. As

discussed above, the level of analysis conducted

and resources needed to inspect the holding

company and to assign the consolidated R and F

ratings should be commensurate with the level

15. SLHCs that derive 50 percent or more of their total

consolidated assets or total revenues from activities that are

not ﬁnancial in nature under section 4(k) of the Bank Holding

Company Act of 1956, as amended (12 USC 1843(k)) (com-

mercial SLHCs), and SLHCs that are insurance companies or

hold 25 percent or more of their total consolidated assets in

subsidiaries that are insurance companies (insurance SLHCs)

will receive an “indicative” RFI rating regardless of size.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 7

of risk posed by the subsidiary depository insti-

tution(s) to the federal safety net and the level of

risk posed by the holding company to the sub-

sidiary depository institution(s). The report of

examination by, and other information obtained

from, the functional and primary bank regula-

tors should provide the basis for the consoli-

dated R and F ratings. On-site work, to the

extent it involves areas that are the primary

responsibility of the functional or primary deposi-

tory institution(s) regulator, should be coordi-

nated with and, if possible, conducted by, those

regulators. Examination staff should concentrate

their independent analysis for the R and F rat-

ings around activities and risk management con-

ducted by the parent company and non-

functionallyregulatednondepository subsidiaries,

as well as around activities and risk manage-

ment functions that are related to the subsidiary

depository institution(s), for example, audit func-

tions for the depository institution(s) and com-

pliance with sections 23A and 23B.

Examination staff are required to make an

independent assessment of the impact of the

nondepository entities on the subsidiary deposi-

tory institution(s) in order to assign the I rating.

1062.0.7 RATING DEFINITIONS FOR

THE RFI/C(D) RATING SYSTEM

All component and subcomponent ratings are

rated on a ﬁve-point numeric scale. With the

exception of the I component, ratings will be

assigned in ascending order of supervisory con-

cern as follows:

1—Strong; 2—Satisfactory; 3—Fair; 4— Mar-

ginal; and 5—Unsatisfactory.

A description of the I component ratings can be

found below in subsection 1062.0.7.4, “Impact

Component.”

The component ratings are not derived as a

simple numeric average of the subcomponent

ratings; rather, weight afforded to each subcom-

ponent in the overall component rating will

depend on the severity of the condition of that

subcomponent and the relative importance of

that subcomponent to the consolidated organiza-

tion. Similarly, some components may be given

more weight than others in determining the

composite rating, depending on the situation of

the holding company. Assignment of a compos-

ite rating may incorporate any factor that bears

signiﬁcantly on the overall condition and sound-

ness of the holding company, although generally

the composite rating bears a close relationship

to the component ratings assigned.

1062.0.7.1 Composite Rating

Rating 1 (Strong). Holding companies in this

group are sound in almost every respect; any

negative ﬁndings are basically of a minor nature

and can be handled in a routine manner. Risk

management practices and ﬁnancial condition

provide resistance to external economic and

ﬁnancial disturbances. Cash ﬂow is more than

adequate to service debt and other ﬁxed obliga-

tions, and the nondepository entities pose little

risk to the subsidiary depository institution(s).

Rating 2 (Satisfactory). Holding companies

in this group are fundamentally sound but may

have modest weaknesses in risk-management

practices or ﬁnancial condition. The weaknesses

could develop into conditions of greater concern

but are believed correctable in the normal course

of business. As such, the supervisory response

is limited. Cash ﬂow is adequate to service

obligations, and the nondepository entities are

unlikely to have a signiﬁcant negative impact on

the subsidiary depository institution(s).

Rating 3 (Fair). Holding companies in this

group exhibit a combination of weaknesses in

risk-management practices and ﬁnancial condi-

tion that range from fair to moderately severe.

These companies are less resistant to the onset

of adverse business conditions and would likely

deteriorate if concerted action is not effective in

correcting the areas of weakness. Consequently,

these companies are vulnerable and require more

than normal supervisory attention and ﬁnancial

surveillance. However, the risk management and

ﬁnancial capacity of the company, including the

potential negative impact of the nondepository

entities on the subsidiary depository institu-

tion(s), pose only a remote threat to its contin-

ued viability.

Rating 4 (Marginal). Holding companies in

this group have an immoderate volume of risk

management and ﬁnancial weaknesses, which

may pose a heightened risk of signiﬁcant nega-

tive impact on the subsidiary depository institu-

tion(s). The holding company’s cash ﬂow needs

may be being met only by upstreaming impru-

dent dividends and/or fees from its subsidiaries.

Unless prompt action is taken to correct these

conditions, the organization’s future viability

could be impaired. These companies require

close supervisory attention and substantially

increased ﬁnancial surveillance.

Rating 5 (Unsatisfactory). The critical vol-

ume and character of the risk management and

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 8

ﬁnancial weaknesses of holding companies in

this category, and concerns about the nondeposi-

tory entities negatively impacting the subsidiary

depository institution(s), could lead to insol-

vency without urgent aid from shareholders or

other sources. The imminent inability to prevent

liquidity and/or capital depletion places the hold-

ing company’s continued viability in serious

doubt. These companies require immediate cor-

rective action and constant supervisory atten-

tion.

1062.0.7.2 Risk-Management Component

Rating 1 (Strong). A rating of 1 indicates that

management effectively identiﬁes and controls

all major types of risk posed by the holding

company’s activities. Management is fully pre-

pared to address risks emanating from new

products and changing market conditions. The

board and management are forward-looking and

active participants in managing risk. Manage-

ment ensures that appropriate policies and limits

exist and are understood, reviewed, and ap-

proved by the board. Policies and limits are

supported by risk-monitoring procedures, re-

ports, and management information systems that

provide management and the board with the

information and analysis that is necessary to

maketimelyand appropriatedecisions in response

to changing conditions. Risk-management prac-

tices and the organization’s infrastructure are

ﬂexible and highly responsive to changing indus-

try practices and current regulatory guidance.

Staff has sufﬁcient experience, expertise and

depth to manage the risks assumed by the insti-

tution.

Internal controls and audit procedures are suf-

ﬁciently comprehensive and appropriate to the

size and activities of the institution. There are

few noted exceptions to the institution’s estab-

lished policies and procedures, and none are

material. Management effectively and accu-

rately monitors the condition of the institution

consistent with the standards of safety and sound-

ness, and in accordance with internal and super-

visory policies and practices. Risk-management

processes are fully effective in identifying, moni-

toring, and controlling the risks to the institu-

tion.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the institution’s management of risk is

largely effective, but lacking in some modest

degree. Management demonstrates a responsive-

ness and ability to cope successfully with exist-

ing and foreseeable risks that may arise in carry-

ing out the institution’s business plan. While the

institution may have some minor risk-

management weaknesses, these problems have

been recognized and are in the process of being

resolved. Overall, board and senior management

oversight, policies and limits, risk monitoring

procedures, reports, and management informa-

tion systems are considered satisfactory and

effective in maintaining a safe and sound institu-

tion. Risks are controlled in a manner that does

not require more than normal supervisory atten-

tion.

Theholdingcompany’srisk-management prac-

tices and infrastructure are satisfactory and gen-

erally are adjusted appropriately in response to

changing industry practices and current regula-

tory guidance. Staff experience, expertise and

depth are generally appropriate to manage the

risks assumed by the institution.

Internal controls may display modest weak-

nesses or deﬁciencies, but they are correctable

in the normal course of business. The examiner

may have recommendations for improvement,

but the weaknesses noted should not have a

signiﬁcant effect on the safety and soundness of

the institution.

Rating 3 (Fair). A rating of 3 signiﬁes that

risk-management practices are lacking in some

important ways and, therefore, are a cause for

more than normal supervisory attention. One or

more of the four elements of sound risk manage-

ment (active board and senior management over-

sight; adequate policies, procedures, and limits;

adequate risk-management monitoring and man-

agement information systems; comprehensive

internal controls) is considered less than accept-

able,

and has precluded the institution from

fully addressing one or more signiﬁcant risks to

its operations. Certain risk-management prac-

tices are in need of improvement to ensure that

management and the board are able to identify,

monitor, and control all signiﬁcant risks to the

institution. Also, the risk-management structure

may need to be improved in areas of signiﬁcant

business activity, or staff expertise may not be

commensurate with the scope and complexity of

business activities. In addition, management’s

response to changing industry practices and

regulatory guidance may need to improve.

The internal control system may be lacking in

some important aspects, particularly as indi-

cated by continued control exceptions or by a

failure to adhere to written policies and proce-

dures. The risk-management weaknesses could

16. See SR - 95-51 and SR-16-11.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 9

have adverse effects on the safety and sound-

ness of the institution if corrective action is not

taken by management.

Rating 4 (Marginal). A rating of 4 represents

deﬁcient risk-management practices that fail to

identify, monitor, and control signiﬁcant risk

exposures in many material respects. Generally,

such a situation reﬂects a lack of adequate guid-

ance and supervision by management and the

board. One or more of the four elements of

sound risk management is deﬁcient and requires

immediate and concerted corrective action by

the board and management.

The institution may have serious identiﬁed

weaknesses, such as an inadequate separation of

duties, that require substantial improvement in

internal control or accounting procedures, or

improved adherence to supervisory standards or

requirements. The risk-management deﬁcien-

cies warrant a high degree of supervisory atten-

tion because, unless properly addressed, they

could seriously affect the safety and soundness

of the institution.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates a critical absence of effective risk-

management practices with respect to the identi-

ﬁcation, monitoring, or control over signiﬁcant

risk exposures. One or more of the four ele-

ments of sound risk management is considered

wholly deﬁcient, and management and the board

have not demonstrated the capability to address

these deﬁciencies.

Internal controls are critically weak and, as

such, could seriously jeopardize the continued

viability of the institution. If not already evi-

dent, there is an immediate concern as to the

reliability of accounting records and regulatory

reports and the potential for losses if corrective

measures are not taken immediately. Deﬁcien-

cies in the institution’s risk-management proce-

dures and internal controls require immediate

and close supervisory attention.

1062.0.7.2.1 Risk Management

Subcomponents

Board and Senior Management Oversight

Rating 1 (Strong). An assessment of “Strong”

signiﬁes that the board and senior management

are forward-looking, fully understand the types

of risk inherent in the holding company’s activi-

ties, and actively participate in managing those

risks. The board has approved overall business

strategies and signiﬁcant policies, and ensures

that senior management is fully capable of man-

aging the activities that the holding company

conducts. Consistent with the standards of safety

and soundness, oversight of risk-management

practices is strong and the organization’s overall

business strategy is effective.

Senior management ensures that risk-

management practices are rapidly adjusted in

accordance with enhancements to industry prac-

tices and regulatory guidance, and exposure lim-

its are adjusted as necessary to reﬂect the institu-

tion’s changing risk proﬁle. Policies, limits, and

tracking reports are appropriate, understood, and

regularly reviewed.

Management provides effective supervision

of the day-to-day activities of all ofﬁcers and

employees, including the supervision of the

senior ofﬁcers and the heads of business lines. It

hires staff that possess experience and expertise

consistent with the scope and complexity of the

organization’s business activities. There is a suf-

ﬁcient depth of staff to ensure sound operations.

Management ensures compliance with laws and

regulations and that employees have the integ-

rity, ethical values, and competence consistent

with a prudent management philosophy and

operating style.

Managementresponds appropriately tochanges

in the marketplace. It identiﬁes all risks associ-

ated with new activities or products before they

are launched, and ensures that the appropriate

infrastructure and internal controls are estab-

lished.

Rating 2 (Satisfactory). An assessment of

“Satisfactory” indicates that board and senior

management have an adequate understanding of

the organization’s risk proﬁle and provide largely

effective oversight of risk-management prac-

tices. In this regard, the board has approved all

major business strategies and signiﬁcant poli-

cies, and ensures that senior management is

capable of managing the activities that the hold-

ing company conducts. Oversight of risk-

management practices is satisfactory and the

organization’s overall business strategy is gener-

ally sound.

Senior management generally adjusts risk-

management practices appropriately in accor-

dance with enhancements to industry practices

and regulatory guidance, and adjusts exposure

limits as necessary to reﬂect the institution’s

changing risk proﬁle, although these practices

may be lacking in some modest degree. Poli-

cies, limits, and tracking reports are generally

appropriate, understood, and regularly reviewed,

and the new product approval process ad-

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 10

equately identiﬁes the associated risks and nec-

essary controls.

Senior management’s day-to-day supervision

of management and staff at all levels is gener-

ally effective. The level of stafﬁng, and its expe-

rience, expertise, and depth, is sufﬁcient to oper-

ate the business lines in a safe and sound manner.

Minor weaknesses may exist in the stafﬁng,

infrastructure, and risk-management processes

for individual business lines or products, but

these weaknesses have been identiﬁed by man-

agement, are correctable in the normal course of

business, and are in the process of being ad-

dressed. Weaknesses noted should not have a

signiﬁcant effect on the safety and soundness of

the institution.

Rating 3 (Fair). An assessment of “Fair” sig-

niﬁes that board and senior management over-

sight is lacking in some important way and,

therefore, is a cause for more than normal super-

visory attention. The weaknesses may involve a

broad range of activities or be material to a

major business line or activity. Weaknesses in

one or more aspect of board and senior manage-

ment oversight have precluded the institution

from fully addressing one or more signiﬁcant

risks to the institution. The deﬁciencies may

include a lack of knowledge with respect to the

organization’s risk proﬁle, insufﬁcient oversight

of risk-management practices, ineffective poli-

cies or limits, inadequate or under-utilized man-

agement reporting, an inability to respond to

industry enhancements and changes in regula-

tory guidance, or failure to execute appropriate

business strategies. Stafﬁng may not be adequate

or staff may not possess the experience and

expertise needed for the scope and complexity

of the organization’s business activities. The

day-to-day supervision of ofﬁcer and staff activi-

ties, including the management of senior ofﬁ-

cers or heads of business lines, may be lacking.

Certain risk-management practices are in need

of improvement to ensure that management and

the board is able to identify, monitor, and con-

trol all signiﬁcant risks to the institution. Weak-

nesses noted could have adverse effects on the

safety and soundness of the institution if correc-

tive action is not taken by management.

Rating 4 (Marginal). An assessment of “Mar-

ginal” represents deﬁcient oversight practices

that reﬂect a lack of adequate guidance and

supervision by management and the board. A

number of signiﬁcant risks to the institution

have not been adequately addressed, and the

board and senior management function warrants

a high degree of supervisory attention. Multiple

board and senior management weaknesses are in

need of immediate improvement. They may

include a signiﬁcant lack of knowledge with

respect to the organization’s risk proﬁle, largely

insufﬁcient oversight of risk-management prac-

tices, ineffective policies or limits, inadequate

or considerably under-utilized management re-

porting, an inability to respond to industry en-

hancements and changes in regulatory guidance,

or failure to execute appropriate business strate-

gies. Stafﬁng may not be adequate or possess

the experience and expertise needed for the

scope and complexity of the organization’s busi-

ness activities, and the day-to-day supervision

of ofﬁcer and staff activities, including the man-

agement of senior ofﬁcers or heads of business

lines, may be considerably lacking. These con-

ditions warrant a high degree of supervisory

attention because, unless properly addressed,

they could seriously affect the safety and sound-

ness of the institution.

Rating 5 (Unsatisfactory). An assessment of

“Unsatisfactory” indicates a critical absence of

effective board and senior management over-

sight practices. Problems may include a severe

lack of knowledge with respect to the organiza-

tion’s risk proﬁle, insufﬁcient oversight of risk-

management practices, wholly ineffective poli-

cies or limits, critically inadequate or under-

utilized management reporting, a complete

inability to respond to industry enhancements

and changes in regulatory guidance, or failure to

execute appropriate business strategies. Stafﬁng

may be inadequate, inexpert, and/or inad-

equately supervised. The deﬁciencies require

immediate and close supervisory attention, as

management and the board have not demon-

strated the capability to address them. Weak-

nesses could seriously jeopardize the continued

viability of the institution.

Policies, Procedures, and Limits

Rating 1 (Strong). An assessment of “Strong”

indicates that the policies, procedures, and lim-

its provide for effective identiﬁcation, measure-

ment, monitoring, and control of the risks posed

by all signiﬁcant activities, including lending,

investing, trading, trust, and ﬁduciary activities.

Policies, procedures, and limits are consistent

with the institution’s goals and objectives and

its overall ﬁnancial strength. The policies clearly

delineate accountability and lines of authority

across the institution’s activities. The policies

also provide for the review of new activities to

ensure that the infrastructure necessary to iden-

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 11

tify, monitor, and control the associated risks is

in place before the activities are initiated.

Rating 2 (Satisfactory). An assessment of

“Satisfactory” indicates that the policies, proce-

dures, and limits cover all major business areas,

are thorough and substantially up-to-date, and

provide a clear delineation of accountability and

lines of authority across the institution’s activi-

ties. Policies, procedures, and limits are gener-

ally consistent with the institution’s goals and

objectives and its overall ﬁnancial strength.

Also, the policies provide for adequate due dili-

gence before engaging in new activities or prod-

ucts. Any deﬁciencies or gaps that have been

identiﬁed are minor in nature and in the process

of being addressed. Weaknesses should not have

a signiﬁcant effect on the safety and soundness

of the institution.

Rating 3 (Fair). An assessment of “Fair” sig-

niﬁes that deﬁciencies exist in policies, proce-

dures, and limits that require more than normal

supervisory attention. The deﬁciencies may in-

volve a broad range of activities or be material

to a major business line or activity. The deﬁcien-

cies may include policies, procedures, or limits

(or the lack thereof) that do not adequately

identify, measure, monitor, or control the risks

posed by signiﬁcant activities; are not consistent

with the experience of staff, the organization’s

strategic goals and objectives, or the ﬁnancial

strength of the institution; or do not clearly

delineate accountability or lines of authority.

Also, the policies may not provide for adequate

due diligence before engaging in new activities

or products. Weaknesses noted could have ad-

verse effects on the safety and soundness of the

institution unless corrective action is taken by

management.

Rating 4 (Marginal). An assessment of “Mar-

ginal” indicates deﬁcient policies, procedures,

and limits that do not address a number of

signiﬁcant risks to the institution. Multiple prac-

tices are in need of immediate improvement,

which may include policies, procedures, or lim-

its (or the lack thereof) that ineffectively iden-

tify, measure, monitor, or control the risks posed

by signiﬁcant activities; are not commensurate

with the experience of staff, the institution’s

strategic goals and objectives, or the ﬁnancial

strength of the institution; or do not delineate

accountability or lines of authority. Moreover,

policies may be considerably lacking with re-

gards to providing for effective due diligence

before engaging in new activities or products.

These conditions warrant a high degree of super-

visory attention because, unless properly ad-

dressed, they could seriously affect the safety

and soundness of the institution.

Rating 5 (Unsatisfactory). An assessment of

“Unsatisfactory” indicates a critical absence of

effective policies, procedures, and limits. Poli-

cies, procedures, or limits (or the lack thereof)

are largely or entirely ineffective with regard to

identifying, measuring, monitoring, or control-

ling the risks posed by signiﬁcant activities; are

completely inconsistent with the experience of

staff, the organization’s strategic goals and ob-

jectives, or the ﬁnancial strength of the institu-

tion; or do not delineate accountability or lines

of authority. Also, policies may be completely

lacking with regard to providing for effective

due diligence before engaging in new activities

or products. Critical weaknesses could seriously

jeopardize the continued viability of the institu-

tion and require immediate and close supervi-

sory attention.

Risk Monitoring and MIS

Rating 1 (Strong). An assessment of “Strong”

indicates that risk-monitoring practices and MIS

reportsaddress all material risks. The key assump-

tions, data sources, and procedures used in mea-

suring and monitoring risk are appropriate, thor-

oughly documented, and frequently tested for

reliability. Reports and other forms of communi-

cation are consistent with activities, are struc-

tured to monitor exposures and compliance with

established limits, goals, or objectives, and com-

pare actual versus expected performance when

appropriate. Management and board reports are

accurate and timely and contain sufﬁcient infor-

mation to identify adverse trends and to thor-

oughly evaluate the level of risk faced by the

institution.

Rating 2 (Satisfactory). An assessment of

“Satisfactory” indicates thatrisk-monitoring prac-

tices and MIS reports cover major risks and

business areas, although they may be lacking in

some modest degree. In general, the reports

contain valid assumptions that are periodically

tested for accuracy and reliability and are ad-

equately documented and distributed to the ap-

propriate decisionmakers. Reports and other

forms of communication generally are consis-

tent with activities; are structured to monitor

exposures and compliance with established lim-

its, goals, or objectives; and compare actual

versus expected performance when appropriate.

Management and board reports are generally

accurate and timely, and broadly identify ad-

verse trends and the level of risk faced by the

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 12

institution. Any weaknesses or deﬁciencies that

have been identiﬁed are in the process of being

addressed.

Rating 3 (Fair). An assessment of “Fair” sig-

niﬁes that weaknesses exist in the institution’s

risk-monitoring practices or MIS reports that

require more than normal supervisory attention.

The weaknesses may involve a broad range of

activities or be material to a major business line

or activity. They may contribute to ineffective

risk identiﬁcation or monitoring through inap-

propriate assumptions, incorrect data, poor docu-

mentation, or the lack of timely testing. In addi-

tion, MIS reports may not be distributed to the

appropriate decisionmakers, adequately monitor

signiﬁcant risks, or properly identify adverse

trends and the level of risk faced by the institu-

tion. Weaknesses noted could have adverse effects

on the safety and soundness of the institution if

corrective action is not taken by management.

Rating 4 (Marginal). An assessment of “Mar-

ginal” represents deﬁcient risk-monitoring prac-

tices or MIS reports that, unless properly ad-

dressed, could seriously affect the safety and

soundness of the institution. A number of sig-

niﬁcant risks to the institution are not adequately

monitored or reported. Ineffective risk identiﬁ-

cation may result from notably inappropriate

assumptions, incorrect data, poor documenta-

tion, or the lack of timely testing. In addition,

MIS reports may not be distributed to the appro-

priate decisionmakers, may inadequately moni-

tor signiﬁcant risks, or fail to identify adverse

trends and the level of risk faced by the institu-

tion. The risk monitoring and MIS deﬁciencies

warrant a high degree of supervisory attention

because, unless properly addressed, they could

seriously affect the safety and soundness of the

institution.

Rating 5 (Unsatisfactory). An assessment of

“Unsatisfactory” indicates a critical absence of

risk monitoring and MIS. They are wholly deﬁ-

cient due to inappropriate assumptions, incor-

rect data, poor documentation, or the lack of

timely testing. Moreover, MIS reports may not

be distributed to the appropriate decisionmak-

ers, fail to monitor signiﬁcant risks, or fail to

identify adverse trends and the level of risk

faced by the institution. These critical weak-

nesses require immediate and close supervisory

attention, as they could seriously jeopardize the

continued viability of the institution.

Internal Controls

Rating 1 (Strong). An assessment of “Strong”

indicates that the system of internal controls is

robust for the type and level of risks posed by

the nature and scope of the organization’s activi-

ties. The organizational structure establishes

clear lines of authority and responsibility for

monitoring adherence to policies, procedures,

and limits, and wherever applicable, exceptions

are noted and promptly investigated. Reporting

lines provide clear independence of the control

areas from the business lines and separation of

duties throughout the organization. Robust pro-

cedures exist for ensuring compliance with appli-

cable laws and regulations, including consumer

laws and regulations. Financial, operational, and

regulatory reports are reliable, accurate, and

timely. Internal audit or other control review

practices provide for independence and objectiv-

ity. Internal controls and information systems

are thoroughly tested and reviewed; the cover-

age, procedures, ﬁndings, and responses to au-

dits and review tests are well documented; iden-

tiﬁed material weaknesses are given thorough

and timely high-level attention; and manage-

ment’s actions to address material weaknesses

are objectively reviewed and veriﬁed. The board

or its audit committee regularly reviews the

effectiveness of internal audits and other control

review activities.

Rating 2 (Satisfactory). An assessment of

“Satisfactory” indicates that the system of inter-

nal controls adequately covers major risks and

business areas, with some modest weaknesses.

In general, the control functions are independent

from the business lines, and there is appropriate

separation of duties. The control system sup-

ports accuracy in record-keeping practices and

reporting systems, is adequately documented,

and veriﬁes compliance with laws and regula-

tions, including consumer laws and regulations.

Internal controls and information systems are

adequately tested and reviewed, and the cover-

age, procedures, ﬁndings, and responses to au-

dits and review tests are documented. Identiﬁed

material weaknesses are given appropriate atten-

tion and management’s actions to address mate-

rial weaknesses are objectively reviewed and

veriﬁed. The board or its audit committee reviews

the effectiveness of internal audits and other

control review activities. Any weaknesses or

deﬁciencies that have been identiﬁed are modest

in nature and in the process of being addressed.

Rating 3 (Fair). An assessment of “Fair” sig-

niﬁes that weaknesses exist in the system of

internal controls that require more than normal

supervisory attention. The weaknesses may in-

volve a broad range of activities or be material

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 13

to a major business line or activity. The weak-

nesses may include insufﬁcient oversight of

internal controls and audit by the board or its

audit committee; unclear or conﬂicting lines of

authority and responsibility; a lack of indepen-

dence between control areas and business activi-

ties; or ineffective separation of duties. The

internal control system may produce inadequate

or untimely risk coverage and veriﬁcation, includ-

ing monitoring compliance with both safety and

soundness and consumer laws and regulations;

inaccurate records or ﬁnancial, operational, or

regulatory reporting; a lack of documentation

for work performed; or a lack of timeliness in

management review and correction of identiﬁed

weaknesses. Weaknesses noted could have ad-

verse effects on the safety and soundness of the

institution if corrective action is not taken by

management.

Rating 4 (Marginal). An assessment of “Mar-

ginal” represents a deﬁcient internal control sys-

tem that does not adequately address a number

of signiﬁcant risks to the institution. The deﬁ-

ciencies may include neglect of internal controls

and audit by the board or its audit committee;

conﬂicting lines of authority and responsibility;

a lack of independence between control areas

and business activities; or no separation of du-

ties in critical areas. The internal control system

may produce inadequate, untimely, or nonexis-

tent risk coverage and veriﬁcation in certain

areas, including monitoring compliance with

both safety and soundness and consumer laws

and regulations; inaccurate records or ﬁnancial,

operational, or regulatory reporting; a lack of

documentation for work performed; or infre-

quent management review and correction of

identiﬁed weaknesses. The internal control deﬁ-

ciencies warrant a high degree of supervisory

attention because, unless properly addressed,

they could seriously affect the safety and sound-

ness of the institution.

Rating 5 (Unsatisfactory). An assessment of

“Unsatisfactory” indicates a critical absence of

an internal control system. There may be no

oversight by the board or its audit committee;

conﬂicting lines of authority and responsibility;

no distinction between control areas and busi-

ness activities; or no separation of duties. The

internal control system may produce totally

inadequate or untimely risk coverage and veriﬁ-

cation, including monitoring compliance with

both safety and soundness and consumer laws

and regulations; completely inaccurate records

or regulatory reporting; a severe lack of docu-

mentation for work performed; or no manage-

ment review and correction of identiﬁed weak-

nesses. Such deﬁciencies require immediate and

close supervisory attention, as they could seri-

ously jeopardize the continued viability of the

institution.

1062.0.7.3 Financial Condition

Component

Rating 1 (Strong). A rating of 1 indicates that

the consolidated holding company is ﬁnancially

sound in almost every respect; any negative

ﬁndings are basically of a minor nature and can

be handled in a routine manner. The capital

adequacy, asset quality, earnings, and liquidity

of the consolidated holding company are more

than adequate to protect the company from rea-

sonably foreseeable external economic and ﬁnan-

cial disturbances. The company generates more

than sufﬁcient cash ﬂow to service its debt and

ﬁxed obligations with no harm to subsidiaries of

the organization.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the consolidated holding company is

fundamentally ﬁnancially sound, but may have

modest weaknesses correctable in the normal

course of business. The capital adequacy, asset

quality, earnings and liquidity of the consoli-

dated holding company are adequate to protect

the company from external economic and ﬁnan-

cial disturbances. The company also generates

sufﬁcient cash ﬂow to service its obligations;

however, areas of weakness could develop into

areas of greater concern. To the extent minor

adjustments are handled in the normal course of

business, the supervisory response is limited.

Rating 3 (Fair). A rating of 3 indicates that

the consolidated holding company exhibits a

combination of weaknesses ranging from fair to

moderately severe. The company has less than

adequate ﬁnancial strength stemming from one

or more of the following: modest capital deﬁ-

ciencies, substandard asset quality, weak earn-

ings, or liquidity problems. As a result, the

holding company and its subsidiaries are less

resistant to adverse business conditions. The

ﬁnancial condition of the holding company will

likely deteriorate if concerted action is not taken

to correct areas of weakness. The company’s

cash ﬂow is sufﬁcient to meet immediate obliga-

tions, but may not remain adequate if action is

not taken to correct weaknesses. Consequently,

the holding company is vulnerable and requires

more than normal supervision. Overall ﬁnancial

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 14

strength and capacity are still such as to pose

only a remote threat to the viability of the com-

pany.

Rating 4 (Marginal). A rating of 4 indicates

that the consolidated holding company has either

inadequate capital, an immoderate volume of

problem assets, very weak earnings, serious

liquidity issues, or a combination of factors that

are less than satisfactory. An additional weak-

ness may be that the holding company’s cash

ﬂow needs are met only by upstreaming impru-

dent dividends and/or fees from subsidiaries.

Unless prompt action is taken to correct these

conditions, they could impair future viability.

Holding companies in this category require close

supervisory attention and increased ﬁnancial

surveillance.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates that the volume and character of ﬁnancial

weaknesses of the holding company are so criti-

cal as to require urgent aid from shareholders or

other sources to prevent insolvency. The immi-

nent inability of such a company to service its

ﬁxed obligations and/or prevent capital deple-

tion due to severe operating losses places its

viability in serious doubt. Such companies re-

quire immediate corrective action and constant

supervisory attention.

1062.0.7.3.1 The Financial Condition

Subcomponents

The ﬁnancial condition subcomponents can be

evaluated along business lines, product lines, or

legal entity lines—depending on which type of

review is most appropriate for the holding com-

pany structure.

Capital Adequacy

Rating 1 (Strong). A rating of 1 indicates that

the consolidated holding company maintains

more than adequate capital to support the vol-

ume and risk characteristics of all parent and

subsidiary business lines and products; provide

a sufﬁcient cushion to absorb unanticipated losses

arising from the parent and subsidiary activities;

and support the level and composition of parent

and subsidiary borrowing. In addition, a com-

pany assigned a rating of 1 has more than sufﬁ-

cient capital to provide a base for the growth of

risk assets and the entry into capital markets as

the need arises for the parent company and

subsidiaries.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the consolidated holding company

maintains adequate capital to support the vol-

ume and risk characteristics of all parent and

subsidiary business lines and products; provide

a sufﬁcient cushion to absorb unanticipated losses

arising from the parent and subsidiary activities;

and support the level and composition of parent

and subsidiary borrowing. In addition, a com-

pany assigned a rating of 2 has sufﬁcient capital

to provide a base for the growth of risk assets

and the entry into capital markets as the need

arises for the parent company and subsidiaries.

Rating 3 (Fair). A rating of 3 indicates that

the consolidated holding company may not main-

tain sufﬁcient capital to ensure support for the

volume and risk characteristics of all parent and

subsidiary business lines and products; the unan-

ticipated losses arising from the parent and sub-

sidiary activities; or the level and composition

of parent and subsidiary borrowing. In addition,

a company assigned a rating of 3 may not main-

tain a sufﬁcient capital position to provide a

base for the growth of risk assets and the entry

into capital markets as the need arises for the

parent company and subsidiaries. The capital

position of the consolidated holding company

could quickly become inadequate in the event of

asset deterioration or other negative factors and

therefore requires more than normal supervisory

attention.

Rating 4 (Marginal). A rating of 4 indicates

that the capital level of the consolidated holding

company is signiﬁcantlybelowthe amount needed

to ensure support for the volume and risk char-

acteristics of all parent and subsidiary business

lines and products; the unanticipated losses aris-

ing from the parent and subsidiary activities;

and the level and composition of parent and

subsidiary borrowing. In addition, a company

assigned a rating of 4 does not maintain a sufﬁ-

cient capital position to provide a base for the

growth of risk assets and the entry into capital

markets as the need arises for the parent com-

pany and subsidiaries. If left unchecked, the

consolidated capital position of the company

might evolve into weaknesses or conditions that

could threaten the viability of the institution.

The capital position of the consolidated holding

company requires immediate supervisory atten-

tion.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates that the level of capital of the consolidated

holding company is critically deﬁcient and in

need of immediate corrective action. The con-

solidated capital position threatens the viability

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 15

of the institution and requires constant supervi-

sory attention.

Asset Quality

Rating 1 (Strong). A rating of 1 indicates that

the holding company maintains strong asset

quality across all parts of the organization, with

a very low level of criticized and nonperforming

assets. Credit risk across the organization is

commensurate with management’s abilities and

modest in relation to credit risk-management

practices.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the holding company maintains satis-

factory asset quality across all parts of the orga-

nization, with a manageable level of criticized

and nonperforming assets. Any identiﬁed weak-

nesses in asset quality are correctable in the

normal course of business. Credit risk across the

organization is commensurate with manage-

ment’s abilities and generally modest in relation

to credit risk-management practices.

Rating 3 (Fair). A rating of 3 indicates that

the asset quality across all or a material part of

the consolidated holding company is less than

satisfactory. The holding company may be fac-

ing a decrease in the overall quality of assets

currently maintained on and off balance sheet.

The holding company may also be experiencing

an increase in credit-risk exposure that has not

been met with an appropriate improvement in

risk-management practices. Holding companies

assigned a rating of 3 require more than normal

supervisory attention.

Rating 4 (Marginal). A rating of 4 indicates

that the holding company’s asset quality is deﬁ-

cient. The level of problem assets and/or unmiti-

gated credit risk subjects the holding company

to potential losses that, if left unchecked, may

threaten its viability. Holding companies as-

signed a rating of 4 require immediate supervi-

sory attention.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates that the holding company’s asset quality is

critically deﬁcient and presents an imminent

threat to the institution’s viability. Holding com-

panies assigned a rating of 5 require immediate

remedial action and constant supervisory atten-

tion.

Earnings

Rating 1 (Strong). A rating of 1 indicates that

the quantity and quality of the holding com-

pany’s consolidated earnings over time are more

than sufﬁcient to make full provision for the

absorption of losses and/or accretion of capital

when due consideration is given to asset quality

and holding company growth. Generally, hold-

ing companies with a 1 rating have earnings

well above peer-group averages.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the quantity and quality of the holding

company’s consolidated earnings over time are

generally adequate to make provision for the

absorption of losses and/or accretion of capital

when due consideration is given to asset quality

and holding company growth. Generally, hold-

ing companies with a 2 rating have earnings that

are in line with or slightly above peer-group

averages.

Rating 3 (Fair). A rating of 3 indicates that

the holding company’s consolidated earnings

are not fully adequate to make provisions for the

absorption of losses and the accretion of capital

in relation to company growth. The consoli-

dated earnings of companies rated 3 may be

further clouded by static or inconsistent earn-

ings trends, chronically insufﬁcient earnings, or

less than satisfactory asset quality. Holding com-

panies with a 3 rating generally have earnings

below peer-group averages. Such holding com-

panies require more than normal supervisory

attention.

Rating 4 (Marginal). A rating of 4 indicates

that the holding company’s consolidated earn-

ings, while generally positive, are clearly not

sufﬁcient to make full provision for losses and

the necessary accretion of capital. Holding com-

panies with earnings rated 4 may be character-

ized by erratic ﬂuctuations in net income, poor

earnings (and the likelihood of the development

of a further downward trend), intermittent losses,

chronically depressed earnings, or a substantial

drop from the previous year. The earnings of

such companies are generally substantially be-

low peer-group averages. Such holding compa-

nies require immediate supervisory attention.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates that the holding company is experiencing

losses or a level of earnings that is worse than

that described for the 4 rating. Such losses, if

not reversed, represent a distinct threat to the

holding company’s solvency through erosion of

capital. Such holding companies require imme-

diate and constant supervisory attention.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 16

Liquidity

Rating 1 (Strong). A rating of 1 indicates that

the holding company maintains strong liquidity

levels and well-developed funds-management

practices. The parent company and subsidiaries

have reliable access to sufﬁcient sources of

funds on favorable terms to meet present and

anticipated liquidity needs.

Rating 2 (Satisfactory). A rating of 2 indi-

cates that the holding company maintains satis-

factory liquidity levels and funds-management

practices. The parent company and subsidiaries

have access to sufﬁcient sources of funds on

acceptable terms to meet present and anticipated

liquidity needs. Modest weaknesses in funds-

management practices may be evident, but those

weaknesses are correctable in the normal course

of business.

Rating 3 (Fair). A rating of 3 indicates that

the holding company’s liquidity levels or funds-

management practices are in need of improve-

ment. Holding companies rated 3 may lack

ready access to funds on reasonable terms or

may evidence signiﬁcant weaknesses in funds-

management practices at the parent company or

subsidiary levels. However, these deﬁciencies

are considered correctable in the normal course

of business. Such holding companies require

more than normal supervisory attention.

Rating 4 (Marginal). A rating of 4 indicates

that the holding company’s liquidity levels or

funds-management practices are deﬁcient. Insti-

tutions rated 4 may not have or be able to obtain

a sufﬁcient volume of funds on reasonable terms

to meet liquidity needs at the parent company or

subsidiary levels and require immediate supervi-

sory attention.

Rating 5 (Unsatisfactory). A rating of 5 indi-

cates that the holding company’s liquidity levels

or funds-management practices are critically

deﬁcient and may threaten the continued viabil-

ity of the institution. Institutions rated 5 require

constant supervisory attention and immediate

external ﬁnancial assistance to meet maturing

obligations or other liquidity needs.

1062.0.7.4 Impact Component

The I component rating reﬂects the aggregate

potential impact of the nondepository entities on

the subsidiary depository institution(s). It is

rated on a ﬁve-point numerical scale. Ratings

will be assigned in ascending order of supervi-

sory concern as follows:

1—low likelihood of signiﬁcant negative im-

pact;

2—limited likelihood of signiﬁcant negative

impact;

3—moderate likelihood of signiﬁcant nega-

tive impact;

4—considerable likelihood of signiﬁcant nega-

tive impact; and

5—high likelihood of signiﬁcant negative im-

pact.

Rating 1 (Low Likelihood of Signiﬁcant Nega-

tive Impact). A rating of 1 indicates that the

nondepository entities of the holding company

are highly unlikely to have a signiﬁcant nega-

tive impact on the subsidiary depository institu-

tion(s) due to the sound ﬁnancial condition of

the nondepository entities, the strong risk-

management practices within the nondepository

entities, or the corporate structure of the holding

company. The holding company maintains an

appropriate capital allocation across the organi-

zation commensurate with associated risks. Intra-

group exposures, including servicing agree-

ments, areveryunlikelyto undermine the ﬁnancial

condition of the subsidiary depository institu-

tion(s). Parent company cash ﬂow is sufﬁcient

and not dependent on excessive dividend pay-

ments from subsidiaries. The potential risks

posed to the subsidiary depository institution(s)

by strategic plans, the control environment, risk

concentrations, or legal or reputational issues

within or facing the nondepository entities are

minor in nature and can be addressed in the

normal course of business.

Rating 2 (Limited Likelihood of Signiﬁcant

Negative Impact). A rating of 2 indicates a

limited likelihood that the nondepository enti-

ties of the holding company will have a signiﬁ-

cant negative impact on the subsidiary deposi-

tory institution(s) due to the adequate ﬁnancial

condition of the nondepository entities, the satis-

factory risk-management practices within the

parent nondepository entities, or the corporate

structure of the holding company. The holding

company maintains adequate capital allocation

across the organization commensurate with asso-

ciated risks. Intra-group exposures, including

servicing agreements, are unlikely to undermine

the ﬁnancial condition of the subsidiary deposi-

tory institution(s). Parent company cash ﬂow is

satisfactory and generally does not require exces-

sive dividend payments from subsidiaries. The

potential risks posed to the subsidiary deposi-

tory institution(s) by strategic plans, the control

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 17

environment, risk concentrations, or legal or

reputational issues within the nondepository en-

tities are modest and can be addressed in the

normal course of business.

Rating 3 (Moderate Likelihood of Signiﬁcant

Negative Impact). A rating of 3 indicates a

moderate likelihood that the aggregate impact of

the nondepository entities of the holding com-

pany on the subsidiary depository institution(s)

will have a signiﬁcant negative impact on the

subsidiary depository institution(s) due to weak-

nesses in the ﬁnancial condition and/or risk

management practices of the nondepository enti-

ties. The holding company may have only mar-

ginally sufﬁcient allocation of capital across the

organization to support risks. Intra-group expo-

sures, including servicing agreements, may have

the potential to undermine the ﬁnancial condi-

tion of the subsidiary depository institution(s).

Parent company cash ﬂow may at times require

excessive dividend payments from subsidiaries.

Strategic growth plans, weaknesses in the con-

trol environment, risk concentrations or legal or

reputational issues within the nondepository en-

tities may pose signiﬁcant risks to the subsidiary

depository institution(s). A holding company

assigned a 3 impact rating requires more than

normal supervisory attention, as there could be

adverse effects on the safety and soundness of

the subsidiary depository institution(s) if correc-

tive action is not taken by management.

Rating 4 (Considerable Likelihood of Signiﬁ-

cant Negative Impact). A rating of 4 indicates

that there is a considerable likelihood that the

nondepository entities of the holding company

will have a signiﬁcant negative impact on the

subsidiary depository institution(s) due to weak-

nesses in the ﬁnancial condition and/or risk-

management practices of the nondepository enti-

ties. A 4-rated holding company may have

insufﬁcient capital within the nondepository en-

tities to support their risks and activities. Intra-

group exposures, including servicing agree-

ments, may also have the immediate potential to

undermine the ﬁnancial condition of the subsid-

iary depository institution(s). Parent company

cash ﬂow may be dependent on excessive divi-

dend payments from subsidiaries. Strategic

growth plans, weaknesses in the control envi-

ronment, risk concentrations or legal or reputa-

tional issues within the nondepository entities

may pose considerable risks to the subsidiary

depository institution(s). A holding company

assigned a 4 impact rating requires immediate

remedial action and close supervisory attention

because the nondepository entities could seri-

ously affect the safety and soundness of the

subsidiary depository institution(s).

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 18

Rating 5 (High Likelihood of Signiﬁcant Nega-

tive Impact). A rating of 5 indicates a high

likelihood that the aggregate impact of the non-

depository entities of the holding company on

the subsidiary depository institution(s) is or will

become signiﬁcantly negative due to substantial

weaknesses in the ﬁnancial condition and/or

risk-management practices of the nondepository

entities. Strategic growth plans, a deﬁcient con-

trol environment, risk concentrations or legal or

reputational issues within the nondepository en-

tities may pose critical risks to the subsidiary

depository institution(s). The parent company

also may be unable to meet its obligations with-

out excessive support from the subsidiary deposi-

tory institution(s). The holding company re-

quires immediate and close supervisory attention,

as the nondepository entities seriously jeopar-

dize the continued viability of the subsidiary

depository institution(s).

1062.0.7.5 (D) Depository Institutions

Component

The (D) component identiﬁes the overall condi-

tion of the subsidiary depository institution(s) of

the holding company. For holding companies

with only one subsidiary depository institution,

the (D) component rating generally will mirror

the CAMELS composite rating for that deposi-

tory institution. To arrive at a (D) component

rating for holding companies with multiple sub-

sidiary depository institutions, the CAMELS

composite ratings for each of the depository

institutions should be weighted, giving consider-

ation to asset size and the relative importance of

each depository institution within the overall

structure of the organization. In general, it is

expected that the resulting (D) component rating

will reﬂect the lead depository institution’s

CAMELS composite rating.

If in the process of analyzing the ﬁnancial

condition and risk-management programs of the

consolidated organization, a major difference of

opinion regarding the safety and soundness of

the subsidiary depository institution(s) emerges

between the Federal Reserve and the depository

institution’s primary regulator, then the (D) rat-

ing should reﬂect the Federal Reserve’s evalua-

tion.

RFI Rating System 1062.0

BHC Supervision Manual February 2019

Page 19

Supervisory Guidance for Assessing Risk Management at

Supervised Institutions with Total Consolidated Assets

Less than $100 Billion Section 1062.1

Managing risks is fundamental to the business

of banking. Accordingly, the Federal Reserve

places signiﬁcant supervisory emphasis on an

institution’s management of risk, including its

system of internal controls, when evaluating the

overall effectiveness of an institution’s risk man-

agement. An institution’s failure to establish a

management structure that adequately identiﬁes,

measures, monitors, and controls the risks of its

activities has long been considered unsafe-and-

unsound conduct. Principles of sound manage-

ment should apply to the entire spectrum of

risks facing an institution including, but not

limited to, credit, market, liquidity, operational,

compliance, and legal risk:

• Credit risk arises from the potential that a

borrower or counterparty will fail to perform

on an obligation.

• Market risk is the risk to a ﬁnancial institu-

tion’s condition resulting from adverse move-

ments in market rates or prices, including, but

not limited to, interest rates, foreign exchange

rates, commodity prices, or equity prices.

• Liquidity risk is the potential that a ﬁnancial

institution will be unable to meet its obliga-

tions as they come due because of an inability

to liquidate assets or obtain adequate funding

(referred to as “funding liquidity risk”) or that

it cannot easily unwind or offset speciﬁc expo-

sures without signiﬁcantly lowering market

prices because of inadequate market depth or

market disruptions (referred to as “market

liquidity risk”).

• Operational risk is the risk resulting from

inadequate or failed internal processes, people,

and systems or from external events.

• Compliance risk is the risk of regulatory sanc-

tions, ﬁnes, penalties or losses resulting from

failure to comply with laws, rules, regula-

tions, or other supervisory requirements appli-

cable to a ﬁnancial institution.

• Legal risk is the potential that actions against

the institution that result in unenforceable

contracts, lawsuits, legal sanctions, or adverse

judgments can disrupt or otherwise negatively

affect the operations or condition of a ﬁnan-

cial institution.

The risk-management expectations outlined in

this guidance are applicable to all supervised

institutions with total consolidated assets less

than $100 billion, including state member banks,

bank holding companies, savings and loan hold-

ing companies, and foreign banking organiza-

tions with combined total U.S. assets of less

than $100 billion. This guidance also applies to

insurance and commercial savings and loan

holding companies with total consolidated assets

less than $100 billion by providing core risk-

management guidance. Reserve Bank staff may

further consult with Board staff on appropriately

tailoring this guidance for these institutions.

This guidance is not applicable to intermediate

holding companies of foreign banking organiza-

tionsestablishedpursuant to the FederalReserve’s

Regulation YY with total consolidated assets of

$50 billion or more.

These risks and the activities associated with

them are addressed in greater detail in the Fed-

eral Reserve’s supervision manuals and other

guidance documents.

In practice, an institu-

tion’s business activities present various combi-

nations, concentrations, and interrelationships

of these risks depending on the nature and scope

of the particular activity. The following discus-

sion provides guidelines for the supervisory

assessment of the overall effectiveness of an

institution’s risk management and its formal or

informal systems for identifying, measuring,

monitoring, and controlling these risks. Refer to

SR-16-11 and its attachment.

1062.1.1 ELEMENTS OF RISK

MANAGEMENT

When evaluating the risk management at an

institution as part of the evaluation of the over-

all effectiveness of management, examiners

should place primary consideration on ﬁndings

relating to the following elements of a sound

risk-management system:

1. This deﬁnition conforms to the Basel Committee on

Banking Supervision’s “Principles for the Sound Manage-

ment of Operational Risk,” June 2011, Bank for International

Settlements.

2. Refer to the Federal Reserve’s Commercial Bank Exami-

nation Manual, this Bank Holding Company Supervision

Manual, Examination Manual for U.S. Branches and Agencies

of Foreign Banking Organizations, and relevant FFIEC Exami-

nation Manuals.

BHC Supervision Manual November 2021

Page 1

• board

and senior management oversight

• policies, procedures, and limits

• risk monitoring and management information

systems

• internal controls

Each of these elements is described further

below, along with a list of considerations rel-

evant to assessing each element. Examiners

should recognize that the considerations speci-

ﬁed in these guidelines are intended only to

assist in the evaluation of risk-management prac-

tices and are not a checklist of requirements for

each institution.

An institution’s risk-management processes

are expected to evolve in sophistication, com-

mensurate with the institution’s asset growth,

complexity, and risk. At a larger or more com-

plex organization, the institution should have

more sophisticated risk-management processes

that address the full range of risks regardless of

where the activity is conducted in the organiza-

tion. Moreover, while a holding company should

be able to assess the major risks of the consoli-

dated organization, examiners should expect a

parent company that centrally manages the op-

erations and functions of its subsidiary banks to

have more comprehensive, detailed, and devel-

oped risk-management systems than a parent

company that delegates the management of risks

to relatively autonomous subsidiaries.

For a small community banking organization

(CBO) engaged solely in traditional banking

activities and whose senior management is ac-

tively involved in the details of day-to-day

operations, relatively basic risk-management sys-

tems may be adequate. In accordance with the

Interagency Guidelines Establishing Standards

for Safety and Soundness, a CBO is expected, at

a minimum, to have internal controls, informa-

tion systems, and internal audits that are appro-

priate for the size of the institution and the

nature, scope, and risk of its activities.

The risk-management processes of a regional

banking organization (RBO) would typically

contain detailed guidelines that set speciﬁc pru-

dent limits on the principal types of risks rel-

evant to a RBO’s consolidated activities.

Fur-

thermore, because of the diversity and the

geographic dispersion of their activities, these

institutions will require relatively more sophisti-

cated information systems that provide manage-

ment with timely information that supports the

management of risks. The information systems,

in turn, should provide management with infor-

mation that present a consolidated and inte-

grated view of risks that are relevant to the

duties and responsibilities of individual manag-

ers, senior management, and the board of direc-

tors.

Consistent with the principle of national treat-

ment,

the Federal Reserve has the same super-

visory goals and standards for the U.S. opera-

tions of FBOs as for domestic organizations of

similar size, scope, and complexity. Given the

added element of foreign ownership, an FBO’s

risk-management processes and control func-

tions for the U.S. operations may be imple-

mented domestically or outside of the United

States. In cases where these functions are per-

formed outside of the United States, the FBO’s

oversight function, policies and procedures, and

information systems need to be sufﬁciently trans-

parent to allow U.S. supervisors to assess their

adequacy. Additionally, the FBO’s U.S. senior

management need to demonstrate and maintain

a thorough understanding of all relevant risks

affecting the U.S. operations and the associated

management information systems, used to man-

age and monitor these risks within the U.S.

operations.

The information systems at a larger institu-

tion will naturally require frequent monitoring

and testing by independent control areas and by

both internal and external auditors, to ensure the

integrity of the information used by the board of

directors and senior management in overseeing

compliance with policies and limits. Therefore,

3. For the purpose of this guidance, for foreign banking

organizations, “board of directors” refers to the equivalent

governing body of the U.S. operations of the FBO.

4. If these subsidiaries are regulated by another federal

banking agency, Federal Reserve examiners should rely to the

fullest extent possible on the conclusions drawn by relevant

regulators regarding risk management. See also,

SR-16-4,

“Relying on the Work of the Regulators of the Subsidiary

Insured Depository Institution(s) of Bank. Holding Compa-

nies and Savings and Loan Holding Companies with Total

Consolidated Assets of Less than $100 Billion.”

5. Refer to 12 CFR 208, Appendix D-1, the Interagency

Guidelines Establishing Standards for Safety and Soundness.

6. The Federal Reserve considers an RBO to be a midsize

ﬁnancial institution with total consolidated assets between

$10 and $100 billion.

7. Subpart C of the Federal Reserve’s Regulation YY

includes risk committee requirements for bank holding com-

panies with total consolidated assets between $50 billion and

$100 billion.

8. National treatment requires nondiscrimination between

domestic and foreign ﬁrms, or treatment of foreign entities

that is no less favorable than that accorded to domestic

enterprises in like circumstances. The International Banking

Act of 1978 generally gives foreign banks operating in the

United States the same powers as domestic banking organiza-

tions and subjects them to the same restrictions and obliga-

tions.

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BHC Supervision Manual November 2021

Page 2

an institution’s risk oversight function needs to

be sufﬁciently independent of the business lines

to achieve an adequate separation of duties and

the avoidance of conﬂicts of interest.

1062.1.1.1 Board and Senior

Management Oversight

The board of directors has the responsibility for

establishing the level of risk that the institution

should take. Accordingly, the board of directors

should approve the institution’s overall business

strategies and signiﬁcant policies, including those

related to managing risks. Further, the board of

directors should also ensure that senior manage-

ment is fully capable of implementing the insti-

tution’s business strategies and risk limits. In

evaluating senior management, the board of

directors should consider whether management

is taking the steps necessary to identify, mea-

sure, monitor, and control these risks.

The board of directors should collectively

have a balance of skills, knowledge, and experi-

ence to clearly understand the activities and

risks to which the institution is exposed. The

board of directors should take steps to develop

an appropriate understanding of the risks the

institution faces, through brieﬁngs from experts

internal to their organization and potentially

from external experts. The institution’s manage-

ment information systems should provide the

board of directors with sufﬁcient information to

identify the size and signiﬁcance of the risks.

Using this knowledge and information, the board

of directors should provide clear guidance regard-

ing the level of exposures acceptable to the

institution and oversee senior management’s

implementation of the procedures and controls

necessary to comply with approved policies.

Senior management is responsible for imple-

menting strategies set by the board of directors

in a manner that controls risks and that complies

with laws, rules, regulations, or other supervi-

sory requirements on both a long-term and day-

to-day basis. Accordingly, senior management

should be fully involved in and possess sufﬁ-

cient knowledge of all activities to ensure that

appropriate policies, controls, and risk monitor-

ing systems are in place and that accountability

and lines of authority are clearly delineated.

Senior management is also responsible for estab-

lishing and communicating a strong awareness

of the need for effective risk management, inter-

nal controls, and high ethical business practices.

To fulﬁll these responsibilities, senior manage-

ment needs to have a thorough understanding of

banking and ﬁnancial market activities and de-

tailed knowledge of the institution’s activities,

including the internal controls that are necessary

to limit the related risks.

In assessing the quality of the oversight pro-

vided by the board of directors and senior man-

agement, examiners should consider the

following:

• The board of directors has approved signiﬁ-

cant policies to establish risk tolerances for

the institution’s activities and periodically

reviews risk exposure limits to align with

changes in the institution’s strategies, address

newactivitiesandproducts, andreactto changes

in the industry and market conditions.

• Senior management has identiﬁed and has a

clear understanding and working knowledge

of the risks inherent in the institution’s activi-

ties. Senior management also remains in-

formed about these risks as the institution’s

business activities evolve or expand and as

changes and innovations occur in ﬁnancial

markets and risk-management practices.

• Senior management has identiﬁed and re-

viewed risks associated with engaging in new

activities or introducing new products to en-

sure that the necessary infrastructure and inter-

nal controls are in place to manage the related

risks.

• Senior management has ensured that the insti-

tution’s activities are managed and staffed by

personnel with the knowledge, experience,

and expertise consistent with the nature and

scope of the institution’s activities and risks.

• All levels of senior management provide ap-

propriate management of the day-to-day activi-

ties of ofﬁcers and employees, including over-

sight of senior ofﬁcers or heads of business

lines.

• Senior management has established and main-

tains effective information systems to identify,

measure, monitor, and control the sources of

risks to the institution.

1062.1.1.2 Policies, Procedures, and

Limits

Although an institution’s board of directors ap-

proves an institution’s overall business strategy

and policy framework, senior management de-

velops and implements the institution’s risk-

management policies and procedures that ad-

dress the types of risks arising from its activities.

Once the risks are properly identiﬁed, the insti-

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BHC Supervision Manual November 2021

Page 3

tution’s policies and procedures should provide

guidance for the day-to-day implementation of

business strategies, including limits designed to

prevent excessive and imprudent risks. An insti-

tution should have policies and procedures that

address its signiﬁcant activities and risks with

the appropriate level of detail to address the

type and complexity of the institution’s opera-

tions. A smaller, less complex institution that

has effective senior management directly in-

volved in day-to-day operations would gener-

ally not be expected to have policies as sophisti-

cated as larger institutions. In a larger institution,

where senior managers rely on widely-dispersed

staffs to implement strategies for more varied

and complex businesses, far more detailed poli-

cies and procedures would generally be expected.

In either case, senior management is expected to

ensure that policies and procedures address the

institution’s material areas of risk and that poli-

cies and procedures are modiﬁed when neces-

sary to respond to signiﬁcant changes in the

institution’s activities or business conditions.

The following guidelines should assist exam-

iners in evaluating an institution’s policies,

procedures, and limits

• The institution’s policies, procedures, and lim-

its provide for adequate identiﬁcation, mea-

surement, monitoring, and control of the risks

posed by its signiﬁcant risk-taking activities.

• The institution’s policies, procedures, and lim-

its are consistent with its stated strategy and

risk proﬁle.

• The policies and procedures establish account-

ability and lines of authority across the institu-

tion’s activities.

• The policies and procedures provide for the

review and approval of new business lines,

products, and activities, as well as material

modiﬁcations to existing activities, services,

and products, to ensure that the institution has

the infrastructure necessary to identify, mea-

sure, monitor, and control associated risks

before engaging in a new or modiﬁed busi-

ness line, product, or activity.

1062.1.1.3 Risk Monitoring and

Management Information Systems

Institutions of all sizes are expected to have risk

monitoring and management information sys-

tems in place that provide the board of directors

and senior management with timely information

and a clear understanding of the institution’s

business activities and risk exposures. The so-

phistication of risk monitoring and management

information systems should be commensurate

with the complexity and diversity of the institu-

tion’s operations. Accordingly, a smaller and

less complex institution may require less fre-

quent management and board reports to support

risk monitoring activities. For example, these

reports may include, daily or weekly balance

sheets and income statements, a watch list for

potentially troubled loans, a report on past due

loans, an interest rate risk report, and similar

items. In contrast, a larger, more complex insti-

tution would be expected to have much more

comprehensive reporting and monitoring sys-

tems, which includes more frequent reporting to

board and senior management, tighter monitor-

ing of high-risk activities, and the ability to

aggregate risks on a fully consolidated basis

across all business lines, legal entities, and

activities.

In assessing an institution’s measurement and

monitoring of risk and its management reports

and information systems, examiners should

consider whether these conditions exist:

• The institution’s risk monitoring practices and

reports address all of its material risks.

• Key assumptions, data sources, models, and

procedures used in measuring and monitoring

risks are appropriate and adequately docu-

mented and tested for reliability on an on-

going basis.

• Reports and other forms of communication

address the complexity and range of an insti-

tution’s activities, monitor key exposures and

compliance with established limits and strat-

egy, and as appropriate, compare actual versus

expected performance.

• Reports to the board of directors and senior

management are accurate, and provide timely

and sufﬁcient information to identify any ad-

verse trends and to evaluate the level of risks

faced by the institution.

1062.1.1.4 Internal Controls

An effective internal control structure is critical

to the safe and sound operation of an institution.

Effective internal controls promote reliable ﬁnan-

cial and regulatory reporting, safeguard assets,

and help to ensure compliance with relevant

laws, rules, regulations, supervisory require-

9. See also SR-11-7, “Guidance on Model Risk Manage-

ment.”

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BHC Supervision Manual November 2021

Page 4

ments, and institutional policies. Therefore, an

institution’s senior management is responsible

for establishing and maintaining an effective

system of controls, including the enforcement of

ofﬁcial lines of authority and the appropriate

segregation of duties.

Adequate segregation of duties is a funda-

mental and essential element of a sound risk

management and internal control system. Fail-

ure to implement and maintain an adequate seg-

regation of duties can constitute an unsafe-and-

unsound practice and possibly lead to serious

losses or otherwise compromise the integrity of

the institution’s internal controls. Serious lapses

or deﬁciencies in internal controls, including

inadequate segregation of duties, may warrant

supervisory action, including formal enforce-

ment action.

Internal controls should be tested by an inde-

pendent party who reports either directly to the

institution’s board of directors or its designated

committee, which is typically the audit

committee.

However, small CBOs whose size

and complexity do not warrant a full scale inter-

nal audit function may rely on regular reviews

of essential internal controls conducted by other

institution personnel. Given the importance of

appropriate internal controls to institutions of all

sizes and risk proﬁles, the results of audits or

reviews, whether conducted by an internal audi-

tor or by other personnel, should be adequately

documented, as should management’s responses

to the ﬁndings. In addition, communication chan-

nels should allow for adverse or sensitive ﬁnd-

ings to be reported directly to the board of

directors or to the relevant board committee.

In evaluating internal controls, examiners

should consider whether these conditions are

met:

• The system of internal controls is appropriate

to the type and level of risks posed by the

nature and scope of the institution’s activities.

• The institution’s organizational structure estab-

lishes clear lines of authority and responsibil-

ity for risk management and for monitoring

adherence to policies, procedures, and limits.

• Internal audit or other control functions, such

as loan review and compliance, provide for

independence and objectivity.

• The ofﬁcial organizational structures reﬂect

actual operating practices and management

responsibilities and authority over a particular

business line or activity.

• Financial, operational, risk management, and

regulatory reports are reliable, accurate, and

timely; and wherever applicable, material ex-

ceptions are noted and promptly investigated

or remediated.

• Policies and procedures for control functions

support compliance with applicable laws, rules,

regulations, or other supervisory require-

ments.

• Internal controls and information systems are

adequately tested and reviewed; the coverage,

procedures, ﬁndings, and responses to audits,

regulatory examinations, and other review

tests are adequately documented; identiﬁed

material weaknesses are given appropriate and

timely, high-level attention; and manage-

ment’s actions to address material weaknesses

are objectively veriﬁed and reviewed.

• The institution’s board of directors, or audit

committee, and senior management are respon-

sible for developing and implementing an

effective system of internal controls and that

the internal controls are operating effectively.

1062.1.1.5 Conclusions

Examiners are expected to assess risk manage-

ment for an institution and assign formal ratings

of “risk management” as described in the Com-

mercial Bank Examination Manual for state

member banks, this manual for holding compa-

nies, and the Examination Manual for U.S.

Branches and Agencies of Foreign Banking

Organizations.

In reports of examination or

inspection, and in transmittal letters to the boards

of directors of state member banks, holding

companies,

and to the FBO ofﬁcer of the U.S.

operations, examination staff should speciﬁcally

10. Given the importance of the internal audit function,

several additional policy statements have been issued. For

comprehensive guidance on internal audit, see

SR-03-5,

“Amended Interagency Guidance on the Internal Audit Func-

tion and its Outsourcing” and for institutions with more than

$10 billion in assets, see

SR-13-1/ CA-13-1, “Supplemental

Policy Statement on the Internal Audit Function and Its Out-

sourcing.”

11. Refer to section 1200.1 of the Commercial Bank Exami-

nation Manual; section 1062.0 of the Bank Holding Company

Supervision Manual; and section 2003.1 of the Examination

Manual for U.S. Branches and Agencies of Foreign Banking

Organizations. For savings and loan holding companies, see

also

SR-14-9, “Incorporation of Federal Reserve Policies into

the Savings and Loan Holding Company Supervision Pro-

gram.”

12.

SR-16-11 applies to insurance and commercial savings

and loan holding companies with total consolidated assets less

than $100 billion by providing core risk-management guid-

ance. Reserve Bank staff should further consult with Board

staff on appropriately tailoring this guidance for these institu-

tions.

Assessing Risk Management at Institutions with Total Consolidated Assets Less than $100 Billion 1062.1

BHC Supervision Manual November 2021

Page 5

reference the types and nature of corrective

actions that need to be taken by an institution to

address noted risk management and internal

control deﬁciencies. Where appropriate, the Fed-

eral Reserve will advise an institution that super-

visory action will be initiated, if the institution

fails to timely remediate risk-management weak-

nesses when such failures create the potential

for serious losses or if material deﬁciencies or

situations threaten its safety and soundness.

Such supervisory actions may include formal

enforcement actions against the institution, or

its responsible ofﬁcers and directors, or both,

and would require the immediate implementa-

tion of all necessary corrective measures.

If bank or holding company subsidiaries are

regulated by another federal banking agency,

Federal Reserve examiners should rely to the

fullest extent possible on the conclusions drawn

by relevant regulators regarding risk manage-

ment. See also, SR-16-4, “Relying on the Work

of the Regulators of the Subsidiary Insured

Depository Institution(s) of Bank Holding Com-

panies and Savings and Loan Holding Compa-

nies with Total Consolidated Assets of Less

than $100 Billion.”

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BHC Supervision Manual November 2021

Page 6

Holding Company Ratings Applicability and

Inspection Frequency Section 1063.0

The purpose of this section is to provide an

overview of the inspection scope and frequency

expectations for bank holding companies (BHCs)

and savings and loan holding companies (SLHCs)

supervised by the Federal Reserve. The Federal

Reserve utilizes different rating systems to as-

sess these and other holding companies.

BHCs and non-insurance, non-commercial

SLHCs with total consolidated assets of $100 bil-

lion or more generally are subject to the large

ﬁnancial institution (LFI) rating system. (See

section 1060.0 of this manual.) U.S. intermedi-

ate holding companies of foreign banking orga-

nizations with combined U.S. assets of $50 bil-

lion or more established pursuant to the Federal

Reserve’s Regulation YY are also subject to the

LFI rating system.

BHCs and non-insurance and non-

commercial SLHCs with less than $100 billion

in total consolidated assets generally are subject

to the RFI rating system. (See section 1062.0 of

this manual.) However, noncomplex holding

companies with less than $3 billion in total

consolidated assets only receive the risk-

management rating and composite rating from

the RFI rating system.

BHCs exempt from the prohibitions of sec-

tion 4 of the Bank Holding Company Act of 1956,

as amended, as a result of any of the following

exemptions, will not be subject to any required

periodic inspection:

1. section4(a)(2)—permanent grandfather rights

2. section 4(c)(i)—labor, agricultural, or horti-

cultural organization

3. section 4(c)(ii)—85 percent family-owned

4. section 4(c)(12)—irrevocable declaration to

cease to be a BHC

5. section 4(d)—hardship exemption

However, the Reserve Bank should continue

to monitor the ﬁnancial condition of such hold-

ing companies and should conduct inspections

whenever there is any indication of a potential

problem in a subsidiary bank.

BHC Supervision Manual February 2023

Page 1

1063.0.1 RATING SYSTEMS FOR HOLDING COMPANIES

Rating System Rating System Components Applicability

LFI rating

(

SR-19-3/CA-19-2)

• Capital planning and positions

• Liquidity risk management and

positions

• Governance and controls

• BHCs with total consolidated assets of

$100 billion or more

• Non-insurance, non-commercial

SLHCs with total consolidated assets

of $100 billion or more

• U.S. intermediate holding companies

of foreign banking organizations with

combined U.S. assets of $50 billion or

more established under the Board’s

Regulation YY

RFI rating

(

SR-19-4/CA-19-3)

• Risk management (4 subcomponents)

C Board and senior management

oversight,

C Policies, procedures, and limits,

C Risk monitoring and management

information systems, and

C Internal controls

• Financial condition (4 subcompo-

nents)

C Capital,

C Asset quality,

C Earnings, and

C Liquidity

• Impact

• Composite rating

• Depository institutions

• BHCs with $3 billion or more and less

than $100 billion in total consolidated

assets

• Non-insurance and non-commercial

SLHCs with $3 billion or more and

less than $100 billion in total consoli-

dated assets

• Complex BHCs and complex non-

insurance and non-commercial SLHCs

with less than $3 billion in total con-

solidated assets

Modiﬁed RFI rating

(

SR-13-21)

• Risk-management

(no subcomponents)

• Composite rating

Noncomplex BHCs and noncomplex

non-insurance and non-commercial

SLHCs with less than $3 billion in total

consolidated assets

Supervised

insurance

organization

rating (

SR-22-8)

• Governance and controls,

• Capital management, and

• Liquidity management

Supervised insurance organizations

Indicative RFI

rating

Indicates to the ﬁrm how it would be

rated if the RFI rating system was

formally applied.

Commercial SLHCs

1. A supervised insurance organization is a depository institution holding company that is an insurance underwriting

company, or that has over 25 percent of its consolidated assets held by insurance underwriting subsidiaries or has been otherwise

designated as a supervised insurance organization by Federal Reserve staff.

2. SLHCs are considered to be “commercial SLHCs” if they derive 50 percent or more of their total consolidated assets or

total revenues from activities that are not ﬁnancial in nature under section 4(k) of the Bank Holding Company Act of 1956, as

amended (12 USC 1843(k)).

Holding Company Ratings Applicability and Inspection Frequency 1063.0

BHC Supervision Manual February 2023

Page 2

1063.0.2 GENERAL INSPECTION FREQUENCY FOR A HOLDING COMPANY

Total consolidated asset size

Type of holding company $100 billion

or more

$10 billion

or more and

less than

$100 billion

$3 billion

or more and

less than

$10 billion

Less than

$3 billion

(complex)

Less than

$3 billion

(non-

complex)

Bank holding company

Ratings (or indicative

ratings) assigned and

communicated to ﬁrms on

at least an annual basis,

and more frequently as

warranted.

See the table below and

SR letter 13-21,

and its

attachment for more information

on inspection frequency and scope.

Non-insurance and

non-commercial savings and

loan holding company

Commercial savings and loan

holding company

Intermediate holding

company

U.S. intermediate holding companies of foreign banking organizations

established under the Board’s Regulation YY that have $50 billion

or more in total consolidated assets are assigned an LFI rating on

at least an annual basis, and more frequently as warranted.

Supervised insurance

organization

“Complex” supervised insurance organizations are assigned ratings on

an annual basis.

Noncomplex supervised insurance organizations

are assigned ratings no less often than every other year.

1. BHCs exempt from the prohibitions of section 4 of the Bank Holding Company Act of 1956, as amended, are not subject to

any required periodic inspection.

2. SLHCs are considered to be “commercial savings and loan holding companies” if they derive 50 percent or more of their

total consolidated assets or total revenues from activities that are not ﬁnancial in nature under section 4(k) of the Bank Holding

Company Act of 1956, as amended (12 USC 1843(k)).

3. A supervised insurance organization is automatically classiﬁed as “complex” if its depository institution’s average assets

exceed $100 billion.

Holding Company Ratings Applicability and Inspection Frequency 1063.0

BHC Supervision Manual February 2023

Page 3

1063.0.3 Small Holding Company Inspection Scope and Frequency

Asset size $3 billion or more and less than $10 billion Less than $3 billion

Complexity

Complex Noncomplex Complex Noncomplex

Type of rating Complete RFI rating Complete RFI rating Complete RFI rating

Risk-management rating

and composite rating only

Scope and frequency

Rating of

1 or 2

Full scope on-site inspection is

expected annually.

Additional targeted follow-up may

be needed in response to off-site

surveillance program results.

Off-site targeted inspection is

expected every two years.

Additional targeted follow-up may

be needed in response to off-site

surveillance program results.

Off-site review should be

conducted upon receipt of the lead

DI exam report or an updated

rating from the primary supervisor

using surveillance results and

relevant supervisory and ﬁnancial

information. If the information

obtained off-site is not sufﬁcient for

the Reserve Bank to determine the

overall condition of the company

and to assign a complete RFI rating,

the Reserve Bank should conduct an

on-site review of the company.

Any on-site review should be

targeted at those areas where

additional information or analysis is

needed to assign a complete

supervisory rating.

If all subsidiary DIs have a management component

rating and a composite supervisory rating of “1”

or “2” and no material holding company issues

are otherwise indicated, the Reserve Bank should

assign only a composite rating and risk-manage-

ment rating to the holding company based on the

ratings of the lead DI.

Rating of

3, 4, or 5

Full scope on-site inspection is

expected annually.

If the primary supervisor has

conducted an interim examination

or changed the rating at the lead

depository institution (DI), the

Reserve Bank should conduct an

additional targeted inspection and

update the rating if necessary. The

targeted inspection may be

conducted off-site and should start

within 60 days of receiving the

examination report for the lead DI.

Additional targeted follow-up may

be needed in response to off-site

surveillance program results.

Full-scope off-site inspection is

expected annually.

If the primary supervisor has

conducted an interim examination

or changed the rating at the lead DI,

the Reserve Bank staff should

conduct an additional targeted

inspection and update the rating if

necessary. This targeted inspection

may be conducted off-site and

should start within 60 days of

receiving the examination report for

the lead DI.

Additional targeted follow-up may

be needed in response to off-site

surveillance program results.

If one or more subsidiary DIs have a management

component rating or a composite supervisory rating

of “3,” “4,” or “5” or a material holding company

issue is otherwise indicated, an off-site review is

expected upon receipt of the lead DI exam report

or an updated rating from the primary supervisor

using surveillance results and relevant supervisory

and ﬁnancial information. If the information

obtained off-site is not sufﬁcient for the Reserve

Bank to determine the overall condition of the

company and to assign a risk-management rating

and a composite rating, contact the holding company

to obtain more information.

Report

expectations

Rating of

1, 2, or 3

A letter-format report template has been developed for supervision staff completing reports for holding

companies that receive a complete RFI rating and have a composite rating of 1, 2, or 3.

Off-site reviews culminate in the issuance of a

transmittal letter communicating the ratings to the

company. Information in the transmittal letter review

focuses on parent and nonbanking activities.

Examiners also rely on the primary regulator’s work

on the subsidiary insured depository institution and

relevant surveillance results.

Rating of

4 or 5

Letter-format report of inspection may be prepared as indicated in the Community Bank Supervision Process

section of the Commercial Bank Examination Manual.

1. Full-scope inspection covers all areas of interest to the Federal Reserve in depth; targeted inspections will focus intensely on one or two activities.

2. Complexity factors include the size and structure of the company; the extent of intercompany transactions between insured depository institution subsidiaries and the holding company or

uninsured subsidiaries of the holding company; the risk, scale and complexity of activities of any nondepository subsidiaries; and the degree of leverage at the holding company, including the

extent of its debt outstanding to the public. Other factors are also noted in the text of SR-13-21.

Holding Company Ratings Applicability and Inspection Frequency 1063.0

BHC Supervision Manual February 2023

Page 4

Nondisclosure of Supervisory Ratings and Conﬁdential

Supervisory Information Section 1065.0

1065.0.1 LIMITED DISCLOSURE OF

CONFIDENTIAL COMPOSITE AND

COMPONENT RATINGS IN

INSPECTIONS AND EXAMINATIONS

The Federal Reserve provides senior manage-

ment and directors of supervised ﬁnancial insti-

tutions the numeric and alphabetic component

ratings assigned under various supervisory rat-

ing systems.

(See SR-96-26, “Provision of Indi-

vidual Components of Supervisory Rating Sys-

tems to Management and Boards of Directors.”)

This disclosure includes the ratings assigned to

management under the holding company rating

systems.

Depending upon the size and complexity of

the organization, the disclosure of the rating and

its components is made to the holding company

in writing through formal examination or inspec-

tion reports, reports summarizing the results of

targeted reviews, a roll-up of those reviews into

a comprehensive report, any other supervisory

communication, or some combination thereof.

In conjunction with disclosing the ratings and

their components to a holding company, exam-

iners or supervisory ofﬁcials should clearly ex-

plain what the ratings mean to the board of

directors and management. During the exit meet-

ing, the examiner should discuss key overall

inspection ﬁndings, including preliminary com-

posite and component numeric ratings.

Indisclosing the assignedratings, theexaminer-

in-charge should remind the board of directors

and management that the ratings are part of the

ﬁndings of the inspection or supervisory activity

and are privileged and conﬁdential under appli-

cable law.

When examiners change a ﬁrm’s

ratings, examiners need to inform the ﬁrm’s

board of directors and management about the

rating change. Examiners should not disclose

ratings to the holding company’s directors and

management until preliminary approval has been

received from the appropriate senior Reserve

Bank supervisory ofﬁcials.

1065.0.2 CONFIDENTIALITY OF THE

SUPERVISORY RATING AND OTHER

NONPUBLIC SUPERVISORY

INFORMATION

The holding company inspection report and

other supervisory communications constitute or

contain the Board’s conﬁdential supervisory

information (CSI), which is nonpublic informa-

tion belonging to the Board.

The Board’s Rules

Regarding Availability of Information speciﬁ-

cally provide that, except in very limited cir-

cumstances, supervised ﬁnancial institutions may

not disclose CSI outside of the ﬁnancial institu-

tion, including inspection or examination ﬁnd-

ings, nor make any representations concerning

an examination or inspection report or the re-

port’s ﬁndings, without the prior written permis-

sion of the Board.

Any person who discloses or

uses CSI except as expressly permitted by the

appropriate federal banking agency or as pro-

vided by the agency’s regulations may be sub-

ject to the criminal penalties provided in

18 USC 641.

The legal prohibition on the release of CSI

applies to all ﬁnancial institutions examined by

the agencies, including bank and savings and

loan holding companies, Edge corporations, and

the U.S. branches or agencies of foreign banking

organizations that receive conﬁdential supervi-

sory ratings, including the LFI rating, RFI/C(D)

rating, ROCA rating, and CAMEO rating.

1. The supervisory ratings are disclosed for the following

rating systems:

• CAMELS (state member banks)

• RFI/C(D) and Large Financial Institution (LFI) rating

system (bank holding companies, and savings and

loan holding companies)

• CAMEO (Edge and agreement corporations and over-

seas subsidiaries of U.S. banks)

• ROCA (U.S. branches and agencies of foreign bank-

ing organizations)

• Uniform Interagency Trust Rating System (UITRS)

• The interagency Uniform Rating System for Informa-

tion Technology (URSIT)

2. See

SR-19-3 / CA-19-2, “Large Financial Institution

(LFI) Rating System” and

SR-19-4 / CA-19-3, “Supervisory

Rating System for Holding Companies with Total Consoli-

dated Assets Less Than $100 billion.”

3. The inspection report should also include appropriate

language stating that the ﬁndings of the inspection are privi-

leged and conﬁdential under applicable law.

4. See, e.g., 12 CFR 261.2(c)(1), 261.20(g), and

261.22(e).

5. 12 CFR part 261, subpart C. The regulation authorizes

supervised ﬁnancial institutions to disclose CSI to their direc-

tors, ofﬁcers, and employees and to the directors, ofﬁcers, and

employees of their parent holding companies. 12 CFR

261.20(b)(1). In addition, institutions may also disclose CSI

to their outside counsel and auditors on the premises of the

institution. 12 CFR 261.20(b)(2).

6. RFI/C(D), LFI, ROCA, and CAMEO ratings are as-

signed by the Federal Reserve Board as a result of an exami-

nation or inspection. For noncomplex holding companies with

assets of $3 billion or less, only risk-management and com-

posite ratings are assigned. ROCA ratings are assigned to the

U.S. branches, agencies, and commercial lending companies

of foreign banking organizations. The ROCA rating compo-

nents are risk management, operational controls, compliance,

BHC Supervision Manual February 2020

Page 1

with the CAMELS rating, examiners communi-

cate these ratings to the regulated institutions in

reports or other supervisory communications,

which are the property of the Board.

Financial institutions that receive requests for

conﬁdential supervisory ratings should refer all

requesters to the following publicly available

information in lieu of disclosing any CSI, includ-

ing the CAMELS rating:

• for banks and savings associations, an institu-

tion’s quarterly reports of condition (Call Re-

ports) (see 12 USC 1817)

• for holding companies or foreign banks with

U.S. operations, an institution’s quarterly and

annual FR Y or H-(b)11 reports (see 12

USC 1844, 3106, 3108, 601–604a,

and 611–631)

• for national banks, the annual disclosure state-

ment (see 12 CFR 18.3)

• for banks, an institution’s Uniform Bank Per-

formance Report (UBPR), which is available

to all interested parties at

www.fﬁec.gov and

is designed for summary and in-depth analy-

sis of banks;

• an institution’s publicly available ﬁlings, if

any, ﬁled with the appropriate federal banking

agency (15 USC 78(I)(i)) or with the U.S. Se-

curities and Exchange Commission

• any reports or ratings on the institution com-

piled by private companies that track the per-

formance of ﬁnancial institutions

• any reports or ratings issued by private rating

services on public debt issued by an institu-

tion

• any publicly available cease-and-desist order

or enforcement proceeding against an institu-

tion

• any reports or other sources of information on

institution performance or internal matters

created by the institution that do not contain

information prohibited from release by law or

regulation

1065.0.3 CONFIDENTIALITY

PROVISIONS IN THIRD-PARTY

AGREEMENTS

Under the Federal Reserve’s statutory examina-

tion authority, examiners may review all books

and records maintained on the premises of a

ﬁnancial institution that is subject to Federal

Reserve supervision. This authority extends to

any and all documents on the premises. In addi-

tion, under the Board’s Rules Regarding Avail-

ability of Information, other than as set forth in

the rules, Board-supervised organizations are

prohibited from disclosing CSI to third parties

without prior written permission of the Board’s

General Counsel. CSI is deﬁned to include any

information related to the examination or inspec-

tion of a banking organization, including super-

visory ratings.

Signiﬁcantly, Board staff has

taken the position that identiﬁcation of informa-

tion requested by, or provided to, supervisory

staff—including the fact that an inspection has

taken or will take place—is related to an inspec-

tion and falls within the deﬁnition of CSI. Ac-

cordingly, it is contrary to Federal Reserve regu-

lation and policy for agreements between a

banking organization and its counterparties (for

example, mutual funds, hedge funds, and other

trading counterparties) or other third parties to

contain conﬁdentiality provisions that

1. restrict the banking organization from pro-

viding information to Federal Reserve super-

visory staff;

2. require or permit, without the prior approval

of the Federal Reserve, the banking organiza-

tion to disclose to a counterparty that any

information will be or was provided to Fed-

eral Reserve supervisory staff; or

3. require or permit, without the prior approval

of the Federal Reserve, the banking organiza-

tion to inform a counterparty of a current or

upcoming Federal Reserve inspection or any

nonpublic Federal Reserve supervisory ini-

tiative or action.

Banking organizations that have entered into

agreements containing such conﬁdentiality

provisions are subject to legal risk. (See

SR-07-

, “Conﬁdentiality Provisions in Third-Party

Agreements,” and

SR-97-17, “Access to Books

and Records of Financial Institutions During

Examinations and Inspections.”)

and asset quality. CAMEO ratings are assigned to Edge corpo-

rations and the overseas branches and subsidiaries of U.S.

banks. The CAMEO ratings components are capital, asset

quality, management, earnings, and operations and internal

controls.

7. Information on enforcement actions taken by the Fed-

eral Reserve may be found at

https://www.federalreserve.gov/

apps/enforcementactions/search.aspx

Information on enforcement actions taken by other federal

agencies, such as the Securities and Exchange Commission,

the Financial Crimes Enforcement Network, and the Depart-

ment of Justice, as well as foreign authorities, may also be

publicly available.

8. See 12 CFR 261.2(c)(1)(i).

Nondisclosure of Supervisory Ratings and Conﬁdential Supervisory Information 1065.0

BHC Supervision Manual February 2020

Page 2

Communication of Supervisory Findings Section 1070.1

1070.1.1 INTRODUCTION

This section on the communication of supervi-

sory ﬁndings is based on the guidance in

SR-13-13/CA-13-10, “Supervisory Consider-

ations for the Communication of Supervisory

Findings,” which applies to all Federal Reserve-

supervised banking organizations. In a supervi-

sory ﬁnding, examiners should convey, if evi-

dent, both the root cause of the ﬁnding and the

potential effect of the ﬁnding on the organiza-

tion. Examiners should also consider the “State-

ment Clarifying the Role of Supervisory Guid-

ance,” for more information on communication

of supervisory ﬁndings, including the appropri-

ate identiﬁcation of issues that could have a

negative effect on safety and soundness on the

ﬁnancial institution; could cause consumer harm;

or could cause violations of laws, regulations,

ﬁnal agency orders, or other legally enforceable

conditions.

1070.1.2 COMMUNICATION OF

SUPERVISORY FINDINGS

Communication of supervisory ﬁndings to the

organization’s board of directors is an important

part of the supervision of a banking organiza-

tion. While the board itself may not directly

undertake the work to remediate supervisory

ﬁndings as senior management is responsible

for the organization’s day-to-day operations, it

is nevertheless important that the board be made

aware of signiﬁcant supervisory issues and ulti-

mately be accountable for the safety and sound-

ness and assurance of compliance with applica-

ble laws and regulations of the organization.

Depending upon the size and complexity of

the organization, supervisory ﬁndings are com-

municated in writing through formal examina-

tion or inspection reports, reports summarizing

the results of targeted reviews, a roll-up of those

reviews into a comprehensive report, any other

supervisory communication, or some combina-

tion thereof. These written communications (re-

ferred to collectively as “reports” in this sec-

tion) are generally directed to the board of

directors, or an executive-level committee of the

board as appropriate.

In turn, the board of

directors (or executive-level committee of the

board) typically will direct the organization’s

management to take corrective action and will

provide management with appropriate oversight,

including approvals of proposed management

actions as necessary.

To be effective, the communication of super-

visory ﬁndings must be (1) written in clear and

concise language, (2) prioritized based upon

degree of importance, and (3) focused on any

signiﬁcant matters that require attention. Reserve

Banks must formally communicate matters re-

quiring immediate attention (MRIAs) and mat-

ters requiring attention (MRAs) resulting from

any supervisory activity to the organization in

these written reports. In order to promote an

understanding of these terms, examiners should

include deﬁnitions of MRIAs and MRAs in all

supervisory documents communicating supervi-

sory ﬁndings.

When included in a safety-and-

soundness examination or inspection report,

MRIAs and MRAs shouldbe listed in the “Matters

Requiring Attention” section. In the case of

ﬁndings from consumer compliance examina-

tions, MRIAs and MRAs should be reﬂected in

the “Executive Summary and Examination

Ratings” section of the consumer affairs report

of examination. Only outstanding MRIAs and

MRAs are required to be discussed in the report;

however, examiners have discretion to discuss

closed MRIAs and MRAs in the report if such

discussion would be meaningful.

For large banking organizations, an annual

roll-up report summarizes the signiﬁcant ﬁnd-

ings, based on outstanding MRIAs or MRAs,

included in the reports of targeted reviews or

other supervisory activities conducted during

the supervisory cycle. These ﬁndings may be

grouped by major supervisory issues, rating

components, risks, or themes. This information

should enable the banking organization’s board

of directors and any executive-level committee

of the board to understand the substance and

status of outstanding MRIAs or MRAs and

focus their attention on the most critical and

time-sensitive issues.

1. 12 CFR part 262, appendix A and 86 Fed. Reg. 18,179

(April 8, 2021).

2. An executive-level committee of the board (such as, the

audit committee or risk committee) typically meets regularly,

keeps minutes of those meetings, and is accountable to and

routinely reports to the board of directors.

3. In a safety-and-soundness report, these deﬁnitions could

be included on the “Scope” page, in an appendix, or as a

footnote on the “Matters Requiring Attention” section. In a

consumer compliance report, these deﬁnitions could be included

on the “Executive Summary and Examination Ratings”

section.

BHC Supervision Manual November 2021

Page 1

Communications to banking organizations con-

cerning safety-and-soundness or consumer com-

pliance MRIAs or MRAs must specify a time-

frame within which the banking organization

must complete the corrective actions. In certain

circumstances, examiners may require the bank-

ing organization to submit an action plan that

identiﬁes remedial actions to be completed within

speciﬁed timeframes. Action plans with

intermediate- and long-term timeframes that

span more than one supervisory or examination

cycle with regard to safety-and-soundness mat-

ters, or a 12-month period with regard to con-

sumer compliance issues, should include interim

progress targets. Both safety-and-soundness and

consumer protection or compliance consider-

ations will remain a priority in determining

whether the organization’s timeframes to cor-

rect the matter are reasonable.

1070.1.2.1 Matters Requiring Immediate

Attention

MRIAs arising from an examination, inspection,

or any other supervisory activity are matters of

signiﬁcant importance and urgency that the Fed-

eral Reserve requires banking organizations to

address immediately and include (1) matters

that have the potential to pose signiﬁcant risk to

the safety and soundness of the banking organi-

zation; (2) matters that represent signiﬁcant non-

compliance with applicable laws or regulations;

(3) repeat criticisms that have escalated in impor-

tance due to insufﬁcient attention or inaction by

the banking organization; and (4) in the case of

consumer compliance examinations, matters that

have the potential to cause signiﬁcant consumer

harm. An MRIA will remain an open issue until

resolution and examiners conﬁrm the banking

organization’s corrective actions.

Required language. Federal Reserve examiners

are expected to use the following standardized

language to communicate MRIAs to the board

of directors (or executive-level committee of the

board):

“The board of directors (or executive-level

committee of the board), or banking organiza-

tion is required to immediately...”

Timeframe. The expected timeframe for a bank-

ing organization to address MRIAs is generally

short, and may be “immediate,” in the case of

heightened safety-and-soundness or consumer

compliance risk. For MRIAs that are necessary

to preserve or restore the viability of a banking

organization, the timeframe should take into

account any potential losses to the Federal De-

posit Insurance Corporation’s Deposit Insurance

Fund, including the possibility that a delay in

action will increase the potential for loss or the

cost of resolution.

Organization response. Following its review of

MRIAs discussed in the report, the banking

organization’s board of directors is required to

respond to the Reserve Bank in writing regard-

ing corrective action taken or planned along

with a commitment to corresponding time-

frames.

Supervisory follow-up. The Reserve Bank must

follow up on MRIAs to assess progress and

verify satisfactory completion. The timeframe

for follow-up should correspond with the time-

frame speciﬁed for the action being required,

and should be appropriate for the severity of the

matter requiring the corrective action. The means

of follow-up may vary depending upon the

nature and severity of the matter requiring the

action. Follow-up may take the form of a subse-

quent examination, a targeted review, or any

other supervisory activity deemed suitable for

evaluating the issue at hand.

In some cases, when follow-up indicates the

organization’s corrective action has not been

satisfactory, the initiation of additional formal

or informal investigation or enforcement action

may be necessary. In such cases, examiners

should consult with enforcement staff.

In all

instances, examiners are expected to exercise

judgment as to the supervisory activities best

suited for evaluating a particular issue. Once

follow-up is completed, examiners are expected

to clearly and fully document the rationale for

their decision to close any issue. Examiners are

also expected to communicate in writing the

results of their work and ﬁndings to the banking

organization.

1070.1.2.2 Matters Requiring Attention

MRAs constitute matters that are important and

that the Federal Reserve is expecting a banking

organization to address over a reasonable period

4. Such consultation should be made in accordance with

existing guidance to Reserve Bank supervisory staff on the

processing of enforcement actions, which provides that rec-

ommendations concerning formal enforcement actions should

be submitted to the Board’s Legal Division.

Communication of Supervisory Findings 1070.1

BHC Supervision Manual February 2020

Page 2

of time but when the timing need not be “imme-

diate.” While issues giving rise to MRAs must

be addressed to ensure the banking organization

operates in a safe and sound and compliant

manner, the threat to safety and soundness is

less immediate than with issues giving rise to

MRIAs. Likewise, consumer compliance con-

cerns that require less immediate resolution

should be communicated as an MRA. An MRA

typically will remain an open issue until resolu-

tion and conﬁrmation by examiners that the

banking organization has taken corrective action.

If a banking organization does not adequately

address an MRA in a timely manner, examiners

may elevate an MRA to an MRIA. Similarly, a

change in circumstances, environment, or strat-

egy can also lead to an MRA becoming an

MRIA. The key distinction between MRIAs and

MRAs is the nature and severity of matters

requiring corrective action as well as the imme-

diacy with which the banking organization must

begin and complete corrective actions.

Required language. Federal Reserve examiners

are expected to use the following standardized

language to communicate MRAs to the board of

directors (or executive-level committee of the

board):

“The board of directors (or executive-level

committee of the board), or banking organiza-

tion is required to...”

Timeframe. Communications to banking organi-

zations about MRAs must specify a timeframe

within which the corrective action is expected to

be completed. The timeframe, at least initially,

may require estimation because the banking

organization may ﬁrst need to complete prelimi-

nary planning to establish the timeframe for

initiating and completing the corrective action.

The timeframes for MRAs are likely to become

more precise over time as planning evolves and

circumstances make the completion of the MRAs

more urgent. Timeframes that span more than

one examination cycle for safety-and-soundness

issues or that exceed 12 months for consumer

compliance issues should include appropriate

interim progress reports.

Organization response. Following its review of

the report, the banking organization’s board of

directors is required to provide a written response

to the Reserve Bank regarding its plan, prog-

ress, and resolution of the MRA.

Supervisory follow-up. The Reserve Bank must

follow-up on MRAs to assess progress and

verify satisfactory completion. The timeframe

for follow-up should correspond with the time-

frame during which actions are to be completed.

For intermediate- or long-term corrective actions

for MRAs, Reserve Bank follow-up may consist

of assessing the organization’s progress to ad-

dress the MRAs, whether satisfactory or unsatis-

factory, and noting whether the initial estimated

timeframe continues to be reasonable or war-

rants adjustment.

The means of supervisory follow-up may

vary based upon the nature and severity of the

matter for which corrective action is expected.

Follow-up may take the form of a subsequent

examination, targeted review, continuous moni-

toring, reliance on validation work conducted

by internal audit function, reliance on the results

of examinations conducted by other supervisors,

or any other supervisory activity deemed suit-

able for evaluating the issue at hand.

In some cases, when follow-up indicates the

organization’s corrective action has not been

satisfactory, the initiation of additional formal

or informal investigation or enforcement action

may be necessary. In all instances, examiners

are expected to exercise judgment regarding the

supervisory activities best suited for evaluating

a particular issue. Once follow-up is complete,

examiners are expected to clearly and fully

document the rationale for their decision to

close any issue. Examiners also are expected to

communicate in writing the results of their work

and ﬁndings to the organization.

1070.1.2.3 Supervisory Considerations

The volume of MRIAs and MRAs should be

one of the many considerations in assigning a

supervisory rating to a banking organization.

The presence of a large number of MRIAs or

MRAs may indicate that additional formal or

informal investigation may be necessary or that

the initiation of a formal or informal enforce-

ment action may be warranted.

5. Examiners may choose to rely on the work of internal

audit when internal audit’s overall function and related pro-

cesses are effective, as discussed in

SR-13-1/CA-13-1, “Supple-

mental Policy Statement on the Internal Audit Function and

Its Outsourcing.” (See this manual’s section entitled “Internal

Control and Audit Function, Oversight, and Outsourcing.”)

When relying on internal audit to follow up on MRAs, exam-

iners are expected to review the relevant workpapers and,

when necessary, meet with internal audit staff who docu-

mented the resolution of the issue.

Communication of Supervisory Findings 1070.1

BHC Supervision Manual February 2020

Page 3

Irrespective of the number of MRIAs or

MRAs, in some cases, additional formal or

informal investigation may be necessary or the

initiation of a formal or informal enforcement

action may be warranted based on the severity

of the issues, the repeat nature of issues, lack of

responsiveness of management, violations of

law, insider abuse, fraud, or other material deﬁ-

ciency. In any of these cases, examiners should

consult with the Board’s enforcement staff.

1070.1.3 FACTORS IN ESCALATING

ISSUES INTO ENFORCEMENT

ACTIONS

The volume of open MRIAs and MRAs and the

materiality of the issues therein to the safety and

soundness of the banking organization are impor-

tant overarching considerations in determining

whether examiners need to consult with the

Board’s enforcement staff in escalating issues

into enforcement actions.

In addition to the

guidance presented in SR-13-13/CA-13-10, ex-

aminers should consider the following key fac-

tors in determining whether to recommend addi-

tional formal or informal investigation or

enforcement action:

• the organization’s supervisory ratings and

ﬁnancial condition;

• whether the issues involve unsafe or unsound

practices, violations of laws, noncompliance

with regulations, insider abuse, fraud, or other

material deﬁciencies;

• the severity or repetitive or intentional nature

of the issues;

• management’s willingness and ability to cor-

rect the issues;

• management’s history of instituting timely

remedial or corrective actions;

• whether management already initiated correc-

tive action or established procedures to pre-

vent future deﬁciencies;

• whether criminal or other regulatory authori-

ties are taking a formal enforcement or pros-

ecutorial action against the same institution;

• the organization’s history of violations of

laws, noncompliance with regulations and un-

safe and unsound unsatisfactory practices; and

• any other circumstances that warrant use of an

enforcement action.

This manual’s section, “Formal Corrective

Actions,” provides more information on formal

supervisory actions, which regulators issue to

correct practices that the regulators believe to be

unlawful, unsafe, or unsound. See also the Com-

mercial Bank Examination Manual’s section

entitled, “Formal and Informal Supervisory

Actions,” for more information.

6. Issues are considered closed if the banking organization

implements and examiners verify and validate the effective-

ness of the corrective action, or if the organization’s practices

are no longer a concern because of a change in the organiza-

tion’s circumstances.

7. See

SR-19-3/CA-19-2, “Large Financial Institution (LFI)

Rating System,” and

SR-19-4/CA 19-3, “Supervisory Rating

System for Holding Companies with Total Consolidated Assets

Less Than $100 billion.”

8. See 12 USC 1818(b)(1).

Communication of Supervisory Findings 1070.1

BHC Supervision Manual February 2020

Page 4

Considerations in Assigning and Revising Supervisory Ratings

Section 1072.0

1072.0.1

GENERAL CONSIDERATIONS

IN REVISING SUPERVISORY RATINGS

Supervisory ratings can affect an institution’s

risk-based deposit insurance premium; statutory

and regulatory requirements, including applica-

tions and the prompt-corrective-action provi-

sions of the Federal Deposit Insurance Act;

supervisory reporting and inspection or exami-

nation requirements; and other factors. Given

these implications, supervisory ratings should

reﬂect an institution’s current ﬁnancial condi-

tion and risk proﬁle. As such, Federal Reserve

examiners should revise supervisory ratings

whenever there is strong evidence that the ﬁnan-

cial condition or risk proﬁle of an institution has

signiﬁcantly changed.

Supervisory ratings may be revised as a result

of on-site or off-site supervisory activities. For

example, a signiﬁcant change in an institution’s

ﬁnancial condition may be evident from some

combination of the following: off-site informa-

tion or monitoring, reports of examinations con-

ducted by another agency, meetings or other

communications with management of the insti-

tution, published ﬁnancial reports or press re-

leases, an institution’s status reports in connec-

tion with an enforcement action, and information

generated by ongoing surveillance activities.

When examiners change a component of one

of the supervisory rating systems, they should

consider whether other applicable ratings should

change, based on information available at that

time. The factors contributing to a change in the

rating of a component rating may affect one or

more of the other ratings in the rating system,

such as the composite rating (if applicable).

Further, a rating change at the holding company

may precipitate a rating change at the subsidiary

depository institution or vice versa.

Any change to a component or composite

rating and the rationale for that change must be

communicated by Federal Reserve supervisory

staff in writing via a supervisory letter or report

to the board of directors of the affected institu-

tion (or to the senior U.S. management ofﬁcial

in the case of a U.S. branch, agency, ofﬁce, or

nonbank subsidiary of a foreign bank) and to the

appropriate state and federal supervisory agen-

cies. Federal Reserve Bank examiners should

follow internal procedures for reviewing, vet-

ting, and approving interim rating changes with

Reserve Bank management and Federal Reserve

Board staff, as well as communicating ratings

changes to supervised institutions.

1072.0.2 UPGRADES OF

SUPERVISORY RATINGS AT

COMMUNITY BANKING

ORGANIZATIONS

In 2012, the Federal Reserve issued guidance

instructing examiners to use balanced judgment

and consider progress by institutions in address-

ing supervisory issues and in restoring an insti-

tution to satisfactory condition when assigning

ratings. See

SR-12-4, “Upgrades of Supervisory

Ratings for Banking Organizations with $10 Bil-

lion or Less in Total Consolidated Assets.”

Examiners should upgrade an institution’s super-

visory rating when there is a demonstrated im-

provement in the institution’s ﬁnancial condi-

tion and risk-management practices, and where

improvement is likely to continue. In particular,

the Federal Reserve supervisory staff should

evaluate the strength of an institution’s core

ﬁnancial components, overall risk management,

and board of directors’ oversight in assessing

whether an upgrade is warranted.

Additional speciﬁc considerations include the

extent to which

• the level of capital and capital planning pro-

cess are appropriate relative to risk character-

istics;

• core earnings have improved, and this trend is

demonstrably sustainable;

• asset quality is improving, as evidenced by a

material decline of adversely classiﬁed and

1. For more information, see SR-99-17, “Supervisory Rat-

ings for State Member Banks, Bank Holding Companies and

Foreign Banking Organizations, and Related Requirements

for the National Examination Data System.” The guidance in

SR-99-17 and this manual section generally applies to the

supervisory rating systems for bank holding companies and

savings and loan holding companies; state member banks;

U.S. branches and agencies of foreign banking organizations;

and Edge and agreement corporations, overseas subsidiaries

of U.S. banks, and U.S. nonbank subsidiaries of foreign bank-

ing organizations.

2. For more information on the scope and applicability of

the holding company rating systems see

SR-13-21, “Inspec-

tion Frequency and Scope Requirements for Bank Holding

Companies and Savings and Loan Holding Companies with

Total Consolidated Assets of $10 Billion or Less,”

SR-19-3/

CA-19-2

, “Large Financial Institution (LFI) Rating System,”

and attachment 1 to

SR-19-4/CA-19-3, “Supervisory Rating

System for Holding Companies with Total Consolidated Assets

Less Than $100 billion.”

BHC Supervision Manual November 2021

Page 1

nonperforming assets, and this trend is expected

to continue;

• liquidity and interest rate risk positions gener-

ally are managed prudently and, in a manner,

consistent with applicable supervisory guid-

ance;

• management’s projections and assumptions

related to core ﬁnancial factors referred to

above are reasonable and subject to regular

board review and oversight;

• risk-management capabilities have improved

to address principal weaknesses that contrib-

uted to prior ratings, and policies and prac-

tices have been implemented that focus on

sustainability commensurate with the bank’s

risk proﬁle; and

• the board provides strategic review and over-

sight of the institution’s core ﬁnancial factors

and risk management and actively engages in

the process of correcting deﬁciencies.

The Federal Reserve supervisory staff also

should consider whether the institution has made

demonstrable and sustained improvement in par-

ticular areas relevant to the institution’s opera-

tion and ﬁnancial condition as noted in reports

of examination and condition.

1072.0.3 LARGE FINANCIAL

INSTITUTIONS AND THE LFI

RATING SYSTEM

While smaller banks and holding companies

generally are examined at a speciﬁc point in

time, larger holding companies are subject to

continuous monitoring and ongoing supervi-

sion, which includes several supervisory events

or assessments over the course of the supervi-

sory cycle. Federal Reserve policy guidelines

state that Federal Reserve supervisory staff should

assign larger holding companies the appropriate

holding company ratings on an annual basis and

more frequently as warranted. (See

SR-19-4/

CA-19-3

.) The Federal Reserve has internal

processes and procedures for initiating and ap-

propriately vetting ratings changes. This process

involves a coordinated vetting of assigning and

revising ratings for large holding companies

subject to the LFI rating system.

For larger holding companies, rating changes

typically are precipitated by the completion of

signiﬁcant supervisory assessments completed

throughout the supervisory cycle. For instance,

horizontal supervisory events and supervisory

events assessing a ﬁrm’s ability to address mate-

rial ﬁndings identiﬁed in previous supervisory

events are common instances when Federal

Reserve examiners should consider the need to

adjust an institution’s ratings. In all cases, exam-

iners should revise the supervisory ratings when

an institution’s ﬁnancial or operational strength

and resilience change and no longer meet the

criteria for the existing rating.

The importance of examiners providing timely

and accurate assessments of a larger holding

company’s ﬁnancial and operational condition

is reﬂected in the LFI rating system. As de-

scribed in this manual’s section entitled, “Large

Financial Institution Rating System,” each LFI

component rating is assigned along a four-level

scale. A ﬁrm is rated “Conditionally Meets

Expectations” when it has certain material ﬁnan-

cial or operational weaknesses in its practices or

capabilities, which may place the institution’s

prospects for remaining safe and sound through

a range of conditions at risk if not resolved in a

timely manner during the normal course of busi-

ness. Firms assigned a “Conditionally Meets

Expectations” rating should not be rated as such

for a prolonged period. The LFI ratings frame-

work does not have a ﬁxed timeline for how

long a ﬁrm can be rated “Conditionally Meets

Expectations.” Instead, the LFI ratings frame-

work reﬂects an understanding that timelines

depend on the particular issue(s), noting that the

Federal Reserve will work with the institution to

develop appropriate timeframes for resolving

the supervisory issues leading to the “Condition-

ally Meets Expectations” rating.

Considerations in Assigning and Revising Supervisory Ratings Section 1072.0

BHC Supervision Manual November 2021

Page 2

Formal Corrective Actions

Section 1075.0

1075.0.1 STATUTORY TOOLS FOR

FORMAL SUPERVISORY ACTION

The Federal Reserve supervises the following

entities and has the statutory authority to take

formal enforcement actions against them:

• state member banks

• bank holding companies (BHCs)

• savings and loan holding companies (SLHCs)

• nonbank subsidiaries of BHCs and of SLHCs

• Edge Act and agreement corporations

• branches and agencies of foreign banking

organizations operating in the United States

and their parent banks

• systemically important nonbank ﬁnancial com-

panies designated by the Financial Stability

Oversight Council (FSOC) for supervision by

the Federal Reserve

• ofﬁcers, directors, employees, and certain other

categories of individuals or entities associated

with the above banks, companies, and organi-

zations (referred to as “institution-afﬁliated

parties”)

The initial consideration and determination of

whether formal action is required usually results

from an examination or inspection. As such,

Federal Reserve supervisory staff must include

comments and conclusions in an examination

report or other supervisory communications that

are well supported, factually accurate, consis-

tent, and void of editorial or inﬂammatory state-

ments.

Statutory tools are available to the Federal

Reserve Board if formal enforcement action is

warranted against a BHC or SLHC (collectively,

“holding company”), nonbank subsidiaries, or

institution-afﬁliated parties. The primary objec-

tives of formal actions include

• correcting practices that the regulators believe

to be unlawful, unsafe, or unsound;

• ensuring that appropriate corrective action

programs are developed and used by ﬁnancial

institutions subject to formal actions;

• minimizing losses to ﬁnancial institutions and

the Federal Deposit Insurance Fund;

• ensuring that Federal Reserve requirements

are complied with to the fullest extent pos-

sible by ﬁnancial institutions and individuals;

and

• ensuring that institution-afﬁliated parties who

engage in an unsafe or unsound practice or

violate the law are permanently barred from

the banking industry, ﬁned, or both, for their

malfeasance.

In addition to an institution’s supervisory rat-

ings, compliance with statutes and regulations,

and ﬁnancial and managerial condition, Federal

Reserve supervisory and legal staff consider

numerous factors in determining whether to rec-

ommend additional formal or informal investi-

gation or enforcement action. See the “Commu-

nication of Supervisory Findings” section in this

manual to review factors in escalating issues

into enforcement actions.

The Board does not issue an enforcement

action on the basis of a “violation” of or “non-

compliance” with supervisory guidance. This

includes various types of Board or interagency

supervisory guidance, interagency statements,

advisories, letters, policy statements, questions

and answers, and frequently asked questions.

While supervisory guidance provides examples

of practices that the Board generally considers

consistent with safety-and-soundness standards

or other applicable laws and regulations, super-

visory guidance does not have the force and

effect of law. See 12 C.F.R. part 262, appen-

dix A, “Statement Clarifying the Role of Super-

visory Guidance.”

This section discusses the following topics:

• Board jurisdiction under the law

• actions or practices that may trigger the

statutory remedies

• Board staff procedures

• the elements of a corrective order

• temporary orders

• written agreements

• suspensions and removals

• enforcement of orders

• civil money penalties

• indemniﬁcation payments and golden

parachutes

• termination of certain nonbank subsidiary

activities or ownership

• coordination of formal enforcement actions

among federal banking agencies

1. For more information on informal supervisory actions,

see the Commercial Bank Examination Manual section (1050.1)

entitled, “Formal and Informal Supervisory Actions.”

BHC Supervision Manual February 2023

Page 1

1075.0.2 TYPES OF CORRECTIVE

ACTIONS

Generally, under section 8 of the Federal De-

posit Insurance Act (FDI Act), 12 U.S.C. 1818(b),

the Board may use its cease and desist authority

and other enforcement tools against (1) a BHC,

(2) a nonbank subsidiary of a BHC, and (3) any

institution-afﬁliated party.

The term “institution-

afﬁliated party” includes any director, ofﬁcer,

employee, controlling shareholder (other than a

BHC), or agent, and any other person who has

ﬁled or is required to ﬁle a change in control

notice. Further, institution-afﬁliated parties gen-

erally include

• shareholders;

• consultants;

• joint venture partners or any other person who

participates in the conduct of the affairs of a

BHC or nonbank subsidiary; and

• independent contractors, including attorneys,

appraisers, and accountants who knowingly or

recklessly participate in any violation of law

or regulation, breach of ﬁduciary duty, or

unsafe or unsound practice that causes (or is

likely to cause) more than a minimal ﬁnancial

loss to, or a signiﬁcant adverse effect on, an

institution.

The Board’s jurisdiction over an institution-

afﬁliated party extends for up to six years after

the party’s resignation, termination of employ-

ment, or separation caused by the closing of a

ﬁnancial institution, provided that any notice

(such as a notice of intent to remove from ofﬁce

and of prohibition) is served on the party before

the end of a six-year period.

1075.0.2.1 Cease and Desist Orders

Generally, under 12 U.S.C. 1818(b), the Board

may use its cease and desist authority against a

BHC and any institution-afﬁliated party when it

ﬁnds that the entity or party is engaging, has

engaged, or is about to engage in (1) a violation

of law, rule, or regulation; (2) a violation of a

condition imposed in writing by the Board in

connection with the granting of any application

or any written agreement; or (3) an unsafe or

unsound practice in conducting the business of

the institution. Section 12 U.S.C. 1818(b)(3)

makes clear that the cease and desist authority

applies to BHCs and Edge and agreement corpo-

rations, as well as to all institution-afﬁliated

parties associated with them.

A cease and desist order may require the

BHC or person subject to the order to (1) cease

and desist from the unsafe or unsound practices

or legal violations and (2) take afﬁrmative action

to correct the violations or practices. Afﬁrma-

tive actions are actions necessary to restore the

BHC to a safe and sound condition, and include

• improving the BHC’s consolidated capital by

restricting dividends and new debt;

• conserving the BHC’s assets so it can serve as

a source of strength to the bank;

• employing qualiﬁed ofﬁcers or employees; or

• taking any other action the Board determines

to be appropriate.

An individual may be required to reimburse

the company for unauthorized or improper pay-

ments received, or both.

Most cease and desist orders are issued by

consent. When Board staff, in conjunction with

the appropriate Reserve Bank, determines that a

cease and desist action is necessary, the BHC or

party is permitted an opportunity to consent to

the issuance of the order without the need for

the issuance of a notice of charges and a con-

tested administrative hearing. Board staff drafts

the proposed cease and desist order and, with

Reserve Bank staff, presents it to the BHC or

individual for consent. If the BHC or individual

voluntarily agrees to settle the case by the issu-

ance of a consent cease and desist order, the

proposed consent order will be presented to

senior Board ofﬁcials for approval, at which

time the order will be ﬁnal and binding.

When a BHC or person fails to consent to a

cease and desist order, the Board may issue a

notice of charges to the entity or party. The

notice of charges contains a detailed statement

describing the facts constituting the alleged vio-

lations or unsafe or unsound practices. The issu-

ance of the notice of charges starts a formal

process that includes the convening of a public

administrative hearing to be conducted before

an administrative law judge.

After the hearing,

the judge makes a recommended decision to the

2. The Board’s authority under 12 U.S.C. 1818 also extends

to SLHCs, their nonbank subsidiaries, and their institution-

afﬁliated parties.

3. The Board is authorized to issue regulations further

deﬁning which individuals should be considered institution-

afﬁliated parties. Similarly, the Board may determine whether

an individual is an institution-afﬁliated party on a case-by-

case basis (see 12 U.S.C. 1813(u)).

4. A private hearing may be held if the Board determines

that holding a public hearing would be contrary to the public

interest.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 2

Board. A hearing must be held within 30 to 60

days of service of the notice of charges, unless a

later date is set by the administrative law judge.

After the Board considers the record of the

proceeding, including the administrative law

judge’s recommended decision, the Board deter-

mines whether to issue a ﬁnal cease and desist

order. BHCs and individuals who are subject to

cease and desist orders that were issued as a

result of contested proceedings may appeal the

Board’s issuance of the order to the appropriate

federal court.

1075.0.2.2 Temporary Cease and Desist

Orders

The Board may, in conjunction with issuing a

notice of charges, issue a temporary cease and

desist order against a BHC or an institution-

afﬁliated party to effect immediate correction

(pursuant to 12 U.S.C. 1818(c)). The Board may

issue a temporary cease and desist order to a

BHC when the violation or unsafe or unsound

practice described in the notice of charges, or

the continuation of the violation or practice is

likely to

• cause insolvency of a BHC or its subsidiary

bank,

• weaken the condition of the BHC,

• cause a signiﬁcant dissipation in earnings, or

• prejudice the interests of the subsidiary bank’s

depositors before the completion of the pro-

ceedings resulting from the notice of charges.

The Board may also issue a temporary order

if it determines that a BHC’s or nonbank subsid-

iary’s books and records are so incomplete or

inaccurate that the Board is unable to determine,

through the normal supervisory process, the

BHC’s or nonbank subsidiary’s ﬁnancial condi-

tion or the details or purpose of any transaction

that may have a material effect on the BHC’s

condition. The temporary order may require the

BHC or nonbank subsidiary to take the same

corrective actions as a cease and desist order.

The advantage of issuing a temporary cease and

desist order is that it is effective immediately

after it is served on the BHC or individual.

Within 10 days after being served with a tempo-

rary order, however, the BHC or individual may

appeal to a U.S. district court for relief from the

order. Unless set aside by the district court, the

temporary order stays in effect until the Board

issues a ﬁnal cease and desist order or dismisses

the action.

1075.0.2.3 Written Agreements

When circumstances warrant a less severe pub-

lic action than a cease and desist order, it may

be appropriate to execute a written agreement

with a supervised institution. The provisions of

a written agreement may relate to any of the

problems found at the institution or involving

institution-afﬁliated parties. Written agreements

are drafted by Board staff, in consultation with

Reserve Bank staff, and must be approved by

the Board’s Director of the Division of Supervi-

sion and Regulation. After approval by the Gen-

eral Counsel, the Reserve Bank may enter into

the written agreement under delegated authority

(12 C.F.R. 265.11(a)(15)).

1075.0.2.4 Prohibition and Removal

Authority

The Board is authorized by 12 U.S.C. 1818(e) to

remove any current institution-afﬁliated party of

a BHC and its nonbank subsidiaries for certain

violations and misconduct and to prohibit per-

manently from the banking industry any current

or former institution-afﬁliated party from future

involvement with any insured depository institu-

tion, BHC or SLHC, and non-bank subsidiary.

The Board is authorized to initiate removal or

prohibition actions when

1. the institution-afﬁliated party has directly or

indirectly—

a. violated any law, regulation, cease and

desist order, condition imposed in writ-

ing, or any written agreement;

b. engaged in any unsafe or unsound prac-

tice; or

c. breached a ﬁduciary duty; and

2. the Board determines that, because of the

violation, unsafe or unsound practice, or

breach—

a. the institution has suffered or will suffer

ﬁnancial loss or other damage;

b. the interests of depositors have been or

could be prejudiced; or

c. the institution-afﬁliated party has received

ﬁnancial gain or other beneﬁt from the

violation or practice; and

3. such violation, practice, or breach—

a. involves personal dishonesty; or

b. demonstrates a willful or continuing dis-

regard for the safety or soundness of the

institution.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 3

In addition to this legal authority, the statute

separately authorizes the Board to initiate re-

moval or prohibition actions against (1) any

institution-afﬁliated party who has committed a

violation of any provision of the Bank Secrecy

Act that was not inadvertent or unintentional,

(2) any ofﬁcer or director who has knowledge

that an institution-afﬁliated party has violated

the money-laundering statutes and did not take

appropriate action to stop or prevent the reoc-

currence of such a violation, or (3) any ofﬁcer or

director who violates the prohibitions on man-

agement interlocks.

Like a cease and desist order, a removal or

prohibition order may be issued either by con-

sent or after an administrative process initiated

by the issuance of a notice of intent to remove

and prohibit. If an institution-afﬁliated party’s

actions warrant immediate removal from the

BHC, the Board is authorized to suspend the

person temporarily from the BHC pending the

outcome of the complete administrative process.

An institution-afﬁliated party currently associ-

ated with a BHC may also be suspended or

removed for cause based on actions taken while

formerly associated with a different insured

depository institution, BHC, or business institu-

tion.

Under 12 U.S.C. 1818(g), the Board is autho-

rized to suspend from ofﬁce or prohibit from

further participation any institution-afﬁliatedparty

charged or indicted for the commission of a

crime involving personal dishonesty or breach

of trust that is punishable by imprisonment for a

term exceeding one year under state or federal

law, if the continued participation might threaten

either the interests of depositors or public conﬁ-

dence in the institution. The Board may also

suspend or prohibit any individual charged with

a violation of the money-laundering statutes.

The suspension can remain in effect until the

criminal action is disposed of or until the sus-

pension is terminated by the Board. The Board

may also initiate a removal or prohibition action

against an institution-afﬁliated party who has

been convicted of, or has entered into a pretrial

diversion or similar program for, a crime involv-

ing personal dishonesty or breach of trust if his

or her continued service would threaten the

interests of the institution’s depositors or impair

public conﬁdence in the institution. The Board

is required to issue such an order against any

institution-afﬁliated party who has been con-

victed of, or pleaded to, a violation of the

money-laundering statutes.

Furthermore, section 19 of the Federal De-

posit Insurance Act (12 U.S.C. 1829) prohibits

any individual who has been convicted of, or

has entered into a pretrial diversion or similar

program for, a crime involving dishonesty, breach

of trust, or money laundering from (1) serving

as an institution-afﬁliated party of; (2) directly

or indirectly participating in the affairs of; and

(3) owning or controlling, directly or indirectly,

an insured depository institution without the

FDIC’s prior approval. The statute also prohib-

its such an individual from holding any of the

above-listed positions at a holding company or

an Edge Act or agreement corporation without

the Board’s prior approval. The penalty for a

knowing violation of this law is a potential ﬁne

of up to $1 million per day, imprisonment for up

to ﬁve years, or both. The criminal penalty

applies to both the individual and the employing

institution.

1075.0.2.5 Termination of Nonbank

Activity

The Board is authorized by 12 U.S.C. 1844(e) to

order a BHC to terminate certain activities of its

nonbank subsidiary (other than a nonbank sub-

sidiary of a bank) or to sell its shares of the

nonbank subsidiary. When the Board has rea-

sonable cause to believe that the BHC’s continu-

ation of any activity or ownership or control of

any of its nonbank subsidiaries constitutes a

serious risk to the ﬁnancial safety, soundness, or

stability of the BHC, and if the activity, owner-

ship, or control is inconsistent with sound bank-

ing principles or inconsistent with the purposes

of the Bank Holding Company Act (BHC Act)

or the Financial Institutions Supervisory Act

of 1966, the Board may order the BHC to termi-

nate the activity or sell control of the nonbank

subsidiary.

1075.0.2.6 Violations of Final Orders and

Written Agreements

When any ﬁnal order or temporary cease and

desist order has been violated, the Board may

apply to a U.S. district court for enforcement of

the action. Violations of ﬁnal orders and written

agreements may also give rise to the assessment

of civil money penalties against the offending

BHC or institution-afﬁliated parties, as circum-

stances warrant. The civil money penalty is

assessed in the same manner as described in the

5. See 12 U.S.C. 1818(e)(2).

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 4

‘‘Civil Money Penalties’’ section below. Any

institution-afﬁliated party who violates a suspen-

sion or removal order is subject to a criminal

ﬁne of up to $1 million, imprisonment for up to

ﬁve years, or both.

1075.0.2.7 Civil Money Penalties

The Board is authorized to address misconduct

by any institution or institution-afﬁliated party

through the imposition of civil money penalties

under a variety of statutes, including most com-

monly 12 U.S.C. 1818(i)(2). The statutory maxi-

mums are adjusted annually for inﬂation; cur-

rent maximums may be found at 12 C.F.R. 263.65.

Under 12 U.S.C. 1818(i)(2), the Board may

assess a ﬁrst-tier civil money penalty against

any institution or institution-afﬁliated party for a

violation of (1) law or regulation; (2) a ﬁnal

cease-and-desist, temporary cease-and-desist,

suspension, removal, or prohibition order; (3) a

condition imposed in writing by the Board in

connection with the granting of an application

or other request; and (4) a written agreement.

A second-tier civil money penalty can be

assessed for a violation, an unsafe or unsound

practice recklessly engaged in, or a breach of

ﬁduciary duty when the violation, practice, or

breach is part of a pattern of misconduct, causes

or is likely to cause more than a minimal loss, or

results in pecuniary gain or other beneﬁt for the

offender. A third-tier civil money penalty can be

assessed for any knowing violation, unsafe or

unsound practice, or breach of any ﬁduciary

duty when the offender knowingly or recklessly

caused a substantial loss to the ﬁnancial institu-

tion or received substantial pecuniary gain or

other beneﬁt. Civil money penalties may also be

assessed, under the three-tier penalty framework

described above, for any violation of the Change

in Bank Control Act and for violations of the

anti-tying provisions of federal banking law,

among other provisions (12 U.S.C. 1972).

The Board may also assess civil money penal-

ties for the submission of any late, false, or

misleading reports required by the BHC Act and

Regulation Y of the Board under the three-tier

penalty structure of 12 U.S.C. 1847(d) or, for

SLHCs, 12 U.S.C. 1467a(r). If a BHC maintains

procedures that are reasonably adapted to avoid

inadvertent errors and unintentionally fails to

publish any report, submits any false or mislead-

ing report or information, or is minimally late

with the report, it can be assessed a ﬁrst-tier

civil money penalty. The ﬁnancial institution

has the burden of proving that the error was

inadvertent under these circumstances. If the

error was not inadvertent, a second-tier penalty

can be assessed for all false or misleading

reports or information submitted to the Board. If

the submission was done in a knowing manner

or with reckless disregard for the law, a third-

tier penalty can be assessed for each day of the

violation. Notwithstanding the above, violations

of the BHC Act (with the exception of late,

false, or inaccurate report violations as de-

scribed above) may be addressed by the assess-

ment of civil money penalties under 12 U.S.C.

1847(d).

1075.0.2.8 Administration of Formal

Actions

1075.0.2.8.1 Publication of Final Orders

Under 12 U.S.C. 1818(u), the Board is required

to publish and make publicly available any ﬁnal

order issued for any administrative enforcement

proceeding it initiates.

These orders include

cease and desist, removal, prohibition, and civil

money penalty assessments. The Board is also

required to publish and make publicly available

any written agreement or other written state-

ment that it may enforce, unless the Board deter-

mines that publication of the order or agreement

would be contrary to the public interest.

1075.0.2.8.2 Public Hearings

Under 12 U.S.C. 1818(u), all formal hearings,

including contested cease and desist, removal,

and civil money penalty proceedings, are open

to the public unless the Board determines that a

public hearing would be contrary to the public

interest. Transcripts of all testimony; copies of

all documents submitted as evidence in the hear-

ing, which could include examination and inspec-

tion reports and supporting documents (except

those ﬁled under seal); and all other documents,

such as the notice and the administrative law

judge’s recommended decision, are available to

the public. These documents could include ex-

aminer’s workpapers, ﬁle memorandums, re-

ports of examination and inspection, and corre-

spondence between a problem institution or

wrongdoer and the Federal Reserve Bank. Ap-

6. For enforcement actions against an entity supervised by

the Federal Reserve, see the

Board’s public website.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 5

propriate actions should always be taken to

ensure that all written material prepared in con-

nection with any supervisory matter be accurate

and free of insupportable conclusions or opin-

ions.

1075.0.2.8.3 Subpoena Power

Under 12 U.S.C. 1818(n), which is made appli-

cable to BHCs by 12 U.S.C. 1818(b)(3) and

1844(f), the Board has the authority to issue

subpoenas directly or through its delegated rep-

resentatives, as well as the authority to adminis-

ter oaths or take depositions in connection with

an examination or inspection.

1075.0.3 PROHIBITED

INDEMNIFICATION PAYMENTS AND

GOLDEN PARACHUTE PAYMENTS

Prohibited indemniﬁcation payments and golden

parachute payments are governed by sec-

tion 18(k) of the FDI Act (12 U.S.C. 1828(k))

and the FDIC’s accompanying regulations at

12 C.F.R. part 359.

1075.0.3.1 Prohibited Indemniﬁcation

Payments

Holding companies or insured depository insti-

tutions may seek to indemnify their ofﬁcers,

directors, and employees from any judgments,

ﬁnes, claims, or settlements, whether civil, crimi-

nal, or administrative. The bylaws of some hold-

ing companies or insured depository institutions

may have broadly worded indemniﬁcation pro-

visions, or the holding company or institution

may have entered into separate indemniﬁcation

agreements with its institution-afﬁliated parties.

Such indemniﬁcation provisions may be incon-

sistent with federal banking law and regulations,

as well as with safe-and-sound banking prac-

tices.

Supervisory and examiner staff should be

alert to the limitations and prohibitions on indem-

niﬁcation imposed by section 18(k) of the FDI

Act and the accompanying Federal Deposit In-

surance Corporation (FDIC) regulations.

The

law and regulations apply to indemniﬁcation

agreements and payments made by a holding

company or insured depository institution to

any institution-afﬁliated party, regardless of the

holding company’s or institution’s ﬁnancial con-

dition. The purpose of the law and regulations is

to preserve the deterrent effects of administra-

tive enforcement actions by ensuring that indi-

viduals subject to ﬁnal enforcement actions bear

the costs of any judgments, ﬁnes, and associated

legal expenses and to safeguard the assets of

ﬁnancial institutions.

A prohibited indemniﬁcation payment includes

any payment (or agreement to make a payment)

by a holding company or insured depository

institution to an institution-afﬁliated party to

pay or reimburse such person for any liability or

legal expense incurred in any federal banking

agency administrative proceeding that results in

a ﬁnal order or settlement in which the institution-

afﬁliated party is assessed a civil money pen-

alty; is removed or prohibited from banking; or

is required to cease and desist from or take any

afﬁrmative action, including making restitution,

with respect to the holding company or deposi-

tory institution.

The FDIC’s regulations provide criteria for

making permissible indemniﬁcation payments.

A holding company or insured depository insti-

tution may make or agree to make a reasonable

indemniﬁcation payment if all of the following

conditions are met:

i. the institution’s board of directors deter-

mines in writing after due investigation and

consideration that the institution-afﬁliated

party acted in good faith and the best inter-

ests of the institution;

ii. the board of directors determines in writing

after due investigation and consideration that

the payment will not materially affect the

institution’s safety and soundness;

iii. the payment does not fall within the deﬁni-

tion of a prohibited indemniﬁcation pay-

ment; and

iv. the institution-afﬁliated party agrees in writ-

ing to reimburse the institution, to the extent

not covered by permissible insurance, for

the portion of the advanced indemniﬁcation

payments which subsequently become pro-

hibited indemniﬁcation payments.

The statute and FDIC regulations reinforce

the Federal Reserve’s long-standing policy that

an institution-afﬁliated party who engages in

misconduct should not be insulated from the

7. See 12 U.S.C. 1828(k). The prohibition begins when a

proceeding is instituted, which is when a notice of charges is

issued.

8. 12 C.F.R. 359.1(l).

9. 12 C.F.R. 359.5(a).

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 6

consequences of their misconduct. From a safety-

and-soundness perspective, a holding company

should not divert its assets to pay a ﬁne or other

ﬁnal judgment issued against an institution-

afﬁliated party for misconduct that presumably

violates the holding company’s policy of com-

pliance with applicable laws, especially when

the individual’s misconduct has already harmed

the holding company.

Holding companies should review their by-

laws and any outstanding indemniﬁcation agree-

ments, as well as insurance policies, to ensure

that they conform with the requirements of fed-

eral law and regulations. If a holding company

fails to take appropriate action to bring its

indemniﬁcation provisions into compliance with

federal laws and regulations, appropriate

follow-up supervisory action may be taken. As

part of the supervisory process, which will include

merger and acquisition applications, Federal

Reserve supervisory staff and examiners will

review identiﬁed agreements having

indemniﬁcation-related issues for compliance

with federal laws and regulations.

1075.0.3.2 Golden Parachute Payments

FDIC regulations prohibit holding companies

and their insured depository institution subsidi-

aries from making golden parachute payments

except in certain circumstances. As described in

12 C.F.R. 359.0(b), the limitations on golden

parachute payments apply to

• troubled insured depository institutions which

seek to enter into contracts to pay or to make

golden parachute payments to their institution-

afﬁliated parties;

• depository institutionholding companieswhich

are troubled and seek to enter into contracts to

pay or to make golden parachute payments to

their institution-afﬁliated parties; and

• healthy holding companies which seek to en-

ter into contracts to pay or to make golden

parachute payments to institution-afﬁliated par-

ties of a troubled insured depository institu-

tion subsidiary.

The purposes of the law and regulations include

safeguarding the assets of ﬁnancial institutions

and limiting rewards to institution-afﬁliated par-

ties who may have contributed to the institu-

tion’s troubled condition. (See

SR-03-6, “Guid-

ance Regarding Restrictions on Institutions in

Troubled Condition.”)

A golden parachute payment is any payment

(or agreement to make any payment) in the

nature of compensation for the beneﬁt of any

current or former institution-afﬁliated party that

meets three criteria.

1. The payment or agreement must be contin-

gent on, or by its terms payable on or after,

the termination of the institution-afﬁliated

party’s primary employment or afﬁliation.

2. The agreement is made, or the payment is to

be made on or after, or made in contempla-

tion of, among other things, a determination

that the holding company or its insured deposi-

tory institution subsidiary is in a troubled

condition.

3. The payment is payable to an institution-

afﬁliated party who is terminated while a

holding company or its insured depository

institution subsidiary meets any of the troubled

condition criteria in the golden parachute

regulations.

The deﬁnition of a golden parachute payment

also covers a payment made by a holding com-

pany that is not in a troubled condition to an

institution-afﬁliated party of an insured deposi-

tory institution subsidiary that is in a troubled

10. For additional information, consult SR-02-17, “Guid-

ance Regarding Indemniﬁcation Agreements and Payments.”

The guidance in SR-02-17 and

SR-03-6 also apply to SLHCs.

See

SR-14-9, “Incorporation of Federal Reserve Policies into

the Savings and Loan Holding Company Supervision Pro-

gram.” For additional considerations for institutions in choos-

ing indemniﬁcation insurance policies, see

SR-19-12, “State-

ment Regarding Insurance Policies for Directors and Ofﬁcers.”

11. See 12 C.F.R. 359.1(f)(1)(ii). The Board’s Regula-

tion Y (12 C.F.R. 225.71) states that “troubled condition” for

a regulated institution means an institution that (1) has a

composite rating, as determined in its most recent report of

examination or inspection, of 4 or 5 under the CAMELS

rating system or the Federal Reserve Bank Holding Company

rating system; (2) is subject to a cease-and-desist order or

formal written agreement that requires action to improve the

ﬁnancial condition of the institution, unless otherwise in-

formed in writing by the Board or Reserve Bank; or (3) is

informed in writing by the Board or Reserve Bank that it is in

troubled condition for purposes of the requirements of sub-

part H of Regulation Y on the basis of the institution’s most

recent report of condition or report of examination or inspec-

tion, or other information available to the Board or Reserve

Bank. Note that under the Federal Reserve’s holding company

rating system for large ﬁnancial institutions, there is no pre-

sumption that a ﬁrm rated “Deﬁcient-1” would be deemed to

be in troubled condition. Whether a ﬁrm rated “Deﬁcient-1”

receives a troubled condition designation will be determined

by the facts and circumstances of the situation. However,

ﬁrms rated “Deﬁcient-1” due to ﬁnancial weaknesses in either

capital or liquidity would be more likely to be deemed in

troubled condition than ﬁrms rated “Deﬁcient-1” due solely to

issues of governance or controls. See 83 Fed. Reg. 58,724

(November 21, 2018) and 84 Fed. Reg. 4309 (February 15,

2019) for more information.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 7

condition, if the other criteria in the deﬁnition

are met. This circumstance may arise when a

holding company, as part of an agreement to

acquire a troubled holding company, bank, or

savings association, proposes to make payments

to the troubled institution’s institution-afﬁliated

parties that are conditioned on their termination

of employment.

Holding companies or insured depository in-

stitutions may request permission from the ap-

propriate federal banking agency to make or

enter into an agreement to make a golden para-

chute payment by ﬁling an application in accor-

dance with FDIC ﬁling instructions at

12 C.F.R. 303.244. The appropriate federal bank-

ing agency may approve the application under

one of the exceptions in 12 C.F.R. 359.4(a)

(1)-(3). In determining the permissibility of the

payment, the Federal Reserve may consider

whether, and to what degree, the individual was

in a position of managerial or ﬁduciary responsi-

bility, the length of time the individual was

afﬁliated with the institution and the reasonable-

ness of the payment, and any other factors or

circumstances that would indicate that the pro-

posed payment would be contrary to the pur-

poses of the statute or regulations. Generally,

FDIC approval will also be required before a

payment is permissible.

A holding company or state member bank

requesting approval to make a golden parachute

payment or enter into an agreement to make

such a payment should submit its request simul-

taneously to the appropriate FDIC regional of-

ﬁce and the Reserve Bank. The Reserve Bank

should forward the golden parachute application

to appropriate Board staff for a ﬁnal determina-

tion on the permissibility of the request. Golden

parachute payments or agreements may be ap-

proved by the Board’s Director of the Division

of Supervision and Regulation in conjunction

with the General Counsel. Denials are not del-

egated by the Board of Governors to Board or

Reserve Bank staff.

If a holding company or state member bank

makes or enters into an agreement to make a

golden parachute payment without prior regula-

tory approval, appropriate follow-up supervi-

sory action should be taken. This follow-up

could include an enforcement action requiring

the offending institution-afﬁliated party to reim-

burse the institution for the amount of the pro-

hibited payment. When a holding company or

state member bank is identiﬁed as having golden

parachute-related issues in the supervisory pro-

cess, those issues should be carefully reviewed

for compliance with the law and the FDIC’s

regulations. The appropriate Reserve Bank super-

visory staff and the appropriate staff of the

Board’s Division of Supervision and Regulation

and Legal Division should be notiﬁed and con-

sulted on the golden parachute-related issues.

1075.0.4 ENFORCEMENT ACTIONS

FOR BANK SECRECY ACT/ANTI

MONEY LAUNDERING COMPLIANCE

PROGRAM FAILURES

In 2020, the federal banking agencies (FBAs)

issued a joint statement updating their existing

enforcement guidance to enhance transparency

regarding how they evaluate enforcement actions

that are required by statute when ﬁnancial insti-

tutions fail to meet Bank Secrecy Act/anti-

money laundering (BSA/AML) obligations.

The statement addresses how the agencies evalu-

ate violations of individual components (known

as pillars) of the BSA/AML compliance pro-

gram. The statement also clariﬁes that isolated

or technical violations or deﬁciencies are gener-

ally not considered the kinds of problems that

would result in a mandatory enforcement action.

The statement promotes a consistent approach

to the application of section 8(s) of the FDI Act.

See

SR-20-19, “Joint Statement on Enforcement

of Bank Secrecy Act/Anti-Money Laundering

Requirements.”

1075.0.5 COORDINATION OF

FORMAL ENFORCEMENT ACTIONS

AMONG FEDERAL BANKING

AGENCIES

When an FBA determines to take a formal

enforcement action against any federally insured

depositoryinstitution,depositoryinstitutionhold-

ing company, non-bank afﬁliate, or institution-

afﬁliated party, the agencies evaluate whether

12. FDIC regulations exclude from the deﬁnition of a

golden parachute payment several types of payments, such as

payments made pursuant to a qualiﬁed pension or retirement

plan; a beneﬁt plan or bona ﬁde deferred compensation plan

(which are further deﬁned in FDIC regulations); or a sever-

ance plan that provides beneﬁts to all eligible employees, does

not exceed the base compensation paid over the preceding

12 months, and otherwise meets the regulatory deﬁnition of

nondiscriminatory and other conditions in the regulations.

13. FBA refers to the Board of Governors of the Federal

Reserve System, the Federal Deposit Insurance Corporation,

the National Credit Union Administration, and the Ofﬁce of

the Comptroller of the Currency.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 8

the enforcement action involves the interests of

another FBA. Examples of such interests include

unsafe or unsound practices or signiﬁcant viola-

tions of law by an insured depository institution,

non-bank afﬁliate, or depository institution hold-

ing company or misconduct by an institution-

afﬁliated party that may have signiﬁcant connec-

tions with an institution regulated by another

FBA. If it is determined that one or more other

FBAs have an interest in the enforcement action,

the FBA proposing the enforcement action noti-

ﬁes the other FBA(s). For more information, see

SR-18-4/CA-18-5, “Policy Statement on Inter-

agency Notiﬁcation of Formal Enforcement

Actions,” and 83 Fed. Reg. 27,371 (June 12,

2018).

1075.0.6 APPOINTMENT OF

DIRECTORS AND SENIOR

EXECUTIVE OFFICERS

Under section 32 of the FDI Act (12 U.S.C.

1831i) and subpart H of Regulation Y (12 C.F.R.

225.71 et seq.), any BHC or state member bank

must provide 30 days’ written notice to the

Board before appointing any new director or

senior executive ofﬁcer,

or changing the respon-

sibilities of any senior executive ofﬁcer so that

the ofﬁcer would assume a different senior ofﬁ-

cer position if

• the regulated institution is in troubled condi-

tion;

• the regulated institution does not meet mini-

mum capital requirements applicable to the

institution as determined on the basis of the

institution’s most recent report of condition or

report of examination or inspection; or

• the Board determines, in connection with its

review of a capital restoration plan required

under section 38 of the Federal Deposit Insur-

ance Act or subpart D of the Board’s Regula-

tion H (prompt corrective action require-

ments), or otherwise, that such notice is

appropriate.

Subpart H of Regulation Y sets forth the

procedures for ﬁling and the content of the

notice. If a BHC or state member bank that is in

a troubled condition appoints a director or senior

ofﬁcer without the required 30-day prior written

notice, appropriate follow-up supervisory action

should be taken.

The Board may disapprove a notice if it ﬁnds

that the competence, experience, character, or

integrity of the proposed individual indicates

that his or her service would not be in the best

interest of the institution’s depositors or the

public. A disapproved individual or the institu-

tion that ﬁled the notice may appeal the Federal

Reserve’s notice of disapproval under the proce-

dures set forth in Regulation Y. While the appeal

is pending, the individual may not serve as a

director or senior executive ofﬁcer of a BHC or

a state member bank.

1075.0.7 DISCIPLINARY ACTIONS

AGAINST ACCOUNTANTS AND

ACCOUNTING FIRMS PERFORMING

CERTAIN AUDIT SERVICES

Section 36 of the FDI Act authorizes the federal

bank regulatory agencies to take disciplinary

actions against independent public accountants

and accounting ﬁrms that perform audit services

covered by the act’s provisions. Section 36, as

implemented by part 363 of the FDIC rules (12

C.F.R. part 363), requires that each federally

insured depository institution with total assets

of $500 million or more obtain an audit of its

ﬁnancial statements and an attestation on man-

agement’s assertions concerning internal con-

trols over ﬁnancial reporting performed by an

independent public accountant (the accountant).

The insured depository institution must include

the accountant’s audit and attestation reports in

its annual report. See

SR-94-3, “Supervisory

Guidance on the Implementation of Section 112

of the FDIC Improvement Act.”

The audit requirement can be fulﬁlled by an

independent audit of a BHC where the insured

subsidiary bank (1) has total assets of less than

$5 billion or (2) has total assets of $5 billion or

more and has a composite CAMELS rating of 1

or 2. See

SR-13-11, “Filing Procedures for

Annual Independent Audits and Reports Re-

quired Under Federal Deposit Insurance Corpo-

ration (FDIC) Rules,” for more information.

Section 36 and the rules enacted pursuant

thereto set forth the practices and procedures to

remove, suspend, or debar, for good cause, an

accountant or ﬁrm from performing audit and

testation services for an insured state member

bank, or BHC that obtains audit services for an

14. The Board or Reserve Bank, under extraordinary cir-

cumstances, may permit an individual to serve as a director or

senior executive ofﬁcer before a notice is provided; however,

this permission does not affect the Federal Reserve’s authority

to disapprove a notice within 30 days of its ﬁling.

Formal Corrective Actions 1075.0

BHC Supervision Manual February 2023

Page 9

insured subsidiary bank.

Immediate suspen-

sions are permitted in limited circumstances.

Also, an accountant or accounting ﬁrm is pro-

hibited from performing audit services for the

covered institution if an authorized agency has

taken such a disciplinary action against the

accountant or ﬁrm, or if the U.S. Securities and

Exchange Commission or the Public Company

Accounting Oversight Board has taken certain

disciplinary action against the accountant

or ﬁrm.

15. The rules provide that certain violations of law, negli-

gent conduct, reckless violations of professional standards, or

lack of qualiﬁcations to perform auditing services may be

considered good cause.

Formal Corrective Actions 1075.0

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Page 10

Federal Reserve System Holding Company

Surveillance Program Section 1080.0

The Federal Reserve’s Holding Company (HC)

Surveillance Program covers top-tier bank and

savings and loan holding companies. It deploys

risk identiﬁcation algorithms and other surveil-

lance products to process ﬁnancial and eco-

nomic data and generate forward-looking, action-

able intelligence on HCs. Results are used to

assess exposures, outlooks, and possible compli-

ance shortcomings, with the goal of calibrating

supervisory resources to risk. (Refer to

SR-15-16

and its attachment.)

The surveillance program’s objectives cover

these areas: (1) HC monitoring, (2) industry

analysis, and (3) metric distribution. HC moni-

toring consists of forward-looking metrics tar-

geting high-risk HCs and those with emerging

ﬁnancial difﬁculties for enhanced supervisory

attention, while identifying low-risk HCs for

more streamlined approaches. The metrics also

detect possible regulatory violations or depar-

tures from supervisory guidance and feed into

ﬁnancial reports on individual HCs. In industry

analysis, aggregate data views and accompany-

ing ﬁnancial analyses inform Federal Reserve

leaders of broad ﬁnancial institution conditions

and trends. In metric distribution, web applica-

tions deliver surveillance results to examiners

and other supervisory staff.

As fully integrated into the supervisory pro-

cess, the HC Surveillance Program involves

three distinct phases. First, data are processed

by the risk identiﬁcation algorithms, ranging

from simple rules to ﬁnancial models, machine

learning, and signal processing. The algorithmic

system’s main components are the Outlier List,

Watch List, HC Monitoring Screen, and Inter-

company Transactions Exception List, all de-

scribed below. When the algorithms detect de-

partures from expected patterns involving HCs,

the results are transmitted via Performance Re-

port Information and Surveillance Monitoring

(PRISM), a web application available to Federal

Reserve examiners and other supervisory staff

for interactive data analysis.

The second phase begins as supervisory staff

use additional surveillance products to conﬁrm

the initial impressions presented by ﬁrst-phase

surveillance results. Key examples of these addi-

tional products are the Bank Holding Company

Performance Report (BHCPR), a quarterly ﬁnan-

cial report on individual HCs, described below,

and the Focus Report, a web application avail-

able to Federal Reserve examiners and other

supervisory staff for interactive risk assessment.

In addition, aggregate data views and reports of

ﬁnancial condition at the supervisory portfolio

and industry levels can help place a particular

HC’s status in context.

The third phase involves the development of

supervisory responses to the information gener-

ated in the ﬁrst two. A primary goal is to focus

supervisory resources on excessive risk-taking,

the risk of emerging ﬁnancial difﬁculties, and

possible regulatory compliance shortcomings.

When problems are identiﬁed, follow-up by

examiners promotes correction and resolution.

By also identifying low-risk situations, the HC

Surveillance Program promotes the application

of more streamlined supervisory approaches for

such cases.

1080.0.1 OUTLIER LIST

An Outlier List highlights HCs with elevated

risk-taking and identiﬁes those with expanded

or new areas of risk-taking. It is supported by

“Outlier Metrics” in the form of algorithms gen-

erating risk classiﬁcations of low, moderate, or

high for individual risk and performance dimen-

sions. The Outlier List includes HCs (FR Y-9C

ﬁlers only) categorized as high risk within at

least one risk or performance dimension. The

risk identiﬁcation algorithms can be based on a

broad range of approaches and may evolve over

time.

Examiners and other supervisory staff use the

Outlier List to monitor a HC’s risk-taking and

promote adequate risk management and mitiga-

tion, with the goal of bolstering HCs’ capacity

to prevent or buffer ﬁnancial losses. The Outlier

List and its metrics also assist supervisory staff

in scoping HC inspections. No regular write-up

or documentation requirement is tied to the Out-

lier List.

1080.0.2 WATCH LIST

The Watch List identiﬁes the risk of emerging

ﬁnancial weaknesses among HCs. It includes

FR Y-9C ﬁlers with composite safety-and-

soundness ratings consistent with ﬁnancial viabil-

ity, but surveillance grades of ’D’ or ’F,’ point-

ing to the possibility of deterioration in inspection

ﬁndings going forward.

To generate the surveillance grades, the Hold-

ing Company Statistical Assessment of Bank

Risk (HC-SABR) early-warning model is ap-

BHC Supervision Manual November 2021

Page 1

plied to ﬁnancial and supervisory information

for each HC ﬁling consolidated ﬁnancial state-

ments on the FR Y-9C. The HC-SABR rating

consists of the composite RFI rating most recent-

ly assigned to an HC via the inspection process,

coupled with a surveillance letter grade (A, B,

C, D, or F) reﬂecting the HC’s estimated ﬁnan-

cial condition relative to others in the same

rating class.

HC-SABR ratings are designed for use both

in monitoring and in determining the scope of

an inspection. An accompanying Schedule of

Risk Factors (SRF) highlights speciﬁc indica-

tors leading the model to ﬂag a particular HC as

strong or weak. Through ongoing monitoring,

examiners and other supervisory staff review

each Watch List HC to assess its ﬁnancial condi-

tion and discern whether substantial deteriora-

tion is evident or impending. In such cases,

supervisory staff determine whether an inspec-

tion or other supervisory initiative might be

needed. The Watch List, much like the Outlier

List and its metrics, can also be used in scoping

HC inspections to target potentially deteriorat-

ing situations for the most extensive reviews.

At times, Reserve Bank staff may need to

produce supporting documentation to explain

the reasons for an HC’s placement on the Watch

List and outline the appropriate supervisory

response. For HCs other than community bank-

ing organizations (CBOs), this type of informa-

tion is often already contained in quarterly super-

visorywrite-ups outsideof the Watch Listprocess.

Separate surveillance write-ups are required for

CBO HCs on the Watch List when any of the

following criteria are met:

1. The current HC-SABR rating is worse than

the prior quarter; or

2. The HC-SABR rating is the same as the prior

quarter, but the SRF identiﬁes one or more

new contributing factors; or

3. The most recent requirement for a write-up

occurred four quarters earlier.

The assessments and conclusions comprising

a write-up should be brief and supported by

analysis. A Watch List write-up should accom-

plish the following:

1. summarize the factors leading to Watch List

placement;

2. describe any response from the HC to those

factors;

3. assess the likelihood of further ﬁnancial dete-

rioration;

4. judge whether assigned safety-and-soundness

ratings are accurate; and

5. determine whether the timing of the next

inspection should be accelerated.

Follow-up action associated with newly iden-

tiﬁed problems must be initiated promptly by

Reserve Banks. Follow-up action may include

correspondence or meetings with an HC’s man-

agement or an on-site inspection. Problem situa-

tions should be closely monitored by supervi-

sory staff until they have been corrected or

otherwise resolved.

1080.0.3 HC MONITORING SCREEN

The HC Monitoring Screen includes a focus on

the parent company and non-depository subsidi-

aries; addresses issues such as cash ﬂow, lever-

age, and complexity; identiﬁes risks to deposi-

tory institution subsidiaries; and helps monitor

compliance with regulations and supervisory

guidance. It provides examiners and other super-

visory staff with additional perspective on the

risk position and ﬁnancial condition of HCs by

supplementing the Outlier List and Watch List.

The FR Y-9SP is utilized, among other reports,

allowing the HC Monitoring Screen to provide a

surveillance view of smaller HCs. Those HCs

that fail screening criteria are identiﬁed, with

the criteria themselves updated periodically.

Examiners and other supervisory staff review

HC Monitoring Screen results quarterly and fol-

low up with supervisory initiatives when appro-

priate. Detailed instructions may accompany

parts of the screen linked to speciﬁc supervisory

programs, as for example, the guidance dis-

cussed in this manual’s section 1080.1, “Sur-

veillance Program for Small Holding Compa-

nies,” and further described in

SR-13-21. Unless

otherwise instructed as part of a speciﬁc super-

visory program, staff are not generally required

to produce surveillance write-ups or maintain

surveillance documentation for HCs on the HC

Monitoring Screen.

1080.0.4 INTERCOMPANY

TRANSACTIONS EXCEPTION LIST

The Intercompany Transactions Exception List

(ITEL) helps track compliance with section 23A

of the Federal Reserve Act. The ITEL is a

specialized monitoring process utilizing data

Federal Reserve System Holding Company Surveillance Program Section 1080.0

BHC Supervision Manual November 2021

Page 2

from the FR Y-8, together with information

from the bank Call report.

Foreachdepositoryinstitutionpossiblyexceed-

ing section 23A limits, supervisory staff per-

form the following: (1) follow up with the HC

submitting the FR Y-8 to verify the data are

accurate; (2) if an error caused the exception,

require an amended report; and (3) if the data

are correct, and a depository institution appears

to have had covered transactions exceeding sec-

tion 23A limits, determine the nature and extent

of the apparent violation. Reserve Bank staff

produce a written review of their ﬁndings for

each depository institution on the list. The review

addresses any apparent violations or reporting

errors, along with any corrective action taken.

1080.0.5 THE SURVEILLANCE

PROGRAM’S BHC PERFORMANCE

REPORT

The HC Surveillance Program generates quar-

terly ﬁnancial reports on individual HCs, includ-

ing a publicly available BHCPR consisting of

consolidated and parent-only ﬁnancial informa-

tion and peer-group percentiles for HCs ﬁling

the FR Y-9C. The information is useful in ana-

lyzing HCs on the Outlier List, Watch List, or

HC Monitoring Screen. By reviewing the per-

formance reports, examiners and other supervi-

sory staff gain insight into potential HC weak-

nesses. For example, parent leverage, cash-ﬂow,

and coverage ratios can indicate problems at the

parent level that could adversely affect deposi-

tory institution subsidiaries. Information on the

parent’s income from subsidiaries can poten-

tially indicate problems at non-depository sub-

sidiaries that could negatively affect depository

institution subsidiaries.

The ﬁnancial indicators produced by the

BHCPR are leveraged in surveillance models

such as HC-SABR and used in the ﬁnancial

analysis of HCs. Some documentation is re-

quired to help support the report. Speciﬁcally,

the BHCPR’s peer group analysis involves the

identiﬁcation of HCs that for a variety of rea-

sons could be considered atypical.

To support this process, Reserve Bank staff

annually produce a list of atypical HCs. The list

provides the name, location, and ID RSSD of a

company; and the reason why the HC is consid-

ered atypical. HCs removed from the atypical

list relative to the previous year are also identi-

ﬁed and discussed.

1080.0.6 ROLE IN INSPECTION

PROCESS

HCs identiﬁed through the surveillance process

as (1) taking on positions or pursuing strategies

that could lead to problem situations, (2) having

a weak or declining ﬁnancial condition, or (3) fail-

ing to comply with regulations should, in gen-

eral, be inspected more intensely and frequently

than companies without such deﬁciencies.

Regarding the positions and strategies of HCs,

the Outlier List is designed to identify excessive

risk-taking, as are parts of the HC Monitoring

Screen. Similarly, the Watch List is intended to

identify companies having a weak or declining

ﬁnancial condition, as are parts of the HC Moni-

toring Screen. Also, the HC Monitoring Screen

and the ITEL help detect possible compliance

problems among HCs and their subsidiaries.

The full array of risk identiﬁcation algorithms

and products deployed in the HC Surveillance

Program can be used in the scheduling and

scoping of HC inspections, so as to target, in a

timely manner, the riskiest situations for the

most extensive reviews, while conserving super-

visory resources when risk is low. The examiner-

in-charge should exercise prudent supervisory

judgment and consider an HC’s status on each

surveillance list and screen, together with all

other available information sources, including

the BHCPR and Focus Report, when determin-

ing the scope and nature of the inspection work

required.

Federal Reserve System Holding Company Surveillance Program Section 1080.0

BHC Supervision Manual November 2021

Page 3

Surveillance Program for Small Holding Companies

Section 1080.1

The surveillance program for holding compa-

nies having total consolidated assets of less than

$3 billion is described below. (See

SR-13-21,

“Inspection Frequency and Scope Requirements

for Bank Holding Companies and Savings and

Loan Holding Companies with Total Consoli-

dated Assets of $10 Billion or Less.”) The sur-

veillance program is a primary tool for identify-

ing potentiallysigniﬁcantchangesin the condition

of these organizations between reviews and for

targeting the work of any onsite reviews. Quar-

terly surveillance screens identify potential

parent-company and nonbank issues that may

adversely affect afﬁliated insured depository

institutions. In particular, the screens address

parent-company cash ﬂow, intercompany trans-

actions, parent-company leverage, and consoli-

dated capital ratios, where applicable. The sur-

veillance screens are periodically updated to

reﬂect industry trends and issues, as well as

changes in regulatory reporting requirements.

Upon receipt and ﬁnalization of FR Y-9 data,

Board surveillance staff provides each Reserve

Bank with the results of the small holding com-

pany surveillance screens on a quarterly basis.

Reserve Banks should evaluate this information

and make a determination as to any appropriate

supervisory actions within 45 days of the Board

staff notice. In doing so, Reserve Banks should

determine whether the screen results reveal that

the holding company or its afﬁliates could pose

or exacerbate a material risk to a depository

institution subsidiary. If the screen results reveal

no basis for a signiﬁcant concern, no further

action is required. Reserve Banks should also

review the quarterly FR Y-8 data on transac-

tions between an insured depository institution

and its afﬁliates that are subject to section 23A

of the Federal Reserve Act and Regulation W.

Reserve Banks should document their FR Y-8

reviews and follow up on any potential viola-

tions.

If a Reserve Bank determines that the screen

results reveal the potential for material risk to a

depository institution, the Reserve Bank should

take appropriate follow-up action within 90 days

after initially receiving the surveillance results

from Board staff. Follow-up actions may include

• contacting the holding company to obtain

more information,

• requesting from the holding company a cor-

rective action plan,

• implementing heightened monitoring proce-

dures, or

• updating the holding company’s complexity

designation.

If an onsite review is recommended for a com-

plex holding company, the review should com-

mence within 90 days of the Reserve Bank’s

initial notiﬁcation of the surveillance results

from Board staff. The ratings assigned as a

result of the onsite review should be promptly

entered into the National Examination Data Sys-

tem (NED) and communicated to the company,

Board staff, and appropriate state and federal

regulatory authorities within 120 days of that

notiﬁcation.

In addition to the above surveillance monitor-

ing screens, Board surveillance staff also pro-

vide Reserve Banks with program support screens

containing additional information to assist in the

supervision of small holding companies. One

set of support screens identiﬁes companies that

have been designated as noncomplex, but which

exhibit characteristics of complex organizations.

Reserve Banks are to evaluate any such compa-

nies to determine whether their designation as

noncomplex should be changed and their super-

vision program modiﬁed accordingly. A second

set of support screens monitors compliance of

ﬁnancial holding companies with the capital,

managerial, and Community Reinvestment Act

standards set forth in the Gramm-Leach-Bliley

Act.

Surveillance information is crucial to identify-

ing potential issues between reviews and for

ensuring that onsite work is risk focused. Accord-

ingly, Reserve Banks should continue taking

steps to ensure the accuracy of the regulatory

reports that provide the basis for the surveillance

program. In particular, System staff is to follow

up promptly on any identiﬁed inaccuracies.

BHC Supervision Manual November 2021

Page 1

Introduction To Topics For Supervisory Review

Section 2000.0

Discussed within these subsections are topics

associated with regard to the overall bank

holding company organization. Included is gen-

eral information, inspection objectives and

procedures, and in some instances references to

laws, interpretations, and Board orders. The

primary topics addressed are the supervision of

subsidiaries, grandfather rights, commitments,

extensions of credit to BHC ofﬁcials, man-

agement information systems, taxes, funding,

control and ownership, reporting by foreign

and domestic banking organizations, formal

corrective actions, sharing of criminal referral

information, investment transactions, recog-

nition and control of risk, purchase and sale of

U.S. Government guaranteed loans, and venture

capital.

BHC Supervision Manual December 1992

Page 1

Supervision of Subsidiaries

Section 2010.0

WHAT’S NEW IN THIS REVISED

SECTION

This section is revised to include a revision of

the Federal Deposit Insurance Act (FDIA) that

requires a BHC or SLHC to serve as a ‘‘source

of strength’’ to its depository institution subsidi-

aries. See section 38A of the FDIA and section

616(d) of the Dodd-Frank Act.

The relative merit of the degree of supervision

is dependent upon a number of factors, and must

be analyzed in light of efﬁciency and operating

performance. The degree and nature of control

over subsidiary organizations in a holding

company system usually falls between two

extremes: a tightly controlled, centralized net-

work similar to a branch system, or a loosely

controlled, decentralized system with each sub-

sidiary operating autonomously. A bank holding

company might originate as a ‘‘shell’’ corpora-

tion organized by investors interested in pur-

chasing a bank, or by a bank interested in reor-

ganizing into a holding company structure in

order to expand through acquisition of nonbank

concerns or other banks. The management and

directorate of such a holding company are often

the same as that of the bank. As the holding

company expands through acquisitions, the par-

ent may continue to exercise control through the

staff of the lead bank, or may form a separate

staff to overview the operations of all subsidi-

aries. The relative merit of the degree of super-

vision is dependent upon a number of factors,

and must be analyzed in light of efﬁciency and

operating performance.

The level at which policies are established

and supervised, the frequency of contact

between the parent and subsidiaries, and the

extent to which ofﬁcers and directors of the

parent serve also as ofﬁcers and directors of the

subsidiary organizations are indicative of the

level of control exercised by the parent. A cen-

tralized bank holding company is characterized

by the placement of directors and ofﬁcers of the

parent company (or those of the lead bank) in

each of its subsidiaries, with frequent group

meetings held between the ofﬁcers of the lead

bank or holding company and those of the sub-

sidiary organizations. While this is an efﬁcient

method of operation, this type of organization

builds in the potential for conﬂicts of interest for

those individuals who serve in dual capacities.

Corporate policies should recognize this poten-

tial and provide guidance for resolution. The

overriding principle should be that no member

of the bank holding company organization

should be disadvantaged by a transaction with

another afﬁliate. Management of the investment

portfolio, budgets, tax planning, personnel, cor-

respondent relationships, loans and loan partici-

pations, and liability management are usually

controlled by the parent or lead bank in a cen-

tralized system.

A decentralized system is one in which the

banks act independently of the parent company,

with infrequent contacts with afﬁliates, place-

ment of parent or lead bank directors and ofﬁ-

cers in less than a majority of the banks within

the system and infrequent reporting by subsidi-

aries concerning investments and operating per-

formance. The bank holding company might act

only in a minor advisory capacity. In such a

decentralized system each subsidiary operates

as a relatively autonomous unit, with authority

and responsibility for certain actions delegated

by the parent to the board and/or chief executive

ofﬁcer of each subsidiary.

It is the responsibility of the directors and

management of the parent company to establish

and supervise the policies of subsidiaries, either

directly or through delegation of authority. The

importance of written policies in a delegated,

decentralized organization cannot be over-

emphasized, and the selection of qualiﬁed ofﬁ-

cers to carry out policies is equally important. If

written policies have not been developed by the

holding company, the examiner should recom-

mend that major policies be written and commu-

nicated to subsidiaries. Policies should ensure

that subsidiaries are not managed for cross pur-

poses and should avoid concentrations of risks

on a consolidated basis.

2010.0.1 POLICY STATEMENT ON

THE RESPONSIBILITY OF BANK

HOLDING COMPANIES TO ACT AS

SOURCES OF STRENGTH TO THEIR

SUBSIDIARY BANKS

The Board is concerned about situations where

a bank has been threatened with failure

notwithstanding the availability of resources to

its parent bank holding company. In order to

assure that the Board’s policy that bank hold-

ing companies serve as sources of ﬁnancial

strength to subsidiary banks is understood by

bank holding companies, the Board has issued a

BHC Supervision Manual January 2013

Page 1

general policy statement reafﬁrming and

articulating these principles, and conﬁrming that

the policy applies to failing bank situations.

This long-standing policy has been recognized

by the Supreme Court in its decision in Board of

Governors v. First Lincolnwood Corp., 439 U.S.

234 (1978), and has been incorporated explicitly

in the Board’s Regulation Y, 12 C.F.R.

225.4(a)(1).

A fundamental and long-standing principle

underlying the Federal Reserve’s supervision

and regulation of bank holding companies is

that bank holding companies should serve as

sources of ﬁnancial and managerial strength to

their subsidiary banks. The Federal Deposit

Insurance Act (FDIA) requires that a bank hold-

ing company or savings and loan holding com-

pany act as a source of strength to its depository

institution(s). The term ‘‘source of strength’’

means the ability of a company that directly or

indirectly owns or controls an insured deposi-

tory institution to provide ﬁnancial assistance to

such insured depository institution in the event

of ﬁnancial stress to the insured depository insti-

tution. (See the FDIA, section 38A(a)–(c).) It is

the policy of the Board that in serving as a

source of strength to its subsidiary banks, a bank

holding company should stand ready to use

available resources to provide adequate capital

funds to its subsidiary banks during periods of

ﬁnancial stress or adversity and should maintain

the ﬁnancial ﬂexibility and capital-raising

capacity to obtain additional resources for assist-

ing its subsidiary banks in a manner consistent

with the provisions of this policy statement.

Since the enactment of the Bank Holding

Company Act in 1956, the Board has formally

stated on numerous occasions that a bank hold-

ing company should act as a source of ﬁnancial

and managerial strength to its subsidiary banks.

As the Supreme Court recognized, in the 1978

First Lincolnwood decision, Congress has

expressly endorsed the Board’s long-standing

view that holding companies must serve as a

“source of strength to subsidiary ﬁnancial insti-

tutions.”

In addition to frequent pronounce-

ments over the years and the 1978 Supreme

Court decision, this principle has been incorpo-

rated explicitly in Regulation Y since 1983. In

particular, Section 225.4(a)(1) of Regulation Y

provides that:

“A bank holding company shall serve as a

source of ﬁnancial and managerial strength to

its subsidiary banks and shall not conduct its

operations in an unsafe or unsound manner.”

The important public policy interest in the sup-

port provided by a bank holding company to its

subsidiary banks is based upon the fact that in

acquiring a commercial bank, a bank holding

company derives certain beneﬁts at the

corporate level that result, in part, from the

ownership of an institution that can issue

federally-insured deposits and has access to

Federal Reserve credit. The existence of the

federal “safety net” reﬂects important

governmental concerns regarding the critical

ﬁduciary responsibilities of depository institu-

tions as custodians of depositors’ funds and

their strategic role within our economy as

operators of the payments system and impartial

providers of credit. Thus, in seeking the

advantages ﬂowing from the ownership of a

commercial bank, bank holding companies have

an obligation to serve as a source of strength

and support to their subsidiary banks.

An important determinant of a bank’s ﬁnan-

cial strength is the adequacy of its capital base.

Capital provides a buffer for individual banking

organizations to absorb losses in times of ﬁnan-

cial strain, promotes the safety of depositors’

funds, helps to maintain conﬁdence in the bank-

ing system, and supports the reasonable expan-

sion of banking organizations as an essential

element of a strong and growing economy. A

strong capital cushion also limits the exposure

of the federal deposit insurance fund to losses

experienced by banking institutions. For these

reasons, the Board has long considered adequate

capital to be critical to the soundness of indi-

vidual banking organizations and to the safety

and stability of the banking and ﬁnancial

system.

Accordingly, it is the Board’s policy that a

bank holding company should not withhold

ﬁnancial support from a subsidiary bank in a

weakened or failing condition when the holding

company is in a position to provide the support.

A bank holding company’s failure to assist a

troubled or failing subsidiary bank under these

circumstances would generally be viewed as an

unsafe and unsound banking practice or a viola-

tion of Regulation Y or both.

Where necessary, the Board is prepared to

take supervisory action to require such assis-

tance. Finally, the Board recognizes that there

may be unusual and limited circumstances

where ﬂexible application of the principles set

forth in this policy statement might be neces-

1. Board of Governors v. First Lincolnwood Corp., 439

U.S. 234, 252 (1978), citing S. Rep. No. 95–323, 95th Cong.,

1st Sess. 11 (1977).

Supervision of Subsidiaries 2010.0

BHC Supervision Manual January 2013

Page 2

sary, and the Board may from time to time

identify situations that may justify exceptions to

the policy.

This statement is not meant to establish new

principles of supervision and regulation; rather,

as already noted, it builds on public policy con-

siderations as reﬂected in banking laws and

regulations and long-standing Federal Reserve

supervisory policies and practices. A bank hold-

ing company’s failure to meet its obligation to

serve as a source of strength to its subsidiary

bank(s), including an unwillingness to provide

appropriate assistance to a troubled or failing

bank, will generally be considered an unsafe

and unsound banking practice or a violation of

Regulation Y, or both, particularly if appropriate

resources are on hand or are available to the

bank holding company on a reasonable basis.

Consequently, such a failure will generally

result in the issuance of a cease and desist order

or other enforcement action as authorized under

banking law and as deemed appropriate under

the circumstances.

2010.0.2 BOARD ORDER

REQUESTING A WAIVER FROM THE

BOARD’S SOURCE OF STRENGTH

POLICY

On December 23, 1991, the Board approved an

application of a BHC to eventually acquire

100 percent of the outstanding stock of another

BHC under a 5 year option. Initially, the BHC

would acquire approximately 26 percent of the

acquiree’s total capital by purchasing a 15-year

subordinated capital note agreement. It would

then have the option to acquire all of the remain-

ing stock within 5 years. The acquiring BHC

requested that the Board waive any requirement

of the Board that it serve as a source of ﬁnancial

strength to the subsidiary bank (the Board’s

“Source of Strength” policy) of the BHC

acquired until such time that the option is exer-

cised to acquire the actual ownership of all the

shares. The Board considered the request and

determined that it would not be appropriate to

waive the responsibility to serve as a source of

ﬁnancial strength to the bank in this case. The

Board noted that the option agreement and the

capital note agreement together provide a

mechanism for the acquiring BHC to exert con-

trol over the future ownership of the acquired

BHC and many of the most important manage-

ment decisions. Refer to 1992 FRB 159 and the

F.R.R.S. at 4-271.3.

2010.0.3 INSPECTION OBJECTIVES

1. To determine whether the board of direc-

tors of the parent company is cognizant of and

performing its duties and responsibilities.

2. To determine the adequacy of written poli-

cies and compliance with such policies by the

parent and its subsidiaries.

3. To determine whether the board is prop-

erly informed as to the ﬁnancial conditions,

trends and policies of its subsidiaries.

4. To determine the level of supervision over

subsidiaries and whether the supervision as

structured has a beneﬁcial or detrimental effect

upon the subsidiaries.

2010.0.4 INSPECTION PROCEDURES

1. Determine if the holding company main-

tains its own staff, or whether the holding com-

pany management and directorate are the same

as those of a subsidiary.

2. Determine whether the board of directors

of the parent company reviews the audit reports,

regulatory examination reports, and board min-

utes of its subsidiaries.

3. Determine the extent to which subsidiaries

rely upon the parent for investment and lending

guidance.

4. Determine which speciﬁc functions and

decisions are performed only at the parent com-

pany level.

5. Determine the extent to which repre-

sentatives of the parent company serve as ofﬁ-

cers and/or directors of subsidiaries.

6. Review minutes of the board and execu-

tive committees of the parent to determine

whether the parent company reviews loan de-

linquency reports, comparative balance sheets

and comparative income statements of the

subsidiaries.

7. Review the extent of inﬂuence and control

over both bank and nonbank subsidiaries.

8. Determine the degree of inﬂuence by the

parent company over:

a. Appointment of ofﬁcers;

b. Salary administration;

c. Budget and tax planning;

d. Capital expenditures;

e. Dividend policy;

f. Investment portfolio management;

g. Loan portfolio management;

h. Asset/liability and interest rate/risk

management.

Supervision of Subsidiaries 2010.0

BHC Supervision Manual January 2013

Page 3

9. Determine the degree to which man-

agement of the subsidiary companies interfaces

with management of the parent company to

discuss policies.

Supervision of Subsidiaries 2010.0

BHC Supervision Manual January 2013

Page 4

Supervision of Subsidiaries

(Funding Policies) Section 2010.1

The responsibility for the performance of the

organization rests with the board of directors

of the parent company. Parent company man-

agement should have policies in place to pre-

vent funding practices that put at risk the wel-

fare of the subsidiary banks or the consolidated

organization.

The parent’s supervision and control of sub-

sidiary funding activities and the funding

between itself and its subsidiaries should be

thus evaluated. The parent should be expected

to maintain policies for itself and its subsidiaries

that provide guidance and controls for funding

practices. The presence and wording of funding

policies and the degree to which the policies

are followed by the subsidiaries, and the effec-

tiveness of the policies in reducing risk to the

entire organization should also be assessed.

The importance of the parent’s involvement

in funding decisions and the need for monitor-

ing and control at the parent level needs to be

emphasized. As a minimum, the parent’s fund-

ing policies should address the following areas:

1. Capitalization—The holding company’s

policy on capital levels should address capital

for the bank subsidiaries, the nonbank subsidi-

aries, and the consolidated organization. The

policy for bank and consolidated capital should

be consistent with the Board’s Capital Ade-

quacy Guidelines and should address the asset

quality of the entity in question. The policy for

nonbank capital should include maintaining the

capital level at industry standards and should

also address the asset quality of the subsidiary,

the holding company’s capital for each entity

should address what measures would be taken

in the event capital falls below a targeted level.

Capital should also be addressed at the

parent company level by specifying the degree

of double leverage that the parent is willing

to accept. The parent’s capital policy should

provide some measure of assessing each indi-

vidual subsidiary’s capital adequacy in the

context of the double leverage within the

organization.

The capital policies should include the

method for calculating dividends from each

entity. The amount of dividends from subsidi-

aries to the parent is affected by the parent’s

philosophy on the distribution of capital

throughout the organization. Some companies

tend to keep minimum capital levels in their

subsidiary banks by transferring the excess capi-

tal to the parent in the form of dividends. The

parent then invests these funds for its own bene-

ﬁt, and downstreams the funds as needed. Other

companies calculate dividends based strictly on

the parent’s cash needs and thus keep any excess

capital at the bank level.

2. Asset/Liability Management—The holding

company’s policies in the area of asset/liability

management should include interest rate sensi-

tivity matching, maturity matching, and the use

of interest rate futures and forwards. These top-

ics should be addressed for each entity as well

as the organization as a whole. It is the parent’s

responsibility to see that each entity is operating

consistently with the corporate goals.

The interest rate sensitivity policies should

be designed to reduce the organization’s vulner-

ability to interest rate movements. Policies con-

cerning the asset/liability rate sensitivity match

should not be limited to the subsidiary lead

bank. The rate charged on parent company debt

and the rate received by the parent on its

advances to subsidiaries should also be

addressed to monitor the parent’s ability to ser-

vice its debt in the face of changing interest

rates. The policy should specify what degree of

mismatching is considered acceptable. The

interest rate sensitivity matching of the organi-

zation should be monitored on a frequent basis

through the timely preparation of a matching

schedule.

Maturity matching policies should be

designed to provide adequate liquidity to the

organization. These policies should not be lim-

ited to the subsidiary lead bank, since a parent

company serving as a funding vehicle for non-

bank subsidiaries can have substantial exposure

through its advances to these subsidiaries. The

holding company’s policies should include some

measure of the liquidity of the assets in the

nonbank subsidiary (determined partially by the

quality of these assets), for comparison against

the parent’s source of funding. The policies

should quantify the maximum degree of expo-

sure in the organization that is considered

acceptable to management. The reporting in this

area should clearly indicate the current exposure

and thus the potential for liquidity problems.

The holding company’s policies ad-

dressing interest rate futures and forwards

should be consistent with the Board’s policy in

this area. Involvement in this activity should be

geared towards hedging against interest rate

movements rather than speculating that interest

BHC Supervision Manual December 1992

Page 1

rates will either increase or decrease. The policy

should specify what use of futures and forwards

is considered appropriate.

3. Funding of Nonbank Subsidiaries—The

parent company should have policies addressing

how nonbank subsidiaries fund their activities.

If the subsidiaries obtain their own funding,

market discipline may be a factor in controlling

the activities of the subsidiaries. However, the

parent cannot rely solely on market discipline

due to the risks from interdependence. The par-

ent company is still responsible under the cen-

tralized accountability approach to approve and

supervise the subsidiaries’ funding policies.

If the subsidiaries obtain funds from the

parent, the risk from interdependence is

increased. The subsidiary is less able to stand

alone since it is reliant on the parent for fund-

ing. If the parent capitalizes the nonbank subsid-

iary through borrowed funds, bank capital is put

at risk due to the increased exposure of the

organization. If the borrowing results in double-

leverage, the risk is increased since less “hard”

capital is available for support. The parent’s

policy on advances to nonbank subsidiaries

should address this additional risk by specifying

the level of borrowings that is considered

acceptable relative to nonbank capital and con-

solidated capital. The terms of the borrowings

should also be speciﬁed, and should be consis-

tent with the company’s asset/liability manage-

ment policies. The policy should include contin-

gency measures to be used in the event of

liquidity problems.

2010.1.1 INSPECTION OBJECTIVES

1. To determine if the parent’s funding poli-

cies adequately address funding risks to the

organization.

2. To determine if the implementation of the

parent’s policies is effective in controlling fund-

ing risks to the organization.

3. To determine if the parent is adequately

informed of actual funding practices and

decisions.

2010.1.2 INSPECTION PROCEDURES

1. Review the funding policies at the parent

and the subsidiary levels.

2. Determine how effectively the policies are

implemented throughout the organization.

3. Discuss with management the funding

practices of each subsidiary and any interorgani-

zational funding.

Supervision of Subsidiaries (Funding Policies) 2010.1

BHC Supervision Manual December 1992

Page 2

Supervision of Subsidiaries

(Loan Administration and Lending Standards) Section 2010.2

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2016, section 2010.2.5 is

revised to reference SR-15-17, “Interagency

Statement on Prudent Risk Management for

Commercial Real Estate Lending” and its

attachment. Refer to the Board’s December 18,

2015, press release.

2010.2.05 LOAN ADMINISTRATION

The examiner should make a qualitative assess-

ment of the parent’s supervision and control of

subsidiary lending activities. The System’s abil-

ity to evaluate the effectiveness of a company’s

supervision and control of subsidiary lending

activities can be strengthened not only by evalu-

ating the parent’s role in light of efﬁciency and

operating performance, but also by evaluating

the quality of control and supervision.

In order to assess quality, there must be a

standard measure against which a company’s

policies can be evaluated. Establishing the mini-

mum areas that a company’s loan-administration

policies should address will create a standard

that will aid in evaluating the quality of the

company’s control and its supervision of that

activity.

Current inspection procedures include the

testing of subsidiaries’ compliance with a parent

company’s policies. This section summarizes

the parent’s responsibilities with regard to

supervising subsidiary lending. It deﬁnes the

internal and external factors that should be con-

sidered in the formulation of loan policies and a

strategic plan. It also outlines the minimum

elements that the lending policies should

include.

Internal and external factors that a banking

organization should consider when formulating

its loan policies and strategic plan are—

1. the size and ﬁnancial condition of the credit-

extending subsidiaries,

2. the expertise and size of the lending staff,

3. the need to avoid undue concentrations of

risk,

4. compliance with all respective laws and

regulations, and

5. market conditions.

Following are the components that generally

form the basis for a sound loan policy:

1. Geographic limits. The trade area should be

clearly deﬁned and loan ofﬁcers should be

fully aware of speciﬁc geographic limita-

tions for lending purposes. Such a policy

avoids approval of loans to customers out-

side the trade area in opposition to primary

objectives. The primary trade area should

be distinguished from any secondary trade

area so that emphasis for each trade area

may be properly placed.

2. Distribution of loans by category. Limita-

tions based on aggregate percentages of

total loans in commercial, real estate, con-

sumer, and other categories are common.

Such policies are beneﬁcial; however, they

should contain provisions for deviations

that are approved by the directorate or a

committee. This allows credit to be distrib-

uted in relation to the market conditions of

the trade area. During times of heavy loan

demand in one category, an inﬂexible loan-

distribution policy would cause that cate-

gory to be slighted in favor of another.

Deviations from loan distributions by cate-

gory may be beneﬁcial but are appropriate

only until the risk of further increasing the

loan concentration outweighs the beneﬁts

to be derived from expanding the portfolio

to satisfy credit demand. See compo-

nent 11, “Concentrations of credit,” below.

3. Types of loans. The lending policy should

state the types of loans that will be made

and the maximum amount for each type of

loan. The policy should also set forth

guidelines to follow in making speciﬁc

loans. Decisions about the types of loans to

be granted should be based on the exper-

tise of the lending ofﬁcers, the deposit

structure, and anticipated creditworthy

demands of the trade area. Sophisticated

credits or loans secured by collateral that

require more than normal supervision

should be avoided unless or until there are

the necessary personnel to properly

administer them. Information systems and

internal controls should be in place to

identify, monitor, and control the types of

credit that have resulted in abnormal loss.

The amount of real estate and other types

BHC Supervision Manual January 2016

Page 1

of term loans should be considered in rela-

tion to the amount of stable funds.

4. Maximum maturities. The loan policy

should call for underwriting standards that

ensure realistic repayment plans. Loan

maturities should be set by taking into con-

sideration the anticipated source of repay-

ment, the purpose of the loan, the type of

property, and the useful life of the collat-

eral. For term loans, the lending policy

should state the maximum time within

which loans may be amortized. Speciﬁc

procedures should be developed for situa-

tions requiring balloon payments and/or

modiﬁcation of the original terms of the

loan. If a clean-up period

5. Loan pricing. Rates on various loan types

must be sufﬁcient to cover the cost of

funds loaned and the servicing of the loan,

including overhead and possible losses,

while providing an acceptable margin of

proﬁt over the long run. These costs must

be known and taken into consideration

before rates are established. Periodic

reviews should be conducted to determine

whether adjustments are necessary to re-

ﬂect changes in costs or competitive fac-

tors. Speciﬁc guidelines for other factors,

such as compensating balances and com-

mitment fees, are also germane to loan

pricing.

6. Loan amount to appraised value. The pol-

icy should outline where the responsibility

for appraisals rests and should deﬁne for-

mal, standard appraisal procedures, includ-

ing procedures for possible reappraisals in

case of renewal or extension. Acceptable

types of appraisals and limits on the dollar

amount and the type of property that per-

sonnel are authorized to appraise should be

outlined. Circumstances requiring apprais-

als by qualiﬁed independent appraisers

should be described. The maximum ratio of

the loan amount to appraised value,

the

method of valuation, and differences for

various types of property should be

detailed. The policy should contain a sched-

ule listing the downpayment requirements

for ﬁnancing consumer goods and business

equipment.

7. Loan amount to market value of pledged

securities. In addition to the legal restric-

tions imposed by Federal Reserve Regula-

tion U, the lending policy should set forth

margin requirements for all types of securi-

ties acceptable as collateral. Margin require-

ments should be related to the marketability

of the security (for example, closely held,

over-the-counter, actively traded). The pol-

icy should assign responsibility and set a

frequency for the periodic pricing of the

collateral.

8. Financial information. Extension of credit

on a safe and sound basis depends on com-

plete and accurate information regarding

the borrower’s credit standing. One pos-

sible exception is when the loan is predi-

cated on readily marketable collateral, the

disposition of which was originally desig-

nated as the source of repayment for the

advance. Current and complete ﬁnancial

information is necessary, including second-

ary sources of repayment, not only at the

inception of the loan, but also throughout

the term of the advance. The lending pol-

icy should deﬁne the ﬁnancial-statement

requirements for businesses and individu-

als at various borrowing levels and should

include requirements for audited, nonau-

dited, ﬁscal, interim, operating, cash-ﬂow,

and other statements.

It should include ex-

ternal credit checks required at various in-

tervals. The requirements for ﬁnancial

information should be deﬁned in such a

way that any credit-data exception would

be a clear violation of the lending policy.

9. Limits and guidelines for loan partici-

pations. Section 2020.2 provides signiﬁcant

information regarding intercompany loan

participations between holding company

afﬁliates. The lending policy should place

11. A “clean-up period” is when a borrower is asked to

repay the entire balance of a credit line and to refrain from

further borrowing for a speciﬁed period of time.

2. This is often referred to as the loan-to-value ratio.

3. On March 30, 1993, federal bank regulators set forth an

expanded interagency policy to encourage small-business

lending. Under the policy, banks and thrifts that are well or

adequately capitalized and that are rated CAMELS 1 or 2 may

make small-business and agricultural loans, the aggregate

value of which cannot exceed 20 percent of their total capital.

To qualify for the exemption, each loan may not exceed the

lesser of $900,000 or 3 percent of the institution’s total

capital. Further, the loans selected for this exemption by the

institution may not be delinquent as of the selection date and

may not be made to an insider. The loans must be separately

listed or have an accounting segregation from other loans in

the portfolio. They “will be evaluated solely on the basis of

performance and will be exempt from examiner criticism of

documentation.” The institution’s records must include an

evaluation of its ability to collect the loan in determining the

adequacy of its allowance for loan and lease losses. If a loan

becomes more than 60 days past due, it may be reviewed and

classiﬁed by an examiner based on its credit quality, not the

level of loan documentation.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 2

limits on the amount of loans purchased

from any one source and also place an

aggregate limit on such loans. The policy

should set forth credit standards for any

loan purchased as well as require that com-

plete documentation be maintained by the

purchasing entities. The policy should

deﬁne the extent of contingent liability,

holdback and reserve requirements, and the

manner in which the loan will be handled

and serviced.

10. Loans to insiders. Lending policies should

address loans to insiders. Such policies

should incorporate applicable regulatory

limitations (for example, Federal Reserve

Regulation O) and should also address situ-

ations in which it would be prudent to exer-

cise certain restrictions even though not

explicitly required to do so by regulation

(for example, loans by nonbank subsidiaries

to insiders).

11. Concentrations of credit. Credit concentra-

tions may be deﬁned as loans collateralized

by a common security; loans to one bor-

rower or related group of borrowers; loans

dependent upon a particular agricultural

commodity; aggregate loans to major

employers, their employees, and their major

suppliers; loans within industry groups; out-

of-territory loans; aggregate amount of

paper purchased from any one source; or

those loans that often have been included in

other homogeneous risk groupings. Credit

concentrations, by their nature, are

dependent on common key factors, and

when weaknesses develop, they have an

adverse impact on each individual loan

making up the concentration.

In identifying asset concentrations, com-

mercial real estate loans and residential real

estate loans can be viewed separately when

their performance is not subject to similar

economic or ﬁnancial risks. In the same

vein, commercial real estate development

loans need not necessarily be grouped with

residential real estate development loans,

especially when the residential developer

has ﬁrm, reliable purchase contracts for the

sale of the homes upon completion. Even

within the commercial development and

construction sector, distinctions for concen-

tration purposes may be made, when appro-

priate, between those loans that have ﬁrm

take-out commitments and those that do

not. Groups or classes of real estate loans

should, of course, be combined and viewed

as concentrations when they do share sig-

niﬁcant common characteristics and are

similarly affected by adverse economic,

ﬁnancial, or business developments.

Banking organizations should establish

and adhere to policies that control “concen-

tration risk.” The lending policy should

address the risk involved in various concen-

trations and indicate those that should be

avoided or limited. However, before con-

centrations can be limited or reviewed,

accounting systems must be in place to

allow for the retrieval of information neces-

sary to determine and monitor concentra-

tions. The lending policy should provide for

frequent monitoring and reporting of all

concentrations.

Banking organizations with asset concen-

trations are expected to put in place effec-

tive internal policies, systems, and controls

to monitor and manage this risk. Concentra-

tions that involve excessive or undue risks

require close scrutiny and should be

reduced over a reasonable period of time.

When there is a need to reduce asset con-

centrations, banking organizations are nor-

mally expected to develop a plan that is

realistic, prudent, and achievable in view of

the particular circumstances and market

conditions. In situations where concentra-

tion levels have built up over an extended

period, it may take time—in some cases

several years—to achieve a more balanced

and diversiﬁed portfolio. What is critical is

that adequate systems and controls are in

place for reducing undue or excessive con-

centrations in accordance with a prudent

plan, along with strong credit policies and

loan-administration standards to control the

risks associated with new loans, and

adequate capital to protect the institution

while its portfolio is being restructured.

Institutions that have in place effective

internal controls to manage and reduce con-

centrations over a reasonable period of time

need not automatically refuse credit to

sound borrowers simply because of the bor-

rower’s industry or geographic location.

This principle applies to prudent loan

renewals and rollovers, as well as to new

extensions of credit that are underwritten in

a sound manner.

The purpose of a lending organization’s

policies should be to improve the overall

quality of its portfolio. The replacement of

unsound loans with sound loans can

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 3

enhance the quality of a portfolio, even

when concentration levels are not reduced.

12. Reﬁnancing or renewal of loans. Reﬁnanc-

ings or renewals should be structured in a

manner that is consistent with sound bank-

ing, supervisory, and accounting practices,

and in a manner that protects the banking

organization and improves its prospects for

collecting or recovering on the asset.

13. Loan origination and loan approvals. The

policy should establish loan-origination and

loan-approval procedures, both generally

and by size and type of loan. The loan

limitations for all lending ofﬁcers should be

set accordingly. Lending limits should also

be set for group authority, allowing a com-

bination of ofﬁcers or a committee to

approve larger loans. Reporting procedures

and the frequency of committee meetings

should also be deﬁned. The loan policy

should further establish identiﬁcation,

review, and approval procedures for excep-

tion loans, including real estate and other

loans with loan-to-value percentages in

excess of supervisory limits.

14. Loan-administration procedures for loans

secured by real estate. The loan policy

should establish loan-administration proce-

dures covering documentation, disburse-

ment, collateral administration and inspec-

tion, escrow administration, collection, loan

payoffs, and loan review. Documentation

procedures would specify, among other

things, the types and frequency of ﬁnancial

statements and the requirements for verify-

ing information provided by the borrower.

They would also cover the type and fre-

quency of collateral evaluations (appraisals

and other estimates of value). In addition,

loan-administration policies should address

procedures for servicing and participation

agreements and other loan-administration

procedures such as those for claims process-

ing (for example, seeking recovery on

defaulted loans that are partially or fully

guaranteed by a government entity or insur-

ance program).

15. Collection and foreclosure and the

reporting and disclosure of delinquent obli-

gations and charge-offs. The lending policy

should deﬁne delinquent obligations, pro-

vide guidelines on when loans are to be

placed on nonaccrual or to be restructured,

dictate appropriate procedures for reporting

to senior management and to the directorate

past-due credits, and provide appropriate

guidance on the extent of disclosure of such

credits. The policy should establish and

require a follow-up collection procedure

that is systematic and progressively stronger

and should set forth guidelines (where

applicable) for close surveillance by a loan

work-out division. It should also address

extensions and other forms of forbearance,

the acceptance of deeds in lieu of foreclo-

sure, and the timing of foreclosure. The

policy must be consistent with supervisory

instructions in the ﬁnancial statements of

condition and income for ﬁnancial institu-

tions and BHCs (bank call report and the

FR Y-9C and the other FR Y-series

reports). Guidelines should be established

to ensure that all accounts are presented to

and reviewed by management for charge-

off after a stated period of delinquency. See

section 2065.1 for disclosure, accounting,

and reporting issues related to nonaccrual

loans and restructured debt.

16. Reserve for loan losses and provisions for

loan losses. The policy should set forth the

parameters that management considers in

determining an appropriate level of loan-

loss reserves as well as provisions neces-

sary to attain this level.

Because an analysis of the allowance for

loan and lease losses (ALLL) requires an

assessment of the relative credit risks in the

portfolio, many banking organizations, for

analytical purposes, attribute portions of the

ALLL to loans and other assets classiﬁed

“substandard” by management or a supervi-

sory agency. Management may do this

because it believes, based on past history or

other factors, that there may be unidentiﬁed

losses associated with loans classiﬁed sub-

standard in the aggregate.

Furthermore, management may use this

as an analytical approach in estimating the

total amount necessary for the ALLL and in

comparing the ALLL to various categories

of loans over time. As a general rule, an

individual loan classiﬁed substandard may

remain in an accrual status as long as the

regulatory reporting requirements for

accrual treatment are met, even when an

attribution of the ALLL has been made.

17. Other. The policy should address the han-

dling of exceptions to the policy as well as

4. For subsidiaries that are insured depository institutions,

real estate loans that are in excess of supervisory loan-to-

value limits are to be identiﬁed in the subsidiaries’ records.

The aggregate amount of these loans is to be reported quar-

terly to the depository institution’s board of directors.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual December 1999

Page 4

provide for adherence to the policy via

internal audits, centralized loan review,

and/or “director’s examinations.” The pol-

icy should be reviewed annually to deter-

mine if it continues to be compatible with

the BHC’s objectives as well as market

conditions.

2010.2.1 UNIFORM REAL ESTATE

LENDING STANDARDS

On December 23, 1992, the Board announced

adoption of a uniform rule and guidelines on

real estate lending, along with the FDIC, OCC,

and OTS, as mandated by section 304 of the

Federal Deposit Insurance Corporation

Improvement Act of 1991 (FDICIA). The

Board’s Regulation H (12 C.F.R. 208, Member-

ship of State Banking Institutions in the Federal

Reserve System) was amended to implement the

uniform real estate lending standards for state

member banks. Although the Board did not

directly apply the regulation to bank holding

companies and their nonbank subsidiaries, those

entities are expected to conduct and to supervise

real estate lending activities prudently, consis-

tent with safe and sound lending standards.

The agencies’ regulations require that each

insured depository institution adopt and main-

tain comprehensive written real estate lending

policies appropriate to the institution and the

nature and scope of its lending activities. Lend-

ing policies must be reviewed and approved by

the institution’s board of directors at least annu-

ally. The policies are to include standards for

loan diversiﬁcation and prudent underwriting as

well as loan-administration procedures and

documentation, approval, and reporting require-

ments. Depository institutions’ policies are to

reﬂect consideration of the appendix to the

banking agencies’ regulations, “Interagency

Guidelines for Real Estate Lending Policies.”

The guidelines are designed to help an institu-

tion formulate and maintain real estate lending

policy that is appropriate to its size and the

nature and scope of its operations, as required

by the regulations. These guidelines are gener-

ally comparable to the inspection guidance pro-

vided in this section.

2010.2.2 LENDING STANDARDS FOR

COMMERCIAL LOANS

The lending decision is properly that of the

senior management and boards of directors of

banking institutions, and not of their supervi-

sory agencies. However, in fulﬁlling their roles,

directors and senior managers have the obliga-

tion to monitor lending practices and to ensure

that their policies are enforced and that lending

practices generally remain within the overall

ability of the institution to manage. The follow-

ing subsections describe certain sound practices

regarding lending standards and credit-approval

processes for commercial loans.

Sound lending practices address formal credit

policies, formal credit-staff approval of transac-

tions, loan-approval documentation, the use of

forward-looking tools in the approval process,

and management and lender information sys-

tems. In addition to evaluating adherence to

these sound practices during inspections, super-

visory personnel and examiners may wish to

discuss these standards with loan portfolio man-

agers at institutions where a full credit review is

being performed. Senior management should be

made aware of the potential for deterioration in

the loan portfolio if lending discipline is not

maintained, whether from inadequate assess-

ment or communication of lending risks, incom-

plete adherence to prudent lending standards

that reﬂect the risk appetite of the board of

directors, or both.

Examiners should evaluate whether adequate

internal oversight exists and whether institution

management has timely and accurate informa-

tion. As always, examiners should also discuss

matters of concern with the institution and

include them in their reports of inspection, even

if cited practices and problem loans have not yet

reached harmful or criticized levels. Such cau-

tionary remarks help to alert institution manage-

ment to potential or emerging sources of con-

cern and may help to deter future problems.

Any practices that extend beyond prudent

bounds should be promptly corrected. See

SR-98-18.

2010.2.2.1 Sound Practices in Loan

Standards and Approval

Certain sound practices in lending can help to

maintain strong credit discipline and ensure that

an institution’s decision to take risk in lending is

5. This guidance is derived, in part, from the June 1998

Federal Reserve supervisory staff report, “The Signiﬁcance of

Recent Changes in Bank Lending Standards: Evidence from

the Loan Quality Assessment Project.’’

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual December 1999

Page 5

well informed, balanced, and prudent. Several

of these sound practices are listed and described

below.

2010.2.2.1.1 Formal Credit Policies

The Federal Reserve and other supervisory

authorities have long stressed the importance of

formal written credit policies in a sound credit-

risk-management process. Such policies can

provide crucial discipline to an institution’s

lending process, especially when the institu-

tion’s standards are under assault due to intense

competition for loans. They can serve to com-

municate formally an institution’s appetite for

credit risk in a manner that will support sound

lending decisions, while focusing appropriate

attention on loans being considered that diverge

from approved standards.

In developing and reﬁning loan policies, some

institutions specify “guidance minimums’’ for

ﬁnancial performance ratios that apply to certain

types of loans or borrowers (for example, com-

mercial real estate). Such guidance makes

explicit that loans not meeting certain ﬁnancial

tests (based on current performance, projected

future performance, or both) should in general

not be made, or alternatively should only be

made under clearly speciﬁed situations. Institu-

tions using this approach most effectively tend

to avoid specifying standards for broad ranges

of lending situations and instead focus on those

areas of lending most vulnerable to excessive

optimism, or where the institution expects loan

volume to grow most signiﬁcantly.

Formal policies can also provide lending dis-

cipline by clearly stating the type of covenants

to be imposed for speciﬁc loan types. When

designed and enforced properly, ﬁnancial cov-

enants can help signiﬁcantly to reduce credit

losses by communicating clear thresholds for

ﬁnancial performance and potentially triggering

corrective or protective action at an early stage.

Often, however, loan-approval documents do

not describe the key ﬁnancial covenants even

when discussions with institutional staff dis-

close that such covenants are present. The staff

and/or management of many institutions

acknowledge that they have a “common prac-

tice’’ of imposing certain types of covenants on

various types of loans. They indicate that such a

practice is well known to lenders and others at

the institution (but not articulated in their writ-

ten loan policies), so that describing the actual

covenants in the loan-approval document would

be redundant. However, management and other

approving authorities within an institution then

receive no formal positive indication that “com-

mon practice’’ controls have been imposed and

no indication of the level of ﬁnancial perfor-

mance that the covenants require of the bor-

rower. As such, management and other approv-

ing authorities may be inadequately informed as

to the risks and controls associated with the loan

under consideration. In contrast, loan policies

can create a clear expectation that (1) all key

covenants should be described in loan-approval

documents, (2) certain covenant types should be

applied to all loans meeting certain criteria, and

(3) explicit approval of any exception to these

policies is necessary if such covenant require-

ments are to be waived.

Internal processes and requirements for

underwriting decisions should be consistent with

the nature, size, and complexity of the banking

organization’s (BO) activities. Departures from

underwriting policies and standards, however,

can have serious consequences for BOs of all

sizes. Internal controls and credit reviews should

be established and maintained to ensure compli-

ance with those policies and procedures. When

there are continued favorable economic and

ﬁnancial conditions, compliance monitoring of

the BO’s lending policies and procedures needs

to be diligent to make certain that there is no

undue reliance on optimistic outlooks for bor-

rowers. Undue reliance on continued favorable

economic conditions can be demonstrated by

the following characteristics:

1. dependence on very rapid growth in a bor-

rower’s revenue as the “most likely’’ case

2. heavy reliance on favorable collateral

appraisals and valuations that may not be

sustainable over the longer term

3. greater willingness to make loans without

scheduled amortization prior to the loan’s

ﬁnal maturity

4. willingness to readily waive violations of

key covenants, to release collateral or guar-

antee requirements, or even to restructure

loan agreements, without corresponding con-

cessions on the part of the borrower, on the

assumption that a favorable environment will

allow the borrower to recover quickly

Among the adverse effects of undue reliance

on a continued favorable economy is the possi-

bility that problem loans will not be identiﬁed

properly or in a timely manner. Timely identiﬁ-

cation of problem loans is critical for providing

a full awareness of the BO’s risk position,

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 6

informing management and directors of that

position, taking steps to mitigate risk, and pro-

viding a proper assessment of the adequacy of

the allowance for credit losses and capital.

Similarly, an overreliance on continued ready

access to ﬁnancial markets on favorable terms

can originate from the following situations:

1. explicit reliance on future public market debt

or equity offerings, or on other sources of

reﬁnancing, as the ultimate source of princi-

pal repayment, which presumes that market

liquidity and the market’s appetite for such

instruments will be favorable at the time that

the facility is to be repaid

2. ambiguous or poorly supported analysis of

the sources of repayment of the loan’s princi-

pal, together with implicit reliance for repay-

ment on some realization of the implied mar-

ket valuation of the borrower (for example,

through reﬁnancing, asset sales, or some

form of equity infusion), which also assumes

that markets will be receptive to such trans-

actions at the time that the facility is to be

repaid

3. measuring a borrower’s leverage (for exam-

ple, debt-to-equity) based solely on the mar-

ket capitalization of the ﬁrm without regard

to “book’’ equity, thereby implicitly assum-

ing that currently unrealized appreciation in

the value of the ﬁrm can be readily realized if

needed

4. more generally, extending loans with a risk

proﬁle that more closely resembles the pro-

ﬁle of an equity investment, under circum-

stances that leave additional credit or default

as the borrower’s only resort if favorable

expectations are not met

Banking organizations that become lax in adher-

ing to established loan-underwriting policies and

procedures, as a result of overreliance on favor-

able economic and ﬁnancial market conditions,

may have signiﬁcant credit concentrations that

are at great risk to possible economic and ﬁnan-

cial market downturns. See SR-99-23.

Some institutions have introduced credit scor-

ing techniques into their small-business lending

in an effort to improve credit discipline while

allowing heavier reliance on statistical analysis

rather than detailed and costly analysis of indi-

vidual loans. Institutions should take care to

make balanced and careful use of credit scoring

technology for small-business lending and, in

particular, avoid using this technology for loans

or credit relationships that are large or complex

enough to warrant a formal and individualized

credit analysis.

In formalizing their lending standards and

practices, institutions are not precluded from

making loans that do not meet all written stan-

dards. Exceptions to policies, though, should be

approved and monitored by management. For-

mal reporting that describes exceptions to loan

policies, by type of exception and organiza-

tional unit, can be extremely valuable for

informing management and directors of the

number and nature of material deviations from

the policies that they have designed and

approved.

2010.2.2.1.2 Formal Credit-Staff

Approval of Transactions

Credit discipline is also enhanced when experi-

enced credit professionals are involved in the

approval process and are independent of the line

lending functions.

Such staff can play a vital

role in ensuring adherence to formal policies

and in ensuring that individual loan approvals

are consistent with the overall risk appetite of

the institution. These independent credit profes-

sionals can be most valuable if they have the

authority to reject a loan that does not meet the

institution’s credit standards or, alternatively, if

they must concur with a loan before it can be

approved.

Providing credit staff with independent

approval authority over lending decisions, rather

than with a more traditional requirement for

“consultation’’ between the lending function and

credit staff, allows credit staff to inﬂuence out-

comes on a broad and ongoing basis. This inﬂu-

ence and indeed the ability of credit staff to

reinforce lending discipline is clearly enhanced

by their early involvement in negotiations with

borrowers; a more traditional approach might be

to only involve credit staff once the loan pro-

6. See section 2122.0 and SR-98-25, “Sound Credit-Risk

Management and the Use of Internal Credit-Risk-Rating Sys-

tems at Large Banking Organizations.’’ Federal Reserve guid-

ance on credit-risk management and mitigation covers both

loans and other forms of on- and off-balance-sheet credit

exposure.

7. For example, loan ofﬁcers might be compensated for

bringing loan business into the institution. Independent credit

professionals, however, would be another person who would

not be compensated for bringing any loan business into the

institution. That person would, however, serve as a quality

control monitor that would have the independent authority to

reject a loan(s) and to ensure that the institution’s risk appetite

and credit standards are not exceeded.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 7

posal is well developed, allowing credit staff the

opportunity to have only minor inﬂuence on the

outcome of negotiations except in extreme

cases. Maintaining a proper balance of lending

and control functions calls for a degree of part-

nership between line lenders and credit staff, but

also requires that the independence of credit

staff not be compromised by conﬂicting com-

pensation policies or reporting structures.

Independent credit staff can also support

sound lending practice by maintaining complete

and centralized credit ﬁles that contain all key

documents relevant to each loan, including com-

plete loan-approval packages. Such ﬁles ensure

that decisions are well documented and avoid

undue reliance on the ﬁles maintained by indi-

vidual loan ofﬁcers.

2010.2.2.1.3 Loan-Approval Documents

Institutions can help ensure a careful loan-

approval decision by requiring thorough and

standardized loan-approval documents. Thor-

oughness can be enhanced by requiring formal

analysis of the borrower’s ﬁnancial condition,

key characteristics and trends in the borrower’s

industry, information on collateral and its valua-

tion, as well as ﬁnancial analysis of the entities

providing support or guarantees and formal

forward-looking analyses appropriate to the size

and type of loan being considered. Incorporat-

ing such elements into standardized formats and

requiring that analysis and supporting commen-

tary be complete and in adequate depth allows

approving authorities access to all relevant

information on the risk proﬁle of the borrower.

Loan-approval documents should also include

all material details on the proposed loan agree-

ment itself, including key ﬁnancial covenants.

Standardization of formats, and to some extent

content, can be useful in ensuring that all rel-

evant information is provided to management

and other approving authorities in a manner that

is understandable. Standard formats also draw

attention to cases in which certain key informa-

tion is not presented.

One area of particular interest in this regard is

analysis and commentary on participations in

syndicated loans. While it may be tempting to

rely on the analysis and documentation provided

by the agent institution to the transaction, it has

been long-standing Federal Reserve policy that

participating institutions should conduct their

own analysis of the borrower and the transac-

tions, particularly if the risk appetite or portfolio

characteristics of the agent differs from that of

the participating institution.

2010.2.2.1.4 Use of Forward-Looking

Tools in the Approval Process

During continued periods of favorable economic

conditions, institutions should guard against

complacency and, in particular, the temptation

to base expectations of a borrower’s future

ﬁnancial performance almost exclusively on that

borrower’s recent performance. In making lend-

ing decisions, and in evaluating their loan port-

folio, institutions should give sufﬁcient consid-

eration to the potential for negative events or

developments that might limit the ability of

borrowers to fulﬁll their loan obligations.

Unforeseen changes in interest rates, sales rev-

enue, and operating expenses can have material

and adverse effects on the ability of many bor-

rowers to meet their obligations. In prior

decades, inadequate attention to these possibili-

ties during the underwriting process contributed

signiﬁcantly to asset-quality problems in the

system. Also, sudden turmoil within various

countries can result in quick changes in cur-

rency valuations and economic conditions.

Examiners should evaluate the frequency and

adequacy with which institutions conduct

forward-looking analysis of borrower ﬁnancial

performance when considering an institution’s

credit-risk-management process. Formal use of

forward-looking ﬁnancial analysis in the loan-

approval process, and ﬁnancial projections in

particular, can be important in guarding against

such complacency, especially when ﬁnancial

institutions are competing intensely to attract

borrowers. Such projections, if they include less

favorable scenarios for the key determinants of

the borrower’s ﬁnancial performance, can help

to contain undue optimism and ensure that man-

agement and other approving authorities within

the organization are formally presented with a

robust analysis of the risks associated with each

credit. They also provide credit staff and other

risk-management personnel with information

that is important for ensuring adherence to the

institution’s lending standards and overall appe-

tite for loan risk.

The formal presentation of ﬁnancial projec-

tions and/or other forms of forward-looking

analyses of the borrower is important in making

explicit the conditions required for a loan to

perform and in communicating the vulnerabili-

ties of the transaction to those responsible for

approving loans. Analyses also provide a useful

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 8

benchmark against which institutions can assess

the borrower’s future performance. Although it

may be tempting to avoid analyzing detailed

projections for smaller borrowers, such as

middle-market ﬁrms, these customers may col-

lectively represent a signiﬁcant portion of the

institution’s loan portfolio. As such, applying

formal forward-looking analysis even on a basic

level assists the institution in identifying and

managing the overall risk of its lending

activities.

Detailed analysis of industry performance and

trends can be a useful supplement to such analy-

ses. Such projections have the most value in

maintaining credit discipline when, rather than

only describing the single “most likely’’ sce-

nario for future events, they characterize the

kind of negative events that might impair the

performance of the loan in the future.

2010.2.2.1.5 Stress Testing of the

Borrower’s Financial Capacity

The analysis of alternative scenarios, or “stress

testing,’’ should generally focus on the key

determinants of performance for the borrower

and the loan, such as the level of interest rates,

the rate of sales or revenue growth, or the rate at

which expense reductions can be realized.

Meaningful stress testing of the prospective bor-

rower’s ability to meet its obligations is a vital

part of a sound credit decision. Failure to recog-

nize the potential for adverse events—whether

speciﬁc to the borrower or its industry (for

example, a change in the regulatory climate or

the emergence of new competitors) or, alterna-

tively, to the economy as a whole (for example,

a recession)—can prove costly to a banking

organization.

Mechanical reliance on threshold ﬁnancial

ratios (and the “cushion’’ they imply) alone is

generally not sufﬁcient, particularly for complex

loans and loans to leveraged borrowers or others

that must perform exceptionally well to meet

their ﬁnancial obligations successfully. Scenario

analysis speciﬁc to the borrower, its industry,

and its business plan is critical to identify the

key risks of a loan. Such an analysis should

have a signiﬁcant inﬂuence on the decision to

extend credit and, if credit is extended, on the

decisions as to the appropriate loan size, repay-

ment terms, collateral or guarantee require-

ments, ﬁnancial covenants, and other elements

of the loan’s structure.

When properly conducted, meaningful stress

testing can include assessing the effect the fol-

lowing situations or events will have on the

borrower:

1. unexpected reductions in revenue growth or

reversals, including shocks to revenue of the

type and magnitude that would normally be

experienced during a recession

2. unfavorable movements in market interest

rates, especially for ﬁrms with high debt

burdens

3. unplanned increases in capital expenditures

due to technological obsolescence or com-

petitive factors

4. deterioration in the value of collateral, guar-

antees, or other potential sources of principal

repayment

5. adverse developments in key product or input

markets

6. reversals in, or the borrower’s reduced access

to, public debt and equity markets

Proper stress testing typically incorporates an

evaluation of the borrower’s alternatives for

meeting its ﬁnancial obligations under each sce-

nario, including asset sales, access to alternative

funding or reﬁnancing, or ability to raise new

equity. In particular, the evaluation should focus

not only on the borrower’s ability to meet near-

term interest obligations, but also on its ability

to repay the principal of the obligation. See

SR-99-23.

2010.2.2.1.6 Management and

Lender Information

Management information systems that support

the loan-approval process should clearly indi-

cate the composition of the institution’s current

portfolio or exposure to allow for consideration

of whether a proposed new loan—regardless of

its own merits—might affect this composition

sufﬁciently to be inconsistent with the institu-

tion’s risk appetite. In particular, institutions

active in commercial real estate lending should

know the nature and magnitude of aggregate

exposure within relevant subclasses, such as by

the type of property being ﬁnanced (that is,

ofﬁce, residential, or retail).

In addition to portfolio information, institu-

tions should be encouraged to acquire or

develop information systems that provide ready

access for lenders and credit analysts to infor-

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 9

mation sources that can support and enhance the

ﬁnancial analysis of proposed loans. Depending

on the nature of an institution’s borrowers,

appropriate information sources may include

industry ﬁnancial data, economic data and fore-

casts, and other analytical tools such as bank-

ruptcy scoring and default-probability models.

2010.2.3 LEVERAGED LENDING

Leveraged lending has been a ﬁnancing vehicle

for transactions involving mergers and acquisi-

tions, business recapitalizations, and business

expansions.

It is an important type of ﬁnancing

for national and global economies, and the U.S.

ﬁnancial industry plays an integral role in mak-

ing credit available and syndicating that credit

to investors. Leveraged transactions are charac-

terized by a degree of ﬁnancial leverage that

may signiﬁcantly exceed industry norms as

measured by ratios such as debt-to-assets, debt-

to-equity, cash ﬂow-to-total debt, or other ratios

and standards that are unique to a particular

industry. Leveraged borrowers, however, can

have a diminished ability to respond to chang-

ing economic conditions or unexpected events,

creating signiﬁcant implications for an institu-

tion’s overall credit-risk exposure and chal-

lenges for bank risk-management systems.

Leveraged lending activities can be conducted

in a safe-and-sound fashion if pursued with a

risk-management structure that provides for the

appropriate underwriting, pricing, monitoring,

and controls. Comprehensive credit analysis

processes, frequent monitoring, and detailed

portfolio reports are needed to better understand

and manage the inherent risk in leveraged port-

folios. Sound valuation methodologies must be

used in addition to ongoing stress testing and

monitoring.

Financial institutions should ensure they do

not unnecessarily heighten risks by originating

and then distributing poorly underwritten loans.

For example, a poorly underwritten leveraged

loan that is pooled with other loans or is partici-

pated with other institutions may generate risks

for the ﬁnancial system. The leveraged lending

guidance that follows is designed to assist ﬁnan-

cial institutions in providing leveraged lending

to creditworthy borrowers in a safe-and-sound

manner.

On March 21, 2013, the Federal Reserve

Board, along with the Ofﬁce of the Comptroller

of the Currency (OCC) and the Federal Deposit

Insurance Corporation (FDIC), issued “Inter-

agency Guidance on Leveraged Lending.”

The

statement provides guidance about risk rating

leveraged-ﬁnanced loans. See SR-13-3 and its

attachment.

2010.2.3.1 Interagency Guidance on

Leveraged Lending

The vast majority of community banks should

not be affected by this guidance, as they have

limited involvement in leveraged lending. Com-

munity and smaller institutions that are involved

in leveraged lending activities should discuss

with their primary regulator the implementation

of cost-effective controls appropriate for the

complexity of their exposures and activities.

2010.2.3.1.1 Risk-Management

Framework

Given the high-risk proﬁle of leveraged transac-

tions, ﬁnancial institutions engaged in leveraged

lending should adopt a risk-management frame-

work that has an intensive and frequent review

and monitoring process. The framework should

have as its foundation written risk objectives,

risk-acceptance criteria, and risk controls. A

lack of robust risk-management processes and

controls at a ﬁnancial institution with signiﬁcant

8. For the purpose of this guidance, references to leveraged

ﬁnance, or leveraged transactions encompass the entire debt

structure of a leveraged obligor (including loans and letters of

credit, mezzanine tranches, senior and subordinated bonds)

held by both bank and nonbank investors. References to

leveraged lending and leveraged loan transactions and credit

agreements refer to all debt with the exception of bond and

high-yield debt held by both bank and nonbank investors.

9. For purposes of this guidance, the term “ﬁnancial insti-

tution” or “institution” includes national banks, federal sav-

ings associations, and federal branches and agencies super-

vised by the OCC; state member banks, bank holding

companies, savings and loan holding companies, and all other

institutions for which the Federal Reserve is the primary

federal supervisor; and state nonmember banks, foreign banks

having an insured branch, state savings associations, and all

other institutions for which the FDIC is the primary federal

supervisor.

10. This guidance augments previously issued supervisory

statements on sound credit-risk management. Refer to

SR-98-18, “Lending Standards for Commercial Loans.”

11. The agencies do not intend that a ﬁnancial institution

that originates a small number of less complex, leveraged

loans should have policies and procedures commensurate with

a larger, more complex leveraged loan origination business.

However, any ﬁnancial institution that participates in lever-

aged lending transactions should follow applicable supervi-

sory guidance provided in “Participations Purchased” of this

section.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 10

leveraged lending activities could contribute to

supervisory ﬁndings that the ﬁnancial institution

is engaged in unsafe and unsound banking prac-

tices. This guidance outlines the agencies’ mini-

mum expectations on the following topics:

• Leveraged Lending Deﬁnition

• General Policy Expectations

• Participations Purchased

• Underwriting Standards

• Valuation Standards

• Pipeline Management

• Reporting and Analytics

• Risk Rating Leveraged Loans

• Credit Analysis

• Problem-Credit Management

• Deal Sponsors

• Credit Review

• Stress Testing

• Conﬂicts of Interest

• Reputational Risk

• Compliance

2010.2.3.1.2 Leveraged Lending

Deﬁnition

The policies of ﬁnancial institutions should

include criteria to deﬁne leveraged lending that

are appropriate to the institution.

For example,

numerous deﬁnitions of leveraged lending exist

throughout the ﬁnancial services industry and

commonly contain some combination of the fol-

lowing:

• proceeds used for buyouts, acquisitions, or

capital distributions

• transactions where the borrower’s Total Debt

divided by EBITDA (earnings before interest,

taxes, depreciation, and amortization) or

Senior Debt divided by EBITDA exceed

4.0 * EBITDA or 3.0 * EBITDA, respec-

tively, or other deﬁned levels appropriate to

the industry or sector

• a borrower recognized in the debt markets as

a highly leveraged ﬁrm, which is character-

ized by a high debt-to-net-worth ratio

• transactions when the borrower’s post-

ﬁnancing leverage, as measured by its lever-

age ratios (for example, debt-to-assets, debt-

to-net-worth, debt-to-cash ﬂow, or other

similar standards common to particular indus-

tries or sectors), signiﬁcantly exceeds industry

norms or historical levels

A ﬁnancial institution engaging in leveraged

lending should deﬁne it within the institution’s

policies and procedures in a manner sufﬁciently

detailed to ensure consistent application across

all business lines. A ﬁnancial institution’s deﬁ-

nition should describe clearly the purposes and

ﬁnancial characteristics common to these trans-

actions, and should cover risk to the institution

from both direct exposure and indirect exposure

via limited-recourse ﬁnancing secured by lever-

aged loans, or ﬁnancing extended to ﬁnancial

intermediaries (such as conduits and special pur-

pose entities (SPEs)) that hold leveraged loans.

2010.2.3.1.3 General Policy Expectations

A ﬁnancial institution’s credit policies and pro-

cedures for leveraged lending should address

the following:

• Identiﬁcation of the ﬁnancial institution’s risk

appetite, including clearly deﬁned amounts of

leveraged lending that the institution is will-

ing to underwrite (for example, pipeline lim-

its) and is willing to retain (for example,

transaction and aggregate hold levels). The

institution’s designated risk appetite should

be supported by an analysis of the potential

effect on earnings, capital, liquidity, and other

risks that result from these positions, and

should be approved by its board of directors.

• A limit framework that includes limits or

guidelines for single obligors and transac-

tions, aggregate hold portfolio, aggregate

pipeline exposure, and industry and geo-

graphic concentrations. The limit framework

should identify the related management-

approval authorities and exception-tracking

provisions. In addition to notional pipeline

limits, the agencies expect that ﬁnancial insti-

tutions with signiﬁcant leveraged transactions

will implement underwriting-limit frame-

12. This guidance is not meant to include asset-based loans

unless such loans are part of the entire debt structure of a

leveraged obligor. Asset-based lending is a distinct segment

of the loan market that is tightly controlled or fully monitored,

secured by speciﬁc assets, and usually governed by a borrow-

ing formula (or “borrowing base”).

13. Cash should not be netted against debt for purposes of

this calculation.

14. The designation of a ﬁnancing as “leveraged lending”

is typically made at loan origination, modiﬁcation, extension,

or reﬁnancing. “Fallen angels” or borrowers that have exhib-

ited a signiﬁcant deterioration in ﬁnancial performance after

loan inception and subsequently become highly leveraged

would not be included within the scope of this guidance,

unless the credit is modiﬁed, extended, or reﬁnanced.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 11

works that assess stress losses, ﬂex terms,

economic capital usage, and earnings at risk

or that otherwise provide a more nuanced

view of potential risk.

• Procedures for ensuring the risks of leveraged

lending activities are appropriately reﬂected

in an institution’s allowance for loan and lease

losses (ALLL) and capital adequacy analyses.

• Credit and underwriting approval authorities,

including the procedures for approving and

documenting changes to approved transaction

structures and terms.

• Guidelines for appropriate oversight by senior

management, including adequate and timely

reporting to the board of directors.

• Expected risk-adjusted returns for leveraged

transactions.

• Minimum underwriting standards (see the

“Underwriting Standards” section below).

• Effective underwriting practices for primary

loan origination and secondary loan acquisi-

tion.

2010.2.3.1.4 Participations Purchased

Financial institutions purchasing participations

and assignments in leveraged lending transac-

tions should 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 and approval criteria, and

in-house limits that would be employed if the

purchasing organization were originating the

loan. At a minimum, policies should include

requirements for

• obtaining and independently analyzing full

credit information both before the participa-

tion is purchased and on a timely basis there-

after;

• obtaining from the lead lender copies of all

executed and proposed loan documents, legal

opinions, title insurance policies, Uniform

Commercial Code (UCC) searches, and other

relevant documents;

• carefully monitoring the borrower’s perfor-

mance throughout the life of the loan; and

• establishing appropriate risk-management

guidelines as described in this document.

2010.2.3.1.5 Underwriting Standards

A ﬁnancial institution’s underwriting standards

should be clear, written, and measurable, and

should accurately reﬂect the institution’s risk

appetite for leveraged lending transactions. A

ﬁnancial institution should have clear underwrit-

ing limits regarding leveraged transactions,

including the size that the institution will

arrange both individually and in the aggregate

for distribution. The originating institution

should be mindful of reputational risks associ-

ated with poorly underwritten transactions, as

these risks may ﬁnd their way into a wide vari-

ety of investment instruments and exacerbate

systemic risks within the general economy. At a

minimum, an institution’s underwriting stan-

dards should consider the following:

• Whether the business premise for each trans-

action is sound and the borrower’s capital

structure is sustainable regardless of whether

the transaction is underwritten for the institu-

tion’s own portfolio or with the intent to dis-

tribute. The entirety of a borrower’s capital

structure should reﬂect the application of

sound ﬁnancial analysis and underwriting

principles.

• A borrower’s capacity to repay and the ability

to de-lever to a sustainable level over a rea-

sonable period. As a general guide, institu-

tions also should consider whether base-case

cash-ﬂow projections show the ability to fully

amortize senior secured debt or repay a sig-

niﬁcant portion of total debt over the medium

term.

Also, projections should include one

or more realistic downside scenarios that

reﬂect key risks identiﬁed in the transaction.

15. Flex terms allow the arranger to change interest-rate

spreads during the syndication process to adjust pricing to

current liquidity levels.

16. Refer to other joint agency guidance regarding pur-

chased participations: OCC Loan Portfolio Management

Handbook, www.occ.gov/publications/publications-by-type/

comptrollers-handbook/lpm.pdf, “Loan Participations”; Board

Commercial Bank Examination Manual, www.federalreserve

.gov/boarddocs/supmanual/cbem/cbem.pdf, section 2045.1,

“Loan Participations, the Agreements and Participants”; and

FDIC Risk Management Manual of Examination Policies,

“Section 3.2-Loans,” www.fdic.gov/regulations/safety/

manual/section3-2.html#otherCredit, Loan Participations (last

updated Feb. 2, 2005).

17. In general, the base-case cash-ﬂow projection is the

borrower or deal sponsor’s expected estimate of ﬁnancial

performance using the assumptions that are deemed most

likely to occur. The ﬁnancial results for the base case should

be better than those for the conservative case but worse than

those for the aggressive or upside case. A ﬁnancial institution

may adjust the base-case ﬁnancial projections, if necessary.

The most realistic ﬁnancial projections should be used when

measuring a borrower’s capacity to repay and de-lever.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 12

• Expectations for the depth and breadth of due

diligence on leveraged transactions. This

should include standards for evaluating vari-

ous types of collateral, with a clear deﬁnition

of credit-risk-management’s role in such due

diligence.

• Standards for evaluating expected risk-

adjusted returns. The standards should include

identiﬁcation of expected distribution strate-

gies, including alternative strategies for fund-

ing and disposing of positions during market

disruptions, and the potential for losses during

such periods.

• The degree of reliance on enterprise value and

other intangible assets for loan repayment,

along with acceptable valuation methodolo-

gies, and guidelines for the frequency of peri-

odic reviews of those values.

• Expectations for the degree of support pro-

vided by the sponsor (if any), taking into

consideration the sponsor’s ﬁnancial capacity,

the extent of its capital contribution at incep-

tion, and other motivating factors. Institutions

looking to rely on sponsor support as a sec-

ondary source of repayment for the loan

should be able to provide documentation,

including, but not limited to, ﬁnancial or

liquidity statements, showing recently docu-

mented evidence of the sponsor’s willingness

and ability to support the credit extension.

• Whether credit-agreement terms allow for the

material dilution, sale, or exchange of collat-

eral or cash-ﬂow-producing assets without

lender approval.

• Credit-agreement covenant protections,

including ﬁnancial performance (such as debt-

to-cash ﬂow, interest coverage, or ﬁxed-

charge coverage), reporting requirements, and

compliance monitoring. Generally, a leverage

level after planned asset sales (that is, the

amount of debt that must be serviced from

operating cash ﬂow) in excess of 6* Total

Debt/EBITDA raises concerns for most indus-

tries.

• Collateral requirements in credit agreements

that specify acceptable collateral and risk-

appropriate measures and controls, including

acceptable collateral types, loan-to-value

guidelines, and appropriate collateral-

valuation methodologies. Standards for asset-

based loans that are part of the entire debt

structure also should outline expectations for

the use of collateral controls (for example,

inspections, independent valuations, and pay-

ment lockbox), other types of collateral and

account maintenance agreements, and peri-

odic reporting requirements.

• Whether loan agreements provide for distribu-

tion of ongoing ﬁnancial and other relevant

credit information to all participants and

investors.

Nothing in the preceding standards should be

considered to discourage providing ﬁnancing to

borrowers engaged in workout negotiations, or

as part of a pre-packaged ﬁnancing under the

bankruptcy code. Neither are they meant to dis-

courage well-structured, standalone asset-based

credit facilities to borrowers with strong lender

monitoring and controls, for which a ﬁnancial

institution should consider separate underwrit-

ing and risk-rating guidance.

2010.2.3.1.6 Valuation Standards

Institutions often rely on enterprise value and

other intangibles when (1) evaluating the feasi-

bility of a loan request; (2) determining the debt

reduction potential of planned asset sales;

(3) assessing a borrower’s ability to access the

capital markets; and (4) estimating the strength

of a secondary source of repayment. Institutions

may also view enterprise value as a useful

benchmark for assessing a sponsor’s economic

incentive to provide ﬁnancial support. Given the

specialized knowledge needed for the develop-

ment of a credible enterprise valuation and the

importance of enterprise valuations in the under-

writing and ongoing risk-assessment processes,

enterprise valuations should be performed by

qualiﬁed persons independent of an institution’s

origination function.

There are several methods used for valuing

businesses. The most common valuation meth-

ods are assets, income, and market. Asset valua-

tion methods consider an enterprise’s under-

lying assets in terms of its net going-concern or

liquidation value. Income valuation methods

consider an enterprise’s ongoing cash ﬂows or

earnings and apply appropriate capitalization or

discounting techniques. Market valuation meth-

ods derive value multiples from comparable

company data or sales transactions. However,

ﬁnal value estimates should be based on the

method or methods that give supportable and

credible results. In many cases, the income

method is generally considered the most reli-

able.

There are two common approaches employed

when using the income method. The “capital-

ized cash ﬂow” method determines the value of

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 13

a company as the present value of all future cash

ﬂows the business can generate in perpetuity.

An appropriate cash ﬂow is determined and then

divided by a risk-adjusted capitalization rate,

most commonly the weighted average cost of

capital. This method is most appropriate when

cash ﬂows are predictable and stable. The “dis-

counted cash ﬂow” method is a multiple-period

valuation model that converts a future series of

cash ﬂows into current value by discounting

those cash ﬂows at a rate of return (referred to

as the “discount rate”) that reﬂects the risk

inherent therein. This method is most appropri-

ate when future cash ﬂows are cyclical or vari-

able over time. Both income methods involve

numerous assumptions, and therefore, support-

ing documentation should fully explain the

evaluator’s reasoning and conclusions.

When a borrower is experiencing a ﬁnancial

downturn or facing adverse market conditions, a

lender should reﬂect those adverse conditions in

its assumptions for key variables such as cash

ﬂow, earnings, and sales multiples when assess-

ing enterprise value as a potential source of

repayment. Changes in the value of a bor-

rower’s assets should be tested under a range of

stress scenarios, including business conditions

more adverse than the base-case scenario. Stress

tests of enterprise values and their underlying

assumptions should be conducted and docu-

mented at origination of the transaction and

periodically thereafter, incorporating the actual

performance of the borrower and any adjust-

ments to projections. The institution should per-

form its own discounted cash-ﬂow analysis to

validate the enterprise value implied by proxy

measures such as multiples of cash ﬂow, earn-

ings, or sales.

Enterprise value estimates derived from even

the most rigorous procedures are imprecise and

ultimately may not be realized. Therefore, insti-

tutions relying on enterprise value or illiquid

and hard-to-value collateral should have poli-

cies that provide for appropriate loan-to-value

ratios, discount rates, and collateral margins.

Based on the nature of an institution’s leveraged

lending activities, the institution should estab-

lish limits for the proportion of individual trans-

actions and the total portfolio that are supported

by enterprise value. Regardless of the methodol-

ogy used, the assumptions underlying enterprise

value estimates should be clearly documented,

well supported, and understood by the institu-

tion’s appropriate decisionmakers and risk-

oversight units. Further, an institution’s valua-

tion methods should be appropriate for the

borrower’s industry and condition.

2010.2.3.1.7 Pipeline Management

Market disruptions can substantially impede the

ability of an underwriter to consummate syndi-

cations or otherwise sell down exposures, which

may result in material losses. Accordingly,

ﬁnancial institutions should have strong risk

management and controls over transactions in

the pipeline, including amounts to be held and

those to be distributed. A ﬁnancial institution

should be able to differentiate transactions

according to tenor, investor class (for example,

pro-rata and institutional), structure, and key

borrower characteristics (for example, industry).

In addition, an institution should develop and

maintain the following:

• A clearly articulated and documented appetite

for underwriting risk that considers the poten-

tial effects on earnings, capital, liquidity, and

other risks that result from pipeline exposures.

• Written policies and procedures for deﬁning

and managing distribution failures and “hung”

deals, which are identiﬁed by an inability to

sell down the exposure within a reasonable

period (generally 90 days from transaction

closing). The ﬁnancial institution’s board of

directors and management should establish

clear expectations for the disposition of pipe-

line transactions that are not sold according to

their original distribution plan. Such transac-

tions that are subsequently reclassiﬁed as

hold-to-maturity should also be reported to

management and the board of directors.

• Guidelines for conducting periodic stress tests

on pipeline exposures to quantify the potential

impact of changing economic and market con-

ditions on the institution’s asset quality, earn-

ings, liquidity, and capital.

• Controls to monitor performance of the pipe-

line against original expectations, and regular

reports of variances to management, including

the amount and timing of syndication and

distribution variances and reporting of

recourse sales to achieve distribution.

• Reports that include individual and aggregate

transaction information that accurately risk

rates credits and portrays risk and concentra-

tions in the pipeline.

• Limits on aggregate pipeline commitments.

• Limits on the amount of loans that an institu-

tion is willing to retain on its own books (that

is, borrower, counterparty, and aggregate hold

levels), and limits on the underwriting risk

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 14

that will be undertaken for amounts intended

for distribution.

• Policies and procedures that identify accept-

able accounting methodologies and controls

in both functional as well as dysfunctional

markets, and that direct prompt recognition of

losses in accordance with generally accepted

accounting principles.

• Policies and procedures addressing the use of

hedging to reduce pipeline and hold expo-

sures, which should address acceptable types

of hedges and the terms considered necessary

for providing a net credit exposure after

hedging.

• Plans and provisions addressing contingent

liquidity and compliance with the Board’s

Regulation W (12 CFR part 223) when mar-

ket illiquidity or credit conditions change,

interrupting normal distribution channels.

2010.2.3.1.8 Reporting and Analytics

The agencies expect ﬁnancial institutions to dili-

gently monitor higher-risk credits, including

leveraged loans. A ﬁnancial institution’s man-

agement should receive comprehensive reports

about the characteristics and trends in such

exposures at least quarterly, and summaries

should be provided to the institution’s board of

directors. Policies and procedures should iden-

tify the ﬁelds to be populated and captured by a

ﬁnancial institution’s Management Information

Systems, which should yield accurate and timely

reporting to management and the board of direc-

tors that may include the following:

• Individual and portfolio exposures within and

across all business lines and legal vehicles,

including the pipeline.

• Risk-rating distribution and migration analy-

sis, including maintenance of a list of those

borrowers who have been removed from the

leveraged portfolio due to improvements in

their ﬁnancial characteristics and overall risk

proﬁle.

• Industry mix and maturity proﬁle.

• Metrics derived from probabilities of default

and loss given default.

• Portfolio performance measures, including

noncompliance with covenants, restructurings,

delinquencies, non-performing amounts, and

charge-offs.

• Amount of impaired assets and the nature of

impairment (that is, permanent, or tempo-

rary), and the amount of the ALLL attribut-

able to leveraged lending.

• The aggregate level of policy exceptions and

the performance of that portfolio.

• Exposures by collateral type, including unse-

cured transactions and those where enterprise

value will be the source of repayment for

leveraged loans. Reporting should also con-

sider the implications of defaults that trigger

pari passu (in a fair way) treatment for all

lenders and, thus, dilute the secondary support

from the sale of collateral.

• Secondary-market-pricing data and trading

volume, when available.

• Exposures and performance by deal sponsors.

Deals introduced by sponsors may, in some

cases, be considered exposure to related bor-

rowers. An institution should identify, aggre-

gate, and monitor potential related exposures.

• Gross and net exposures, hedge counterparty

concentrations, and policy exceptions.

• Actual versus projected distribution of the

syndicated pipeline, with regular reports of

excess levels over the hold targets for the

syndication inventory. Pipeline deﬁnitions

should clearly identify the type of exposure.

This includes committed exposures that have

not been accepted by the borrower, commit-

ments accepted but not closed, and funded

and unfunded commitments that have closed

but have not been distributed.

• Total and segmented leveraged lending expo-

sures, including subordinated debt and equity

holdings, alongside established limits. Reports

should provide a detailed and comprehensive

view of global exposures, including situations

when an institution has indirect exposure to

an obligor or is holding a previously sold

position as collateral or as a reference asset in

a derivative.

• Borrower and counterparty leveraged lending

reporting should consider exposures booked

in other business units throughout the institu-

tion, including indirect exposures such as

default swaps and total return swaps, naming

the distributed paper as a covered or refer-

enced asset or collateral exposure through

repo transactions. Additionally, the institution

should consider positions held in available-

for-sale or traded portfolios or through struc-

tured investment vehicles owned or sponsored

by the originating institution or its subsidi-

aries or afﬁliates.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 15

2010.2.3.1.9 Risk Rating

Leveraged Loans

Previously, the agencies issued guidance on rat-

ing credit exposures and credit-rating systems,

which applies to all credit transactions, includ-

ing those in the leveraged lending category.

The risk rating of leveraged loans involves

the use of realistic repayment assumptions to

determine a borrower’s ability to de-lever to a

sustainable level within a reasonable period. For

example, supervisors commonly assume that the

ability to fully amortize senior secured debt or

the ability to repay at least 50 percent of total

debt over a ﬁve- to seven-year period provides

evidence of adequate repayment capacity. If the

projected capacity to pay down debt from cash

ﬂow is nominal with reﬁnancing the only viable

option, the credit will usually be adversely rated

even if it has been recently underwritten. In

cases when leveraged loan transactions have no

reasonable or realistic prospects to de-lever, a

substandard rating is likely. Furthermore, when

assessing debt service capacity, extensions and

restructures should be scrutinized to ensure that

the institution is not merely masking repayment

capacity problems by extending or restructuring

the loan.

If the primary source of repayment becomes

inadequate, the agencies believe that it would

generally be inappropriate for an institution to

consider enterprise value as a secondary source

of repayment unless that value is well sup-

ported. Evidence of well-supported value may

include binding purchase and sale agreements

with qualiﬁed third parties or thorough asset

valuations that fully consider the effect of the

borrower’s distressed circumstances and poten-

tial changes in business and market conditions.

For such borrowers, when a portion of the loan

may not be protected by pledged assets or a

well-supported enterprise value, examiners gen-

erally will rate that portion doubtful or loss and

place the loan on nonaccrual status.

2010.2.3.1.10 Credit Analysis

Effective underwriting and management of

leveraged lending risk is highly dependent on

the quality of analysis employed during the

approval process as well as ongoing monitoring.

A ﬁnancial institution’s policies should address

the need for a comprehensive assessment of

ﬁnancial, business, industry, and management

risks including, whether

• cash-ﬂow analyses rely on overly optimistic

or unsubstantiated projections of sales, mar-

gins, and merger and acquisition synergies;

• liquidity analyses include performance met-

rics appropriate for the borrower’s industry,

predictability of the borrower’s cash ﬂow,

measurement of the borrower’s operating cash

needs, and ability to meet debt maturities;

• projections exhibit an adequate margin for

unanticipated merger-related integration costs;

• projections are stress tested for one or more

downside scenarios, including a covenant

breach;

• transactions are reviewed at least quarterly to

determine variance from plan, the related risk

implications, and the accuracy of risk ratings

and accrual status. From inception, the credit

ﬁle should contain a chronological rationale

for and analysis of all substantive changes to

the borrower’s operating plan and variance

from expected ﬁnancial performance;

• enterprise and collateral valuations are inde-

pendently derived or validated outside of the

origination function, are timely, and consider

potential value erosion;

• collateral liquidation and asset sale estimates

are based on current market conditions and

trends;

• potential collateral shortfalls are identiﬁed and

factored into risk rating and accrual decisions;

• contingency plans anticipate changing condi-

tions in debt or equity markets when expo-

sures rely on reﬁnancing or the issuance of

new equity; and

• the borrower is adequately protected from

interest rate and foreign exchange risk.

2010.2.3.1.11 Problem-Credit

Management

A ﬁnancial institution should formulate indi-

vidual action plans when working with borrow-

ers experiencing diminished operating cash

ﬂows, depreciated collateral values, or other

signiﬁcant plan variances. Weak initial under-

writing of transactions, coupled with poor struc-

18. Board SR-98-25, “Sound Credit Risk Management and

the Use of Internal Credit Risk Ratings at Large Banking

Organizations”; OCC Comptroller’s Handbooks “Rating

Credit Risk” and “Leveraged Lending”; and FDIC Risk Man-

agement Manual of Examination Policies, “Loan Appraisal

and Classiﬁcation.”

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 16

ture and limited covenants, may make problem-

credit discussions and eventual restructurings

more difﬁcult for an institution as well as result

in less favorable outcomes.

A ﬁnancial institution should formulate credit

policies that deﬁne expectations for the manage-

ment of adversely rated and other high-risk bor-

rowers whose performance departs signiﬁcantly

from planned cash ﬂows, asset sales, collateral

values, or other important targets. These poli-

cies should stress the need for workout plans

that contain quantiﬁable objectives and mea-

sureable time frames. Actions may include

working with the borrower for an orderly resolu-

tion while preserving the institution’s interests,

sale of the credit in the secondary market, or

liquidation of collateral. Problem credits should

be reviewed regularly for risk rating accuracy,

accrual status, recognition of impairment

through speciﬁc allocations, and charge-offs.

2010.2.3.1.12 Deal Sponsors

A ﬁnancial institution that relies on sponsor

support as a secondary source of repayment

should develop guidelines for evaluating the

qualiﬁcations of ﬁnancial sponsors and should

implement processes to regularly monitor a

sponsor’s ﬁnancial condition. Deal sponsors

may provide valuable support to borrowers such

as strategic planning, management, and other

tangible and intangible beneﬁts. Sponsors may

also provide sources of ﬁnancial support for

borrowers that fail to achieve projections. Gen-

erally, a ﬁnancial institution rates a borrower

based on an analysis of the borrower’s stand-

alone ﬁnancial condition. However, a ﬁnancial

institution may consider support from a sponsor

in assigning internal risk ratings when the insti-

tution can document the sponsor’s history of

demonstrated support as well as the economic

incentive, capacity, and stated intent to continue

to support the transaction. However, even with

documented capacity and a history of support,

the sponsor’s potential contributions may not

mitigate supervisory concerns absent a docu-

mented commitment of continued support. An

evaluation of a sponsor’s ﬁnancial support

should include the following:

• the sponsor’s historical performance in sup-

porting its investments, ﬁnancially and other-

wise

• the sponsor’s economic incentive to support,

including the nature and amount of capital

contributed at inception

• documentation of degree of support (for

example, a guarantee, comfort letter, or verbal

assurance)

• consideration of the sponsor’s contractual

investment limitations

• to the extent feasible, a periodic review of the

sponsor’s ﬁnancial statements and trends, and

an analysis of its liquidity, including the abil-

ity to fund multiple deals

• consideration of the sponsor’s dividend and

capital contribution practices

• the likelihood of the sponsor supporting a

particular borrower compared to other deals

in the sponsor’s portfolio

• guidelines for evaluating the qualiﬁcations of

a sponsor and a process to regularly monitor

the sponsor’s performance

2010.2.3.1.13 Credit Review

A ﬁnancial institution should have a strong and

independent credit-review function that demon-

strates the ability to identify portfolio risks and

documented authority to escalate inappropriate

risks and other ﬁndings to its senior manage-

ment. Due to the elevated risks inherent in lever-

aged lending, and depending on the relative size

of a ﬁnancial institution’s leveraged lending

business, the institution’s credit-review function

should assess the performance of the leveraged

portfolio more frequently and in greater depth

than other segments in the loan portfolio. Such

assessments should be performed by individuals

with the expertise and experience for these types

of loans and the borrower’s industry. Portfolio

reviews should generally be conducted at least

annually. For many ﬁnancial institutions, the

risk characteristics of leveraged portfolios, such

as high reliance on enterprise value, concentra-

tions, adverse risk rating trends, or portfolio

performance, may dictate reviews that are more

frequent.

A ﬁnancial institution should staff its internal

credit-review function appropriately and ensure

that the function has sufﬁcient resources to

ensure timely, independent, and accurate assess-

ments of leveraged lending transactions.

Reviews should evaluate the level of risk, risk

rating integrity, valuation methodologies, and

the quality of risk management. Internal credit

reviews should include the review of the institu-

tion’s leveraged lending practices, policies, and

procedures to ensure that they are consistent

with regulatory guidance.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 17

2010.2.3.1.14 Stress Testing

A ﬁnancial institution should develop and

implement guidelines for conducting periodic

portfolio stress tests on loans originated to hold

as well as loans originated to distribute, and

sensitivity analyses to quantify the potential

impact of changing economic and market condi-

tions on its asset quality, earnings, liquidity, and

capital.

The sophistication of stress testing

practices and sensitivity analyses should be con-

sistent with the size, complexity, and risk char-

acteristics of the institution’s leveraged loan

portfolio. To the extent a ﬁnancial institution is

required to conduct enterprise-wide stress tests,

the leveraged portfolio should be included in

any such tests.

2010.2.3.1.15 Conﬂicts of Interest

A ﬁnancial institution should develop appropri-

ate policies and procedures to address and to

prevent potential conﬂicts of interest when it

has equity and lending positions. For example,

an institution may be reluctant to use an aggres-

sive collection strategy with a problem borrower

because of the potential impact on the value of

an institution’s equity interest. A ﬁnancial insti-

tution may encounter pressure to provide ﬁnan-

cial or other privileged client information that

could beneﬁt an afﬁliated equity investor. Such

conﬂicts also may occur when the underwriting

ﬁnancial institution serves as ﬁnancial advisor

to the seller and simultaneously offers ﬁnancing

to multiple buyers (that is, stapled ﬁnancing).

Similarly, there may be conﬂicting interests

among the different lines of business within a

ﬁnancial institution or between the ﬁnancial

institution and its afﬁliates. When these situa-

tions occur, potential conﬂicts of interest arise

between the ﬁnancial institution and its custom-

ers. Policies and procedures should clearly

deﬁne potential conﬂicts of interest, identify

appropriate risk-management controls and pro-

cedures, enable employees to report potential

conﬂicts of interest to management for action

without fear of retribution, and ensure compli-

ance with applicable laws. Further, management

should have an established training program for

employees on appropriate practices to follow to

avoid conﬂicts of interest and provide for report-

ing, tracking, and resolution of any conﬂicts of

interest that occur.

2010.2.3.1.16 Reputational Risk

Leveraged lending transactions are often syndi-

cated through the ﬁnancial and institutional mar-

kets. A ﬁnancial institution’s apparent failure to

meet its legal responsibilities in underwriting

and distributing transactions can damage its

market reputation and impair its ability to com-

pete. Similarly, a ﬁnancial institution that dis-

tributes transactions, which over time have sig-

niﬁcantly higher default or loss rates and

performance issues, may also see its reputation

damaged.

2010.2.3.1.17 Compliance

The legal and regulatory issues raised by lever-

aged transactions are numerous and complex.

To ensure potential conﬂicts are avoided and

laws and regulations are adhered to, an institu-

tion’s independent compliance function should

periodically review the institution’s leveraged

lending activity. This guidance is consistent with

the principles of safety and soundness and other

agency guidance related to commercial lending.

In particular, because leveraged transactions

often involve a variety of types of debt and bank

products, a ﬁnancial institution should ensure

that its policies incorporate safeguards to pre-

vent violations of anti-tying regulations. Section

106(b) of the Bank Holding Company Act

Amendments of 1970

prohibits certain forms

of product tying by ﬁnancial institutions and

their afﬁliates. The intent behind Section 106(b)

is to prevent ﬁnancial institutions from using

their market power over certain products to

obtain an unfair competitive advantage in other

products.

In addition, equity interests and certain debt

instruments used in leveraged transactions may

constitute “securities” for the purposes of fed-

eral securities laws. When securities are

19. See interagency guidance “Supervisory Guidance on

Stress Testing for Banking Organizations with More Than

$10 Billion in Total Consolidated Assets” (see Board SR

Letter 12-7 and its attachment), 77 Fed. Reg. 29458 (May 17,

2012), at www.gpo.gov/fdsys/pkg/FR-2012-05-17/html/2012-

11989.htm, and the joint “Statement to Clarify Supervisory

Expectations for Stress Testing by Community Banks,”

May 14, 2012, by the OCC at www.occ.gov/news-issuances/

news-releases/2012/nr-ia-2012-76a.pdf; the Board at

www.federal reserve.gov/newsevents/press/bcreg/

bcreg20120514b1.pdf; and the FDIC at www.fdic.gov/news/

news/press/2012/pr12054a.pdf. See also FDIC ﬁnal rule,

Annual Stress Test, 77 Fed. Reg. 62417 (Oct. 15, 2012) (to be

codiﬁed at 12 CFR part 325, subpart C).

9k. 12 USC 1972.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 18

involved, an institution should ensure compli-

ance with applicable securities laws, including

disclosure and other regulatory requirements.

An institution should also establish policies and

procedures to appropriately manage the internal

dissemination of material, nonpublic informa-

tion about transactions in which it plays a role.

2010.2.4 CREDIT-RISK

MANAGEMENT GUIDANCE FOR

HOME EQUITY LENDING

On May 16, 2005, the federal bank and thrift

regulatory agencies collectively issued the fol-

lowing interagency guidance. The guidance is

intended to promote sound credit-risk manage-

ment practices at banking organizations

that

have home equity lending programs, including

open-end home equity lines of credit (HELOCs)

and closed-end home equity loans (HELs).

Banking organizations’ credit-risk management

practices for home equity lending need to keep

pace with the rapid growth in home equity lend-

ing and should emphasize compliance with

sound underwriting standards and practices.

The risk factors listed below, combined with

an inherent vulnerability to rising interest rates,

suggest that banking organizations need to fully

recognize the risk embedded in their home

equity portfolios. Following are the speciﬁc

product, risk-management, and underwriting

risk factors and trends that deserve scrutiny:

1. interest-only features that require no amorti-

zation of principal for a protracted period

2. limited or no documentation of a borrower’s

assets, employment, and income (known as

“low do’’ or “no doc’’ lending)

3. higher loan-to-value (LTV) and debt-to-

income (DTI) ratios

4. lower credit-risk scores for underwriting

home equity loans;

5. greater use of automated valuation models

(AVMs) and other collateral-evaluation tools

for the development of appraisals and

evaluations

6. an increase in the number of transactions

generated through a loan broker or other

third party

Home equity lending can be conducted in a

safe and sound manner if pursued with the

appropriate risk-management structure, includ-

ing adequate allowances for loan and lease

losses and appropriate capital levels. Sound

practices call for fully articulated policies that

address marketing, underwriting standards,

collateral-valuation management, individual-

account and portfolio management, and

servicing.

Banking organizations should ensure that

risk-management practices keep pace with the

growth and changing risk proﬁle of home equity

portfolios. Management should actively assess a

portfolio’s vulnerability to changes in consum-

ers’ ability to pay and the potential for declines

in home values. Active portfolio management is

especially important for banking organizations

that project or have already experienced signiﬁ-

cant growth or concentrations, particularly in

higher-risk products such as high-LTV, “low

doc’’ or “no doc,’’ interest-only, or third-party-

generated loans. (See SR-05-11.)

2010.2.4.1 Credit-Risk Management

Systems

2010.2.4.1.1 Product Development and

Marketing

In the development of any new product offering,

product change, or marketing initiative, manage-

ment should have a review and approval process

that is sufﬁciently broad to ensure compliance

with the banking organization’s internal policies

and applicable laws and regulations

and to

evaluate the credit, interest-rate, operational,

compliance, reputation, and legal risks. In par-

ticular, risk-management personnel should be

involved in product development, including an

evaluation of the targeted population and the

product(s) being offered. For example, material

21. The agencies are the Board of Governors of the Federal

Reserve System, the Ofﬁce of the Comptroller of the Cur-

rency, the Federal Deposit Insurance Corporation, and the

National Credit Union Administration. The interagency guid-

ance frequently uses the term “ﬁnancial institutions.’’ Bank

holding companies have ﬁnancial institutions and various

credit-extending nonbanking subsidiaries. The combined

entity is being referred to in this guidance as a banking

organization.

22. Applicable laws include the Federal Trade Commis-

sion Act; the Equal Credit Opportunity Act (ECOA); the

Truth in Lending Act (TILA), including the Home Ownership

and Equity Protection Act (HOEPA); the Fair Housing Act;

the Real Estate Settlement Procedures Act (RESPA); and the

Home Mortgage Disclosure Act (HMDA), as well as applica-

ble state consumer protection laws.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 19

changes in the targeted market, origination

source, or pricing could have a signiﬁcant

impact on credit quality and should receive

senior management approval.

When HELOCs or HELs are marketed or

closed by a third party, banking organizations

should have standards that provide assurance

that the third party also complies with applica-

ble laws and regulations, including those on

marketing materials, loan documentation, and

closing procedures. (For further details on agent

relationships, see section 2010.2.4.1.3, “Third-

Party Originations.’’) Finally, management

should have appropriate monitoring tools and

management information systems (MIS) to mea-

sure the performance of various marketing ini-

tiatives, including offers to increase a line,

extend the interest-only period, or adjust the

interest rate or term.

2010.2.4.1.2 Origination and

Underwriting

All relevant risk factors should be considered

when establishing product offerings and under-

writing guidelines. Generally, these factors

should include a borrower’s income and debt

levels, credit score (if obtained), and credit his-

tory, as well as the loan size, collateral value

(including valuation methodology), lien posi-

tion, and property type and location.

Consistent with the Federal Reserve’s regula-

tions on real estate lending standards, prudently

underwritten home equity loans should include

an evaluation of a borrower’s capacity to

adequately service the debt.

Given the home

equity products’ long-term nature and the large

credit amount typically extended to a consumer,

an evaluation of repayment capacity should con-

sider a borrower’s income and debt levels and

not just a credit score.

Credit scores are based

upon a borrower’s historical ﬁnancial perfor-

mance. While past performance is a good indi-

cator of future performance, a signiﬁcant change

in a borrower’s income or debt levels can

adversely alter the borrower’s ability to pay.

How much veriﬁcation these underwriting fac-

tors require will depend upon the individual

loan’s credit risk.

HELOCs generally do not have interest-rate

caps that limit rate increases.

Rising interest

rates could subject a borrower to signiﬁcant

payment increases, particularly in a low-

interest-rate environment. Therefore, underwrit-

ing standards for interest-only and variable-rate

HELOCs should include an assessment of the

borrower’s ability to amortize the fully drawn

line over the loan term and to absorb potential

increases in interest rates.

2010.2.4.1.3 Third-Party Originations

Banking organizations often use third parties,

such as mortgage brokers or correspondents, to

originate loans. When doing so, they should

have strong control systems to ensure the qual-

ity of originations and compliance with all

applicable laws and regulations, and to help

prevent fraud.

Brokers are ﬁrms or individuals, acting on

behalf of either the banking organization or the

borrower, who match the borrower’s needs with

institutions’ mortgage-origination programs.

Brokers take applications from consumers.

Although they sometimes process the applica-

tion and underwrite the loan to qualify the appli-

cation for a particular lender, they generally do

not use their own funds to close loans. Whether

brokers are allowed to process and perform any

underwriting will depend on the relationship

between the banking organization and the bro-

ker. For control purposes, the banking organiza-

tion should retain appropriate oversight of all

critical loan-processing activities, such as veriﬁ-

cation of income and employment and indepen-

dence in the appraisal and evaluation function.

Correspondents are ﬁnancial companies that

usually close and fund loans in their own name

and subsequently sell them to a lender. Banking

organizations commonly obtain loans through

correspondents and, in some cases, delegate the

underwriting function to the correspondent. In

delegated underwriting relationships, a banking

organization grants approval to a correspondent

ﬁnancial company to process, underwrite, and

close loans according to the delegator’s process-

ing and underwriting requirements and is com-

mitted to purchase those loans. The delegating

23. On December 23, 1992, the Federal Reserve

announced the adoption of uniform rules on real estate lend-

ing standards and issued the Interagency Guidelines for Real

Estate Lending Policies. See subsection 2010.2.1. See also 12

C.F.R., section 208.51 and appendix C.

24. The Interagency Guidelines Establishing Standards for

Safety and Soundness also call for documenting the source of

repayment and assessing the ability of the borrower to repay

the debt in a timely manner. See 12 C.F.R. 208, appendix D-1.

25. While there may be periodic rate increases, the lender

must state in the consumer credit contract the maximum

interest rate that may be imposed during the term of the

obligation. See 12 C.F.R. 226.30(b).

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2013

Page 20

banking organization should have systems and

controls to provide assurance that the correspon-

dent is appropriately managed, is ﬁnancially

sound, and provides mortgages that meet the

banking organization’s prescribed underwriting

guidelines and that comply with applicable con-

sumer protection laws and regulations. A

quality-control unit or function in the delegating

banking organization should closely monitor the

quality of loans that the correspondent under-

writes. Monitoring activities should include

post-purchase underwriting reviews and ongo-

ing portfolio-performance-management

activities.

Both brokers and correspondents are compen-

sated based upon mortgage-origination volume

and, accordingly, have an incentive to produce

and close as many loans as possible. Therefore,

banking organizations should perform compre-

hensive due diligence on third-party originators

prior to entering a relationship. In addition, once

a relationship is established, the banking organi-

zation should have adequate audit procedures

and controls to verify that the third parties are

not being paid to generate incomplete or fraudu-

lent mortgage applications or are not otherwise

receiving referral or unearned income or fees

contrary to RESPA prohibitions.

Monitoring

the quality of loans by origination source, and

uncovering such problems as early payment

defaults and incomplete packages, enables man-

agement to know if third-party originators are

producing quality loans. If ongoing credit or

documentation problems are discovered, the

banking organization should take appropriate

action against the third party, which could

include terminating its relationship with the

third party.

2010.2.4.1.4 Collateral-Valuation

Management

Competition, cost pressures, and advancements

in technology have prompted banking organiza-

tions to streamline their appraisal and evaluation

processes. These changes, coupled with banking

organizations underwriting to higher LTVs, have

heightened the importance of strong collateral-

valuation management policies, procedures, and

processes.

Banking organizations should have appropri-

ate collateral-valuation policies and procedures

that ensure compliance with the Federal

Reserve’s appraisal regulations

and the Inter-

agency Appraisal and Evaluation Guidelines

(the guidelines).

In addition, the banking orga-

nization should—

1. establish criteria for determining the appro-

priate valuation methodology for a particular

transaction, based on the risk in the transac-

tion and loan portfolio (For example, higher-

risk transactions or nonhomogeneous prop-

erty types should be supported by more-

thorough valuations. The banking

organization should also set criteria for deter-

mining the extent to which an inspection of

the collateral is necessary.)

2. ensure that an expected or estimated value of

the property is not communicated to an

appraiser or individual performing an

evaluation

3. implement policies and controls to preclude

“value shopping’’ (Use of several valuation

tools may return different values for the same

property. These differences can result in sys-

tematic overvaluation of properties if the

valuation choice becomes driven by the high-

est property value. If several different valua-

tion tools or AVMs are used for the same

property, the banking organization should

adhere to a policy for selecting the most

reliable method, rather than the highest

value.)

4. require sufﬁcient documentation to support

the collateral valuation in the appraisal or

evaluation

2010.2.4.1.5 AVMs

When AVMs are used to support evaluations or

appraisals, the banking organization should vali-

date the models on a periodic basis to mitigate

the potential valuation uncertainty in the model.

As part of the validation process, the banking

organization should document the validation’s

26. In addition, a banking organization that purchases loans

subject to TILA’s rules for HELs with high rates or high

closing costs (loans covered by HOEPA) can incur assignee

liability unless the banking organization can reasonably show

that it could not determine the transaction was a loan covered

by HOEPA. Also, the nature of its relationship with brokers

and correspondents may have implications for liability under

ECOA, and for reporting responsibilities under HMDA.

27. 12 C.F.R. 208, subpart E, and 12 C.F.R. 225, sub-

part G.

28. See SR-94-55, dated October 27, 1994. These revised

guidelines include the June 1994 amendments. See also sec-

tion 2231.0.15, appendix A.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2005

Page 21

analysis, assumptions, and conclusions. The

validation process includes back-testing a repre-

sentative sample of the valuations against mar-

ket data on actual sales (where sufﬁcient infor-

mation is available). The validation process

should cover properties representative of the

geographic area and property type for which the

tool is used.

Many AVM vendors, when providing a value,

will also provide a “conﬁdence score,’’ which

usually relates to the accuracy of the value

provided. Conﬁdence scores, however, come in

many different formats and are calculated based

on differing scoring systems. Banking organiza-

tions that use AVMs should have an understand-

ing of how the model works as well as what the

conﬁdence scores mean. Conﬁdence levels

should be established by the banking organiza-

tion that are appropriate for the risk in a given

transaction or group of transactions.

When tax-assessment valuations are used as a

basis for the collateral valuation, the banking

organization should be able to demonstrate and

document the correlation between the assess-

ment value of the taxing authority and the prop-

erty’s market value as part of the validation

process.

2010.2.4.1.6 Account Management

Since HELOCs often have long-term, interest-

only payment features, banking organizations

should have risk-management techniques that

identify higher-risk accounts and adverse

changes in account risk proﬁles, thereby

enabling management to implement timely pre-

ventive action (e.g., freezing or reducing lines).

Further, a banking organization should have

risk-management procedures to evaluate and

approve additional credit on an existing line or

extending the interest-only period. Account-

management practices should be appropriate for

the size of the portfolio and the risks associated

with the types of home equity lending.

Effective account-management practices for

large portfolios or portfolios with high-risk char-

acteristics include—

1. periodically refreshing credit-risk scores on

all customers;

2. using behavioral scoring and analysis of indi-

vidual borrower characteristics to identify

potential problem accounts;

3. periodically assessing utilization rates;

4. periodically assessing payment patterns,

including borrowers who make only mini-

mum payments over a period of time or those

who rely on the line to keep payments

current;

5. monitoring home values by geographic area;

and

6. obtaining updated information on the collat-

eral’s value when signiﬁcant market factors

indicate a potential decline in home values,

or when the borrower’s payment perfor-

mance deteriorates and greater reliance is

placed on the collateral.

The frequency of these actions should be

commensurate with the risk in the portfolio.

Banking organizations should conduct annual

credit reviews of HELOC accounts to determine

whether the line of credit should be continued,

based on the borrower’s current ﬁnancial

condition.

When appropriate, banking organizations

should refuse to extend additional credit or

reduce the credit limit of a HELOC, bearing in

mind that under Regulation Z such steps can be

taken only in limited circumstances. These

include, for example, when the value of the

collateral declines signiﬁcantly below the

appraised value for purposes of the HELOC,

default of a material obligation under the loan

agreement, or deterioration in the borrower’s

ﬁnancial circumstances.

In order to freeze or

reduce credit lines due to deterioration in a

borrower’s ﬁnancial circumstances, two condi-

tions must be met: (1) there must be a “mate-

rial’’ change in the borrower’s ﬁnancial circum-

stances and (2) as a result of this change, the

banking organization must have a reasonable

belief that the borrower will be unable to fulﬁll

the plan’s payment obligations.

Account-management practices that do not

adequately control authorizations and provide

for timely repayment of over-limit amounts may

signiﬁcantly increase a portfolio’s credit risk.

Authorizations of over-limit home equity lines

of credit should be restricted and subject to

appropriate policies and controls. A banking

29. Under the Federal Reserve’s risk-based capital guide-

lines, an unused HELOC commitment with an original matu-

rity of one year or more may be allocated a zero percent

conversion factor if the banking organization conducts at least

an annual credit review and is able to unconditionally cancel

the commitment (i.e., prohibit additional extensions of credit,

reduce the credit line, and terminate the line) to the full extent

permitted by relevant federal law. See 12 C.F.R. 208, appen-

dix A, III.D.4., and 12 C.F.R. 225, appendix A, III.D.4.

30. Regulation Z does not permit these actions to be taken

in circumstances other than those speciﬁed in the regulation.

See 12 C.F.R. 226.5b(f)(3)(vi)(A)–(F).

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2005

Page 22

organization’s practices should require over-

limit borrowers to repay in a timely manner the

amount that exceeds established credit limits.

Management information systems should be

sufﬁcient to enable management to identify,

measure, monitor, and control the unique risks

associated with over-limit accounts.

2010.2.4.1.7 Portfolio Management

Banking organizations should implement an

effective portfolio credit-risk management pro-

cess for their home equity portfolios that

includes the following.

2010.2.4.1.7.1 Policies

The Federal Reserve’s real estate lending stan-

dards regulations require that a banking organi-

zation’s real estate lending policies be consis-

tent with safe and sound banking practices and

that the banking organization’s board of direc-

tors review and approve these policies at least

annually. Before implementing any changes to

policies or underwriting standards, management

should assess the potential effect on the banking

organization’s overall risk proﬁle, which would

include the effect on concentrations, proﬁtabil-

ity, and delinquency and loss rates. The accu-

racy of these estimates should be tested by

comparing them with actual experience.

2010.2.4.1.7.2 Portfolio Objectives and Risk

Diversiﬁcation

Effective portfolio management should clearly

communicate portfolio objectives, such as

growth targets, utilization, rate-of-return

hurdles, and default and loss expectations. For

banking organizations with signiﬁcant concen-

trations of HELs or HELOCs, limits should be

established and monitored for key portfolio seg-

ments, such as geographic area, loan type, and

higher-risk products. When appropriate, consid-

eration should be given to the use of risk miti-

gants, such as private mortgage insurance, pool

insurance, or securitization. As the portfolio

approaches concentration limits, the banking

organization should analyze the situation sufﬁ-

ciently to enable the banking organization’s

board of directors and senior management to

make a well-informed decision to either raise

concentration limits or pursue a different course

of action.

Effective portfolio management requires an

understanding of the various risk characteristics

of the home equity portfolio. To gain this under-

standing, a banking organization should analyze

the portfolio by segment, using criteria such as

product type, credit-risk score, DTI, LTV, prop-

erty type, geographic area, collateral-valuation

method, lien position, size of credit relative to

prior liens, and documentation type (such as “no

doc’’ or “low doc’’).

2010.2.4.1.7.3 Management Information

Systems

By maintaining adequate credit MIS, a banking

organization can segment loan portfolios and

accurately assess key risk characteristics. The

MIS should also provide management with suf-

ﬁcient information to identify, monitor, mea-

sure, and control home equity concentrations.

Banking organizations should periodically

assess the adequacy of their MIS in light of

growth and changes in their appetite for risk.

For banking organizations with signiﬁcant con-

centrations of HELs or HELOCs, MIS should

include, at a minimum, reports and analysis of

the following:

1. production and portfolio trends by product,

loan structure, originator channel, credit

score, LTV, DTI, lien position, documenta-

tion type, market, and property type

2. delinquency and loss-distribution trends by

product and originator channel with some

accompanying analysis of signiﬁcant under-

writing characteristics (such as credit score,

LTV, DTI)

3. vintage tracking

4. the performance of third-party originators

(brokers and correspondents)

5. market trends by geographic area and prop-

erty type to identify areas of rapidly appreci-

ating or depreciating housing values

2010.2.4.1.7.4 Policy and Underwriting-

Exception Systems

Banking organizations should have a process for

identifying, approving, tracking, and analyzing

underwriting exceptions. Reporting systems that

capture and track information on exceptions,

both by transaction and by relevant portfolio

segments, facilitate the management of a port-

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2005

Page 23

folio’s credit risk. The aggregate data is useful

to management in assessing portfolio risk pro-

ﬁles and monitoring the level of adherence to

policy and underwriting standards by various

origination channels. Analysis of the informa-

tion may also be helpful in identifying correla-

tions between certain types of exceptions and

delinquencies and losses.

2010.2.4.1.7.5 High-LTV Monitoring

To clarify the real estate lending standards regu-

lations and interagency guidelines, the agencies

issued Guidance on High Loan-To-Value

(HLTV) Residential Real Estate Lending (the

HLTV guidance) in October 1999. The HLTV

guidance clariﬁed the Interagency Real Estate

Lending Guidelines and the supervisory loan-to-

value limits for loans on one- to four-family

residential properties. Banking organizations are

expected to ensure compliance with the supervi-

sory loan-to-value limits of the Interagency Real

Estate Lending Guidelines. The HLTV guidance

outlines controls that the banking organizations

should have in place when engaging in HLTV

lending. Banking organizations should accu-

rately track the volume of HLTV loans, includ-

ing HLTV home equity and residential mort-

gages, and report the aggregate of such loans to

the banking organization’s board of directors.

Speciﬁcally, banking organizations are

reminded that:

1. Loans in excess of the supervisory LTV lim-

its should be identiﬁed in the banking organi-

zation’s records. The aggregate of high-LTV

one-to four-family residential loans should

not exceed 100 percent of the banking orga-

nization’s total capital.

Within that limit,

high-LTV loans for properties other than

one- to four-family residential properties

should not exceed 30 percent of capital.

2. In calculating the LTV and determining com-

pliance with the supervisory LTVs, the bank-

ing organization should consider all senior

liens. All loans secured by the property and

held by the banking organization are reported

as an exception if the combined LTV of a

loan and all senior liens on an owner-

occupied one- to four-family residential

property equals or exceeds 90 percent and if

there is no additional credit enhancement in

the form of either mortgage insurance or

readily marketable collateral.

3. For the LTV calculation, the loan amount is

the legally binding commitment (that is, the

entire amount that the banking organization

is legally committed to lend over the life of

the loan).

4. All real–estate secured loans in excess of

supervisory LTV limits should be aggregated

and included in a quarterly report for the

banking organization’s board of directors.

Certain insurance products help banking

organizations mitigate the credit risks of HLTV

residential loans. Insurance policies that cover a

“pool’’ of loans can be an efﬁcient and effective

credit-risk management tool. But if a policy has

a coverage limit, the coverage may be exhausted

before all loans in the pool mature or pay off.

The Federal Reserve considers pool insurance to

be a sufﬁcient credit enhancement to remove the

HLTV designation in the following circum-

stances: (1) the policy is issued by an acceptable

mortgage insurance company, (2) it reduces the

LTV for each loan to less than 90 percent, and

(3) it is effective over the life of each loan in the

pool.

2010.2.4.1.7.6 Stress Testing for Portfolios

Banking organizations with home equity con-

centrations as well as higher-risk portfolios are

encouraged to perform sensitivity analyses on

key portfolio segments. This type of analysis

identiﬁes possible events that could increase

risk within a portfolio segment or for the port-

folio as a whole. Banking organizations should

consider stress tests that incorporate interest-

rate increases and declines in home values.

Since these events often occur simultaneously,

the agencies recommend testing for these events

together. Banking organizations should also

periodically analyze markets in key geographic

areas, including identiﬁed “soft’’ markets. Man-

agement should consider developing contin-

gency strategies for scenarios and outcomes that

extend credit risk beyond internally established

31. For purposes of the Interagency Real Estate Lending

Standards Guidelines, high-LTV one- to four-family residen-

tial property loans include (1) a loan for raw land zoned for

one- to four-family residential use with an LTV ratio greater

than 65 percent; (2) a residential land development loan or

improved lot loan with an LTV greater than 75 percent; (3) a

residential construction loan with an LTV ratio greater than

85 percent; (4) a loan on non-owner occupied one- to four-

family residential property with an LTV greater than 85 per-

cent; and (5) a permanent mortgage or home equity loan on an

owner-occupied residential property with an LTV equal to or

exceeding 90 percent without mortgage insurance, readily

marketable collateral, or other acceptable collateral.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2005

Page 24

risk tolerances. These contingency plans might

include increased monitoring, tightening under-

writing, limiting growth, and selling loans or

portfolio segments.

2010.2.4.1.8 Operations, Servicing, and

Collections

Effective procedures and controls should be

maintained for such support functions as per-

fecting liens, collecting outstanding loan docu-

ments, obtaining insurance coverage (including

ﬂood insurance), and paying property taxes.

Credit-risk management should oversee these

support functions to ensure that operational risks

are properly controlled.

2010.2.4.1.8.1 Lien Recording

Banking organizations should take appropriate

measures to safeguard their lien position. They

should verify the amount and priority of any

senior liens prior to closing the loan. This infor-

mation is necessary to determine the loan’s LTV

ratio and to assess the credit support of the

collateral. Senior liens include ﬁrst mortgages,

outstanding liens for unpaid taxes, outstanding

mechanic’s liens, and recorded judgments on

the borrower.

2010.2.4.1.8.2 Problem-Loan Workouts and

Loss-Mitigation Strategies

Banking organizations should have established

policies and procedures for problem loan work-

outs and loss-mitigation strategies. Policies

should be in accordance with the requirements

of the FFIEC’s Uniform Retail Credit Classiﬁ-

cation and Account Management Policy, issued

June 2000 (see SR-00-8 and section 2241.0) and

should, at a minimum, address the following:

1. circumstances and qualifying requirements

for various workout programs including

extensions, re-ages, modiﬁcations, and

re-writes (Qualifying criteria should include

an analysis of a borrower’s ﬁnancial capacity

to service the debt under the new terms.)

2. circumstances and qualifying criteria for

loss-mitigating strategies, including

foreclosure

3. appropriate MIS to track and monitor the

effectiveness of workout programs, including

tracking the performance of all categories of

workout loans (For large portfolios, vintage

delinquency and loss tracking also should be

included.)

While banking organizations are encouraged

to work with borrowers on a case-by-case basis,

a banking organization should not use workout

strategies to defer losses. Banking organizations

should ensure that credits in workout programs

are evaluated separately for the allowance for

loan and lease losses (ALLL), because such

credits tend to have higher loss rates than other

portfolio segments.

2010.2.4.1.9 Secondary-Market Activities

More banking organizations are issuing HELOC

mortgage-backed securities (that is, securitizing

HELOCs). Although such secondary-market

activities can enhance credit availability and a

banking organization’s proﬁtability, they also

pose certain risk-management challenges. A

banking organization’s risk-management sys-

tems should address the risks of HELOC

securitizations.

2010.2.4.1.10 Portfolio Classiﬁcations,

Allowance for Loan and Lease Losses,

and Capital

The FFIEC’s Uniform Retail Credit Classiﬁca-

tion and Account Management Policy governs

the classiﬁcation of consumer loans and estab-

lishes general classiﬁcation thresholds that are

based on delinquency. Banking organizations

and the Federal Reserve’s examiners have the

discretion to classify entire retail portfolios, or

segments thereof, when underwriting weak-

nesses or delinquencies are pervasive and pres-

ent an excessive level of credit risk. Portfolios

of high-LTV loans to borrowers who exhibit

inadequate capacity to repay the debt within a

reasonable time may be subject to classiﬁcation.

Banking organizations should establish

appropriate ALLL and hold capital commensu-

rate with the riskiness of their portfolios. In

determining the ALLL adequacy, a banking

organization should consider how the interest-

only and draw features of HELOCs during the

32. See the risk management and capital adequacy of expo-

sures arising from secondary-market credit activities discus-

sion in SR-97-21 (see also section 2129.05).

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2015

Page 25

lines’ revolving period could affect the loss

curves for its HELOC portfolio. Those banking

organizations engaging in programmatic sub-

prime home equity lending or banking organiza-

tions that have higher-risk products are expected

to recognize the elevated risk of the activity

when assessing capital and ALLL adequacy.

2010.2.5 OVERSIGHT OF

CONCENTRATIONS IN

COMMERCIAL REAL ESTATE

LENDING AND SOUND

RISK-MANAGEMENT LENDING

As part of a bank holding company inspection,

the examiner should make an assessment of the

parent company’s supervision and control over

its subsidiary lending activities, which includes

an overall assessment of the banking organiza-

tion’s credit-risk concentrations, including the

risk concentrations in commercial real estate

lending. (See also section 2010.2.) Banking

organizations, including bank holding compa-

nies, are responsible for establishing the neces-

sary and appropriate management oversight of

their bank and nonbank subsidiaries by adminis-

tering, monitoring, and assuring adherence to

the organization’s lending policies and practices

for controlling “concentration risk.” Banking

organizations should therefore have adequate

management information systems (including the

appropriate accounting and internal control sys-

tems) in place to accomplish their supervisory

oversight and to control such credit

concentrations.

The following guidance, Concentrations in

Commercial Real Estate (CRE) Lending, Sound

Risk-Management Practices (the guidance) was

issued on December 6, 2006 (effective on

December 12, 2006).

The guidance was devel-

oped to reinforce sound risk-management prac-

tices for institutions (includes banking organiza-

tions) with high and increasing concentrations

of commercial real estate loans on their balance

sheets. An institution’s strong risk-management

practices and its maintenance of appropriate lev-

els of capital are important elements of a sound

CRE lending program, particularly when an

institution has a concentration in CRE or a CRE

lending strategy leading to a concentration.

However, institutions needing to improve their

risk-management processes may have been pro-

vided the opportunity for some ﬂexibility on the

time frame for complying with the guidance.

This time frame will be commensurate with the

level and nature of CRE concentration risk, the

quality of the institution’s existing risk-

management practices, and its levels of capital.

(See 71 Fed. Reg. 74,580 [December 12, 2006],

the Federal Reserve Board’s press release dated

December 6, 2006, and SR-07-01 and its

attachments.) See also SR-15-17, “Interagency

Statement on Prudent Risk Management for

Commercial Real Estate Lending” and its

attachment and the Board’s December 18, 2015,

press release.

2010.2.5.1 Scope of the CRE

Concentration Guidance

The guidance focuses on those CRE loans for

which the cash ﬂow from the real estate is the

primary source of repayment rather than loans

to a borrower for which real estate collateral is

taken as a secondary source of repayment or

through an abundance of caution. For the pur-

poses of this guidance, CRE loans include those

loans with risk proﬁles sensitive to the condition

of the general CRE market (for example, market

demand, changes in capitalization rates, vacancy

rates, or rents). CRE loans are land development

and construction loans (including one- to four-

family residential and commercial construction

loans) and other land loans. CRE loans also

include loans secured by multifamily property,

and nonfarm nonresidential property where the

primary source of repayment is derived from

rental income associated with the property (that

is, loans for which 50 percent or more of the

source of repayment comes from third-party,

nonafﬁliated, rental income) or the proceeds of

the sale, reﬁnancing, or permanent ﬁnancing of

the property. Loans to real estate investment

33. See the January 2001 Interagency Expanded Guid-

ance for Subprime Lending Programs (section 2128.08) for

supervisory expectations regarding risk-management pro-

cesses, the allowance for loan and lease losses, and capital

adequacy for banking organizations engaging in subprime-

lending programs.

34. The guidance was jointly adopted by the Board of

Governors of the Federal Reserve System, the Ofﬁce of the

Comptroller of the Currency, and the Federal Deposit Insur-

ance Corporation after the bank supervisory agencies’ careful

consideration of the comments received following the initial

issuance of the January 10, 2006, proposed guidance on

concentrations in commercial real estate lending. The ﬁnal

guidance is applicable to state member banks and broadly

applicable to bank holding companies and their nonbank

subsidiaries. For the purposes of this section the references to

banks, institutions, and banking organizations is conﬁned to

those entities for which the Board of Governors of the Federal

Reserve System has supervisory authority.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2015

Page 26

trusts and unsecured loans to developers also

should be considered CRE loans for purposes of

this guidance if their performance is closely

linked to performance of the CRE markets. The

scope of the guidance does not include loans

secured by nonfarm nonresidential properties

where the primary source of repayment is the

cash ﬂow from the ongoing operations and

activities conducted by the party, or afﬁliate of

the party, who owns the property. Rather than

deﬁning a CRE concentration, the guidance’s

“Supervisory Oversight” section describes the

criteria that the Federal Reserve will use as

high-level indicators to identify banks poten-

tially exposed to CRE concentration risk.

2010.2.5.2 CRE Concentration

Assessments

Banks that are actively involved in CRE lending

should perform ongoing risk assessments to

identify CRE concentrations. The risk assess-

ment should identify potential concentrations by

stratifying the CRE portfolio into segments that

have common risk characteristics or sensitivities

to economic, ﬁnancial, or business develop-

ments. A bank’s CRE portfolio stratiﬁcation

should be reasonable and supportable. The CRE

portfolio should not be divided into multiple

segments simply to avoid the appearance of

concentration risk.

The Federal Reserve recognizes that risk

characteristics vary among CRE loans secured

by different property types. A manageable level

of CRE concentration risk will vary by bank

depending on the portfolio risk characteristics,

the quality of risk-management processes, and

capital levels. Therefore, the guidance does not

establish a CRE concentration limit that applies

to all banks. Rather, banks are encouraged to

identify and monitor credit concentrations and

to establish internal concentration limits, and all

concentrations should be reported to senior

management and the board of directors on a

periodic basis. Depending on the results of the

risk assessment, the bank may need to enhance

its risk-management systems.

2010.2.5.3 CRE Risk Management

The sophistication of a bank’s CRE risk-

management processes should be appropriate to

the size of the portfolio, as well as the level and

nature of concentrations and the associated risk

to the bank. Banks should address the following

key elements in establishing a risk-management

framework that effectively identiﬁes, monitors,

and controls CRE concentration risk:

1. board and management oversight

2. portfolio management

3. management information systems

4. market analysis

5. credit underwriting standards

6. portfolio stress testing and sensitivity

analysis

7. credit-risk review function

2010.2.5.3.1 Board and Management

Oversight of CRE Concentration Risk

A bank’s board of directors has ultimate respon-

sibility for the level of risk assumed by the

bank. If the bank has signiﬁcant CRE concentra-

tion risk, its strategic plan should address the

rationale for its CRE levels in relation to its

overall growth objectives, ﬁnancial targets, and

capital plan. In addition, the Federal Reserve’s

real estate lending regulations require that each

bank adopt and maintain a written policy that

establishes appropriate limits and standards for

all extensions of credit that are secured by liens

on or interests in real estate, including CRE

loans. Therefore, the board of directors or a

designated committee thereof should—

1. establish policy guidelines and approve an

overall CRE lending strategy regarding the

level and nature of CRE exposures accept-

able to the bank, including any speciﬁc com-

mitments to particular borrowers or property

types, such as multifamily housing;

2. ensure that management implements proce-

dures and controls to effectively adhere to

and monitor compliance with the bank’s

lending policies and strategies;

3. review information that identiﬁes and quanti-

ﬁes the nature and level of risk presented by

CRE concentrations, including reports that

describe changes in CRE market conditions

in which the bank lends; and

4. periodically review and approve CRE risk

exposure limits and appropriate sublimits

(for example, by nature of concentration) to

conform to any changes in the bank’s strate-

gies and to respond to changes in market

conditions.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 27

2010.2.5.3.2 CRE Portfolio Management

Banks with CRE concentrations should manage

not only the risk of individual loans but also

portfolio risk. Even when individual CRE loans

are prudently underwritten, concentrations of

loans that are similarly affected by cyclical

changes in the CRE market can expose a bank

to an unacceptable level of risk if not properly

managed. Management regularly should evalu-

ate the degree of correlation between related

real estate sectors and establish internal lending

guidelines and concentration limits that control

the bank’s overall risk exposure.

Management should develop appropriate

strategies for managing CRE concentration lev-

els, including a contingency plan to reduce or

mitigate concentrations in the event of adverse

CRE market conditions. Loan participations,

whole loan sales, and securitizations are a few

examples of strategies for actively managing

concentration levels without curtailing new

originations. If the contingency plan includes

selling or securitizing CRE loans, management

should assess periodically the marketability of

the portfolio. This should include an evaluation

of the bank’s ability to access the secondary

market and a comparison of its underwriting

standards with those that exist in the secondary

market.

2010.2.5.3.3 CRE Management

Information Systems

A strong management information system

(MIS) is key to effective portfolio management.

The sophistication of the MIS will necessarily

vary with the size and complexity of the CRE

portfolio and level and nature of concentration

risk. The MIS should provide management with

sufﬁcient information to identify, measure,

monitor, and manage CRE concentration risk.

This includes meaningful information on CRE

portfolio characteristics that is relevant to the

bank’s lending strategy, underwriting standards,

and risk tolerances. A bank should periodically

assess the adequacy of the MIS in light of

growth in CRE loans and changes in the CRE

portfolio’s size, risk proﬁle, and complexity.

Banks are encouraged to stratify the CRE

portfolio by property type, geographic market,

tenant concentrations, tenant industries, devel-

oper concentrations, and risk rating. Other use-

ful stratiﬁcations may include loan structure (for

example, ﬁxed-rate or adjustable), loan purpose

(for example, construction, short-term, or per-

manent), loan-to-value (LTV) limits, debt ser-

vice coverage, policy exceptions on newly

underwritten credit facilities, and afﬁliated loans

(for example, loans to tenants). A bank should

also be able to identify and aggregate exposures

to a borrower, including its credit exposure relat-

ing to derivatives.

Management reporting should be timely and

in a format that clearly indicates changes in the

portfolio’s risk proﬁle, including risk-rating

migrations. In addition, management reporting

should include a well-deﬁned process through

which management reviews and evaluates con-

centration and risk-management reports, as well

as special ad hoc analyses in response to poten-

tial market events that could affect the CRE loan

portfolio.

2010.2.5.3.4 Market Analysis

Market analysis should provide the bank’s man-

agement and board of directors with information

to assess whether its CRE lending strategy and

policies continue to be appropriate in light of

changes in CRE market conditions. A bank

should perform periodic market analyses for the

various property types and geographic markets

represented in its portfolio.

Market analysis is particularly important as a

bank considers decisions about entering new

markets, pursuing new lending activities, or

expanding in existing markets. Market informa-

tion also may be useful for developing sensitiv-

ity analysis or stress tests to assess portfolio

risk.

Sources of market information may include

published research data, real estate appraisers

and agents, information maintained by the prop-

erty taxing authority, local contractors, builders,

investors, and community development groups.

The sophistication of a bank’s analysis will vary

by its market share and exposure, as well as the

availability of market data. While a bank operat-

ing in nonmetropolitan markets may have access

to fewer sources of detailed market data than a

bank operating in large, metropolitan markets, a

bank should be able to demonstrate that it has an

understanding of the economic and business

factors inﬂuencing its lending markets.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 28

2010.2.5.3.5 Credit Underwriting

Standards

A bank’s lending policies should reﬂect the

level of risk that is acceptable to its board of

directors and should provide clear and measur-

able underwriting standards that enable the

bank’s lending staff to evaluate all relevant

credit factors. When a bank has a CRE concen-

tration, the establishment of sound lending poli-

cies becomes even more critical. In establishing

its policies, a bank should consider both internal

and external factors, such as its market position,

historical experience, present and prospective

trade area, probable future loan and funding

trends, staff capabilities, and technology

resources. Consistent with the Federal Reserve’s

real estate lending guidelines, CRE lending poli-

cies should address the following underwriting

standards:

1. maximum loan amount by type of property

2. loan terms

3. pricing structures

4. collateral valuation

5. LTV limits by property type

6. requirements for feasibility studies and sensi-

tivity analysis or stress testing

7. minimum requirements for initial investment

and maintenance of hard equity by the bor-

rower

8. minimum standards for borrower net worth,

property cash ﬂow, and debt service cover-

age for the property

A bank’s lending policies should permit

exceptions to underwriting standards only on a

limited basis. When a bank does permit an

exception, it should document how the transac-

tion does not conform to the bank’s policy or

underwriting standards, obtain appropriate man-

agement approvals, and provide reports to the

board of directors or designated committee

detailing the number, nature, justiﬁcations, and

trends for exceptions. Exceptions to both the

bank’s internal lending standards and the Fed-

eral Reserve’s supervisory LTV limits

should

be monitored and reported on a regular basis.

Further, banks would analyze trends in excep-

tions to ensure that risk remains within the

bank’s established risk tolerance limits.

Credit analysis should reﬂect both the bor-

rower’s overall creditworthiness and project-

speciﬁc considerations as appropriate. In addi-

tion, for development and construction loans,

the bank should have policies and procedures

governing loan disbursements to ensure that the

bank’s minimum borrower equity requirements

are maintained throughout the development and

construction periods. Prudent controls should

include an inspection process, documentation

on construction progress, tracking pre-sold

units, pre-leasing activity, and exception moni-

toring and reporting.

2010.2.5.3.6 CRE Portfolio Stress Testing

and Sensitivity Analysis

A bank with CRE concentrations should per-

form portfolio-level stress tests or sensitivity

analysis to quantify the impact of changing eco-

nomic conditions on asset quality, earnings, and

capital. Further, a bank should consider the sen-

sitivity of portfolio segments with common risk

characteristics to potential market conditions.

The sophistication of stress testing practices and

sensitivity analysis should be consistent with

the size, complexity, and risk characteristics of

the CRE loan portfolio. For example, well-

margined and seasoned performing loans on

multifamily housing normally would require

signiﬁcantly less robust stress testing than most

acquisition, development, and construction

loans.

Portfolio stress testing and sensitivity analy-

sis may not necessarily require the use of a

sophisticated portfolio model. Depending on the

risk characteristics of the CRE portfolio, stress

testing may be as simple as analyzing the poten-

tial effect of stressed loss rates on the CRE

portfolio, capital, and earnings. The analysis

should focus on the more vulnerable segments

of a bank’s CRE portfolio, taking into consider-

ation the prevailing market environment and the

bank’s business strategy.

2010.2.5.3.7 Credit-Risk Review Function

A strong credit-risk review function is critical

for a bank’s self-assessment of emerging risks.

An effective, accurate, and timely risk-rating

system provides a foundation for the bank’s

credit-risk review function to assess credit qual-

ity and, ultimately, to identify problem loans.

35. Refer to the Federal Reserve’s appraisal regulations:

12 C.F.R. 208 subpart E and 12 C.F.R. 225, subpart G.

36. The Interagency Guidelines for Real Estate Lending

state that loans exceeding the supervisory LTV guidelines

should be recorded in the bank’s records and reported to the

board at least quarterly.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 29

Risk ratings should be risk sensitive, objective,

and appropriate for the types of CRE

loans underwritten by the bank. Further, risk

ratings should be reviewed regularly for

appropriateness.

2010.2.5.4 Supervisory Oversight Of

CRE Concentration Risk

As part of its ongoing supervisory monitoring

processes, the Federal Reserve will use certain

criteria to identify banks that are potentially

exposed to signiﬁcant CRE concentration risk.

A bank that has experienced rapid growth in

CRE lending, has notable exposure to a speciﬁc

type of CRE, or is approaching or exceeds the

following supervisory criteria may be identiﬁed

for further supervisory analysis of the level and

nature of its CRE concentration risk:

1. total reported loans for construction, land

development, and other land

represent

100 percent or more of the bank’s total capi-

tal

2. total commercial real estate loans as

deﬁned in this guidance

represent

300 percent or more of the bank’s total

capital, and the outstanding balance of the

bank’s commercial real estate loan port-

folio has increased by 50 percent or more

during the prior 36 months.

The Federal Reserve will use the criteria as a

preliminary step to identify banks that may have

CRE concentration risk. Because regulatory

reports capture a broad range of CRE loans with

varying risk characteristics, the supervisory

monitoring criteria do not constitute limits on a

bank’s lending activity but rather serve as high-

level indicators to identify banks potentially

exposed to CRE concentration risk. Nor do the

criteria constitute a “safe harbor” for banks if

other risk indicators are present, regardless of

their measurements under (1) and (2).

2010.2.5.4.1 Evaluation of CRE

Concentrations

The effectiveness of a bank’s risk-management

practices will be a key component of the super-

visory evaluation of the bank’s CRE concentra-

tions. Examiners will engage in a dialogue with

the bank’s management to assess CRE exposure

levels and risk-management practices. Banks

that have experienced recent, signiﬁcant growth

in CRE lending will receive closer supervisory

review than those that have demonstrated a suc-

cessful track record of managing the risks in

CRE concentrations.

In evaluating CRE concentrations, the Fed-

eral Reserve will consider the bank’s own analy-

sis of its CRE portfolio, including consideration

of factors such as—

1. portfolio diversiﬁcation across property types

2. geographic dispersion of CRE loans

3. underwriting standards

4. level of pre-sold units or other types of take-

out commitments on construction loans

5. portfolio liquidity (ability to sell or securitize

exposures on the secondary market)

While consideration of these factors should

not change the method of identifying a credit

concentration, these factors may mitigate the

risk posed by the concentration.

2010.2.5.4.2 Assessment of Capital

Adequacy for CRE Concentration Risk

The Federal Reserve’s existing capital adequacy

guidelines note that a bank should hold capital

commensurate with the level and nature of the

risks to which it is exposed. Accordingly, banks

with CRE concentrations are reminded that their

capital levels should be commensurate with the

risk proﬁle of their CRE portfolios. In assessing

the adequacy of a bank’s capital, the Federal

Reserve will consider the level and nature of

inherent risk in the CRE portfolio as well as

management expertise, historical performance,

underwriting standards, risk-management prac-

tices, market conditions, and any loan loss

reserves allocated for CRE concentration risk. A

bank with inadequate capital to serve as a buffer

against unexpected losses from a CRE concen-

tration should develop a plan for reducing its

CRE concentrations or for maintaining capital

appropriate to the level and nature of its CRE

concentration risk.

37. For commercial banks as reported in the Call Report

FFIEC 031 and 041, schedule RC-C, item 1a.

38. For purposes of this guidance, the term total capital

means the total risk-based capital as reported for commercial

banks in the Call Report FFIEC 031 and 041 schedule

RC-R—Regulatory Capital, line 21.

39. For commercial banks as reported in the Call Report

FFIEC 031 and 041, schedule RC-C, item 1a.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2016

Page 30

2010.2.6 GUIDANCE ON PRIVATE

STUDENT LOANS WITH

GRADUATED REPAYMENT TERMS

AT ORIGINATION

On January 29, 2015, interagency

guidance

was issued to provide ﬁnancial institutions with

principles applicable to private student loans

that have graduated repayment terms. Financial

institutions that originate private student loans

may offer borrowers graduated repayment terms

in addition to ﬁxed amortizing terms at the time

of loan origination. Graduated repayment terms

are structured to provide for lower initial

monthly payments that gradually increase. Refer

to SR-15-2/CA-15-1 and its attachment.

Although most student loan agreements

include a grace period

to help with the post-

education transition, the agencies and SLC rec-

ognize that students leaving higher education

programs may prefer more ﬂexibility to transi-

tion into the labor market because of a number

of factors, such as competitive job markets,

traditionally low entry-level salaries, and higher

student debt loads. Graduated repayment terms

may align borrowers’ income levels with loan

repayment requirements, provide ﬂexibility to

repay the debt sooner if borrowers’ incomes

increase more quickly than projected, and may

help long-term probability of full repayment.

Financial institutions that originate private

student loans with graduated repayment terms

should prudently underwrite the loans in a man-

ner consistent with safe and sound lending prac-

tices. Financial institutions should provide dis-

closures that clearly communicate the timing

and the amount of payments to facilitate a bor-

rower’s understanding of the loan’s terms and

features.

2010.2.6.1 Principles for Private Student

Loans with Graduated Repayment Terms

at Origination

Financial institutions should consider the fol-

lowing principles in their policies and proce-

dures for underwriting private student loans

with graduated repayment terms at origin-

ation:

• Ensure orderly repayment. Private student

loans should have deﬁned repayment periods

and promote orderly repayment over the life

of the loans. Graduated repayment terms

should ensure timely loan repayment and be

appropriately calibrated according to reason-

able industry and market standards based on

the amount of debt outstanding. Graduated

repayment terms should avoid negative amor-

tization or balloon payments.

• Avoid payment shock.

Graduated repayment

terms should result in monthly payments that

a borrower can meet in a sustained manner

over the life of the loan. Graduated increases

in a borrower’s monthly payment should

begin early in the repayment period and phase

in the amortization of the principal balance to

limit payment shock to the borrower.

• Align payment terms with a borrower’s

income. Graduated repayment terms should

be based on reasonable assumptions about the

ability to repay of the borrower and cosigner,

if any. Lender underwriting should include an

assessment of a borrower’s (and, if applica-

ble, a cosigner’s) ability to repay the highest

amortizing payment over the term of the loan.

Graduated repayment terms should not be

structured in a way that could mask delin-

quencies or defer losses.

• Provide borrowers with clear disclosures.

Financial institutions that offer private student

loans with graduated repayment terms should

provide borrowers with disclosures in compli-

ance with all applicable laws and regulations.

For example, the Truth in Lending Act, as

implemented by Regulation Z, includes spe-

ciﬁc private student loan disclosure content

requirements.

Ensuring that disclosures

clearly communicate the timing and the

40. The agencies consist of the Board of Governors of the

Federal Reserve System, the Consumer Financial Protection

Bureau, the Federal Deposit Insurance Corporation, the

National Credit Union Administration, and the Ofﬁce of the

Comptroller of the Currency.

41. In implementing this guidance, the agencies will exam-

ine ﬁnancial institutions consistent with their respective

authorities.

42. A grace period is the allotted amount of time during

which borrowers are not expected to make payments on

student loans after initially leaving higher education programs

or dropping below half-time enrollment status.

43. In addition to offering graduated repayment terms at

origination, ﬁnancial institutions may also offer graduated

repayment terms as well as other types of workout options to

borrowers experiencing ﬁnancial difﬁculties, as addressed in

″Banking Agencies Encourage Financial Institutions to Work

With Student Loan Borrowers Experiencing Financial Difﬁ-

culties,″ issued July 25, 2013.

44. Payment shock occurs when a borrower experiences a

signiﬁcant increase in the amount of the monthly payment

after a reset date.

45. 12 CFR 1026.46 and 12 CFR 1026.47.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2015

Page 31

amount of payments facilitates borrowers’

understanding of their loans’ terms and fea-

tures.

• Comply with all applicable federal and state

consumer laws and regulations and reporting

standards.

Private student loans with gradu-

ated repayment terms must comply with all

applicable consumer protection laws. These

include, but are not limited to, the Electronic

Fund Transfer Act, the Equal Credit Opportu-

nity Act, federal and state prohibitions against

unfair, deceptive, or abusive acts or practices

(such as section 5 of the Federal Trade Com-

mission Act and sections 1031 and 1036 of

the Dodd-Frank Wall Street Reform and Con-

sumer Protection Act), the Truth in Lending

Act, and the regulations issued pursuant to

those laws.

• Contact borrowers before reset dates. Before

originating private students loans with gradu-

ated repayment terms, ﬁnancial institutions

should develop processes for contacting bor-

rowers before the start of the repayment

period and before each payment reset date.

These contacts can help establish student debt

as a priority in borrowers’ payment hierar-

chies

and aid borrowers in responding effec-

tively to payment increases and other poten-

tial repayment challenges.

2010.2.7 LOAN PARTICIPATIONS,

THE AGREEMENTS AND

PARTICIPANTS

This subsection provides supervisory and

accounting guidance for examiners to use in

their inspection (or examination) and review of

a bank holding company’s (BHC’s) or bank’s

use, purchase, or sale of loan participation

agreements.

BHCs should manage and control

aggregate credit and other risk exposures on a

consolidated basis while recognizing legal dis-

tinctions and possible obstacles to asset move-

ments within the parent company or its subsidi-

aries. Additional guidance, research, and

information on loan participations and loan par-

ticipation agreements will be developed and

considered for future issuance and implemen-

tation.

A loan participation is an agreement that

transfers a stated ownership interest in a loan to

one or more other BHCs or subsidiaries, or

other entities. The transfer represents an owner-

ship interest in an individual ﬁnancial asset. The

lead BHC (or lead subsidiary) retains a partial

interest in the loan, holds all loan documenta-

tion in its own name, services the loan, and

deals directly with the customer for the beneﬁt

of all participants. The lead BHC or lead subsid-

iary should ensure that comprehensive participa-

tion agreements with originating institutions are

in place for each loan facility before they con-

sider purchasing any participating interest.

Many BHCs and their subsidiaries purchase

loans or participate in loans originated by oth-

ers. In some cases, such transactions are con-

ducted with BHC afﬁliates, groups of BHCs or

chain banks, or other subsidiaries. Alternatively,

a purchasing BHC or subsidiary may also wish

to supplement its loan portfolio when loan

demand is weak. In still other cases, a BHC or

subsidiary may purchase or participate in a loan

to accommodate another unrelated bank with

which it has established an ongoing business

relationship.

Purchasing or selling loans, if done properly,

can have a legitimate role in a BHC’s or bank’s

overall asset and liability management and can

contribute to the efﬁcient functioning of the

ﬁnancial system. In addition, these activities

help a BHC or bank diversify its risks and

improve its liquidity.

2010.2.7.1 Board Policies on Loan

Participations

BHCs and their subsidiaries should have sufﬁ-

cient board-approved policies in place that gov-

ern their loan participation activities. At a mini-

mum, the policy should include (1) the

requirements for entering into a loan participa-

tion agreement, (2) limits for the aggregate

amount of loans purchased from and sold to an

outside source, (3) limits of all loans purchased

and sold, (4) limits for the aggregate amount of

loans to particular industries, (5) comprehensive

participation agreements with originating BHCs

or banks, (6) complete analysis and documenta-

tion of the credit quality of obligations pur-

chased, (7) an analysis of the value and lien

status of the collateral, (8) appraisal guidelines,

(9) the maintenance of full independent credit

information on the borrower throughout the

46. Reporting standards include, but are not limited to,

quarterly Consolidated Reports of Condition and Income.

47. Payment hierarchy refers to the prioritization of a

borrower’s payment obligations.

48. As determined by the Board, it is permissible for a

BHC or its subsidiary to make, acquire, broker, or service

loans or other extensions of credit (12 CFR 225.28(b)(1)

and (2)).

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2015

Page 32

term of the loan, (10) guidelines for the timely

transfer of all ﬁnancial and nonﬁnancial credit

information to participant BHCs or banks, and

(11) collection procedures.

2010.2.7.2 Loan Participation Agreement

A loan participation agreement may enable a

smaller lead BHC or lead subsidiary, acting as

transferor, to originate a large loan in excess of

its legal lending limit. Participants having an

ownership interest are able to offset low local

loan demand or invest in large loans without the

burden of servicing the loan or incurring origi-

nation costs. A loan participation agreement

may also allow the originating BHC or subsidi-

ary to facilitate and grant a larger loan without

causing it to have a concentration of credit (i.e.,

enabling risk diversiﬁcation) or an impairment

of its liquidity position. The participation agree-

ment should contain provisions that require the

originator to transfer, in a timely manner, all

ﬁnancial and nonﬁnancial credit information to

the participant banks upon the loan’s origination

and throughout the term of the loan. The agree-

ment should specify the allocation of payments,

losses, and expenses. It should also state that a

participant has the right to perform its own

independent review of the transaction. The

agreement should contain no language indicat-

ing that the lead BHC or lead subsidiary is a

“lender’’ or that a participating BHC or subsidi-

ary is a “borrower.’’ The purchase of loan par-

ticipations without a comprehensive agreement

could be viewed as an unsafe and unsound

banking practice.

2010.2.7.3 Accounting for Loan

Participations

A loan participation agreement usually is struc-

tured to allow the participation transaction to

receive sale treatment of a portion of the loan by

the originating BHC or its subsidiary even

though the participation agreement may restrict

the purchaser when reselling its interest in the

loan, subject to certain conditions.

Sale treat-

ment is achieved by structuring the loan partici-

pation agreement so that interests sold to a

purchaser meet the deﬁnition of a “participating

interest’’ and the transaction satisﬁes all condi-

tions for transfer of control over the interests. In

general, FAS 166 (paragraph 8B) brieﬂy deﬁnes

a participating interest as a portion of a ﬁnancial

asset that

1. conveys proportionate ownership rights with

equal priority to each participating interest

holder.

2. involves no recourse (other than standard

representations and warranties) to, or subor-

dination by, any participating interest holder.

3. does not entitle any participating interest

holder to receive cash before any other par-

ticipating interest holder.

A transfer of a participating interest in an

entire ﬁnancial asset in which the transferor

surrenders control over those interests is to be

accounted for as a sale if and only if all the

following conditions are met:

1. The transferred ﬁnancial assets have been

isolated from the transferor—put presump-

tively beyond the reach of the transferor and

its creditors, even in bankruptcy or other

receivership.

2. Each purchaser has the right to pledge or

exchange the interests it received, and no

condition both constrains the purchaser from

taking advantage of its right to pledge or

exchange and provides more than a trivial

beneﬁt to the transferor.

3. The transferor does not maintain effective

control over the interests.

49. Three sale recognition conditions denote the transfer-

or’s surrender of control under Financial Accounting Stan-

dards (FAS) 166, “Accounting for Transfers of Financial

Assets’’ (an amendment of FAS 140). Those conditions must

be met in order for the originator (transferor) to account for

the transfer of the ﬁnancial assets to the participating trans-

feree as a sale. When a loan participation is accounted for as a

sale, the seller (transferor) removes the participated interest in

the loan from its ﬁnancial statements. FAS 166 applies to both

the transferor (seller) of the participated assets and the trans-

feree (purchaser). (See the complete text of FAS 166 (para-

graphs 8B and 9) that deﬁnes a “participating interest’’ and

the conditions for sale recognition). See also the reporting

instructions for the “Consolidated Financial Statements for

Bank Holding Companies’’ (FR Y-9C), and the FFIEC “Con-

solidated Reports of Condition and Income’’ (FFIEC 031)

(bank Call Report).

50. Transferred ﬁnancial assets are isolated in bankruptcy

or other receivership only if the transferred ﬁnancial assets

would be beyond the reach of the powers of a bankruptcy

trustee or other receiver for the transferor or any of its

consolidated afﬁliates included in the ﬁnancial statements

being presented.

51. Examples of a transferor’s effective control over the

transferred ﬁnancial assets include (a) an agreement that both

entitles and obligates the transferor to repurchase or redeem

the ﬁnancial asset (or its third-party beneﬁcial interests) before

its maturity, (b) an agreement that provides the transferor with

both the unilateral ability to cause the holder to return speciﬁc

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2015

Page 33

2010.2.7.4 Structuring the Loan

Participation Agreement

The written participation agreement should con-

sider contingent events such as a defaulting

borrower, the lead BHC or lead subsidiary

becoming insolvent, or a party to the participant

arrangement that is not performing as expected.

The agreement should clearly state the limita-

tions the originator or participants impose on

each other and any rights that the parties retain.

The participation agreement should clearly

include

• the obligation of the lead BHC or lead subsid-

iary to furnish timely credit information and

to notify the parties of signiﬁcant changes in

the borrower’s status;

• a requirement that the lead BHC or lead sub-

sidiary consult with the participants prior to

any proposed change to the loan, guarantee,

or security agreements, or taking any action

when the borrower defaults;

• the lead BHC’s or lead subsidiary’s and par-

ticipants’ speciﬁc rights if the borrower

defaults;

• the resolution procedures to be followed when

the lead BHC or lead subsidiary or partici-

pants;

— do not agree on the procedures to be taken

when the borrower defaults and/or;

— have potential conﬂicts when the bor-

rower defaults on more than one loan

• provisions for terminating the agency relation-

ship between the lead BHC or lead subsidiary

and the participants upon events such as insol-

vency, breach of duty, negligence, or misap-

propriation by one of the parties to the

agreement.

Some participation agreements may allocate

payments using a method other than a pro rata

sharing based on each participant’s ownership

interest. The ﬁrst principal payment could be

applied based on the participant’s ownership

interest while the remaining payments would be

applied according to the lead BHC’s or lead

subsidiary’s ownership interest. In this situation,

the participation agreement should specify that

if a borrower defaults, the participants would

share subsequent payments and collections in

proportion to their ownership interest at the time

of default.

A participation agreement may provide that

the originating lender allow a participating BHC

or subsidiary to resell, but the originator

reserves the right to call at any time from who-

ever holds the ownership interest. The origina-

tor can then enforce the call option by cutting

off or restricting the ﬂow of interest at the call

date.

In this situation, the originating lender

has retained effective control over the participa-

tion; such a call option precludes sale account-

ing treatment by the transferor. The transaction,

therefore, should be accounted for as a secured

borrowing.

2010.2.7.5 Independent Credit Analysis

A BHC or subsidiary that acquires a loan par-

ticipation should regularly perform a rigorous

credit analysis on its loan participation as if it

had originated the loan. Due to the indirect

relationship that a participant has with a bor-

rower, it may be difﬁcult for the participant to

receive timely credit information to allow it to

conduct a comprehensive credit analysis of the

transaction. However, the participant should not

rely solely on the originator’s credit analysis. It

should gather all available relevant credit infor-

mation, including the details on the collateral’s

value (for example, values determined by an

independent appraisal or an evaluation), lien

status, loan agreements, and the loan’s other

participation agreements that existed prior to

making its commitment to acquire the loan par-

ticipation. A participant also should reach an

agreement with the loan originator (transferor)

that it will provide ongoing, complete, and

timely credit information about the borrower. It

is important for the participants to maintain

current and complete records on their loan par-

ticipations. The absence of such information

may indicate that the originator did not perform

the necessary due diligence prior to making its

decision to acquire the loan participation. Dur-

ing the life of the loan participation, the origina-

tor should monitor the loan’s servicing and

repayment status.

ﬁnancial assets and a more-than-trivial beneﬁt attributable to

that ability, other than through a cleanup call, or (c) an

agreement that permits the transferee to require the transferor

to repurchase the transferred ﬁnancial assets at a price that is

so favorable to the transferee that it is probable that the

transferee will require the transferor to repurchase them.

52. This is not a participating interest—no sale.

53. The cash ﬂows from a loan participation agreement,

except servicing fees, should be divided in proportion to the

third parties’ participating interests.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2010

Page 34

2010.2.7.6 Sales of Loan Participations in

the Secondary Market

If a BHC or a subsidiary has a concentration in

loan participations, it may be possible for it to

sell its participating interests in the secondary

market to reduce its dependence on an asset

group. If the BHC or a subsidiary is not large

enough to participate in the secondary market,

an alternative might be to sell loans without

recourse to another subsidiary or correspondent

bank that also desires to diversify its loan

portfolio.

2010.2.7.7 Sale of Loan Participations

With or Without the Right of Recourse

The parties to a participation agreement (those

having a participating ownership interest) gener-

ally may have no recourse to the transferor or to

each other even though the transferor (e.g., the

originating lender) continues to service the loan.

No participant’s interest should be subordinate

to another. Some loan participation agreements,

however, may give the seller a contractual right

to repurchase the participated loan interest for

purposes of working out or modifying the sale.

When the seller has the right to repurchase the

participation, it may provide the seller with a

call option on a speciﬁc loan participation asset.

If the seller’s right to repurchase precludes the

seller from recognizing the transaction as a sale,

the transaction should be accounted for as a

secured borrowing.

2010.2.7.8 Sales of 100 Percent

Participations

Some loan participation agreements may be

structured so that the transferor sells the entire

underlying loan amount (100 percent) to the

agreement’s participants. If participation agree-

ments are not structured properly they can pose

unnecessary and increased risks (for example,

legal, compliance, or reputational risks) to the

originator and the participants. The originator

would have no ownership in the loan. Such

agreements should therefore clearly state that

the loan participants are participating in the loan

and that they are not investing in a business

enterprise. The policies of a BHC or subsidiary

engaged in such loan participation agreements

should focus on safety and soundness concerns

that include

• the program’s objectives

• the plan of distribution

• the credit requirements that pertain to the

borrower—the originator should structure

100 percent loan participation programs only

for borrowers who meet its credit require-

ments

• the program participant’s accessibility to the

borrower’s ﬁnancial information (as autho-

rized by the borrower)—the originator should

allow potential loan participants to obtain and

review appropriate credit and other informa-

tion that would enable them to make an

informed credit decision.

2010.2.7.9 Participation Transactions

Between Afﬁliates

BHCs or their subsidiaries should not relax their

credit standards when participation agreements

involve their afﬁliates. Such agreements must be

structured to comply with sections 23A and 23B

of the Federal Reserve Act (FRA) and the

Board’s Regulation W. The Federal Reserve has

determined that in certain very limited circum-

stances the purchase or sale of a participation

agreement may be exempt from these

provisions.

2010.2.7.9.1 Transfer of Low-Quality

Assets

In general, a bank cannot purchase a low-quality

asset, including a loan participation from an

afﬁliate. Section 23A of the FRA provides a

limited exception to the general rule prohibiting

the purchase of low-quality assets if the bank

performs an independent credit evaluation and

commits to the purchase of the asset before the

afﬁliate acquires the asset.

Section 223.15 of

the Board’s Regulation W provides an excep-

tion from the prohibition on the purchase of a

low-quality asset by a member bank from an

afﬁliate for certain loan renewals. The rule

allows a member bank that purchased a loan

participation from an afﬁliate to renew its par-

ticipation in the loan, or provide additional fund-

ing under the existing participation, even if the

underlying loan had become a low-quality asset,

so long as certain criteria were met. These

renewals or additional credit extensions may

enable both the afﬁliate and the participating

54. 12 U.S.C. 371c(a)(3).

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2010

Page 35

member bank to avoid or minimize potential

losses. The exception is available only if (1) the

underlying loan was not a low-quality asset at

the time the member bank purchased its partici-

pation and (2) the proposed transaction would

not increase the member bank’s proportional

share of the credit facility. The member bank

must also obtain the prior approval of its entire

board of directors (or its delegees) and it must

give a 20-day post-consummation notice to its

appropriate federal banking agency. A member

bank is permitted to increase its proportionate

share in a restructured loan by 5 percent (or by a

higher percentage with the prior approval of the

bank’s appropriate federal banking agency). The

scope of the exemption includes renewals of

participations in loans originated by any afﬁliate

of the member bank (not just afﬁliated deposi-

tory institutions).

2010.2.7.10 Concentrations of Credit

Involving Loan Participations

BHCs or their subsidiaries should avoid pur-

chasing loans that generate unacceptable credit

concentrations. Such concentrations may arise

solely from the BHC’s or subsidiary’s pur-

chases, or they may arise when loans or pur-

chased participations are aggregated with loans

originated and retained by the purchaser. The

extent of contingent liabilities, holdbacks,

reserve requirements, and the manner in which

loans will be handled and serviced should be

clearly deﬁned. In addition, loans purchased

from another source should be evaluated in the

same manner as originated loans. Guidelines

should be established for the type and frequency

of credit and other information the BHC or its

subsidiary needs to obtain from the originator to

keep itself continually updated on the status of

the credit. Guidelines should also be established

for supplying complete and regularly updated

credit information to the purchasers of loans

originated and sold by the BHC or its subsidiary.

2010.2.7.11 Loan Participations and

Environmental Liability

Environmental risk represents the adverse con-

sequences that result from generating or han-

dling hazardous substances or from being asso-

ciated with the aftermath of contamination.

BHCs or their subsidiaries may be indirectly

liable via their lending activities for the costs

resulting from cleaning up hazardous substance

contamination. BHCs and their subsidiaries

need to be careful that their actions making,

administering, and collecting loans—including

assessing and controlling environmental

liability—cannot be construed as taking an

active role in the management or day-to-day

operations of a borrower’s business. Such

actions could lead to potential liability under the

Comprehensive Environmental Response, Com-

pensation, and Liability Act (CERCLA). BHCs

or their subsidiaries that originate loans to bor-

rowers through loan participation agreements

could be transferring environmental risk and

liability to the holders of participations, thus

making them susceptible to such losses. The

originator should establish and follow policies

and procedures designed to control environmen-

tal risks. See the Commercial Bank Examination

Manual, section 2140.1 (the “Environmental

Liability’’ subsection) for a more detailed dis-

cussion on ways banks can protect themselves

as lenders, and their loan participation agree-

ment holders, from environmental liability.

2010.2.7.12 Red Flag Warning Signals

The following conditions may indicate that there

are signiﬁcant problems with the management

of the BHC’s or a subsidiary’s loan participa-

tion portfolio:

1. the absence of formal loan participation

policies.

2. the absence of any formal participation

agreement.

3. the absence of credit evaluations and inde-

pendent credit analysis.

4. the absence of complete loan documentation.

5. a higher volume of loan participations when

compared to the volume of other loans in the

loan portfolio.

6. missing loan participation agreements and

documentation which should denote the

rights and responsibilities of all participants.

7. the existence of numerous disputes or dis-

agreements among the participants regarding

the receipt of payment(s) in accordance with

the participation agreements, documentation

requirements, or any other signiﬁcant aspects

of the entity’s loan participation transactions.

8. the originator is making loan payments to

loan participation acquirers without receiv-

ing reimbursement by the original borrower.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2010

Page 36

2010.2.8 INSPECTION OBJECTIVES

Loan Administration

1. To determine if the parent’s loan policies are

adequate in relation to the responsibilities it

has for the supervision of its credit-extending

subsidiaries and whether those policies are

consistent with safe and sound lending

practices.

2. To determine if internal and external factors

(for example, the size and ﬁnancial condition

of the credit-extending subsidiary, the size

and expertise of its staff, avoidance of or

control over credit concentrations, market

conditions, and statutory and regulatory com-

pliance) are considered in formulating and

monitoring the organization’s loan policies

and strategic plan.

3. To determine if the loan policy is being

monitored and complied with.

4. To establish whether the loan policy ensures

sound assessments of the value of real estate

and other collateral.

Lending Standards for Commercial Loans

1. To focus on and evaluate the strength of the

credit-risk management process.

2. To determine whether the bank holding

company has formal credit policies that

(1) provide clear guidance on its appetite

for credit risk and (2) support sound lending

decisions.

3. To determine whether experienced credit

professionals who are independent of line

lending functions provide adequate internal

control in the loan-approval process.

4. To evaluate whether loan-approval docu-

ments provide internal approving authori-

ties and management with sufﬁcient infor-

mation on the risks of loans being

considered, and that the information is in a

clear and understandable format.

5. To evaluate whether forward-looking analy-

sis tools are being adequately and appropri-

ately used as part of the loan-approval

process.

6. To determine whether credit-risk manage-

ment information systems provide adequate

information to management and lenders.

7. To incorporate the examiner’s evaluation of

the bank holding company’s adherence to

sound practices into the overall assessment

of credit-risk management.

8. To be alert to indications of insufﬁciently

rigorous risk assessment at banking organi-

zations, particularly inadequate stress test-

ing and excessive reliance on strong eco-

nomic conditions and robust ﬁnancial

markets to support a borrower’s capacity to

service its debts.

9. To be attentive in reviewing a banking orga-

nization’s assessment and monitoring of

credit risk to ensure that undue reliance on

favorable conditions does not lead to

delayed recognition of emerging weak-

nesses in some loans.

10. To ascertain whether the banking organiza-

tion has relied, to a signiﬁcant and undue

extent, on favorable assumptions about bor-

rowers or the economy and ﬁnancial mar-

kets. If so, to carefully consider downgrad-

ing, under the applicable supervisory rating

framework, a banking organization’s risk-

management, management, and/or asset-

quality ratings and, if deemed sufﬁciently

signiﬁcant to the banking organization, its

capital adequacy rating.

11. To determine if the banking organization’s

loan-review activities or other internal con-

trol and risk-management processes have

been weakened by staff turnover, failure to

commit sufﬁcient resources, inadequate

training, and reduced scope or by less-

thorough internal loan reviews. To incorpo-

rate such ﬁndings into the determination of

supervisory ratings.

Leveraged Lending

1. Risk-Management Framework, Deﬁnition,

and Policy Expectations. To determine

a. whether the institution has established a

sound deﬁnition of leveraged lending

that is appropriate for the types of lever-

aged loans that are underwritten and if it

can be applied across all business lines;

b. whether it has adjusted (if necessary) its

risk appetite and limit structure (includ-

ing pipeline limits and overall portfolio

limits) to conform with the institution’s

deﬁnition of leveraged lending and

whether it has the necessary reporting in

place to assess conformance with limits.

c. if there are appropriate policies and pro-

cedures limits in place and if the institu-

tion maintains sound leveraged lending

standards both for transactions that it

intends to hold as well as transactions

that are underwritten to distribute.

d. if the institution’s risk-management

structure has strong and effective pro-

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 37

cesses and controls and if they are appro-

priate based on its leveraged lending

activity.

2. Participations Purchased. To ensure that

the institution applies the same standards of

prudence and credit assessment techniques

and in-house limits that would apply as if it

had originated the loan(s).

3. Underwriting Standards. To assess the

effectiveness of the institution’s underwrit-

ing policy standards for leveraged lending

to determine whether they

a. are clear, written, and measurable;

b. contain underwriting limits that reﬂect

the institution’s deﬁnition and risk appe-

tite for leveraged lending;

c. are applied equally to loans that are

originated to be held and to loans that

are originated to distribute; and

d. fully reﬂect the underwriting standards

listed in the guidance, including:

i. sound business premise and sustain-

able capital structure for each trans-

action

ii. capacity to repay and ability to

de-lever to a sustainable level over a

reasonable period

iii. appropriate depth and breadth of due

diligence

iv. standards for valuating expected risk-

adjusted returns

v. appropriate credit agreement cov-

enant protections

vi. acceptable collateral agreements.

4. Valuation Standards. To determine:

a. whether enterprise valuation methodolo-

gies are appropriate to the borrower’s

industry and condition;

b. whether the assumptions are clearly

documented, well supported, and under-

stood by the institution’s appropriate

decision makers and risk-oversight units

c. whether enterprise valuations are per-

formed by qualiﬁed persons independent

of an institution’s origination function

d. whether an institution has policies and

provides for appropriate loan to value

ratios, discount rates and collateral mar-

gins for loans dependent on enterprise

value or illiquid and hard-to-value collat-

eral.

5. Pipeline Management. To ﬁnd out if there

are strong risk-management standards and

controls over transactions in and to the pipe-

line and if those standards are applied uni-

formly to transactions held in the portfolio

and those that are distributed.

6. Reporting and Analytics.

a. To determine if individual and portfolio

exposures within and across all business

lines and legal vehicles are captured and

reported in the appropriate amount of

detail to senior management and the

board.

b. To determine if the necessary risk infor-

mation (as outlined in the guidance)

about leveraged lending exposures (port-

folio holds and pipeline exposures) are

captured in reports that are distributed

timely and that adequate information is

distributed to senior management and the

institution’s board of directors at least

quarterly.

7. Risk Rating. To verify that leveraged loans

are risk rated based on the borrower’s abil-

ity to repay and de-lever to a sustainable

level.

8. Credit Analysis.

a. To test transactions to determine if

underwriting practices are effective and

comprehensive.

b. To determine if individual leveraged

lending exposures contain a comprehen-

sive assessment of ﬁnancial, business,

industry, and management risks based on

the elements of the guidance.

9. Problem Credit Management.

a. To ascertain whether the institution for-

mulates individual action plans and

expectations

b. To evaluate workout plans to conﬁrm

that they contain quantiﬁable objectives

and measureable time frames

c. To determine if problem credits are regu-

larly reviewed for risk-rating accuracy,

accrual status, impairment status, and

charge off.

10. Deal Sponsors

a. To determine if the institution has guide-

lines for evaluating deal sponsors that

are based on the sponsor’s ability and

willingness to support the transaction

where sponsors are viewed as a source

of repayment.

11. Credit Review

a. To ensure that the institution regularly

conducts an independent credit review of

the leveraged lending portfolio more fre-

quently and in greater depth than other

segments of the portfolio generally at

least annually. For ﬁrms making signiﬁ-

cant changes to policies, underwriting

standards, procedures etc., ensure that a

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 38

credit review is scheduled to test compli-

ance with changes.

b. To ensure that credit review personnel

have the expertise and experience to

evaluate leveraged loans.

12. Stress Testing.

a. To determine if the institution is con-

ducting periodic loan- and portfolio

stress tests on leveraged loan portfolios

or if the portfolio has been incorporated

into enterprise-wide stress testing prac-

tices.

b. To verify the effectiveness of the institu-

tion’s periodic portfolio stress tests (in

accordance with stress testing guidance)

in identifying what effect economic and

market events could have on the institu-

tion’s ﬁnancial condition and leveraged

lending transactions.

13. Conﬂict of Interest. To determine

a. if policies identify and if there are proce-

dures to address transactions in which

the institution holds both an equity and

lending positions;

b. the adequacy and effectiveness of con-

trols and training programs that aim to

curb any potential conﬂicts of interests

that result from leveraged lending.

14. Reputational Risk.

a. To determine if the institution has suf-

fered reputational damage by failing to

meet its legal responsibilities in under-

writing and syndicating leveraged loan

transactions into the wider ﬁnancial mar-

ket.

Credit-Risk Management for Home Equity

Lending

1. To determine if the banking organization has

an appropriate review and approval process

for new product offerings, product changes,

and marketing initiatives.

2. To ascertain whether the banking organiza-

tion has appropriate control procedures for

third parties that generate loans on its behalf

and if the control procedures comply with

the laws and regulations that are applicable

to the organization.

3. To determine if the banking organization has

given full recognition to the risks embedded

in its home equity lending.

4. To determine whether the banking organiza-

tion’s risk-management practices have kept

pace with the growth and changing risk pro-

ﬁle of its home equity portfolios and whether

underwriting standards have eased.

5. To determine whether the loan policy—

a. ensures prudent underwriting standards

for home equity lending, including stan-

dards to ensure that a thorough evaluation

of a borrower’s capacity to service the

debt is conducted (that is, the banking

organization is not relying solely on the

borrower’s credit score);

b. provides risk-management safeguards for

potential declines in home values;

c. ensures that the standards for interest-only

and variable-rate home equity lines of

credit (HELOCs) include an assessment

of a borrower’s ability to (1) amortize the

fully drawn line of credit over the loan

term and (2) absorb potential increases in

interest rates; and

d. provides appropriate collateral-valuation

policies and procedures and provides for

the use and validation of automated valua-

tion models.

Loan Participations, the Agreements and

Participants

1. To ascertain if the BHC engages in the pur-

chase or sale of loans via loan participation

agreements.

2. To determine if the BHC’s lending policy

a. places limits on the amount of loan par-

ticipations originated, purchased, or sold

based on any one source or in the

aggregate;

b. has set credit standards for the BHC’s

borrowers requesting loans as well as

third parties acquiring loan participations

from the bank as originator;

c. requires the same credit standards for loan

participations as it does for other loans;

d. sets the amount of contingent liability,

holdback (retained ownership), and the

manner in which the loan should be ser-

viced; or

e. requires complete loan documentation for

loan participations.

3. To assess the impact of any concentrations of

credit to a borrower, or in the aggregate, that

arise from loans involved in loan participa-

tion agreements.

4. To determine if there are any informal repur-

chase agreements that exist between loan

participation acquirers that are designed to

circumvent the originating BHC’s or its sub-

sidiary’s legal lending limits, disguise delin-

quencies, and avoid adverse classiﬁcations.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 39

5. To determine whether the BHC’s ﬁnancial

condition is compromised by assessing the

impact of the BHC’s loan participations with

its afﬁliates.

6. To ascertain whether loan participation trans-

actions with afﬁliates are in compliance with

sections 23A and 23B of the Federal Reserve

Act and the Board’s Regulation W.

7. To determine if there are disputes between

the BHC or its subsidiaries as originator of

loan participations and its participants.

8. To determine if any loan participations have

been adversely classiﬁed by examiners,

including examiners from other supervisory

agencies (includes loan participations held

by the other institutions).

2010.2.9 INSPECTION PROCEDURES

Loan Administration

1. Obtain an organizational chart and deter-

mine the various levels of responsibility

and job functions of individuals involved

with the lending function.

2. Obtain and review the BHC’s loan policy;

determine if the policy contains the appro-

priate components, as summarized in this

section. Determine how the policy is com-

municated to subsidiaries. Also determine

whether the loan policy reﬂects the Decem-

ber 1992 uniform interagency real estate

lending standards and guidelines as they

apply to subsidiary depository institutions.

3. Obtain a copy of the most recent manage-

ment reports concerning the quality of loans

and other aspects of the loan portfolio

(delinquency list, concentrations, yield

analysis, loan-distribution lists, watch loan

reports, charge-off reports, participation

listings, internal and external audit reports,

etc.). Determine the scope and sufﬁciency

of the work performed by any committees

related to the lending function. Determine if

the information provided to the directorate

and senior management is sufﬁcient for

them to make judgments about the quality

of the portfolio and to determine appropri-

ate corrective action.

4. Determine if an internal process has been

established for the review and approval of

loans that do not conform to internal lend-

ing policy. Establish whether such loans are

supported by written documentation that

clearly states all the relevant credit factors

that culminated in the underwriting deci-

sion. Determine if exception loans of a sig-

niﬁcant size are reported to the board of

directors of the subsidiary or to the holding

company.

5. Review internal and external audit reports

and bank examination reports for critical

comments concerning loan-policy excep-

tions and administration. Determine

whether action was taken in response to any

identiﬁed exceptions. Determine who is

responsible for follow-up and what the time

frames are; seek rationale if no action was

taken or if the action taken was half-

hearted.

6. Review the organization’s ﬁnancial state-

ments, the bank Call Reports, and the BHC

FR Y-series reports submitted to the Fed-

eral Reserve. Determine whether reporting

is accurate and disclosure is sufﬁcient to

indicate the organization’s ﬁnancial posi-

tion and the nature of its loan portfolios,

including nonaccrual loans.

7. When reviewing lending policies, ascertain

whether—

a. the loan policies facilitate extensions of

credit to sound borrowers and facilitate

the workout of problem loans, and

b. the loan policies control and reduce con-

centration risk by placing emphasis on

effective internal policies, systems, and

controls to monitor the risk.

8. Through interviews with, or review of

reports submitted by, the internal auditor,

lending ofﬁcers, loan-review personnel, and

senior management, (1) evaluate the effec-

tiveness of the BHC’s self-monitoring of

adherence to loan policy, (2) determine how

changes to the loan policy occur, (3) deter-

mine how loans made in contradiction to

the loan policy are explained, and (4) deter-

mine the various circumstances involving

levels of approval and what speciﬁc consid-

eration occurs at these levels.

9. Presuming the inspection is concurrent with

a bank’s primary regulator, coordinate, on a

random basis, the selection of loans subject

to classiﬁcation. Determine whether they

conform to loan policy.

10. Review management’s policies and proce-

dures for their determination of an appropri-

ate level of loan-loss reserves.

11. On the “Policies and Supervision” or an

equivalent page of the inspection report,

evaluate the BHC’s oversight regarding

effective lending policy and procedures.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 40

Lending Standards for Commercial Loans

1. Review formal credit policies for clear

articulation of current lending standards,

including—

a. a description of the characteristics of

acceptable loans and (if applicable) “guid-

ance’’ minimum ﬁnancial ratios,

b. standards for the types of covenants to be

imposed for speciﬁc loan types, and

c. the treatment and reporting of policy

exceptions, both for individual loans and

the entire portfolio.

2. Evaluate the role played by independent

credit staff in loan approvals and, in particu-

lar, whether these credit professionals are

adequately experienced, are independent of

line lending functions, and have authority to

reject loans either because of speciﬁc excep-

tions to policy or because the loan does not

meet the institution’s credit-risk appetite.

3. Review written policies and determine oper-

ating practice in preparing loan-approval

documents to evaluate whether sufﬁcient

information is provided on the characteristics

and risks of loans being considered, and

whether such information is provided clearly

and can be easily understood.

4. Based on written policies and review of oper-

ating practice, evaluate whether loans being

considered are evaluated not only on the

basis of the borrower’s current performance

but on the basis of forward-looking analysis

of the borrower.

a. Determine whether ﬁnancial projections

or other forward-looking tools are an inte-

gral part of the preapproval analysis and

loan-approval documents.

b. Determine the extent to which alternative

or “downside’’ scenarios are identiﬁed,

considered, and analyzed in the loan-

approval process.

5. Review credit-risk management information

systems and reports to determine whether

they provide adequate information to man-

agement and lenders about—

a. the composition of the institution’s cur-

rent portfolio or exposure, to allow for

consideration of whether proposed loans

might affect this composition sufﬁciently

to be inconsistent with the institution’s

risk appetite, and

b. data sources, analytical tools, and other

information to support credit analysis.

6. When appropriate, coordinate or conduct suf-

ﬁcient loan reviews and transaction testing in

the lending function to accurately determine

the quality of loan portfolios and other credit

exposures. If deﬁciencies in lending prac-

tices or credit discipline are indicated as a

result of the preexamination risk assessment,

the inspection, or bank or other examina-

tions, arrange for the commitment of sufﬁ-

cient supervisory resources to conduct

in-depth reviews, including transaction test-

ing, that are adequate to ensure that the Fed-

eral Reserve achieves a full understanding of

the nature, scope, and implications of the

deﬁciencies.

7. When reviewing loans, lending policies, and

lending practices—

a. observe and analyze loan-pricing policies

and practices to determine whether the

institution may be unduly weighting the

short-term beneﬁt of retaining or attract-

ing new customers through price conces-

sions, while not giving sufﬁcient consider-

ation to potential longer-term

consequences;

b. be alert for indications of insufﬁciently

rigorous risk assessment, in particular

(1) excessive reliance on strong economic

conditions and robust ﬁnancial markets to

support the capacity of borrowers to ser-

vice their debts and (2) inadequate stress

testing;

c. be attentive in reviewing an institution’s

assessment and monitoring of credit risk

to ensure that undue reliance on favorable

conditions does not lead that institution to

delay recognition of emerging weaknesses

in some loans or to lessen staff resources

assigned to internal loan review;

and

d. give careful consideration to downgrad-

ing, under the applicable supervisory rat-

ing framework, a banking organization’s

risk-management, management, and/or

asset-quality ratings and its capital

adequacy rating (if sufﬁciently signiﬁ-

cant) when there is signiﬁcant and undue

reliance on favorable assumptions about

borrowers or the economy and ﬁnancial

markets, or when that reliance has slowed

the recognition of loan problems.

8. Discuss matters of concern with the senior

management and the board of directors of the

bank holding company and report those areas

55. Examiners should recognize that an increase in classi-

ﬁed or special-mention loans is not per se an indication of lax

lending standards. Examiners should review and consider the

nature of these increases and the surrounding circumstances in

reaching their conclusions about the asset quality and risk

management of an institution.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 41

of concern on core page 1, “Examiner’s

Comments and Matters Requiring Special

Board Attention.’’

Leveraged Lending

Overview

Complete or update the Leveraged Lending

Internal Control Questionnaire if selected for

implementation.

1. Based on an evaluation of internal controls,

determine the scope of the inspection. The

scope should include exposures related

through common ownership, guarantors, or

sponsors. Also include direct and indirect

leveraged lending exposure found in ﬁnan-

cial intermediaries formed to house or dis-

tribute leveraged loans (for example CLOs,

SPEs, conduits etc.).

2. Inspection procedures should include both a

policy review and transaction testing

approach to determine the effectiveness of

the institution’s leveraged lending control

process.

If the institution is found to lack robust risk-

management processes and controls around

leveraged lending that reinforces the institu-

tion’s risk proﬁle, a supervisory ﬁnding of

unsafe and unsound banking practices should be

considered.

3. Applicability/Risk Management Framework

a. At the start of the inspection, ascertain

whether the institution has adopted an

appropriate risk-management framework

for leveraged lending that includes

robust policies, procedures, and risk lim-

its that have been approved by the board

of directors.

b. Implementation of this guidance should

be consistent with the size and risk pro-

ﬁle of the institution.

c. All aspects of the guidance should be

applied to institutions that originate and

distribute leveraged loans.

d. The section on Participations Purchased

should be applied to banking organiza-

tions that have limited involvement in

leveraged lending; community banks

overall may not be materially affected by

the guidance.

4. Deﬁnition of Leveraged Lending

a. Determine if the institution has a written

policy for leveraged lending and if that

policy contains criteria for deﬁning

leveraged lending that are appropriate

for the institution and consistent with the

guidance standards.

b. Determine if the institution’s deﬁnition

includes related exposures and direct and

indirect exposures.

5. General Policy Expectations

a. Review the policy for the key risk ele-

ments referred to in the guidance (See

the section on General Policy Expecta-

tions in the guidance and in the Internal

Control Questionnaire). Determine if the

policy includes the following elements:

• Risk Appetite that clearly deﬁnes the

amount of leveraged lending the insti-

tution is willing to underwrite and is

willing to retain.

• Limit Framework for aggregate port-

folio held on balance sheet, single

obligors and transactions, aggregate

pipeline exposure, industry and geo-

graphic concentrations. For institutions

with signiﬁcant underwriting expo-

sure, determine if limits have been

established for stress losses, ﬂex terms,

economic capital, or earnings at risk

associated with leveraged loans.

• Allowance for loan and lease losses

(ALLL) and capital adequacy analysis

that reﬂect the risk of leveraged lend-

ing activities.

• Credit approval and underwriting

authorities.

• Guidelines for senior management

oversight and timely reporting to

senior management and the board of

directors.

• Expected risk adjusted returns.

• Minimum underwriting standards.

• Underwriting practices for origination

and secondary loan acquisition.

6. Participations Purchased

a. Ascertain if the institution participating

or purchasing into a leveraged loan has a

clear understanding of the credit and the

risks involved and also has a clear under-

standing of its rights and responsibilities

under the participation agreement.

b. Determine if the institution has con-

ducted its own independent underwriting

of participations and has applied the

same standards of prudence, credit

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual January 2014

Page 42

assessment techniques, and in-house lim-

its as if the institution had originated the

loan(s).

c. Verify that the institution has received

copies of all participation documents and

any other documents relevant to the

credit transaction(s).

7. Underwriting Standards

a. Determine if the institution employs

similar and consistent underwriting stan-

dards for leveraged loans it plans to hold

or it plans to distribute.

• Conﬁrm that the institution’s under-

writing standards are clear, written,

measurable, and reﬂect the institu-

tion’s policy-based risk appetite for

leveraged lending.

• Evaluate the underwriting policies and

standards and determine if they con-

tain the elements found in guidance

(Refer to the section on Underwriting

Standards in the guidance and in the

Internal Control Questionnaire):

8. Valuation Standards

a. Conﬁrm that the institution has policies

and procedures in place for estimating

enterprise value or for valuing other

illiquid collateral. If enterprise value is

relied on as a secondary source of repay-

ment, determine the following:

• If one or a combination of the three

methods referred to in the guidance is

used (asset, income, or market valua-

tion).

• If the underlying assumptions and the

resulting values are well documented,

supportable, and credible (Refer to the

Valuations Standards section of the

guidance and the Internal Control

Questionnaire).

• If enterprise value was calculated by

qualiﬁed persons independent of the

origination function.

• If stress tests of key enterprise value

variables and assumptions (such as

cash ﬂow earnings and sales multiples)

are conducted.

• That ﬁrms have policies that provide

for appropriate loan-to-value ratios,

discount rates and collateral margins.

• If the institution has established limits

for the proportion of individual trans-

actions and the total portfolio that are

supported by enterprise value.

9. Pipeline Management

a. Determine if the institution has strong

risk management and controls that are

extended to deals in the pipeline,

whether those deals are intended for

hold, or if they are intended for distribu-

tion.

• Determine if the institution has poli-

cies and procedures for handling distri-

bution failures.

• Determine if there are procedures for

stress testing pipeline deals.

• Ascertain if management reports show

that transactions can be differentiated

based on their key characteristics,

tenor, and investor class (pro-rata and

institutional), structure, and key bor-

rower characteristics (for example,

industry).

• Determine if there are clearly articu-

lated rationales for the effectiveness of

hedging methods and if there is appro-

priate measurement and monitoring.

• Conﬁrm that the institution has devel-

oped and maintained the pipeline pro-

cedures referred to in the guidance (see

the section on Pipeline Management in

the guidance and in the Internal Con-

trol Questionnaire).

10. Reporting and Analytics

a. Ascertain if the institution’s risk-

management framework includes an

intensive and frequent review and moni-

toring process.

b. Establish whether management receives

comprehensive reports about the charac-

teristics and trends of the institution’s

leveraged-lending portfolio at least quar-

terly and if summaries are provided to

the board of directors.

c. Find out if internal reports provide a

detailed and comprehensive view of

global exposures, including situations

when an institution has an indirect expo-

sure to an obligor or is holding a previ-

ously sold position as collateral or as a

reference asset in a derivative. Borrower

and counterparty leveraged lending

reporting should aggregate total expo-

sure and consider exposures booked

across business lines or legal entities.

d. Verify that internal policies identify the

data ﬁelds to be populated and captured

by the institution’s MIS and whether the

reports are accurate, timely, and if the

information is provided to management

and the board of directors.

e. Conﬁrm that MIS reporting on the lever-

aged lending portfolio contains the appli-

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 43

cable measures listed in the guidance.

(Refer to the section on Reporting and

Analytics in the guidance and in the

Internal Control Questionnaire.)

11. Credit Analysis

a. Conduct transaction testing on individual

leveraged lending credits to determine if

the credit analysis contains a comprehen-

sive assessment of ﬁnancial, business,

and industry and management risks.

b. Evaluate individual credits to determine

if they ﬁt the institutions deﬁnition of a

leveraged loan.

c. Determine if individual credits were ana-

lyzed in conjunction with the parameters

in the guidance. (Refer to the section on

Credit Analysis in the guidance and in

the Internal Control Questionnaire).

d. Verify that there are guidelines for evalu-

ating deal sponsors and their willingness

and ability to support the credit.

e. Conﬁrm that sponsors are used as a sec-

ondary and not a primary source of

repayment.

f. Assess the credit agreement to determine

if it contains language for:

• Material dilution, sale, or exchange of

collateral or cash ﬂow producing

assets without lender approval.

• Financial performance covenants;

covenant-lite, and payment-in-kind

(PIK) toggle loan structures

• Reporting requirements and compli-

ance monitoring.

• The distribution of reporting and other

credit information to participants and

investors.

• Acceptable collateral types, loan to

value guidelines and appropriate col-

lateral valuation methodologies

12. Internal Risk Rating

a. Determine if individual loans are risk

rated based on the borrower’s demon-

strated ability to repay the loan and

de-lever over a reasonable period of

time.

• Conﬁrm that the institution has evi-

dence of adequate repayment capacity,

for example borrowers demonstrate

the ability to fully amortize senior debt

or repay at least 50 percent of total

debt over a 5–7 year period. Ensure

that extensions or other restructuring

are not masking an inability to repay.

• Consider adversely rating credits that

do not show the capacity to pay down

debt from cash ﬂow or if reﬁnancing is

the only option for repayment.

• Consider a substandard rating if there

are no reasonable or realistic prospects

for repayment or de-levering.

13. Deal Sponsors

a. If a deal sponsor is relied on as a second-

ary source of repayment, determine if

management has developed guidelines

for evaluating the sponsor’s creditwor-

thiness.

b. Evaluate the sponsor based on the crite-

ria listed in the guidance (See the section

on Deal Sponsors in the guidance and in

the Internal Control Questionnaire).

14. Credit Review/Problem Credit Management

a. Assess credit review staff’s expertise

relative to leveraged lending.

b. Verify that the institution conducts fre-

quent internal credit review of

leveraged-lending portfolio that is done

independently of the origination func-

tion. Portfolio reviews should generally

be conducted no less than annually.

c. Evaluate the institution’s procedures for

dealing with problem credits including if

work out plans contain quantiﬁable

objectives and measurable time frames.

15. Stress Testing

a. Determine if the institution has devel-

oped stress tests for leveraged loans or if

the loans are included in the existing

stress testing protocol.

16. Conﬂicts of Interest/

Reputational Risk/Compliance

a. Conﬁrm that the institution is meeting its

legal responsibilities by underwriting

and distributing transactions that do not

result in undue reputational risk.

b. Determine if potential conﬂicts of inter-

est exist if the institution has both equity

and lending positions in a particular

transaction. Conﬁrm that policies and

procedures are in place to handle con-

ﬂicts of interest.

c. Ascertain whether the institution’s com-

pliance function periodically reviews the

institution’s leveraged-lending activity.

d. Ascertain whether the institution’s poli-

cies incorporate safeguards to prevent

violations of anti-tying regulations.

e. When securities are involved, determine

how the institution ensures compliance

with applicable securities laws, includ-

ing disclosure and other regulatory

requirements.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 44

f. Ascertain what plans and provisions

have been developed to ensure compli-

ance with the Board’s Regulation W (12

CFR part 223).

Credit-Risk Management for Home Equity

Lending

1. Review the credit policies for home equity

lending to determine if the underwriting

standards address all relevant risk factors

(that is, an analysis of a borrower’s income

and debt levels, credit score, and credit

history versus the loan’s size, the collateral

value (including valuation methodology),

the lien position, and the property type and

location.

2. Determine whether the banking organiza-

tion’s underwriting standards include—

a. a properly documented evaluation of

the borrower’s ﬁnancial capacity to

adequately service the debt and

b. an adequately documented evaluation of

the borrower’s ability to (1) amortize the

fully drawn line of credit over the loan

term and (2) absorb potential increases

in interest rates for interest-only and

variable-rate HELOCs.

3. Assess the reasonableness and adequacy of

the analyses and methodologies underlying

the banking organization’s evaluation of

borrowers.

4. If the organization uses third parties to

originate home equity loans, ﬁnd out—

a. if the organization delegates the under-

writing function to a broker or corre-

spondent;

b if the banking organization’s internal

controls for delegated underwriting are

adequate;

c. whether the banking organization retains

appropriate oversight of all critical loan-

processing activities, such as veriﬁcation

of income and employment and the inde-

pendence of the appraisal and evaluation

function;

d. if there are adequate systems and con-

trols to ensure that a third-party origina-

tor is appropriately managed, is ﬁnan-

cially sound, provides mortgages that

meet the banking organization’s pre-

scribed underwriting guidelines, and

adheres to applicable consumer protec-

tion laws and regulations;

e. if the banking organization has a quality-

control unit or function that closely

monitors (monitoring activities should

include post-purchase underwriting

reviews and ongoing portfolio-

performance-management activities) the

quality of loans that the third party

underwrites; and

f. whether the banking organization has

adequate audit procedures and controls

to verify that third parties are not being

paid to generate incomplete or fraudu-

lent mortgage applications or are not

otherwise receiving referral or unearned

income or fees contrary to RESPA

prohibitions.

5. Evaluate the adequacy of the banking orga-

nization’s collateral-valuation policies and

procedures. Ascertain whether the

organization—

a. establishes criteria for determining the

appropriate valuation methodology for a

particular transaction (based on the risk

in the transaction and loan portfolio);

b. sets criteria for determining when a

physical inspection of the collateral is

necessary;

c. ensures that an expected or estimated

value of the property is not communi-

cated to an appraiser or individual per-

forming an evaluation;

d. implements policies and controls to pre-

clude “value shopping’’;

e. requires sufﬁcient documentation to sup-

port the collateral valuation in the

appraisal or evaluation.

6. If the banking organization uses automated

valuation models (AVMs) to support evalu-

ations or appraisals, ﬁnd out if the

organization—

a. periodically validates the models, to

mitigate the potential valuation uncer-

tainty in the model;

b. adequately documents the validation’s

analysis, assumptions, and conclusions;

c. back-tests a representative sample of

evaluations and appraisals supporting

loans outstanding; and

d. evaluates the reasonableness and

adequacy of its procedures for validating

AVMs.

7. If tax-assessment valuations are used as a

basis for collateral valuation, ascertain

whether the banking organization is able to

demonstrate and document the correlation

between the assessment value of the taxing

authority and the property’s market value,

as part of the validation process.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 45

8. Review the risk- and account-management

procedures. Verify that the procedures are

appropriate for the size of the banking

organization’s loan portfolio, as well as

for the risks associated with the types of

home equity lending conducted by the

organization.

9. If the banking organization has large home

equity loan portfolios or portfolios with

high-risk characteristics, determine if the

organization—

a. periodically refreshes credit-risk scores

on all customers;

b. uses behavioral scoring and analysis of

individual borrower characteristics to

identify potential problem accounts;

c. periodically assesses utilization rates;

d. periodically assesses payment patterns,

including borrowers who make only

minimum payments over a period of

time or those who rely on the credit line

to keep payments current;

e. monitors home values by geographic

area; and

f. obtains updated information on the col-

lateral’s value when signiﬁcant market

factors indicate a potential decline in

home values, or when the borrower’s

payment performance deteriorates and

greater reliance is placed on the

collateral.

Determine that the frequency of these

actions is commensurate with the risk in the

portfolio.

10. Verify that annual credit reviews of home

equity line of credit (HELOC) accounts are

conducted. Verify if the reviews of HELOC

accounts determine whether the line of

credit should be continued, based on the

borrower’s current ﬁnancial condition.

11. Determine that authorizations of over-limit

home equity lines of credit are restricted

and subject to appropriate policies and

controls.

a. Verify that the banking organization

requires over-limit borrowers to repay,

in a timely manner, the amount that

exceeds established credit limits.

b. Evaluate the sufﬁciency of management

information systems (MIS) that enable

management to identify, measure, moni-

tor, and control the risks associated with

over-limit accounts.

12. Verify that the organization’s real estate

lending policies are consistent with safe and

sound banking practices and that its board

of directors reviews and approves the poli-

cies at least annually.

13. Determine whether the MIS—

a. allows for the segmentation of the loan

portfolios;

b. accurately assesses key risk characteris-

tics; and

c. provides management with sufﬁcient

information to identify, monitor, mea-

sure, and control home equity concentra-

tions.

14. Determine whether management periodi-

cally assesses the adequacy of its MIS, in

light of growth and changes in the banking

organization’s risk appetite.

15. If the banking organization has signiﬁcant

concentrations of home equity loans (HELs)

or HELOCs, determine if the MIS includes,

at a minimum, reports and analysis of the

following:

a. production and portfolio trends by prod-

uct, loan structure, originator channel,

credit score, loan to value (LTV), debt to

income (DTI), lien position, documenta-

tion type, market, and property type

b. the delinquency and loss-distribution

trends by product and originator chan-

nel, with some accompanying analysis

of signiﬁcant underwriting characteris-

tics (such as credit score, LTV, or DTI)

c. vintage tracking

d. the performance of third-party origina-

tors (brokers and correspondents)

e. market trends by geographic area and

property type, to identify areas of rapidly

appreciating or depreciating housing

values

16. Determine whether the banking organiza-

tion accurately tracks the volume of high-

LTV (HLTV) loans, including HLTV home

equity and residential mortgages, and if the

organization reports the aggregate of these

loans to its board of directors.

17. Determine whether loans in excess of the

supervisory LTV limits are identiﬁed as

high-LTV loans in the banking organiza-

tion’s records. Determine whether the orga-

nization reports, on a quarterly basis, the

dollar value of such loans to its board of

directors.

18. Find out whether the organization has pur-

chased insurance products to help mitigate

the credit risks of its HLTV residential

loans. If a policy has a coverage limit,

determine whether the coverage may be

exhausted before all loans in the pool

mature or pay off.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 46

19. Determine whether the organization’s

credit-risk management function oversees

the support function(s). Evaluate the effec-

tiveness of controls and procedures over

staff persons responsible who are respon-

sible for perfecting liens, collecting out-

standing loan documents, obtaining insur-

ance coverage (including ﬂood insurance),

and paying property taxes.

20. Determine whether policies and procedures

have been established for home equity

problem-loan workouts and loss-mitigation

strategies.

Loan Participations, the Agreements and

Participants

These inspection procedures are designed to

ensure that originated loans that were trans-

ferred via loan participation agreements or cer-

tiﬁcates to state member banks, bank holding

companies, nonbank afﬁliates, or other third par-

ties were carefully evaluated. The procedures

instruct examiners to determine if the asset

transfers were carried out to avoid or circum-

vent classiﬁcation and to determine the effect of

the transfers on the BHC’s ﬁnancial condition

or that of its subsidiaries. In addition, the proce-

dures are designed to ensure that the primary

regulator of another ﬁnancial institution

involved in the asset transfer of any low-quality

assets is notiﬁed.

1. Review the board of directors’ or their des-

ignated committees’ policies and proce-

dures governing how loan participation

agreements and activities are created, trans-

acted, and administered. Refer to section

2010.2.7 for the minimum items that should

be included in board-approved policies on

loan participation activities.

2. Determine if managerial reports provide

sufﬁcient information relative to the size

and risk proﬁle of the loan participation

portfolio and evaluate the accuracy and

timeliness of reports produced for the board

and senior management.

3. For loan participations held (either in whole

or in part) with another lending institution,

review, if applicable,

• the participation certiﬁcates and agree-

ments, on a test basis, to determine if the

contractual terms are being adhered to;

• loan documentation to determine if it

meets the BHC’s (or its subsidiary’s)

underwriting procedures (that is, the

documentation for loan participations

should meet the same standards as the

documentation for other loans the respec-

tive entity originates);

• the transfer of loans immediately before

the date of the inspection to determine if

the loan was either nonperforming or

classiﬁed and if the transfer was made to

avoid possible criticism during the cur-

rent inspection; and

• losses to determine if they are shared on a

pro rata or other basis according to the

terms of the participation agreement.

4. Check participation certiﬁcates or agree-

ments and records to determine whether the

parties share in the risks and contractual

payments on a pro rata or other basis.

5. Determine if loans are purchased on a

recourse basis and that loans are sold on a

nonrecourse basis.

6. Ascertain that the BHC (or its subsidiaries)

do not buy back or pay interest on defaulted

loans in contradiction of the underlying par-

ticipation agreement.

7. Compare the volume of outstanding origi-

nated or purchased loans that were issued in

the form of loan participations with the total

outstanding loan portfolio.

8. Determine if the BHC (or its subsidiaries)

has sufﬁcient expertise to properly evaluate

the volume of loans originated or purchased

and sold as loan participations.

9. Based on the terms of the loan participation

agreements, review the originator’s distri-

bution of the borrower’s payments received

to those entities or persons owning interests

in the loan participations. Ascertain if the

agreement’s recourse provisions may

require accounting for the transactions as a

secured borrowing rather than as a sale.

10. Determine if loans are sold primarily to

accommodate credit overline needs of cus-

tomers or to generate fee income.

11. Determine if loans are purchased or sold to

afﬁliates or other companies; if so, deter-

mine whether the purchasing companies

request and are given sufﬁcient information

to properly evaluate the credit. (Section

23A of the Federal Reserve Act and the

Board’s Regulation W prohibit transfers of

low-quality assets between afﬁliates.) See

sections 2020.0, 2020.1, 2020.2.

12. Investigate any situations in which assets

were transferred before the date of

inspection:

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 47

a. Determine if any were transferred to

avoid possible criticism during the

inspection.

b. Determine whether any of the loan par-

ticipations transferred were nonperform-

ing at the time of transfer, classiﬁed dur-

ing the previous examination, or

transferred for any other reason that may

cause the loans to be considered of ques-

tionable quality.

13. Review the BHC’s policies and procedures

to determine whether loan participations

purchased are required to be given an inde-

pendent, complete, and adequate credit

evaluation. Review asset participations sold

to afﬁliates to determine if the asset pur-

chases were supported by an arm’s-length

and independent credit evaluation.

14. Determine that any assets purchased by the

BHC (or its subsidiaries) were properly

recorded at fair market value at the time of

purchase.

15. Determine that transactions involving trans-

fers of low-quality assets to the parent hold-

ing company or a nonbank afﬁliate are

properly reﬂected at fair market value on

the books of both the bank and the holding

company afﬁliate.

16. If poor-quality assets were transferred by

the BHC to another ﬁnancial institution for

which the Federal Reserve is not the pri-

mary regulator, prepare a memorandum to

be submitted to the Reserve Bank supervi-

sory personnel. The Reserve Bank’s appro-

priate staff will then inform the local ofﬁce

of the primary federal regulator of the other

institution involved in the transfer. The

memorandum should include the following

information, as applicable,

• names of originating and receiving

institutions;

• type of assets involved;

• date (or dates) of transfer;

• total number and dollar amount of assets

transferred;

• status of the assets when transferred (e.g.,

nonperforming, classiﬁed, etc.); and

• any other information that would be help-

ful to the other regulator. Ascertain

whether the bank manages not only the

risk from individual participation loans

but also portfolio risk.

17. Find out if management develops appropri-

ate strategies for managing concentration

levels, including the development of a con-

tingency plan to reduce or mitigate concen-

trations during adverse market conditions

(such a plan may include strategies involv-

ing not only loan participations, but also

whole loan sales). Find out if the BHC’s (or

its subsidiaries’) contingency plan includes

selling loans as loan participations.

18. Ascertain if management periodically

assesses the marketability of its loan partici-

pation portfolio and evaluates the BHC’s

(or its subsidiaries’) ability to access the

secondary market.

19. Verify whether the BHC (or its subsidi-

aries) compare its underwriting standards

for loan participations with those that exist

in the secondary market.

2010.2.10 INTERNAL CONTROL

QUESTIONNAIRE

Applicability/Risk-Management

Framework

1. Has the institution adopted a risk-

management framework around leveraged

lending that includes:

a. A leveraged lending policy that is based

on risk objectives, risk acceptance crite-

ria, and risk controls?

b. Structuring transactions that reﬂect a

sound business premise, have an appro-

priate capital structure, reasonable cash

ﬂow, and balance sheet leverage?

c. A deﬁnition of leveraged lending that

can be applied across all business lines?

d. Well-deﬁned underwriting standards that

deﬁne acceptable leverage levels and

amortization expectations?

e. A limit framework?

f. Sound MIS?

g. Pipeline management procedures, hold

limits, and expected timing for distribu-

tions?

h. Guidelines for stress testing?

2. Is the institution able to identify leveraged

exposures to related borrowers or guaran-

tors?

3. Is the institution able to identify leveraged

loans that are managed in non-lending port-

folios (for example collateralized loan obli-

gations (CLOs), special purpose entities

(SPEs), or other indirect exposures)?

4. Is the institution originating leveraged

loans; participating in leveraged loans, or

both?

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 48

Deﬁnition of Leveraged Lending

1. Has the institution developed an appropri-

ate written deﬁnition for leveraged lending

and incorporated it into the leveraged lend-

ing policy?

2. Is the policy deﬁnition consistent with the

amounts and types of leveraged loans that

the institution is engaged in?

General Policy Expectations

1. Has the institution’s leveraged lending pol-

icy been approved by the board of direc-

tors?

2. Does the leveraged lending policy contain

the following elements:

a. A clear statement of the amounts of

leveraged lending that it is willing to

underwrite and the amount(s) it is will-

ing to hold in its own portfolio?

b. A limit framework that establishes limits

or guidelines around the following as

applicable:

1) Single obligors and transactions?

2) Aggregate hold portfolio?

3) Total pipeline exposure?

4) Industry and geographic concentra-

tion?

5) Notional pipeline limits?

6) Stress losses, ﬂex terms, economic

capital usage, and earnings at risk?

7) Other parameters particular to the

portfolio?

8) The required management approval

authorities and exception tracking

provisions?

c. Procedures for insuring that leveraged

lending risks are appropriately reﬂected

in the institution’s level of allowance for

loan and lease losses (ALLL) and capital

adequacy analysis?

d. Credit and underwriting approval

authorities, including the procedures for

approving and documenting changes to

approved transaction structures and

terms?

e. Guidelines for appropriate oversight by

senior management, including adequate

and timely reporting to the board of

directors?

f. Expected risk-adjusted returns for lever-

aged transactions?

g. Minimum underwriting standards and

underwriting practices for primary loan

origination and secondary loan acquisi-

tion?

Participations Purchased

1. Has the institution, with respect to participa-

tions purchased, done its own independent

underwriting of its portion of the transac-

tion and has it adequately identiﬁed its

risks?

2. Has the institution received copies of all

documentation relevant to the transaction?

3. Is there evidence that the institution has

reviewed the participation agreement and

has a clear understanding of its rights and

responsibilities under the agreement?

Underwriting Standards

1. Is the institution using similar underwriting

standards for leveraged loans it plans to

hold as well as for leveraged loans it plans

to distribute?

2. Are the institution’s underwriting standards

clear, written, and measurable?

3. Do underwriting standards require:

• A sound business premise for each trans-

action and that the borrower’s capital

structure is sustainable?

• A determination and documentation of

the borrower’s capacity to repay and

ability to de-lever to a sustainable level

over a reasonable period?

• Standards for evaluating various types of

collateral?

• Standards for evaluating risk-adjusted

returns?

• The acceptable degree of reliance on

enterprise value and other intangible

assets for loan repayment?

• Expectations for the degree of support

expected to be provided by sponsors?

• A prohibition on material dilution, sale,

or exchange of collateral or cash ﬂow

producing assets without lender

approval?

• A credit agreement that contains ﬁnan-

cial covenants, reporting covenants, and

compliance monitoring? Does the loan

contain covenant-lite and PIK toggle

loan structures? If so, does the borrower

have the ability to repay the loan under

the contractual terms?

• Guidelines for acceptable collateral

types, loan-to value-guidelines, and

acceptable collateral valuation method-

ologies?

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 49

• Loan agreements that provide for the

distribution of ﬁnancial information to

participants and investors?

Valuation Standards

1. Does the institution have policies for valu-

ing illiquid, intangible, or hard to value

collateral that include appropriate LTV

ratios, discount rates, and collateral mar-

gins?

2. Is the institution relying on enterprise value

to conﬁrm a secondary source of repay-

ment?

a. Has the institution documented its valua-

tion approach to calculating enterprise

value?

b. Has the valuation been performed by

qualiﬁed persons independent of the

origination function?

c. Has one or a combination of three meth-

ods been used for determining enterprise

value, asset valuation, income valuation,

or market valuation?

d. If the income method is used, is it based

on capitalized cash ﬂow or discounted

cash ﬂow?

e. Has the institution conﬁrmed proxy mea-

sures such as multiples of cash ﬂow

earnings or sales by performing its own

discounted cash ﬂow analysis?

f. Are stress tests of key variables and

assumptions used in determining enter-

prise value (such as cash ﬂow earnings

and sales multiples) conducted at origi-

nation and periodically thereafter?

g. Does the institution have established lim-

its for the proportion of individual trans-

actions and the total portfolio that are

supported by enterprise value?

Pipeline Management

1. Do strong risk-management controls cover

all transactions in the pipeline, including

amounts planned for hold and those marked

for distribution?

2. Does the institution have the capability to

differentiate transactions based on their key

characteristics, tenor, and investor class

(pro-rata and institutional), structure, and

key borrower characteristics (for example,

industry)?

3. Does the institution have the following con-

trols for pipeline exposure:

• A documented appetite for underwriting

pipeline risk that considers the potential

effects on earnings, capital, and liquid-

ity?

• Written policies and procedures for

“hung deals” or deals that are not sold

down within a reasonable or 90-day

period?

– Have transactions reclassiﬁed as hold-

to-maturity been reported to manage-

ment and the board of directors?

• Guidelines for conducting periodic stress

tests of pipeline exposures?

• Controls to monitor expected vs. actual

performance?

• Reports that show individual and aggre-

gate transaction information, risk ratings

and concentrations?

• Limits on hold levels per borrower,

counterparty, and aggregate hold levels?

• Limits on the amounts intended for dis-

tribution?

• Policies and procedures for acceptable

accounting methods, including prompt

recognition of losses?

• Policies and procedures around accept-

able hedging practices if applicable?

• Plans to address contingent liabilities and

compliance with Sections 23A and 23B

of the Federal Reserve Act and Regula-

tion W?

Reporting and Analytics

1. Does management receive quarterly com-

prehensive reports about the characteristics

and trends of the institution’s leveraged

lending portfolio? Are summaries provided

to the board of directors?

2. Do internal policies identify the data ﬁelds

to be populated and captured by the institu-

tion’s MIS? Are the reports accurate and

timely?

3. As dictated by the size and complexity of

the leveraged lending portfolio, does MIS

reporting on the leveraged lending portfolio

include the following:

a. Individual and portfolio exposures

within and across all business lines and

legal vehicles including the pipeline?

b. Risk-rating distribution and migration

analysis?

c. A list of borrowers who have been

removed from the leveraged-lending

portfolio due to improvements in their

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 50

ﬁnancial characteristics and risk proﬁle?

Is the removal from the proﬁle concur-

rent with a reﬁnance, restructure or some

other modiﬁcation in the loan agree-

ment?

d. Industry mix and maturity proﬁle?

e. Metrics derived from probability of

default and loss-given default?

f. Portfolio performance measures includ-

ing covenant breaches, restructurings,

delinquencies, nonperforming asset

amounts, and charge offs?

g. Amount and nature of impaired assets

and the amount of ALLL attributable to

leveraged lending?

h. The level of policy exceptions in the

portfolio?

i. Exposures by collateral type, including

unsecured transactions when enterprise

values will be the only source of repay-

ment?

j. Defaults that trigger pari-passu treat-

ment for all lenders?

k. Secondary market pricing data and trad-

ing volume (when available)?

l. An aggregation of exposures by and per-

formance of deal sponsors?

m. An indication of gross and net expo-

sures, hedge and counterparty concentra-

tions; and indication of policy excep-

tions?

n. Actual vs. projected distribution levels

of the pipeline with reports of excess

levels of exposure over hold targets?

o. Types of exposure in the pipeline: com-

mitted exposures not accepted by the

borrower; exposures committed and

accepted but not closed; funded and

unfunded commitments closed but not

distributed?

p. Total and segmented exposures: subordi-

nated debt and equity holdings (com-

pared to limits); global exposures; indi-

rect exposure (to an obligor or if the

institution is holding a previously sold

position as collateral or as a reference

asset in a derivative)?

q. Exposures booked in other business units

throughout the institution that are related

to a leveraged loan or borrower? (For

example, default swaps or total return

swaps naming the distributed paper as a

covered or referenced asset or as collat-

eral exposure through repo transactions).

r. Positions held in leveraged loans in

available for sale or traded portfolios or

held in structured-investment vehicles

owned or operated by the originating

institution or its subsidiaries or afﬁliates?

Internal Risk Rating

1. Does the institution have evidence of

adequate repayment capacity? For example,

do borrowers demonstrate the ability to

fully amortize senior debt or repay at least

50 percent of total debt over a ﬁve to seven-

year period?

2. Are there extensions or other restructuring

that are masking an inability to repay?

3. Has the primary source of repayment

become inadequate? Is enterprise value

being relied on as a secondary source of

repayment? Is enterprise value well sup-

ported with binding purchase and sale

agreements with qualiﬁed third parties?

Does enterprise value consider the bor-

rower’s distressed circumstances?

Credit Analysis

1. Does transaction testing of individual lever-

aged lending credits contain the following

elements and show that :

a. Cash ﬂow analysis—The analysis does

not rely on overly optimistic or unsub-

stantiated projections of sales, margins,

or merger and acquisition synergies?

b. Liquidity analysis—There are measures

to determine operating cash needs and

cash needed to meet debt maturities?

Analyze liquidity based on industry per-

formance metrics?

c. Projections—There is adequate margin

for unanticipated merger-related integra-

tion costs?

d. Stress tests—Projections are stress tested

for one or more downside scenarios,

including a covenant breach?

e. Variances from plan—Transactions are

reviewed at least quarterly to determine

variance from plan; does the credit ﬁle

contain a chronological rationale for and

analysis of all changes to the operating

plan and variances from the expected

ﬁnancial performance?

f. Enterprise Value—Were enterprise val-

ues independently derived and validated

outside of the origination function? Were

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 51

values calculated timely and did they

consider value erosion?

g. Collateral shortfalls—Have shortfalls

been identiﬁed and factored into the risk

rating?

h. Collateral liquidation and asset sales—

Are any liquidations and sales based on

current market conditions and trends?

i. Contingency plans—Are there contin-

gency analyses to anticipate changing

conditions in debt or equity markets? Do

the exposures rely on reﬁnancing or the

issuance of new equity?

j. Interest Rate Risk and Foreign Exchange

Risk—Have these risks been addressed

in the analysis? Are mitigants in place?

Problem Credit Management

1. Has the institution formulated and estab-

lished procedures for dealing with problem

credits?

2. Do work out plans contain quantiﬁable

objectives and measurable time frames?

3. Are problem credits regularly reviewed for

risk-rating accuracy, accrual status, recogni-

tion of impairment through speciﬁc alloca-

tions and charge-offs.

Deal Sponsors

1. Has the institution developed guidelines for

evaluating the willingness and ability of

sponsors to support the credit exposure and

a process to regularly monitor sponsor per-

formance?

2. Determine if the credit analysis has consid-

ered:

a. If the sponsor is relied on as a secondary

source of repayment and not a primary

source of repayment?

b. If the sponsor has a historical pattern of

supporting investments, ﬁnancially or

otherwise?

c. If the degree of support has been docu-

mented via a guarantee, comfort level, or

verbal assurance?

d. If there has been a periodic review of the

sponsor’s ﬁnancial statements, an analy-

sis of liquidity, and an analysis of the

sponsor’s ability to support multiple

deals?

e. If consideration has been given to the

sponsor’s dividend and capital contribu-

tion practices and the likelihood that the

sponsor will support the borrower as

compared to other deals in the sponsor’s

portfolio?

Credit Review

1. Does the institution conduct an internal

credit review of the leveraged-lending port-

folio regularly, but at least once per year?

2. Does the institution ensure that credit

review personnel have the knowledge and

ability to identify risks in the leveraged

lending portfolio?

Stress Testing

1. Has the institution developed and imple-

mented guidelines for conducting periodic

portfolio stress tests on loans originated to

hold and on loans originated to distribute?

2. Has the institution conducted periodic loan

and leveraged lending portfolio level stress

tests?

3. If applicable, has the leveraged-lending

portfolio been included in enterprise wide

stress tests?

4. Does stress testing of leveraged credits

include sensitivity analyses to quantify the

potential impact of changing economic and

market conditions on the institution’s asset

quality, earnings, liquidity, and capital?

Reputational Risk

1. Does the institution have procedures, safe-

guards, actions, training, and staff remind-

ers about the potential reputational risk

associated with poorly underwritten origi-

nated leveraged loans?

2. Has there been any failure or apparent fail-

ure by the institution to meet its legal

responsibilities in underwriting and distrib-

uting transactions that could damage its

reputation or its ability to compete?

Conﬂicts of Interest

1. Has the institution developed appropriate

policies and procedures to address and to

prevent potential conﬂicts of interest when

it has both equity and lending positions?

2. Do policies and procedures:

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 52

a. Clearly deﬁne potential conﬂicts of inter-

est?

b. Identify appropriate risk-management

controls and procedures?

c. Enable employees to report potential

conﬂicts of interest to managements

without fear of retribution?

d. Ensure compliance with applicable laws?

3. Has management:

a. Established a training program for

employees on appropriate practices to

follow to avoid conﬂicts of interest?

b. Provided for reporting, tracking, and

resolution of any conﬂicts?

Compliance

1. Does the institution maintain an indepen-

dent compliance review function to periodi-

cally review its leveraged-lending activity?

2. Do the institution’s policies include safe-

guards to prevent violations of anti-tying

regulations?

3. How does the institution ensure compliance

with applicable securities laws, including

disclosure and other regulatory require-

ments when equity interests and certain debt

instruments have been used in leveraged

transactions that may constitute “securities”

under federal securities laws?

4. Have plans and provisions been developed

to ensure compliance with sections 23A and

23B of the Federal Reserve Act and Regula-

tion W?

2010.2.11 APPENDIX I - EXAMINER

LOAN-SAMPLING REQUIREMENTS

FOR CREDIT-EXTENDING NONBANK

SUBSIDIARIES OF BHCS WITH

$10-50 BILLION IN TOTAL

CONSOLIDATED ASSETS

This guidance sets forth loan sampling expecta-

tions for the Federal Reserve’s examination of

state member bank (SMB) and the inspection of

credit-extending nonbank subsidiaries of bank

holding companies (BHCs) with $10-50 billion

in total consolidated assets. Examiners will have

the ﬂexibility, depending upon the structure and

size of subsidiary SMBs or credit-extending

nonbank subsidiaries of BHCs, to utilize the

guidance applicable to smaller organizations

when the subsidiary’s total assets are below $10

billion. This guidance clariﬁes expectations for

the assessment of material

retail credit port-

folios for these institutions. The guidance that

follows has been solely adapted to BHC credit-

extending nonbank subsidiaries.

A thorough review of a BHC’s credit-

extending nonbank subsidiary’s loan and lease

portfolio remains a fundamental element of the

Federal Reserve’s inspection program for these

organizations. Such credit reviews are a primary

means for examiners to (1) evaluate the effec-

tiveness of a BHC’s credit-extending nonbank

internal loan review program and internal grad-

ing systems for determining the reliability of

internal reporting of classiﬁed credits, (2) assess

compliance with applicable guidance and regu-

lations, and (3) determine the efﬁcacy of credit-

risk management and credit administration pro-

cesses. Further, examiners use the ﬁndings from

their credit review to identify the overall the-

matic credit-risk management issues, to assess

asset quality, to assist in the assessment of the

adequacy of the allowance for loan and lease

losses (ALLL), and to inform their analysis of

capital adequacy.

2010.2.11.1 Loan Sampling Methodology

Reserve Banks will establish the annual loan-

sampling objective during the supervisory plan-

ning process. The annual sampling objective

should provide coverage of material exposures,

including those in the retail segments.

Reserve

Banks should plan on conducting at least two

loan quality reviews during the annual supervi-

sory cycle of the BHC’s credit-extending non-

bank subsidiaries with $10−50 billion in total

consolidated assets.

Each review should focus on one or more

material commercial loan segment exposures

using the comparable FR Y-9C Report loan

types and, in total over the annual cycle, should

cover the four highest concentrations for com-

56. A loan portfolio or portfolio segment is considered

material when the portfolio or segment exceeds 25 percent of

total risk-based capital (tier 1 capital plus the allowance for

loan and lease losses) or contributes 25 percent or more to

annual revenues.

57. Commercial loan segments include commercial and

industrial (C&I) loans, 1-4 family construction, other con-

struction loans, multifamily loans, farm loans, non-farm non-

residential owner occupied, and non-farm non-residential

other loans. Retail loan segments include ﬁrst lien mortgages,

closed-end junior liens, home equity lines of credit

(HELOCs), credit cards, automobile loans, and other con-

sumer loans.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 53

mercial credits in terms of total risk-based capi-

tal for any FR Y-9C Report loan type from

Schedule HC-C. Loan segments that generate

substantial revenues are generally likely to entail

higher risk. To the extent that examiners can

determine that a loan category contributes

25 percent or more to annual revenues,

exam-

iners should sample these segments. Examiners

should also sample other loan segments that

they or the bank’s internal loan review have

identiﬁed as exhibiting high-risk characteristics.

Such risk characteristics include liberal under-

writing, high levels of policy exceptions, high-

delinquency trends, rapid growth, new lending

products, concentrations and concentrations to

industry, or signiﬁcant levels of classiﬁed cred-

its. In addition to these risk-focused samples, a

sample of loans to insiders must be reviewed.

Annual loan sampling coverage by examiners

should take into consideration the severity of

the asset quality component rating, the effective-

ness of the internal loan review program, the

results of internal loan portfolio stress testing,

and current asset quality ﬁnancial trends.

During the inspection scoping phase, Reserve

Bank staff should analyze the results of recent

loan review reports or audits prepared for an

institution’s internal use and the Reserve Bank’s

most current assessment of credit-risk manage-

ment to help establish the size and composition

of loans to be selected for review. A nonbank

subsidiary’s internal loan review program

should achieve substantial coverage beyond the

examiners’ annual judgmental sample of mate-

rial loan portfolios. Examiners should review

the ﬁndings and recommendations of the non-

bank subsidiary’s internal loan review program

to help identify areas of risk. In selecting loans

from each segment of the loan portfolio to

review, examiners should include a selection of

the largest loans, problem loans (past due

90 days or more, nonaccrual, restructured, or

internally classiﬁed loans), and newly origi-

nated loans. Examiners should ensure the

sample selection includes robust coverage of

classiﬁed credits. At a minimum, loans selected

for review from commercial loan segments

should represent 10 percent of the committed

dollar amount of credit exposure within the loan

segment.

Sample sizes should be increased beyond the

10 percent minimum, based on examiner judg-

ment, for segments when the inspection scoping

process or the internal loan review program has

identiﬁed

1. deﬁciencies with credit-risk management

and administration practices,

2. unusually high loan growth,

3. credit quality or collateral values that have

been adversely affected since the prior

review by volatile local or national eco-

nomic conditions, or

4. unreliable internal credit-risk grading.

Conversely, sample sizes should be based on the

10 percent minimum if

1. previous inspections concluded that internal

loan review and credit-risk identiﬁcation is

effective,

2. internal loan review has reviewed a loan

segment within the last 12 months and

noted no material weaknesses, and

3. the inspection scoping process reveals no

signiﬁcant credit-risk management issues.

In general, the lower range of 10 percent sam-

pling of each segment or the entire commercial

portfolio would be acceptable when all aspects

of credit risk indicate low and stable risk.

Examiners should determine classiﬁcation

amounts for retail credits using the Uniform

Retail Classiﬁcation Guidance (SR letter 00-8,

“Revised Uniform Retail Credit Classiﬁcation

and Account Management Policy”). Annually,

examiners should focus on one or more material

retail loan segment exposures as divided by the

comparable FR Y-9C Report loan type. Examin-

ers should determine the appropriate sample of

retail loans from material segments based on

risk to be tested for compliance with internal

credit administration policies and underwriting

standards. While there is no minimum coverage

expectation for retail portfolios or segments, the

goal of sampling is to assist examiners in mak-

ing an informed assessment of all aspects of

retail credit-risk management. If applicable,

examiners should evaluate and test secondary

market origination and servicing practices and

quality assurance programs. Examiners should

also sample other retail loan segments, as

needed, from segments the examiners or inter-

nal loan review identify as exhibiting high-risk

characteristics such as liberal underwriting,

58. The 25 percent threshold should be based on internal

MIS and may not be applicable or available in all instances.

For the purposes of this guidance, annual revenue equals net

interest income plus non interest income.

59. Federal Reserve examiners must test and evaluate

Regulation O compliance annually.

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 54

high-delinquency trends, rapid growth, new

lending products, or signiﬁcant levels of classi-

ﬁed credits.

2010.2.11.2 Documentation of Loan

Sampling Analysis and Methodology

Examiners should discuss their analysis and

objectives for achieving loan sampling coverage

with Board staff during the annual supervisory

planning process. Upon reaching a consensus

with Board staff, the analysis and methodology

should be retained in workpapers and docu-

mented in the supervisory plan. Further, examin-

ers should document their loan sample selection

methods in scoping memoranda and in the con-

ﬁdential section of the report of inspection. The

required workpaper documentation of the com-

mercial loan coverage calculation should be

based on total loan commitments and should

generally exclude loans reviewed outside of the

Reserve Bank’s supervisory plan when a

detailed analysis of the loans by an examiner

and an assessment of credit-risk management

were not performed. Review of syndicated loans

and participations, such as those from the

Shared National Credits (SNCs) annual review,

should only be included in the coverage ratio if

Reserve Bank staff reviewed the credit-risk

management aspects of the credit (for example,

adherence to underwriting policies) and these

ﬁndings are included in the examiner’s assess-

ment of overall credit-risk management prac-

tices. Examiners should continue to follow the

SNC grading guidance.

2010.2.11.3 Follow-Up Expectations for

Inspections with Adverse Findings

Examiners should generally consider a credit-

extending nonbank subsidiary’s internal risk-

rating system to be less reliable when examiner

downgrades

or internal loan review down-

grades equal 10 percent of the total number of

loans reviewed, or 5 percent of the total dollar

amount of loans and commitments reviewed.

When a credit-extending nonbank subsidiary’s

risk-rating system is determined to be unreli-

able, examiners may need to expand sampling

to better evaluate the effect of rating differences

on the entity’s ALLL and capital. In such situa-

tions, examiners should direct the BHC and its

credit-extending nonbank subsidiary to take cor-

rective action to validate its internal ratings and

to evaluate whether the ALLL or capital should

be increased. The Reserve Bank will follow-up

with the BHC and its nonbank subsidiary to

assess progress on corrective action and verify

satisfactory completion. The timeframe for

follow-up should correspond with the timeframe

during which actions are to be completed.

All

follow-up actions on adverse ﬁndings should be

discussed with Board staff.

41. Refer to SR-77-377, “Shared National Credit Pro-

gram.”

61. A credit-risk grading difference is considered a down-

grade when (a) a risk rating is changed by the examiner from

an internal Pass rating to a classiﬁed category or (b) a risk

rating is changed by the examiner within the classiﬁed catego-

ries.

62. Refer to SR-13-13/CA -13-10, “Supervisory Consider-

ations for the Communications of Supervisory Findings.”

Loan Administration and Lending Standards 2010.2

BHC Supervision Manual July 2014

Page 55

Supervision of Subsidiaries

(Investments) Section 2010.3

The System’s ability to evaluate the effective-

ness of a company’s supervision and control of

subsidiary investment activities can be strength-

ened not only by evaluating the parent’s role in

light of efﬁciency and operating performance,

but also by evaluating the quality of control and

supervision. In order to assess quality there must

be a standard or measuring block against which

a company’s policies can be evaluated. By es-

tablishing the minimum areas that a company’s

policies should address with respect to subsidi-

ary investments, a standard is created which can

evaluate the quality of company’s control and

supervision of that activity. The examiner needs

to make a qualitative assessment of the parent’s

supervision and control of subsidiary invest-

ment activities.

2010.3.1 INSPECTION OBJECTIVES

1. Determine if the parent’s investment pol-

icy is adequate for the organization.

2. Determine if the investment policy is be-

ing complied with.

2010.3.2 INSPECTION PROCEDURES

1. Determine whether the management has

developed a ﬂow chart on investment authoriza-

tion procedures sufﬁciently detailed to assure

that the execution of transactions precludes the

ability to circumvent policy directives.

2. Determine whether all investment policies

appear to be adequately tailored to ﬁt the busi-

ness needs of each subsidiary. Review the

methods and/or process through which prior

approval of new activities and investments in

new instruments is granted.

3. Determine whether the boards of directors

and the management of subsidiaries appear to

be sufﬁciently involved in their respective roles

to assure that the performance of ﬁduciary re-

sponsibilities of each appears adequate.

4. Assess the adequacy of the level of man-

agement expertise in relation to its involvement

in various investment activities.

5. Evaluate the reasonableness of investment

activity initiated to achieve corporate objectives

in light of its potential impact on the risk expo-

sure of subsidiaries.

6. Assess the adequacy of investment policy

directives in regard to the required mainte-

nance of adequate recordkeeping systems at

subsidiaries.

7. Evaluate policy directives regarding the

appropriateness of accounting practices in re-

gard to transactions involving investment partic-

ipations, swaps, other transfers of investments

as well as specialized investment activities.

8. Evaluate whether investment policies ade-

quately provide for the maintenance of a stable

income stream at bank subsidiaries as well as

the parent company level.

9. Determine whether investment policy di-

rectives adequately address statutory limitations,

particularly those involving intercompany trans-

actions.

10. Evaluate the effectiveness of the bank

holding company’s audit function in assuring

that investment policies and directives are ad-

hered to at each corporate level.

BHC Supervision Manual December 1992

Page 1

Supervision of Subsidiaries

(Consolidated Planning Process) Section 2010.4

This section emphasizes the importance of inte-

grating subsidiaries into a consolidated plan, the

essential elements of the planning process, and

the ultimate accountability of the board of direc-

tors of the holding company. As a minimum, the

parent’s consolidated plan should include the

following ten elements:

1. All plans should address a long-range

goal or focus, intermediate term objectives, and

short-term budgets. A long-range focus is par-

ticularly important during a changing environ-

ment and during expansions of the organization.

Long-range plans generally are broad with a

service or customer orientation and market

share emphasis. These plans provide the entire

organization with a consistent direction and

facilitate changes in the organization arising

from environmental changes. Intermediate goals

generally are narrower in scope. Short-term

budgets are generally developed at the subsidi-

ary level; however, they are subject to review

and revision by the parent in an effort

to maintain consistency throughout the

organization.

2. The planning process should be formal-

ized. A long-range focus, intermediate term ob-

jectives, and budgets should be written and

adopted by the parent’s board of directors to

insure centralized accountability.

3. Plans should be consistent and interre-

lated over the differing time periods. For exam-

ple, budgets should be consistent with long-

range goals—the implementation of a short-

term, high return orientation may be inconsistent

with a long-term goal of increasing market

share, or short-term compensation plans may be

disfunctional in the long run.

4. A consolidated plan should increase the

consistency of goals among differing subsidi-

aries and the parent. The long-range goals, in-

termediate term objectives, and short term goals

and objectives should be periodically reviewed,

preferably, annually, by the BHC’s board of

directors. A consolidated plan should reduce

unnecessary internal competition.

5. A consolidated plan should facilitate the

allocation of resources throughout the organiza-

tion. This is particularly important when the

parent is providing most, or all, of the short-

term funds and long-term capital. As the parent

has an awareness of all subsidiaries, it can better

allocate funds and personnel to areas where they

will be utilized most effectively.

6. Plans should be formulated with an

awareness to possible weaknesses and recog-

nition to areas likely to be inﬂuenced by envi-

ronmental change. For these areas, ﬂexibility

should exist for contingency plans.

7. Methods should be determined, in the

plan, to monitor and evaluate compliance with

the plan.

8. The consolidated plan should have a mea-

surable aspect to determine whether budgets,

objectives, and goals are being met. If they are

not met, determination as to the controllability

of variances should be ascertained.

9. Plans and goals must continually be eval-

uated to determine whether accomplishing the

goal results in the desired and expected out-

come. For example, the desired outcome may be

to increase net income by granting loans with

higher interest rates and above normal risk. The

granting of such loans may result in a need to

increase the provision for loan losses, thus caus-

ing a decrease in earnings.

10. Plans should be ﬂexible enough to re-

main effective in a volatile environment. If plans

are too rigid, they may become disfunctional if

the environment changes and actually constrain

an organization’s ability to react. On the other

hand, ﬂexible goals and plans should enhance

an organization’s ability to compete by provid-

ing the entire organization with a ﬂuid consis-

tent direction.

2010.4.1 INSPECTION OBJECTIVES

1. To determine if the board of directors at

the parent company is cognizant of and perform-

ing its duties and responsibilities.

2. To determine if the level of supervision

over subsidiaries is both adequate and

beneﬁcial.

3. To evaluate the consolidated plan for con-

sistency, controls, and effectiveness.

4. To ascertain if the board of directors of the

parent company is making judgments and deci-

sions based on adequate information ﬂowing

from the management and ﬁnancial reporting

systems of the organization.

2010.4.2 INSPECTION PROCEDURES

1. Evaluate the participation by the board of

directors of the parent company in giving over-

all direction to the organization.

2. Obtain and evaluate descriptions of all im-

BHC Supervision Manual December 1992

Page 1

portant management and ﬁnancial policies, pro-

cedures, and practices.

3. Determine if contradictions or ‘‘conﬂicts’’

between expressed and unexpressed strategies

and between long-term and short-term goals

exist. Also determine that goals are consistent

with concern over safety and soundness.

4. Determine whether the planning process is

sufﬁciently ﬂexible and if contingency plans

exist.

5. Spell out the lines of authority associated

with the planning process.

6. Determine the degree of control exercised

by the parent company over the entire organiza-

tion.

7. Test compliance with policies at all levels.

Supervision of Subsidiaries (Consolidated Planning Process) 2010.4

BHC Supervision Manual December 1992

Page 2

Supervision of Subsidiaries

(Environmental Liability) Section 2010.5

2010.5.1 BACKGROUND

INFORMATION ON

ENVIRONMENTAL LIABILITY

Banking organizations are increasingly becom-

ing exposed to liability associated with the

clean-up of hazardous substance contamination

pursuant to, the Comprehensive Environmental

Response, Compensation and Liability Act

(‘‘CERCLA’’), the federal superfund statute. It

was enacted in response to the growing problem

of improper handling and disposal of hazardous

substances. CERCLA authorizes the Environ-

mental Protection Agency (‘‘EPA’’) to clean-up

hazardous waste sites and to recover costs asso-

ciated with the clean-up from entities speciﬁed

in the statute. The superfund statute is the

primary federal law dealing with hazardous

substance contamination. However, there are

numerous other federal statutes, as well as state

statutes, that establish environmental liability

that could place banking organizations at risk.

For example, underground storage tanks are also

covered by separate federal legislation.

While the superfund statute was enacted a

decade ago, it has been only since the mid-

1980s that court actions have resulted in some

banking organizations being held liable for the

clean-up of hazardous substance contamination.

In this connection, recent court decisions have

had a wide array of interpretations as to whether

banking organizations are owners or operators

of contaminated facilities, and thereby liable

under the superfund statute for clean-up costs.

This has led to uncertainty on the part of bank-

ing organizations as to how to best protect them-

selves from environmental liability.

The relevant provisions of CERCLA, the so-

called ‘‘superfund’’ statute, as it pertains to

banking organizations, indicate which persons

or entities are subject to liability for clean-up

costs of hazardous substance contamination.

These include ‘‘. . . the owner and operator of a

vessel or a facility, (or) any person who at the

time of disposal of any hazardous substance

owned or operated any facility at which such

hazardous substances were disposed of. . . .’’

person or entity that transports or arranges to

transport hazardous substances can also be held

liable for cleaning-up contamination under the

superfund statute.

The liability imposed by the superfund statute

is strict liability which means the government

does not have to prove that the owners or opera-

tors had knowledge of or caused the hazardous

substance contamination. Moreover, liability is

joint and several, which allows the government

to seek recovery of the entire cost of the

clean-up from any individual party that is liable

for those clean-up costs under CERCLA. In this

connection, CERCLA does not limit the bring-

ing of such actions to the EPA, but permits such

actions to be brought by third parties.

CERCLA provides a secured creditor exemp-

tion in the deﬁnition of ‘‘owner and operator’’

by stating that these terms do not include ‘‘. . . a

person, who, without participating in the man-

agement of a vessel or facility, holds indicia of

ownership primarily to protect his security inter-

est in the vessel or facility.’’

However, this

exception has not provided banking organiza-

tions with an effective ‘‘safe harbor’’ because

recent court decisions have worked to limit the

application of this exemption. Speciﬁcally,

courts have held that actions by lenders to pro-

tect their security interests may result in the

banking organization ‘‘participating in the man-

agement’’ of a vessel or facility, thereby voiding

the exemption. Additionally, once the title to a

foreclosed property passes to the banking orga-

nization, courts have held that the exemption no

longer applies and that the banking organization

is liable under the superfund statute as an

‘‘owner’’ of the property. Under some circum-

stances, CERCLA may exempt landowners who

acquire property without the knowledge of pre-

existing conditions (the so-called ‘‘innocent

landowner defense’’). However, the courts have

applied a stringent standard to qualify for this

defense. Because little guidance is provided by

the statute as to what constitutes the appropriate

timing and degree of ‘‘due diligence’’ to suc-

cessfully employ this defense, banking organi-

zations should exercise caution before relying

on it.

2010.5.2 OVERVIEW OF

ENVIRONMENTAL HAZARDS

Environmental risk can be characterized as ad-

verse consequences resulting from having gen-

1. Resource Conservation and Recovery Act of 1986

(RCRA).

2. CERCLA, Section 107(a).

3. CERCLA, Section 101(20)(A)..

BHC Supervision Manual December 1992

Page 1

erated or handled hazardous substances, or other-

wise having been associated with the aftermath

of subsequent contamination. The following dis-

cussion highlights some common environmental

hazards, but by no means covers all environ-

mental hazards.

Hazardous substance contamination is most

often associated with industrial or manufactur-

ing processes that involve chemicals or solvents

in the manufacturing process or as waste prod-

ucts. For years, these types of hazardous sub-

stances were disposed of in land ﬁlls, or just

dumped on industrial sites. Hazardous sub-

stances are also found in many other lines of

business. The following examples demonstrate

the diverse sources of potential hazardous sub-

stance contamination which should be of con-

cern to banking organizations:

• Farmers and ranchers (use of fuel, fertilizers,

herbicides, insecticides, and feedlot runoff).

• Dry cleaners (various cleaning solvents).

• Service station and convenience store opera-

tors (underground storage tanks).

• Fertilizer and chemical dealers and applica-

tors (storage and transportation of chemicals).

• Lawn care businesses (application of lawn

chemicals).

• Trucking ﬁrms (local and long haul transport-

ers of hazardous substances such as fuel or

chemicals).

The real estate industry has taken the brunt of

the adverse affects of hazardous waste contami-

nation. In addition to having land contaminated

with toxic substances, construction methods for

major construction projects, such as commercial

buildings, have utilized materials that have been

subsequently determined to be hazardous, re-

sulting in signiﬁcant declines in their value. For

example, asbestos was commonly used in com-

mercial construction from the 1950’s to the late

1970’s. Asbestos has since been found to be a

health hazard and now must meet certain federal

and, in many instances, state requirements for

costly removal or abatement (enclosing or other-

wise sealing off).

Another common source of hazardous sub-

stance contamination is underground storage

tanks. Leaks in these tanks not only contaminate

the surrounding ground, but often ﬂow into

ground water and travel far away from the orig-

inal contamination site. As contamination

spreads to other sites, clean-up costs escalate.

2010.5.3 IMPACT ON BANKING

ORGANIZATIONS

Banking organizations may encounter losses

arising from environmental liability in several

ways. The greatest risk to banking organiza-

tions, resulting from the superfund statute and

other environmental liability statutes, is the pos-

sibility of being held solely liable for costly

environmental clean-ups such as hazardous sub-

stance contamination. If a banking organization

is found to be a responsible party under

CERCLA, the banking organization may ﬁnd

itself responsible for cleaning-up a contami-

nated site at a cost that far exceeds any outstand-

ing loan balance. This risk of loss results from

an interpretation of the superfund statute as pro-

viding for joint and several liability. Any re-

sponsible party, including the banking organiza-

tion, could be forced to pay the full cost of any

clean-up. Of course, the banking organization

may attempt to recover such costs from the

borrower, or the owner if different than the

borrower, provided that the borrower or owner

continues in existence and is solvent. Banking

organizations may be held liable for the

clean-up of hazardous substance contamination

in situations where the banking organization:

• Takes title to property pursuant to foreclosure;

• Involves the banking organization’s personnel

or contractors engaged by the bank in day-to-

day management of the facility;

• Takes actions designed to make the contami-

nated property salable, possibly resulting in

further contamination;

• Acts in a ﬁduciary capacity, including man-

agement involvement in the day-to-day

operations of industrial or commercial con-

cerns, and purchasing or selling contaminated

property;

• Owns existing, or acquires (by merger or ac-

quisition), subsidiaries involved in activities

that might result in a ﬁnding of environmental

liability;

• Owns existing, or acquires for future expan-

sion, premises that have been previously con-

taminated by hazardous substances. For exam-

ple, site contamination at a branch ofﬁce

where a service station having underground

storage tanks once operated. Also, premises

or other real estate owned could be contami-

nated by asbestos requiring costly clean-up or

abatement.

A more common situation encountered by

banking organizations has been where real prop-

Supervision of Subsidiaries (Environmental Liability) 2010.5

BHC Supervision Manual December 1992

Page 2

erty collateral is found to be contaminated by

hazardous substances. The value of contami-

nated real property collateral can decline dra-

matically, depending on the degree of contami-

nation. As the projected clean-up costs increase,

the borrower may not be able to provide the

necessary funds to remove contaminated materi-

als. In making its determination whether to fore-

close, the banking organization must estimate

the potential clean-up costs. In many cases this

estimated cost has been found to be well in

excess of the outstanding loan balance, and the

banking organization has elected to abandon its

security interest in the property and write off the

loan. This situation occurs regardless of the fact

that the superfund statute provides a secured

creditor exemption. Some courts have not

extended this exemption to situations where

banking organizations have taken title to a prop-

erty pursuant to foreclosure. These rulings have

been based on a strict reading of the statute that

provides the exemption to ‘‘security interests’’

only.

Risk of credit losses can also arise where the

credit quality of individual borrowers (opera-

tors, generators, or transporters of hazardous

substances) deteriorates markedly as a result of

being required to clean up hazardous substance

contamination. Banking organizations must be

aware that signiﬁcant clean-up costs borne by

the borrower could threaten the borrower’s sol-

vency and jeopardize the banking organization’s

ultimate collection of outstanding loans to that

borrower, regardless of the fact that no real

property collateral is involved. Therefore, ulti-

mate collection of loans to fund operations, or to

acquire manufacturing or transportation equip-

ment can be jeopardized by the borrower’s gen-

erating or handling of hazardous substances in

an improper manner. Further, some bankruptcy

courts have required clean-up of hazardous sub-

stance contamination prior to distribution of a

debtor’s estate to secured creditors.

Borrowers may have existing subsidiaries or

may be involved in merger and acquisition

activity that may place the borrower at risk for

the activities of others that result in environmen-

tal liability. Some courts have held that for the

purposes of determining liability under the super-

fund statute, the corporate veil may not protect

parent companies that participate in the day-to-

day operations of their subsidiaries from envi-

ronmental liability and court imposed clean-up

costs. Additionally, borrowers can be held liable

for contamination which occurred prior to their

owning or using real estate.

2010.5.4 PROTECTION AGAINST

ENVIRONMENTAL LIABILITY

Banking organizations have numerous ways to

identify and minimize their exposure to environ-

mental liability. Because environmental liability

is relatively recent, procedures used to safe-

guard against such liability are evolving. The

following discussion brieﬂy describes methods

currently being employed by banking organiza-

tions and others to minimize potential environ-

mental liability.

Banking organizations should have in place

adequate safeguards and controls to limit their

exposure to potential environmental liability.

Loan policies and procedures should address

methods for identifying potential environmental

problems relating to credit requests as well as

existing loans. The loan policy should describe

an appropriate degree of due diligence investi-

gation required for credit requests. Borrowers in

high-risk industries or localities should be held

to a more stringent due diligence investigation

than borrowers in low-risk industries or locali-

ties. In addition to establishing procedures for

granting credit, procedures should be developed

and applied to portfolio analysis, credit monitor-

ing, loan workout situations, and—prior to tak-

ing title to real property—foreclosures. Banking

organizations may avoid or mitigate potential

environmental liability by having sound policies

and procedures designed to identify, assess and

control environmental liability.

At the same time, banking organizations must

be careful that any lending policies and proce-

dures, but especially those undertaken to assess

and control environmental liability, cannot be

construed as taking an active role in participat-

ing in the management or day-to-day operations

of the borrower’s business. Activities which

could be considered active participation in the

management of the borrower’s business, and

therefore subject the bank to potential liability,

include, but are not limited to:

• having bank employees as members of the

borrower’s board of directors or actively par-

ticipating in board decisions;

• assisting in day-to-day management and oper-

ating decisions; and

• actively determining management changes.

These considerations are especially important

when the banking organization is actively in-

volved in loan workouts or debt restructuring.

Supervision of Subsidiaries (Environmental Liability) 2010.5

BHC Supervision Manual June 1996

Page 3

The ﬁrst step in identifying and minimizing

environmental risk is for banking organiza-

tions to perform environmental reviews. Such

reviews may be performed by loan ofﬁcers or

others, and typically identify past practices and

uses of the facility and property, evaluate regu-

latory compliance, if applicable, and identify

potential future problems. This is accomplished

by interviewing persons familiar with present

and past uses of the facility and property,

reviewing relevant records and documents, and

visiting and inspecting the site.

Where the environmental review reveals pos-

sible hazardous substance contamination, an

environmental assessment or audit may be re-

quired. Environmental assessments are made by

personnel trained in identifying potential envi-

ronmental hazards and provide a more thorough

review and inspection of the facility and prop-

erty. Environmental audits differ markedly from

environmental assessments in that independent

environmental engineers are employed to inves-

tigate, in greater detail, those factors listed pre-

viously, and actually test for hazardous sub-

stance contamination. Such testing might

require collecting and analyzing air samples,

surface soil samples, subsurface soil samples, or

drilling wells to sample ground water.

Other measures used by some banking orga-

nizations to assist in identifying and minimizing

environmental liability include: obtaining in-

demnities from borrowers for any clean-up costs

incurred by the banking organization, and

including afﬁrmative covenants in loan agree-

ments (and attendant default provisions) requir-

ing the borrower to comply with all applicable

environmental regulations. Although these mea-

sures may provide some aid in identifying and

minimizing potential environmental liability,

they are not a substitute for environmental

reviews, assessments and audits, because their

effectiveness is dependent upon the ﬁnancial

strength of the borrower.

2010.5.5 CONCLUSION

Potential environmental liability can touch on a

great number of loans to borrowers in many

industries or localities. Moreover, nonlending

activities as well as corporate afﬁliations can

lead to environmental liability depending upon

the nature of the these activities and the degree

of participation that the parent exercises in the

operations of its subsidiaries. Such liability can

result in losses arising from hazardous sub-

stance contamination because banking organiza-

tions are held directly liable for costly court

ordered clean-ups. Additionally, the banking

organization’s ability to collect the loans it

makes may be hampered by signiﬁcant declines

in collateral value, or the inability of a

borrower to meet debt payments after paying

for costly clean-ups of hazardous substance

contamination.

Banking organizations must understand the

nature of environmental liability arising from

hazardous substance contamination. Addition-

ally, they should take prudential steps to identify

and minimize their potential environmental lia-

bility. Indeed, the common thread to environ-

mental liability is the existence of hazardous

substances, not types of borrowers, lines of busi-

ness, or real property.

2010.5.6 INSPECTION OBJECTIVES

1. To determine whether adequate safeguards

and controls have been established to limit

exposure to potential environmental liability.

2. To determine whether the banking organi-

zation has identiﬁed speciﬁc credits and any

lending and other banking and nonbanking

activities that expose the organization to envi-

ronmental liability.

2010.5.7 INSPECTION PROCEDURES

1. Review loan policies and procedures and

establish whether these and other adequate safe-

guards and controls have been established to

avoid or mitigate potential environmental liabil-

ity.

In performing this task, ascertain whether:

a. an environmental policy statement has

been adopted;

b. training programs are being conducted

so that lending personnel are aware of environ-

mental liability issues and are able to identify

borrowers with potential problems;

c. guidelines and procedures have been

established for dealing with new borrowers and

real property offered as collateral.

d. the lending policies and procedures and

other safeguards, including those to assess and

control environmental liability, may not be con-

strued as actively participating in the manage-

ment of day-to-day operations of borrowers’

businesses.

4. Refer to SR-91-20.

Supervision of Subsidiaries (Environmental Liability) 2010.5

BHC Supervision Manual June 1996

Page 4

2. When reviewing individual credits deter-

mine whether the loan policy has been complied

with in regard to a borrower’s activities or

industry that is associated with hazardous sub-

stances or environmental liability.

3. Ascertain whether appropriate periodic

analysis of potential environmental liability is

conducted.

Such analysis should be more rigorous as

the risk of hazardous substance contamination

increases. The following are examples of types

of analyses and procedures that should be pro-

gressively considered as the risk of environmen-

tal liability increases:

• Environmental review—screening of the

borrower’s activities by lending personnel

or real estate appraisers for potential envi-

ronmental problems (using questionnaires,

interviews, or observations).

Review procedures might include a sur-

vey of past ownership and uses of the prop-

erty, a property inspection, a review of adja-

cent or contiguous parcels of property, a

review of company records for past use or

disposal of hazardous materials, and a

review of any relevant Environmental Pro-

tection Agency records.

• Environmental assessment—structured

analysis by a qualiﬁed individual that iden-

tiﬁes the borrower’s past practices, regula-

tory compliance, and potential future

problems. This analysis would include

reviewing relevant documents, visiting and

inspecting the site, and, in some cases, per-

forming limited tests.

• Environmental audit—a professional envi-

ronmental engineer performs a similar

structured analysis as previously indicated

for ‘‘environmental assessments,’’ however,

more comprehensive testing might involve

collecting and analyzing air samples, sur-

face soil samples, subsurface soil samples,

or drilling wells to sample ground water.

4. Determine whether existing loans are

reviewed internally to identify credits having

potential environmental problems.

5. Review recordkeeping procedures and

determine whether there is documentation as to

the due diligence efforts taken at the time of

making loans or acquiring real property.

6. Review loan agreements to determine if

warranties, representations, and indemniﬁca-

tions have been included in loan agreements

designed to protect the banking organization

from losses stemming from hazardous substance

contamination. (Although such provisions pro-

vide some protection for the lender, these agree-

ments are not binding against the government or

third parties. Such contractual protections are

only as secure as the borrower’s ﬁnancial

strength.)

7. For situations involving potential environ-

mental liability arising from a banking organiza-

tion’s nonlending activities, verify that similar

policies and procedures are in place.

5. A banking organization’s policies and procedures relat-

ing to environmental liability should apply to nonlending

situations where appropriate. For example, banking organiza-

tions engaged in trust activities or contemplating a merger or

acquisition should evaluate the possibility of existing or sub-

sequent environmental liability arising from these activities.

Supervision of Subsidiaries (Environmental Liability) 2010.5

BHC Supervision Manual December 1992

Page 5

Supervision of Subsidiaries (Retail Sales of Nondeposit

Investment Products) Section 2010.6

2010.6.1 INTRODUCTION

Some depository institutions are active in sell-

ing uninsured nondeposit investment products,

such as mutual funds or annuities, on their

premises. Depository institutions provide these

services at the retail level, directly or through

various types of arrangements with third parties

(an afﬁliated or non-afﬁliated party).

Depository institutions selling nondeposit

investment products should clearly inform cus-

tomers of the nature and risks associated with

these products. In particular, where nondeposit

investment products are recommended or sold

to retail customers, depository institutions

should fully inform customers and make clear

that the products

• are not insured by the Federal Deposit

Insurance Corporation (FDIC);

• are not deposits or other obligations of the

institution and are not guaranteed by the

institution; and

• are subject to investment risks, including

possible loss of the principal invested.

A depository institution should design sales

activities involving these investment products to

minimize the possibility of customer confusion.

Further, a depository institution should design

sales of the investment products to safeguard

the institution from liability under the applicable

antifraud provisions of the federal securities

laws, which, among other things, prohibit mate-

rially misleading or inaccurate representations

in connection with the sale of securities.

The purpose of this manual section is to pro-

vide an overview of the guidance addressing the

retail sales of nondeposit investment products.

For more information, see

•

SR-94-11, “Interagency Statement on

Retail Sales of Nondeposit Investment

Products” (1994 interagency statement);

•

SR-95-46, “Interpretation of Interagency

Statement on Retail Sales of Nondeposit

Investment Products”; and

•

Commercial Bank Examination Manual,

section 4580.1, “Retail Sales of Nondeposit

Investment Products.”

2010.6.2 1994 INTERAGENCY

STATEMENT SUMMARY

The Federal Reserve Board, along with the other

federal banking agencies, issued an interagency

statement on February 15, 1994, that provides

comprehensive guidance on retail sales of non-

deposit investment products occurring on or

from depository institution premises. See

SR-94-11.

The 1994 interagency statement was issued to

address the expansion by depository institutions

of activities involving the recommendation and

sale to retail customers of nondeposit invest-

ment products, including mutual funds and

annuities, as well as stocks and other investment

products. The 1994 interagency statement

focuses on issues that pertain speciﬁcally to the

retail sale of investment products to customers

on depository institution premises and seeks to

avoid customer confusion of such products with

those that are FDIC insured primarily through

disclosure and separation of sales of investment

products from other banking activities. In addi-

tion, the 1994 interagency statement provides

guidance to depository institutions with respect

to sales practices that are consistent with those

applicable to registered securities brokers and

dealers.

The 1994 interagency statement uniﬁes pro-

nouncements previously issued by the federal

banking supervisory agencies that addressed

various aspects of retail sales programs involv-

ing mutual funds, annuities, and other nonde-

posit investment products. This statement

emphasizes the importance of adopting compre-

hensive policies and procedures governing sales

programs and includes directions relating to the

following matters:

• disclosure and advertising

• the use of identical and similarly named

products

• the separation of sales programs

• the training and supervision of personnel

• sales practices and suitability

• third-party arrangements

The 1994 interagency statement applies to all

depository institutions, including state member

banks, and the U.S. branches and agencies of

foreign banks, supervised by the Federal

Reserve. This statement does not apply directly

to bank holding companies or savings and loan

1. Sales arrangements involving companies afﬁliated with

a depository institution subsidiary of a bank holding company

could be subject to the provisions of section 106 of the Bank

Holding Company Act amendments of 1970, as amended,

12 U.S.C. § 1871 et seq. For more information, see section

3070.0.7.4 of this manual.

BHC Supervision Manual February 2023

Page 1

holding companies (holding companies). How-

ever, the board of directors and management of

holding companies should consider the provi-

sions of the statement with regard to the holding

company’s oversight of its depository institution

subsidiaries that offer such products to retail

customers.

The 1994 interagency statement applies when

retail recommendations or sales of nondeposit

investment products are made by the following

personnel:

• employees of the depository institution

• employees of a third party, which may or

may not be afﬁliated with the institution,

occurring on the premises of the institution

(including telephone sales or recommenda-

tions by employees or from the institution’s

premises and sales or recommendations ini-

tiated by mail from its premises)

• sales resulting from a referral of retail cus-

tomers by the institution to a third party

when the depository institution receives a

beneﬁt for the referral

For these purposes, retail sales include (but

are not limited to) sales to individuals by deposi-

tory institution personnel or third-party person-

nel conducted in or adjacent to a depository

institution’s lobby area. Sales of government

and municipal securities made in a depository

institution’s dealer department located away

from the lobby area are not covered by the 1994

interagency statement.

The guidelines in the 1994 interagency state-

ment generally do not apply to the sale of non-

deposit investment products to nonretail custom-

ers, such as sales to ﬁduciary accounts

administered by an institution.

The disclosures

provided by the interagency statement, however,

should be provided to customers of ﬁduciary

accounts where the customer directs invest-

ments, such as self-directed IRA accounts. Such

disclosures need not be made to customers act-

ing as professional money managers. Fiduciary

accounts administered by an afﬁliated trust com-

pany on the depository institution’s premises

should be treated as ﬁduciary accounts of the

institution. However, as part of its ﬁduciary

responsibility, an institution should take appro-

priate steps to avoid potential customer confu-

sion when providing nondeposit investment

products to the institution’s ﬁduciary customers.

2010.6.3 SUPERVISORY REVIEW

Reserve Bank examiners review nondeposit

investment product sales activities during

examinations of institutions engaging in such

activities on their premises, either directly or

through a third party or an afﬁliate. In general,

examiners review nondeposit investment prod-

uct sales when examining a state member bank

(or a state-licensed U.S. branch or agency of a

foreign bank) that engages directly in the retail

sale of nondeposit investment products. The

review process aims to assess the nature and

sufﬁciency of an institution’s disclosures, the

separation of functions, and the training of per-

sonnel involved with the sales of mutual funds

and other nondeposit products. For more infor-

mation on examination procedures and objec-

tives, see the

Commercial Bank Examination

Manual

2. The 1994 interagency statement does not apply to the

subsidiaries of insured state nonmember banks, which are

subject to separate provisions relating to securities activities.

3. Restrictions on a national bank’s use as ﬁduciary of the

bank’s brokerage service or other entity with which the bank

has a conﬂict of interest, including purchases of the bank’s

proprietary and other products, are set forth in 12 C.F.R. 9.12.

Supervision of Subsidiaries (Retail Sales of Nondeposit Investment Products) 2010.6

BHC Supervision Manual February 2023

Page 2

Supervision of Subsidiaries (Sharing of Facilities and Staff

by Banking Organizations) Section 2010.8

A banking organization should be able to readily

determine for which entity within the bank hold-

ing company an individual is employed, and

members of a banking organization’s staff must

be able to identify which subsidiary of the hold-

ing company employs them. The distinction is

important because complex banking organiza-

tions must take steps to ensure that their ofﬁcials

and employees have both the corporate and

legal authority to carry out their duties, and

because the organization’s personnel should

only be performing activities that are permitted

by law to be carried out by the holding company

or its particular subsidiaries.

2010.8.1 IDENTIFICATION OF

FACILITIES AND STAFF

Generally, unless there are statutory restrictions

or the Federal Reserve or other regulators have

issued explicit written proscriptions, such as

those concerning mutual fund sales on bank

premises, there is no fundamental legal prohibi-

tion on the entities of a banking organization

sharing or using unmarked contiguous facilities

and, in some instances, sharing ofﬁcials and

employees. There are, however, concerns about

safety and soundness and conﬂicts of interest.

These may arise when a banking organization

does not take appropriate actions to deﬁne and

differentiate the functions and responsibilities of

each of its entities and staff.

Good corporate governance requires that a

banking organization be able to readily identify

the authority and responsibilities of its ofﬁcials

and employees at each of its entities, especially

where the entities share facilities or use contigu-

ous ofﬁces that are not clearly marked to indi-

cate the identity of the different entities. This is

necessary to ensure that—

1. an ofﬁcial or employee who makes a com-

mitment to a counterparty on behalf of the

organization has both the corporate and legal

authority to do so,

2. the counterparty understands with whom it is

dealing, and

3. each entity is in compliance with any legal

restrictions under which it operates.

To accomplish the goal of ready identiﬁca-

tion, a banking organization should maintain

well-deﬁned job descriptions for each category

of its staff at each entity. When ofﬁcials and

employees of one entity have responsibilities for

other entities, particularly in shared facilities,

the staff’s responsibilities should be clearly

deﬁned and, when appropriate, disclosed or

made clear to customers and the public in gen-

eral. This procedure clariﬁes for both the public

and the regulators for which entity ofﬁcials or

employees are carrying out their duties and

responsibilities. Also, this clariﬁes whether an

entity is operating within the scope of its char-

ter, license, or other legal restrictions. Finally, a

banking organization should establish and main-

tain appropriate internal controls designed to

ensure the separation of the functions of the

legal entities, when required, as well as have

an adequate audit program to monitor such

activities.

If ofﬁcials and employees have responsibili-

ties for other ofﬁces or afﬁliates of the banking

organization, particularly those that share facili-

ties, these responsibilities should be clearly

deﬁned and, when appropriate, disclosed or

made clear to customers and the public in gen-

eral. This procedure clariﬁes for which entity

employees are carrying out their duties. Further-

more, in establishing employee responsibilities,

management should ensure that they are within

the scope of the entity’s license or charter.

2010.8.2 EXAMINER GUIDANCE ON

SHARING FACILITIES AND STAFF

Examiners should continue to be fully aware of

the issues and potential problems involved in

the sharing of staff and the sharing or use of

unmarked contiguous facilities by the different

entities of a banking organization with varied

activities. At a minimum, examiners should

check to see that a banking organization main-

tains clear records indicating the duties and

responsibilities of the ofﬁcials and employees at

each of its entities. They should also take steps

to check whether, in situations when an ofﬁcial

or employee may perform duties for more than

one entity in a shared facility, the banking orga-

nization has adequate policies and controls in

place to ensure that its staff have the corporate

and legal capacity to commit the organization to

its counterparties and that the duties are carried

out in conformance with the statutory restric-

tions applicable to each of the entities. See

SR-95-34 (SUP).

BHC Supervision Manual December 2000

Page 1

Supervision of Subsidiaries

(Required Absences from Sensitive Positions) Section 2010.9

One of the many basic tenets of internal control

is that a banking organization (bank holding

company, state member bank, and foreign bank-

ing organization) needs to ensure that its

employees in sensitive positions are absent from

their duties for a minimum of two consecutive

weeks. Such a requirement enhances the viabil-

ity of a sound internal control environment

because most frauds or embezzlements require

the continuous presence of the wrongdoer.

In brief, this section contains a statement

emphasizing the need for banking organizations

to conduct an assessment of signiﬁcant risk

areas before developing a policy on required

absences from sensitive positions. After making

this assessment, the organization should require

that employees in sensitive key positions, such

as trading and wire transfer, not be allowed to

transact or otherwise carry out, either physically

or through electronic access, their assigned

duties for a minimum of two consecutive weeks

per year. The prescribed period of absence

should, under all circumstances, be sufﬁcient to

allow all pending transactions to clear. It should

also require that an individual’s daily work be

processed by another employee during the

employee’s absence. (See SR-96-37.)

2010.9.1 STATEMENT ON REQUIRED

ABSENCES FROM SENSITIVE

POSITIONS

A comprehensive system of internal controls is

essential for a ﬁnancial institution to safeguard

its assets and capital, and to avoid undue reputa-

tional and legal risk. Senior management is

responsible for establishing an appropriate sys-

tem of internal controls and monitoring compli-

ance with that system. Although no single con-

trol element should be relied on to prevent fraud

and abuse, these acts are more easily perpetrated

when proper segregation and rotation of duties

do not exist. As a result, the Federal Reserve is

reemphasizing the following prudent banking

practices that should be incorporated into a

banking organization’s internal control proce-

dures. These practices are designed to enhance

the viability of a sound internal control environ-

ment, as most internal frauds or embezzlements

necessitate the constant presence of the offender

to prevent the detection of illegal activities.

When developing comprehensive internal

control procedures, each banking organization

should ﬁrst make a critical assessment of its

signiﬁcant areas and sensitive positions. This

assessment should consider all employees, but

should focus more on those with authority to

execute transactions, signing authority and

access to the books and records of the banking

organization, as well as those employees who

can inﬂuence or cause such activities to occur.

Particular attention should be paid to areas

engaged in trading and wire-transfer operations,

including personnel who may have reconcilia-

tion or other back-ofﬁce responsibilities.

After producing a proﬁle of high-risk areas

and activities, it would be expected that a mini-

mum absence of two consecutive weeks per

year be required of employees in sensitive posi-

tions. The prescribed period of absence should,

under all circumstances, be sufﬁcient to allow

all pending transactions to clear and to provide

for an independent monitoring of the trans-

actions that the absent employee is responsible

for initiating or processing. This practice could

be implemented through a requirement that

affected employees take vacation or leave, the

rotation of assignments in lieu of required vaca-

tion, or a combination of both so the prescribed

level of absence is attained. Some banking orga-

nizations, particularly smaller ones, might con-

sider compensating controls such as continuous

rotation of assignments in lieu of required

absences to avoid placing an undue burden on

the banking organization or its employees.

For the policy to be effective, individuals

having electronic access to systems and records

from remote locations must be denied this

access during their absence. Similarly, indirect

access can be controlled by not allowing others

to take and carry out instructions from the

absent employee. Of primary importance is the

requirement that an individual’s daily work be

processed by another employee during his or

her absence; this process is essential to bring to

the forefront any unusual activity of the absent

employee.

Exceptions to the required-absence policy

may be necessary from time to time. However,

management should exercise the appropriate

discretion and properly document any waivers

that are granted. Internal auditing should be

made aware of individuals who receive waivers

and the circumstances necessitating the

exceptions.

If a banking organization’s internal control

procedures do not now include the above prac-

tices, they should be promptly amended. After

BHC Supervision Manual July 2009

Page 1

the procedures have been enhanced, they should

be disseminated to all employees, and the docu-

mentation regarding their receipt and acknowl-

edgment maintained. Additionally, adherence to

the procedures should be included in the appro-

priate audit schedules, and the auditors should

be cognizant of potential electronic access or

other circumventing opportunities.

The development and implementation of pro-

cedures on required absences from sensitive

positions is just one element of an adequate

control environment. Each banking organization

should take all measures to establish appropriate

policies, limits, and veriﬁcation procedures for

an effective overall risk-management system.

2010.9.2 INSPECTION OBJECTIVES

1. To determine whether a critical assessment

has been performed of a banking organiza-

tion’s signiﬁcant areas and sensitive posi-

tions.

2. To ascertain that sound internal controls

exist, including policies and procedures that

provide assurances that employees in sensi-

tive positions are absent from their duties for

a minimum of two consecutive weeks per

year.

3. To ascertain whether the banking organiza-

tion has taken all measures to establish

appropriate policies, limits, and veriﬁcation

procedures for an effective overall risk-

management system.

4. To establish that the appropriate audit sched-

ules and the audits include a review of mini-

mum absence policies and procedures,

including potential electronic access or other

circumventing actions by employees.

2010.9.3 INSPECTION PROCEDURES

1. Determine that a proﬁle of high-risk areas

and activities is performed on a regular peri-

odic basis.

2. Ascertain if employees assigned to sensitive

positions are required to be absent for a

minimum of two weeks per year while—

a. pending sensitive transactions are moni-

tored while they clear, and

b. daily work is monitored and processed by

another employee during the regularly

assigned employee’s absence.

3. Determine if required internal control proce-

dures for minimum absences (for example,

rotation of assignments, vacation or leave, or

a combination of both) are being used in

sensitive operations such as trading, trust,

wire transfer, reconciliation, or other sensi-

tive back-ofﬁce responsibilities.

4. Ascertain if appropriate policies, limits, and

veriﬁcation procedures have been established

and maintained for an effective overall risk-

managment system.

5. Determine whether the banking

organization—

a. prohibits others from taking and carry-

ing out instructions from the absent

employees, and

b. prevents remote electronic access to sys-

tems and records involving sensitive trans-

actions during the regularly assigned

employee’s required minimum two-week

absence.

6. Ascertain that the banking organization

documents waivers from the two-week mini-

mum absence policies and procedures

involving sensitive positions.

7. Determine that the appropriate audit sched-

ules and the audits include a review of such

procedures, including potential electronic

access or other circumventing actions by

employees.

Supervision of Subsidiaries (Required Absences from Sensitive Positions) 2010.9

BHC Supervision Manual July 2009

Page 2

Supervision of Subsidiaries

(Internal Loan Review) Section 2010.10

Internal loan review is an activity which pro-

vides management with information about the

quality of loans and effectiveness of a banking

organization’s lending policies and procedures.

The objectives of loan-review procedures are to

identify, in a timely manner, existing or emerg-

ing credit-quality problems and to determine

whether internal lending policies are being

adhered to.

The size and complexity of a bank holding

company will dictate the need for and structure

of internal loan review. One-bank holding

companies with no signiﬁcant credit-extending

nonbank subsidiaries will normally establish

internal loan-review procedures within the sub-

sidiary bank. In these cases, there is no need to

evaluate the loan-review procedures during the

inspection.

For larger multibank companies or those with

signiﬁcant credit-extending nonbank subsidi-

aries, internal loan review is usually centralized

at the parent company level. In some cases, a

centralized loan-review function could operate

in the lead bank and cover all afﬁliates within

the organization. However, since parent com-

pany directors and senior management are ulti-

mately accountable for the organization’s asset

quality, an evaluation of the internal loan-review

function should be conducted as part of the

inspection process no matter where the opera-

tions are technically located within the corpo-

rate structure. Since a subsidiary bank’s primary

regulator will normally want to evaluate the

loan-review process as it relates to the respec-

tive bank, a coordination of efforts would be

appropriate. This should be handled on an ad

hoc basis, as deemed necessary by the holding

company’s examiner-in-charge, to avoid unnec-

essary duplication of efforts without com-

promising the independence of the appraisal

process.

Internal loan-review procedures may take

various forms, from senior ofﬁcers’ review of

junior-ofﬁcer loans to the formation of an inde-

pendent department staffed by loan-review

analysts. An effective system will identify

deteriorations in credits, loans that do not com-

ply with written loan policies, and loans with

technical exceptions.

The loan-review program should be delegated

to a qualiﬁed and adequate staff. The review

should be systematic in scope and frequency.

All related extensions of credit should be identi-

ﬁed and analyzed together. A minimum credit

size should be established that allows for an

efﬁcient review while providing adequate cover-

age. The process should also tie problem loans

or technical exceptions to the particular loan

ofﬁcer to allow senior management to evaluate

individual performance. Loans should be

reviewed shortly after origination to determine

their initial quality, technical exceptions, and

compliance with written loan policies. Reason-

able frequency guidelines should be set for nor-

mal reviews, with problem credits receiving spe-

cial and more frequent analysis. An effective

loan-review procedure will incorporate an early

warning system of ‘‘red ﬂags,’’ such as over-

drafts, adverse published reports, and deteriorat-

ing ﬁnancial statements. Loan ofﬁcers should

also be encouraged to inform the organization’s

internal loan-review unit of developing loan

problems, and they should be discouraged from

withholding problem loans or adverse informa-

tion from the review process.

The loan-review process should be indepen-

dent of the loan-approval function, with written

ﬁndings reported to a board or senior manage-

ment committee that is not directly involved in

lending. Follow-up and monitoring of problem

credits should be instituted. The loan ofﬁcer

should be responsible for reporting on any cor-

rective actions taken. The maintenance of

adequate internal controls within the lending

process, in particular for loan review or credit

audit, is critical for maintaining proper incen-

tives for banking organization staff to be rigor-

ous and disciplined in their credit-analysis and

lending decisions. A banking organization’s

credit analyses, loan terms and structures, credit

decisions, and internal rating assignments have

historically been reviewed in detail by experi-

enced and independent loan-review staff. Such

loan reviews have provided both motivation for

better credit discipline within an institution

and greater comfort for examiners—and

management—that internal policies are being

followed and that the banking organization con-

tinues to adhere to sound lending practice.

For larger multibank organizations, loan-

review procedures are usually centralized and

administered at the parent level, with loan-

review staff employed by the parent company.

In some cases, a centralized loan-review func-

tion may operate in the lead bank, covering all

other afﬁliates in the organization. The parent

company directors and senior management are

ultimately accountable for supervision of the

entire organization’s asset quality. Therefore, it

BHC Supervision Manual December 1999

Page 1

should be the System’s responsibility to evalu-

ate top management’s loan-review policies and

procedures as they relate to the subsidiaries,

both bank and nonbank, no matter where the

function is technically established within the

corporate structure. The holding company

examiner-in-charge should attempt to coordi-

nate efforts and cooperate with the respective

banks’ primary supervisors to avoid unneces-

sary duplication, without compromising the

independence of the appraisal process.

During favorable economic and ﬁnancial

markets, relatively low levels of problem loans

and credit losses may increase pressure within

banking organizations to reduce the resources

committed to loan-review functions. These

reductions may include a reduction in staff,

more limited portfolio coverage, and less thor-

ough reviews of individual loans. Undoubtedly,

some useful efﬁciencies may be gained by

reducing loan-review resources, but some bank-

ing organizations may reduce the scope and

depth of loan-review activities beyond levels

that are prudent over the longer horizon. If

reduced too far, the integrity of the lending

process and the discipline of identifying unreal-

istic assumptions and discerning problem loans

in a timely fashion may deteriorate. This may be

especially true when a large proportion of lend-

ers may not have had direct lending experience

during a credit cycle when there was an

economic and ﬁnancial market downturn. See

SR-99-23.

If supervisors and examiners ﬁnd that there

are weaknesses in the internal loan-review func-

tion and in activities or other internal control

and risk-management processes (for example,

staff turnover, failure to commit sufﬁcient

resources, inadequate adherence to established

internal controls, or inadequate training), such

ﬁndings should be discussed with the senior

management of the parent bank holding com-

pany or other management at a corporate-wide

level and, if determined to be a major concern,

presented as comments on the ‘‘Examiner’s

Comments and Matters Requiring Special Board

Attention’’ core page. Findings that could ad-

versely affect afﬁliated insured depository insti-

tutions should be conveyed to the primary fed-

eral or state supervisor of the insured institution.

Those ﬁndings should also be considered when

assigning supervisory ratings.

Shell one-bank holding companies will not

have or need a loan-review program emanating

from the parent company level. Loan review

will normally function within the subsidiary

bank and be supervised by bank directors and

management.

2010.10.1 INSPECTION OBJECTIVES

1. Review the operations of the bank holding

company to determine whether there is an

internal loan-review program. If not, one

should be implemented.

2. Determine whether the loan-review program

is independent from the loan-approval

function.

3. Determine if the loan-review staff is sufﬁ-

ciently qualiﬁed and whether its size is

adequate.

4. Determine whether the scope and frequency

of the loan-review procedure is adequate to

ensure that problems are being identiﬁed.

5. Determine that ﬁndings from the loan-review

process are being properly reported and

receive adequate follow-up attention.

2010.10.2 INSPECTION PROCEDURES

1. Review the holding company’s operations to

determine what types of internal loan-review

procedures are being performed and whether

an internal loan-review program exists.

2. If no internal loan-review program exists,

determine whether the size, complexity, and

ﬁnancial condition of the organization war-

rants implementation of a formal loan-review

process.

3. Review the organizational structure of the

loan-review function to ensure its indepen-

dence from the loan-approval processes.

4. Review the reporting process for internal

loan-review ﬁndings to determine whether a

director committee or independent senior

management committee is being appropri-

ately advised of the ﬁndings. Determine

whether adequate follow-up procedures are

in place.

5. Through loan reviews, transaction testing,

and discussions with loan-review manage-

ment, evaluate the quality, effectiveness and

adequacy of the internal loan-review staff

and internal controls in relation to the organi-

zation’s size and complexity.

6. Review the operation of the loan-review pro-

cess to identify the method for selecting

loans and the manner in which they are ana-

lyzed and graded. Determine whether these

procedures are adequate.

Internal Loan Review 2010.10

BHC Supervision Manual December 1999

Page 2

7. Determine if loan-review activities or other

internal control and risk-management pro-

cesses have been weakened by turnover of

internal loan-review staff; a failure to com-

mit sufﬁcient resources; inadequate internal

controls; inadequate training; or the absence

of other adequate systems, resources, or con-

trols. If such signiﬁcant ﬁndings are found,

discuss those concerns with senior manage-

ment and report those ﬁndings on the core

page 1, ‘‘Examiner’s Comments and Matters

Requiring Special Board Attention.’’

8. Determine what type of ‘‘early warning’’

system is in place and whether it is adequate.

9. Determine how the scope and frequency of

the review procedure is established and

whether this provides adequate coverage.

Internal Loan Review 2010.10

BHC Supervision Manual December 1999

Page 3

Supervision of Subsidiaries (Private-Banking

Functions and Activities) Section 2010.11

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2012, this section has been revised

to reference the Financial Crimes Enforcement

Network’s regulations and those of the Ofﬁce of

Foreign Assets Control, issued by the U.S.

Department of the Treasury (31 C.F.R. 1020).

2010.11.1 OVERVIEW OF PRIVATE

BANKING AND ITS ASSOCIATED

ACTIVITIES

The role of bank regulators in supervising

private-banking activities is (1) to evaluate man-

agement’s ability to measure and control the

risks associated with such activities and (2) to

determine if the proper internal control and audit

infrastructures are in place to support effective

compliance with relevant laws and regulations.

In this regard, the supervisors may determine

that certain risks have not been identiﬁed or

adequately managed by the institution, a poten-

tially unsafe and unsound banking practice.

Private-banking functions may be performed

in a speciﬁc department of a commercial bank

or nonbank subsidiary of a commercial bank, a

bank holding company (including a ﬁnancial

holding company), an Edge corporation or its

foreign subsidiaries, a branch or agency of a

foreign banking organization, or within multiple

areas of an institution. Private banking may be

the sole business of an institution. Regardless of

how an institution is organized or where it is

located, the results of the private-banking

review should be reﬂected in the entity’s overall

supervisory assessment.

This section provides examiners with guid-

ance for reviewing private-banking activities at

all types and sizes of banking organizations,

including ﬁnancial institutions. It is intended to

supplement, not replace, existing guidance on

the inspection or examination of private-banking

activities and to broaden the examiner’s review

of general risk-management policies and prac-

tices governing private-banking activities. In

addition to providing an overview of private

banking, the general types of customers, and the

various products and services typically pro-

vided, the ‘‘Functional Review’’ subsection

describes the critical functions that constitute a

private-banking operation and identiﬁes certain

safe and sound banking practices. These critical

functions are supervision and organization, risk

management, ﬁduciary standards, operational

controls, management information systems,

audit, and compliance. Included in the risk-

management portion is a discussion of the basic

‘‘customer-due-diligence’’ (CDD) principle that

is the foundation for the safe and sound opera-

tion of a private-banking business. See the CDD

rules at 31 C.F.R. 1020. The ‘‘Preparation for

Inspection’’ subsection assists in deﬁning the

inspection scope and provides a list of core

requests to be made in the ﬁrst-day letter. Addi-

tional inspection and examination guidance can

be found in this manual, the Federal Financial

Institutions Examination Council’s (FFIEC)

Bank Secrecy Act/Anti–Money Laundering

(BSA/AML) Examination Manual, the Federal

Reserve System’s Trading and Capital-Markets

Activities Manual, and in the FFIEC’s Informa-

tion Technology Examination Handbook.

In reviewing speciﬁc functional and product-

inspection procedures (as found in the private-

banking activities module that is part of the

framework for risk-focused supervision of large

complex institutions), all aspects of the private-

banking review should be coordinated with the

rest of the inspection to eliminate unnecessary

duplication of effort. Furthermore, this section

has introduced the review of trust activities and

ﬁduciary services, critical components of most

private-banking operations, as part of the over-

all private-banking review. Although the prod-

uct nature of these activities differs from that of

products generated by other banking activities,

such as lending and deposit taking, the func-

tional components of private banking (supervi-

sion and organization, risk management, opera-

tional controls and management information

systems, audit, compliance, and ﬁnancial

condition/business proﬁle) should be reviewed

across product lines.

Private banking offers the personal and dis-

crete delivery of a wide variety of ﬁnancial

services and products to an afﬂuent market,

primarily to high net worth individuals and their

1. Throughout this section, the word institution will be

used to mean all types of banking organizations, including

bank holding companies, their bank and other ﬁnancial institu-

tion subsidiaries, nonbank subsidiaries, and those entities

authorized to operate under section 4(k) of the Bank Holding

Company Act. Institution also includes branches and agencies

of foreign banks and any other types of ﬁnancial institutions

and entities supervised by the Federal Reserve System. The

term ‘‘board of directors’’ will be interchangeable with refer-

ences to the ‘‘senior management’’ of branches and agencies

of foreign banks.

BHC Supervision Manual July 2012

Page 1

corporate interests. A private-banking operation

typically offers its customers an all-inclusive

money-management relationship, including

investment portfolio management, ﬁnancial-

planning advice, offshore facilities, custodial

services, funds transfer, lending services, over-

draft privileges, hold mail, letter-of-credit

ﬁnancing, and bill-paying services. As the afﬂu-

ent market grows, both in the United States and

globally, competition to serve it is becoming

more intense. Consequently, the private-banking

marketplace includes banks, nonbanks, and

other types of banking organizations and ﬁnan-

cial institutions. Private-banking products, ser-

vices, technologies, and distribution channels

are still evolving. A range of private-banking

products and services may be offered to custom-

ers throughout an institution’s global network of

afﬁliated entities—including branches, subsidi-

aries, and representative ofﬁces—in many dif-

ferent regions of the world, including offshore

secrecy jurisdictions.

Typically, private-banking customers are high

net worth individuals or institutional investors

who have minimum investible assets of $1 mil-

lion or more. Institutions often differentiate

domestic from international private banking,

and they may further segregate the international

function on the basis of the geographic location

of their international client base. International

private-banking clients may be wealthy indi-

viduals who live in politically unstable nations

and are seeking a safe haven for their capital.

Therefore, obtaining detailed background infor-

mation and documentation about the interna-

tional client may be more difﬁcult than it

is for the domestic customer. Private-banking

accounts may, for example, be opened in the

name of an individual, a commercial business, a

law ﬁrm, an investment adviser, a trust, a per-

sonal investment company (PIC), or an offshore

mutual fund.

In 2001, the USA Patriot Act (the Patriot Act)

established new and enhanced measures to pre-

vent, detect, and prosecute money laundering

and terrorist ﬁnancing. In general, these mea-

sures were enacted through amendments to the

Bank Secrecy Act (BSA). The measures directly

affecting banking organizations are imple-

mented primarily through regulations issued by

the U.S. Department of the Treasury (31 C.F.R.

1020).

Section 326 of the Patriot Act (see the

BSA at 31 U.S.C. 5318(l)) requires ﬁnancial

institutions (such as banks, savings associations,

trust companies, and credit unions) to have cus-

tomer identiﬁcation programs (CIPs), that is,

programs to collect and maintain certain records

and documentation on customers. Institutions

are to develop and use identity veriﬁcation pro-

cedures to ensure the identity of their customers.

Bank holding companies, as a matter of safety

and soundness, should take appropriate mea-

sures to ensure that their ﬁnancial institution

subsidiaries are in compliance with the cus-

tomer identiﬁcation program (CIP) rule.

The CIP rule (see 31 C.F.R. 1020.220 and 12

C.F.R. 326.8(b)) applies only to a bank, not to a

bank holding company solely because it owns a

bank. Also, a nonbank subsidiary of a bank

holding company is not subject to the CIP rule

for banks solely as a result of being afﬁliated

with a bank in a holding company structure.

Even though this rule is not applicable to bank

holding companies and their nonbank subsidi-

aries (or to savings and loan holding companies

and their non–savings association subsidiaries),

bank holding companies should, as a matter of

safety and soundness, take appropriate measures

throughout the organization to ensure that each

of their entities is in compliance with any appli-

cable CIP rule. New accounts must receive

appropriate due diligence, and a holding com-

pany should generally protect the consolidated

organization from any risks associated with

money laundering and ﬁnancial crime. The bank

holding company may still be subject to other

CIP rules if it has ownership in a functionally

regulated entity, for example, a securities

broker-dealer. (See 31 C.F.R. 1023.220 and

1026.220)

The CIPs are to include measures to—

1. require that certain information be obtained

at account opening (for individuals, the infor-

mation would generally include their name,

address, tax identiﬁcation number, and date

of birth);

2. verify the identity of new account holders

within a reasonable time period;

3. ensure that a banking organization has a rea-

sonable belief that it knows each customer’s

identity;

4. maintain records of the information used to

verify a person’s identity; and

2. For banking organizations, the regulation implementing

the requirements of section 326 of the Patriot Act was jointly

issued by the U.S. Department of the Treasury, through the

Financial Crimes Enforcement Network (FinCEN), and the

Board of Governors of the Federal Reserve System, the Ofﬁce

of the Comptroller of the Currency, the Federal Deposit

Insurance Corporation, and the National Credit Union Admin-

istration.

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 2

5. compare the names of new customers against

government lists of known or suspected ter-

rorists or terrorist organizations.

A customer identiﬁcation program is an impor-

tant component of a ﬁnancial institution’s over-

all anti-money-laundering and BSA compliance

program.

The FFIEC BSA/AML Examination Manual

provides the interagency BSA examination pro-

cedures that should be used to evaluate banking

organizations’ compliance with the regulation.

The scope of the examination or inspection can

be tailored to the reliability of the banking orga-

nization’s compliance-management system and

to the level of risk that the organization assumes.

Relevant interagency guidance (in a frequently-

asked-question format) has been issued to

address the customer identiﬁcation program

rules. (See SR-05-9.)

Private-banking accounts are usually gener-

ated on a referral basis. Every client of a private-

banking operation is assigned a salesperson or

marketer, commonly known as a relationship

manager (RM), as the primary point of contact

with the institution. The RM is generally

charged with understanding and anticipating the

needs of his or her wealthy clients, and then

recommending services and products for them.

The number of accounts an RM handles varies,

depending on the portfolio size or net worth of

the particular accounts. RMs strive to provide a

high level of support, service, and investment

opportunities to their clients and tend to main-

tain strong, long-term client relationships. Fre-

quently, RMs take accounts with them to other

private-banking institutions if they change

employment. Historically, initial and ongoing

due diligence of private-banking clients is not

always well documented in the institution’s ﬁles

because of RM turnover and conﬁdentiality

concerns.

Clients may choose to delegate a great deal of

authority and discretion over their ﬁnancial

affairs to RMs. Given the close relationship

between clients and their account ofﬁcers, an

integral part of the inspection process is assess-

ing the adequacy of managerial oversight of the

nature and volume of transactions conducted

within the private-banking department or with

other departments of the ﬁnancial institution, as

well as determining the adequacy and integrity

of the RM’s procedures. Policy guidelines and

management supervision should provide param-

eters for evaluating the appropriateness of all

products, especially those involving market risk.

Moreover, because of the discretion given to

RMs, management should develop effective pro-

cedures to review the activity of client accounts

in order to protect the client from any unauthor-

ized activity. In addition, ongoing monitoring of

account activity should be conducted to detect

activity that is inconsistent with the client pro-

ﬁle (for example, frequent or sizable unex-

plained transfers ﬂowing through the account).

Finally, as clients develop a return-on-assets

(ROA) outlook to enhance their returns, the use

of leveraging and arbitrage is becoming more

evident in the private-banking business. Exam-

iners should be alert to the totality of the client

relationship product by product, in light of

increasing client awareness and use of deriva-

tives, emerging-market products, foreign

exchange, and margined accounts.

2010.11.1.1 Products and Services

2010.11.1.1.1 Personal Investment

Companies, Offshore Trusts, and

Token-Name Accounts

Private-banking services almost always involve

a high level of conﬁdentiality for clients and

their account information. Consequently, it is

not unusual for private bankers to help their

clients achieve their ﬁnancial-planning, estate-

planning, and conﬁdentiality goals through off-

shore vehicles such as personal investment

companies (PICs), trusts, or more exotic

arrangements, such as hedge fund partnerships.

While these vehicles may be used for legitimate

reasons, without careful scrutiny, they may cam-

ouﬂage illegal activities. Private bankers should

be committed to using sound judgment and

enforcing prudent banking practices, especially

when they are assisting clients in establishing

offshore vehicles or token-name accounts.

Through their global network of afﬁliated

entities, private banks often form PICs for their

clients. These ‘‘shell’’ companies, which are

incorporated in offshore secrecy jurisdictions

such as the Cayman Islands, Channel Islands,

Bahamas, British Virgin Islands, and Nether-

lands Antilles, are formed to hold the cus-

tomer’s assets as well as offer conﬁdentiality by

opening accounts in the PIC’s name. The ‘‘ben-

eﬁcial owners’’ of the shell corporations are

typically foreign nationals. The banking institu-

tion should know and be able to document that

it knows the beneﬁcial owners of such corpora-

tions and that it has performed the appropriate

due diligence to support these efforts. Emphasis

should be placed on verifying the source or

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 3

origin of the customer’s wealth. Similarly, off-

shore trusts established in these jurisdictions

should identify grantors of the trusts and sources

of the grantors’ wealth. Anonymous relation-

ships or relationships in which the RM does not

know and document the beneﬁcial owner should

not be permitted.

PICs are typically passive personal invest-

ment vehicles. However, foreign nationals have

established PICs as operating accounts for busi-

ness entities they control in their home coun-

tries. Accordingly, ﬁnancial institutions should

use extra care when dealing with beneﬁcial

owners of PICs and associated trusts; these vehi-

cles can be used to conceal illegal activities.

2010.11.1.1.2 Deposit-Taking Activities of

Subsidiary Institutions

A client’s private-banking relationship fre-

quently begins with a deposit account and then

expands into other products. In fact, many insti-

tutions require private-banking customers to

establish a deposit account before maintaining

any other accounts. Deposit accounts serve as

conduits for a client’s money ﬂows. To distin-

guish private-banking accounts from retail

accounts, institutions usually require signiﬁ-

cantly higher minimum account balances and

assess higher fees. The private-banking function

or institution should have account-opening pro-

cedures and documentation requirements that

must be fulﬁlled before a deposit account can be

opened. (These standards are described in detail

in the ‘‘Functional Review’’ subsection.)

Most private banks offer a broad spectrum of

deposit products, including multicurrency

deposit accounts that are used by clients who

engage in foreign-exchange, securities, and

derivatives transactions. The client’s transaction

activity, such as wire transfers, check writing,

and cash deposits and withdrawals, is conducted

through deposit accounts (including current

accounts). It is very important that the transac-

tion activity into and out of these deposit

accounts (including internal transfers between

afﬁliated deposit accounts) be closely monitored

for suspicious transactions that are inconsistent

with the client’s proﬁle of usual transactions.

Suspicious transactions could warrant the ﬁl-

ing of a Suspicious Activity Report (SAR). A

bank holding company or any nonbank subsidi-

ary thereof, or a foreign bank that is subject to

the Bank Holding Company Act (or any non-

bank subsidiary of such a foreign bank operat-

ing in the United States), is required to ﬁle a

SAR in accordance with the provision of section

208.62 of the Federal Reserve Board’s Regula-

tion H (12 C.F.R. 208.62) when suspicious

transactions or activities are initially discovered

and warrant or require reporting. See the report-

ing requirements discussed in subsection

2010.11.2.2.1.1 and the expanded examination

procedures for private banking in the FFIEC’s

BSA/AML Examination Manual.

2010.11.1.1.3 Investment Management

In private banking, investment management

usually consists of two types of accounts:

(1) discretionary accounts in which portfolio

managers make the investment decisions on the

basis of recommendations from the bank’s

investment research resources and (2) nondis-

cretionary (investment advisory) accounts in

which clients make their own investment deci-

sions when conducting trades. For nondiscre-

tionary clients, the banks typically offer invest-

ment recommendations subject to the client’s

written approval. Discretionary accounts consist

of a mixture of instruments bearing varying

degrees of market, credit, and liquidity risk that

should be appropriate to the client’s investment

objectives and risk appetite. Both account types

are governed under separate agreements

between the client and the institution.

Unlike depository accounts, securities and

other instruments held in the client’s investment

accounts are not reﬂected on the balance sheet

of the institution because they belong to the

client. These managed assets are usually

accounted for on a separate ledger that is segre-

gated according to the customer who owns the

assets.

2010.11.1.1.4 Credit

Private-banking clients may request extensions

of credit on either a secured or an unsecured

basis. Loans backed by cash collateral or man-

aged assets held by the private-banking function

are quite common, especially in international

private banking. Private-banking clients may

pledge a wide range of their assets, including

cash, mortgages, marketable securities, land, or

buildings, to securitize their loans. Management

should demonstrate an understanding of the pur-

pose of the credit, the source of repayment, the

loan tenor, and the collateral used in the ﬁnanc-

ing. When lending to individuals with high net

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 4

worths, whether on a secured or an unsecured

basis, the creditworthiness determination is bol-

stered by a thorough and well-structured

customer-due-diligence process. If that process

is not thorough, collateral derived from illicit

activities may be subject to government

forfeiture.

Borrowing mechanisms are sometimes estab-

lished to afford nonresident-alien customers the

ability to keep ﬁnancial assets in the United

States and to use such assets (via collateralized

borrowing arrangements) to provide operating

capital for businesses they own and operate in

their home countries. Such arrangements enable

these customers to keep the existence of these

ﬁnancial assets secret from their home-country

authorities and others, while they continue to

use the funds (via collateralized borrowings) to

fund their businesses at home.

Private bankers need to maintain in the

United States adequate CDD information on

such nonresident-alien customers and their pri-

mary business interests. A well-documented

CDD ﬁle may include information on the cus-

tomer from ‘‘who’s who’’ and similar services,

Internet research, foreign tax returns and ﬁnan-

cial statements, checks conducted by the Ofﬁce

of Foreign Assets Control (OFAC), and written

and appropriately documented Call Reports pre-

pared by the RM.

While these lending mechanisms may be used

for legitimate reasons, management needs to

determine whether the arrangements are being

used primarily to obfuscate the beneﬁcial own-

ership of collateral assets, making it difﬁcult for

the customer’s home-country government to

identify who owns the assets. If so, management

needs to further determine whether the practice

varies from both the appropriate standards of

international cooperation for transparency issues

and with prudent banking practices, and if so,

whether the institution is exposed to elevated

legal risk.

2010.11.1.1.5 Payable-Through Accounts

Another product that may be available in

private-banking operations is payable-through

accounts (PTAs). PTAs are transaction deposit

accounts through which U.S. banking entities

(‘‘payable-through banks’’) extend check-

writing privileges to the customers of a foreign

bank. The foreign bank (‘‘master account

holder’’) opens a master checking account with

the U.S. bank and uses this account to provide

its customers with access to the U.S. banking

system. The master account is divided into

‘‘subaccounts,’’ each in the name of one of the

foreign bank’s customers. The foreign bank

extends signature authority on its master

account to its own customers, who may not be

known to the U.S. bank. Consequently, the U.S.

bank may have customers who have not been

subject to the same account-opening require-

ments imposed on its U.S. account holders.

These subaccount customers are able to write

checks and make deposits at the U.S. banking

entity. The number of subaccounts permitted

under this arrangement may be virtually

unlimited.

U.S. banking entities engage in PTAs primar-

ily because they attract dollar deposits from the

domestic market of their foreign correspondents

without changing the primary bank-customer

relationship; PTAs also provide substantial fee

income. Generally, PTAs at U.S. banking enti-

ties have the following characteristics: they are

carried on the U.S. banking entity’s books as a

correspondent bank account, their transaction

volume is high, checks passing through the

account contain wording similar to ‘‘payable

through XYZ bank,’’ and the signatures appear-

ing on checks are not those of authorized ofﬁ-

cers of the foreign bank. See the expanded

examination procedures for PTAs in the

FFIEC’s BSA/AML Examination Manual.

2010.11.1.1.6 Personal Trust and Estates

In trust and estate accounts, an institution offers

management services for a client’s assets. When

dealing with trusts under will, or ‘‘testamentary

trusts,’’ the institution may receive an estate

appointment (executor) and a trustee appoint-

ment if the will provided for the trust from the

probate. These accounts are fully funded at

origination with no opportunity for an outside

party to add to the account, and all activities are

subject to review by the probate or surrogates’

court. On the other hand, with living trusts, or

‘‘grantor trusts,’’ the customer (grantor) may

continually add to and, in some instances, has

control over the corpus of the account. Trusts

and estates require experienced attorneys,

money managers, and generally well-rounded

professionals to set up and maintain the

accounts. In certain cases, bankers may need to

manage a customer’s closely held business or

sole proprietorship. In the case of offshore trust

facilities, recent changes in U.S. law have

imposed additional obligations on those banks

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 5

that function as trustees or corporate manage-

ment for offshore trusts and PICs.

A critical element in offering personal trust

and estate services is the ﬁduciary responsibility

of the institutions to their customers. This

responsibility requires that institutions always

act in the best interest of the clients pursuant to

the trust documentation, perhaps even to the

detriment of the bank. In these accounts, the

bank is the ﬁduciary and the trust ofﬁcer serves

as a representative of the institution. Fiduciaries

are held to higher standards of conduct than

other bankers. Proper administration of trusts

and estates includes strict controls over assets,

prudent investment and management of assets,

and meticulous recordkeeping. See the

expanded procedures for trust and asset manage-

ment services in the FFIEC’s BSA/AML Exami-

nation Manual.

2010.11.1.1.7 Custody Services

Custodial services offered to private-banking

customers include securities safekeeping, receipt

and disbursement of dividends and interest, rec-

ordkeeping, and accounting. Custody relation-

ships can be established in many ways, includ-

ing by referrals from other departments in the

bank or from outside investment advisers. The

customer or a designated ﬁnancial adviser

retains full control of the investment manage-

ment of the property subject to the custodian-

ship. Sales and purchases of assets are made by

instruction from the customer, and cash dis-

bursements are prearranged or as instructed.

Custody accounts involve no investment super-

vision and no discretion. However, the custo-

dian may be responsible for certain losses if it

fails to act properly according to the custody

agreement. Therefore, procedures for proper

administration should be established and

reviewed.

An escrow account is a form of custody

account in which the institution agrees to hold

cash or securities as a middleman, or a third

party. The customer, for example, an attorney or

a travel agency, gives the institution funds to

hold until the ultimate receiver of the funds

‘‘performs’’ in accordance with the written

escrow agreement, at which time the institution

releases the funds to the designated party.

2010.11.1.1.8 Funds Transfer

Funds transfer, another service offered by

private-banking functions, may involve the

transfer of funds between third parties as part of

bill-paying and investment services on the basis

of customer instructions. The adequacy of con-

trols over funds-transfer instructions that are

initiated electronically or telephonically is

extremely important. Funds-transfer requests are

quickly processed and, as required by law,

funds-transfer personnel may have limited

knowledge of the customers or the purpose of

the transactions. Therefore, strong controls and

adequate supervision over this area are critical.

See section 4063.1 and 4125.1 of the Commer-

cial Bank Examination Manual.

2010.11.1.1.9 Hold Mail, No Mail, and

Electronic-Mail Only

Hold-mail, no-mail, or electronic-mail-only

accounts are often provided to private-banking

customers who elect to have bank statements

and other documents maintained at the institu-

tion or e- mailed to them, rather than mailed to

their residence. Agreements for hold-mail

accounts should be in place, and the agreements

should indicate that it was the customer’s choice

to have the statements retained at the bank and

that the customer will pick up his or her mail at

least annually. Variations of hold-mail services

include delivery of mail to a prearranged loca-

tion (such as another branch of the bank) by

special courier or the bank’s pouch system.

2010.11.1.1.10 Bill-Paying Services

Bill-paying services are often provided to

private-banking customers for a fee. If this ser-

vice is provided, an agreement between the bank

and the customer should exist. Typically, a cus-

tomer may request that the bank debit a deposit

account for credit card bills, utilities, rent, mort-

gage payments, or other monthly consumer

charges. In addition, the increased use of the

Internet has given rise to the electronic-mail-

only account, whereby customers elect to have

statements, notices, etc., sent to them only by

e-mail.

2010.11.2 FUNCTIONAL REVIEW

When discussing the functional aspects of a

private-banking operation, functional refers to

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 6

managerial processes and procedures, such as

reporting lines, quality of supervision (including

involvement of the board of directors), informa-

tion ﬂows, policies and procedures, risk-

management policies and methodologies, segre-

gation of duties, management information

systems, operational controls (including BSA/

AML monitoring), and audit coverage. The

examiner should be able to draw sound conclu-

sions about the quality and culture of manage-

ment and stated private-banking policies after

reviewing the functional areas described below.

Speciﬁcally, the institution’s risk-identiﬁcation

process and risk appetite should be carefully

deﬁned and assessed. Additionally, the effective-

ness of the overall control environment main-

tained by management should be evaluated by

an internal or external audit. The effectiveness

of the following functional areas is critical to

any private-banking operation, regardless of its

size or product offerings.

2010.11.2.1 Supervision and Organization

As part of the examiner’s appraisal of an

organization, the quality of supervision of

private-banking activities is evaluated. The ap-

praisal of management covers the full range of

functions and activities related to the operation

of the private bank. The discharge of

responsibilities by bank directors should be ef-

fected through an organizational plan that ac-

commodates the volume and business services

handled, local business practices and the bank’s

competition, and the growth and development

of the institution’s private-banking business.

Organizational planning is the joint responsibil-

ity of senior bank and private-bank manage-

ment, should be integrated with the long-range

plan for the institution, and should be consistent

with any enterprise-wide risk-management

program.

Both the directors and management have

important roles in formulating policies and

establishing programs for private-banking prod-

ucts, operations, internal controls, and audits.

However, management alone must implement

policies and programs within the organizational

framework instituted by the board of directors.

2010.11.2.2 Risk Management

Sound risk-management processes and strong

internal controls are critical to safe and sound

banking generally and to private-banking activi-

ties in particular. Management’s role in ensuring

the integrity of these processes has become

increasingly important as new products and

technologies are introduced. Similarly, the

client-selection, documentation, approval, and

account-monitoring processes should adhere to

sound and well-identiﬁed practices.

The quality of risk-management practices and

internal controls is given signiﬁcant weight in

the evaluation of management and the overall

condition of private-banking operations. A

bank’s failure to establish and maintain a risk-

management framework that effectively identi-

ﬁes, measures, monitors, and controls the risks

associated with products and services should be

considered unsafe and unsound conduct. Fur-

thermore, well-deﬁned management practices

should indicate the types of clients that the

institution will and will not accept and should

establish multiple and segregated levels of

authorization for accepting new clients. Institu-

tions that follow sound practices will be better

positioned to design and deliver products and

services that match their clients’ legitimate

needs, while reducing the likelihood that unsuit-

able clients might enter their client account base.

Deﬁciencies noted in this area are weighted in

context of the relative risk they pose to the

institution and are appropriately reﬂected in the

appraisal of management.

The private-banking function is exposed to a

number of risks, including reputational, ﬁdu-

ciary, legal, credit, operational, and market. A

brief description of some of the different types

of risks follows:

1. Reputational risk is the potential that nega-

tive publicity regarding an institution’s busi-

ness practices and clients, whether true or

not, could cause a decline in the customer

base, costly litigation, or revenue reductions.

2. Fiduciary risk refers to the risk of loss due to

the institution’s failure to exercise loyalty;

safeguard assets; and, for trusts, to use assets

productively and according to the appropri-

ate standard of care. This risk generally

exists in an institution to the extent that it

exercises discretion in managing assets on

behalf of a customer.

3. Legal risk arises from the potential of unen-

forceable contracts, client lawsuits, or

adverse judgments to disrupt or otherwise

negatively affect the operations or condition

of a banking organization. One key dimen-

sion of legal risk is supervisory action that

could result in costly ﬁnes or other punitive

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 7

measures being levied against an institution

for compliance breakdowns.

4. Credit risk arises from the potential that a

borrower or counterparty will fail to perform

on an obligation.

5. Operational risk arises from the potential

that inadequate information systems, opera-

tional problems, breaches in internal con-

trols, fraud, or unforeseen catastrophes will

result in unexpected losses.

Although effective management of all of the

above risks is critical for an institution, certain

aspects of reputational, legal, and ﬁduciary risks

are often unique to a private-banking function.

In this regard, the following customer-due-

diligence policies and practices are essential in

the management of reputational and legal risks

in the private-banking functions. (In addition,

sound ﬁduciary practices and conﬂicts-of-

interest issues that a private-banking operation

may face in acting as ﬁduciary are described in

the subsection on ﬁduciary standards.)

2010.11.2.2.1 Customer-Due-Diligence

Policy and Procedures

Sound customer-due-diligence (CDD) policies

and procedures are essential to minimize the

risks inherent in private banking. The policies

and procedures should clearly describe the tar-

get client base in terms such as ‘‘minimum

investable net worth’’ and ‘‘types of products

sought,’’ as well as speciﬁcally indicate the type

of clientele the institution will or will not accept.

Policies and procedures should be designed to

ensure that effective due diligence is performed

on all potential clients, that client ﬁles are bol-

stered with additional CDD information on an

ongoing basis, and that activity in client

accounts is monitored for transactions that are

inconsistent with the client proﬁle and may con-

stitute unlawful activities, such as money laun-

dering. The client’s identity, background, and

the nature of his or her transactions should be

documented and approved by the back ofﬁce

before opening an account or accepting client

monies. Certain high-risk clients like foreign

politicians or money exchange houses should

have additional documentation to mitigate their

higher risk. See 31 C.F.R. 1020, subpart F, for

due diligence rules.

Money laundering is associated with a broad

range of illicit activities: the ultimate intention

is to disguise the money’s true source—from

the initial placement of illegally derived cash

proceeds to the layers of ﬁnancial transactions

that disguise the audit trail—and make the funds

appear legitimate. Under U.S. money-laundering

statutes, a bank employee can be held person-

ally liable if he or she is deemed to engage in

‘‘willful blindness.’’ This condition occurs when

the employee fails to make reasonable inquiries

to satisfy suspicions about client account

activities.

Since the key element of an effective CDD

policy is a comprehensive knowledge of the

client, the bank’s policies and procedures should

clearly reﬂect the controls needed to ensure the

policy is fully implemented. CDD policies

should clearly delineate the accountability and

authority for opening accounts and for determin-

ing if effective CDD practices have been per-

formed on each client. In addition, policies

should delineate documentation standards and

accountability for gathering client information

from referrals among departments or areas

within the institution as well as from accounts

brought to the institution by new RMs.

In carrying out prudent CDD practices on

potential private-banking customers, manage-

ment should document efforts to obtain and

corroborate critical background information.

Private-banking employees abroad often have

local contacts who can assist in corroborating

information received from the customer. The

information listed below should be corroborated

by a reliable, independent source, when

possible:

1. The customer’s current address and tele-

phone number for his or her primary resi-

dence, which should be corroborated at regu-

lar intervals, can be veriﬁed through a variety

of methods, such as—

a. visiting the residence, ofﬁce, factory, or

farm (with the RM recording the results

of the visit or conversations in a memo-

randum);

b. checking the information against the tele-

phone directory; the client’s residence, as

indicated on his or her national ID card; a

mortgage or bank statement or utility or

property tax bill; or the electoral or tax

rolls;

c. obtaining a reference from the client’s

government or known employer or from

another bank;

d. checking with a credit bureau or profes-

sional corroboration organization; or

e. any other method veriﬁed by the RM.

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 8

2. Sufﬁcient business information about the

customer should be gathered so that the RM

understands the proﬁle of the customer’s

commercial transactions. This information

should include a description of the nature of

the customer’s business operations or means

of generating income, primary trade or busi-

ness areas, and major clients and their geo-

graphic locations, as well as the primary

business address and telephone number.

These items can be obtained through a com-

bination of any of the following sources:

a. a visit to the ofﬁce, factory, or farm

b. a reliable third party who has a business

relationship with the customer

c. ﬁnancial statements

d. Dun and Bradstreet reports

e. newspaper or magazine articles

f. Lexis/Nexis reports on the customer or

customer’s business

g. ‘‘Who’s Who’’ reports from the home

country

h. private investigations

3. Although it is often not possible to get proof

of a client’s wealth, an RM can use his or her

good judgment to derive a reasonable esti-

mate of the individual’s net worth.

4. As part of the ongoing CDD process, the RM

should document in memos or ‘‘call reports’’

the substance of discussions that take place

during frequent visits with the client. Addi-

tional information about a client’s wealth,

business, or other interests provides insight

into potential marketing opportunities for the

RM and the bank, and updates and strength-

ens the CDD proﬁle.

As a rule, most private banks make it a policy

not to accept walk-in clients. If an exception is

made, procedures for the necessary documenta-

tion and approvals supporting the exception

should be in place. Similarly, other exceptions

to policy and procedures should readily identify

the speciﬁc exception and the required due-

diligence and approval process for overriding

existing procedures.

In most instances, all CDD information and

documentation should be maintained and avail-

able for examination and inspection at the loca-

tion where the account is located or where the

ﬁnancial services are rendered. If the bank main-

tains centralized customer ﬁles in locations other

than where the account is located or the ﬁnan-

cial services are rendered, complete customer

information, identiﬁcation, and documentation

must be made available at the location where

the account is located or where the ﬁnancial

services are rendered within 48 hours of a Fed-

eral Reserve examiner’s request. Off-site stor-

age of CDD information will be allowed only if

the bank has adopted, as part of its customer-

due-diligence program, speciﬁc procedures

designed to ensure that (1) the accounts are

subject to ongoing Ofﬁce of Foreign Assets

Control screening that is equivalent to the

screening afforded other accounts, (2) the

accounts are subject to the same degree of

review for suspicious activity, and (3) the bank

demonstrates that the appropriate review of the

information and documentation is being per-

formed by personnel at the offshore location.

CDD procedures should be no different when

the institution deals with a ﬁnancial adviser or

other type of intermediary acting on behalf of a

client. To perform its CDD responsibilities when

dealing with a ﬁnancial adviser, the institution

should identify the beneﬁcial owner of the

account (usually the intermediary’s client, but in

rare cases, it is the intermediary itself) and per-

form its CDD analysis with respect to that ben-

eﬁcial owner. The imposition of an intermediary

between the institution and counterparty should

not lessen the institution’s CDD responsibilities.

The purpose of all private-banking relation-

ships should also be readily identiﬁed. Incoming

customer funds may be used for various pur-

poses, such as establishing deposit accounts,

funding investments, or establishing trusts. The

bank’s CDD procedures should allow for the

collection of sufﬁcient information to develop a

transaction or client proﬁle for each customer,

which will be used in analyzing client transac-

tions. Internal systems should be developed for

monitoring and identifying transactions that may

be inconsistent with the transaction or client

proﬁle for a customer and which may thus con-

stitute suspicious activity.

2010.11.2.2.1.1 Suspicious Activity Reports

The proper and timely ﬁling of Suspicious

Activity Reports (SARs) is an important compo-

nent of a bank’s CDD program. Since 1996, the

federal ﬁnancial institution supervisory agencies

and the Department of the Treasury’s Financial

Crimes Enforcement Network (FinCEN) have

required banking organizations to report known

or suspected violations of law as well as suspi-

cious transactions on a SAR. See the Board’s

SAR regulation (Regulation H, section 208.62

[12 C.F.R. 208.62] and Regulation Y, section

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

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225.4(f) [12 C.F.R. 225.4(f)]).

Law enforce-

ment agencies use the information reported on

the form to initiate investigations, and Federal

Reserve staff use the SAR information in their

examination and oversight of supervised

institutions.

A member bank and a BHC are required to

ﬁle a SAR with the appropriate federal law

enforcement agencies and the Department of the

Treasury. A SAR must be prepared in accor-

dance with the form’s instructions. The com-

pleted SAR is to be sent to FinCEN when an

institution detects—

1. insider abuse involving any amount;

2. violations aggregating $5,000 or more in

which a suspect can be identiﬁed;

3. violations aggregating $25,000 or more

regardless of a potential suspect; or

4. transactions aggregating $5,000 or more that

involve potential money laundering or viola-

tions of the Bank Secrecy Act.

When a SAR is ﬁled, the management of a

member bank must promptly notify its board of

directors or a committee thereof.

A SAR must be ﬁled within 30 calendar days

after the date of initial detection of the facts that

may constitute a basis for ﬁling a SAR. If no

suspect was identiﬁed on the date of detection

of the incident requiring the ﬁling, a member

bank may delay ﬁling a SAR for an additional

30 calendar days in order to identify the suspect.

Reporting may not be delayed more than 60

calendar days after the date of initial detection

of a reportable transaction. In situations involv-

ing violations requiring immediate attention,

such as when a reportable violation is ongoing,

the ﬁnancial institution is required to immedi-

ately notify an appropriate law enforcement

authority and the Board by telephone, in addi-

tion to its timely ﬁling of a SAR.

A banking organization’s internal systems for

capturing suspicious activities should provide

essential information about the nature and vol-

ume of activities passing through customer

accounts. Any information suggesting that sus-

picious activity has occurred should be pursued,

and, if an explanation is not forthcoming, the

matter should be reported to banking organiza-

tion’s management. Examiners should ensure

that the institution’s approach to SARs is proac-

tive and that well-established procedures cover

the SAR process. Accountability should exist

within the organization for the analysis and

follow-up of internally identiﬁed suspicious

activity; this analysis should conclude with a

decision on the appropriateness of ﬁling a SAR.

See the core procedures concerning suspicious-

activity-reporting requirements in the FFIEC

BSA/AML Examination Manual.

2010.11.2.2.2 Credit-Underwriting

Standards

The underwriting standards for private-banking

loans to high net worth individuals should be

consistent with prudent lending standards. The

same credit policies and procedures that are

applicable to any other type of lending arrange-

ment should extend to these loans. At a mini-

mum, sound policies and procedures should

address the following: all approved credit prod-

ucts and services offered by the institution, lend-

ing limits, acceptable forms of collateral, geo-

graphic and other limitations, conditions under

which credit is granted, repayment terms, maxi-

mum tenor, loan authority, collections and

charge-offs, and prohibition against capitaliza-

tion of interest.

An extension of credit based solely on col-

lateral, even if the collateral is cash, does not

ensure repayment. While the collateral en-

hances the bank’s position, it should not substi-

tute for regular credit analyses and prudent

lending practices. If collateral is derived from

illegal activities, it is subject to forfeiture

through the seizure of assets by a government

agency. The bank should perform its due dili-

gence by adequately and reasonably ascertain-

ing and documenting that the funds of its

private-banking customers were derived from

legitimate means. Banks should also verify that

the use of the loan proceeds is for legitimate

purposes.

In addition, bank policies should explicitly

describe the terms under which ‘‘margin loans,’’

loans collateralized by securities, are made and

should ensure that they conform to applicable

regulations. Management should review and

approve daily MIS reports. The risk of market

deterioration in the value of the underlying col-

lateral may subject the lender to loss if the

collateral must be liquidated to repay the loan.

In the event of a ‘‘margin call,’’ any shortage

should be paid for promptly by the customer

3. The Board’s SAR rules apply to state member banks,

bank holding companies and their nonbank subsidiaries that

do not report on a different SAR form (for example, broker-

dealers), Edge and agreement corporations, and the U.S.

branches and agencies of foreign banks supervised by the

Federal Reserve.

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 10

from other sources pursuant to the terms of the

margin agreement.

In addition, policies should address the accep-

tance of collateral held at another location, such

as an afﬁliated entity, but pledged to the private-

banking function. Under these circumstances,

management of the private-banking function

should, at a minimum, receive frequent reports

detailing the collateral type and current valua-

tion. In addition, management of the private-

banking function should be informed of any

changes or substitutions in collateral.

2010.11.2.3 Fiduciary Standards

Fiduciary risk is managed through the mainte-

nance of an effective and accountable commit-

tee structure; retention of technically proﬁcient

staff; and development of effective policies, pro-

cedures, and controls. In managing its ﬁduciary

risk, the bank must ensure that it carries out the

following ﬁduciary duties:

1. Duty of loyalty. Trustees are obligated to

make all decisions based exclusively on the

best interests of trust customers. Except as

permitted by law, trustees cannot place them-

selves in a position in which their interests

might conﬂict with those of the trust

beneﬁciaries.

2. Avoidance of conﬂicts of interest. Conﬂicts

of interest arise in any transaction in which

the ﬁduciary simultaneously represents the

interests of multiple parties (including its

own interests) that may be adverse to one

another. Institutions should have detailed

policies and procedures regarding potential

conﬂicts of interest. All potential conﬂicts

identiﬁed should be brought to the attention

of management and the trust committee, with

appropriate action taken. Conﬂicts of interest

may arise throughout an institution. Care

should be taken by ﬁduciary business lines,

in particular, to manage conﬂicts of interest

between ﬁduciary business lines and other

business lines (including other ﬁduciary busi-

ness lines). Consequently, management

throughout the institution should receive

training in these matters. For more informa-

tion on the supervision of ﬁduciary activities,

see section 3120.0 in this manual and section

4200.0 in the Commercial Bank Examination

Manual.

3. Duty to prudently manage discretionary trust

and agency assets. Since 1994, the majority

of states have adopted laws concerning the

prudent investor rule (PIR) with respect to

the investment of funds in a ﬁduciary capac-

ity. PIR is a standard of review that imposes

an obligation to prudently manage the port-

folio as a whole, focusing on the process of

portfolio management, rather than on the out-

come of individual investment decisions.

Although this rule only governs trusts, the

standard is traditionally applied to all

accounts for which the institution is manag-

ing funds.

2010.11.2.4 Operational Controls

To minimize any operational risks associated

with private-banking activities, management is

responsible for establishing an effective internal

control infrastructure and reliable management

information systems. Critical operational con-

trols over any private-banking activity include

the establishment of written policies and proce-

dures, segregation of duties, and comprehensive

management reporting. Throughout this section,

speciﬁc guidelines and inspection procedures

for assessing internal controls over different

private-banking activities are provided. Listed

below are some of those guidelines that cover

speciﬁc private-banking services.

2010.11.2.4.1 Segregation of Duties

Banking organizations should have guidelines

on the segregation of employees’ duties in order

to prevent the unauthorized waiver of documen-

tation requirements, poorly documented refer-

rals, and overlooked suspicious activities. Inde-

pendent oversight by the back ofﬁce helps to

ensure compliance with account-opening proce-

dures and CDD documentation. Control-

conscious institutions may use independent

units, such as compliance, risk management, or

senior management, to ﬁll this function in lieu

of the back ofﬁce. The audit and compliance

functions of the private-banking entity should

be similarly independent so that they can oper-

ate autonomously from line management.

2010.11.2.4.2 Inactive and Dormant

Accounts

Management should be aware that banking laws

in most states prohibit banks from offering ser-

vices that allow deposit accounts to be inactive

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 11

for prolonged periods of time (generally, 12 or

more months with no externally generated

account-balance activity). These regulations are

based on the presumption that inactive and dor-

mant accounts may be subject to manipulation

and abuse by insiders. Policies and procedures

should delineate when inactivity occurs and

when inactive accounts should be converted to

dormant status. Effective controls over dormant

accounts should include a speciﬁed time

between the last customer-originated activity

and its classiﬁcation as dormant, the segregation

of signature cards for dormant accounts, dual

control of records, and the blocking of the

account so that entries cannot be posted to the

account without review by more than one mem-

ber of senior management.

2010.11.2.4.3 Pass-Through Accounts and

Omnibus Accounts

Pass-through accounts (PTAs) extend checking-

account privileges to the customers of a foreign

bank; several risks are involved in providing

these accounts. In particular, if the U.S. banking

entity does not exercise the same due diligence

and customer vetting for PTAs as it does for

domestic account relationships, the use of PTAs

may facilitate unsafe and unsound banking prac-

tices or illegal activities, including money laun-

dering. Additionally, if accounts at U.S. banking

entities are used for illegal purposes, the entities

could be exposed to reputational risk and risk of

ﬁnancial loss as a result of asset seizures and

forfeitures brought by law enforcement authori-

ties. It is recommended that U.S. banking enti-

ties terminate a payable-through arrangement

with a foreign bank in situations in which

(1) adequate information about the ultimate

users of PTAs cannot be obtained, (2) the for-

eign bank cannot be relied on to identify and

monitor the transactions of its own customers,

or (3) the U.S. banking entity is unable to ensure

that its payable-through accounts are not being

used for money laundering or other illicit pur-

poses.

Omnibus, or general clearing, accounts may

also exist in the private-banking system. They

may be used to accommodate client funds

before an account opening to expedite a new

relationship, or they may fund products such as

mutual funds in which client deposit accounts

may not be required. However, these accounts

could circumvent an audit trail of client transac-

tions. Examiners should carefully review a

bank’s use of such accounts and the adequacy of

its controls on their appropriate use. Generally,

client monies should ﬂow through client deposit

accounts, which should function as the sole

conduit and paper trail for client transactions.

2010.11.2.4.4 Hold-Mail, No-Mail, and

E-Mail-Only Controls

Controls over hold-mail, no-mail, and e-mail-

only accounts are critical because the clients

have relinquished their ability to detect unau-

thorized transactions in their accounts in a

timely manner. Accounts with high volume or

signiﬁcant losses warrant further inquiry. Hold-

mail, no-mail, and e-mail-only account opera-

tions should ensure that client accounts are sub-

ject to dual control and are reviewed by an

independent party.

2010.11.2.4.5 Funds Transfer—Tracking

Transaction Flows

One way that institutions can improve their cus-

tomer knowledge is by tracking the transaction

ﬂows into and out of customer accounts and

payable-through subaccounts. Tracking should

include funds-transfer activities. Policies and

procedures to detect unusual or suspicious

activities should identify the types of activities

that would prompt staff to investigate the cus-

tomer’s activities and should provide guidance

on the appropriate action required for suspicious

activity. The following is a checklist to guide

bank personnel in identifying some potential

abuses:

1. indications of frequent overrides of estab-

lished approval authority or other internal

controls

2. intentional circumvention of approval

authority by splitting transactions

3. wire transfers to and from known secrecy

jurisdictions

4. frequent or large wire transfers for persons

who have no account relationship with the

bank, or funds being transferred into and out

of an omnibus or general clearing account

instead of the client’s deposit account

5. wire transfers involving cash amounts in

excess of $10,000

6. inadequate control of password access

7. customer complaints or frequent error

conditions

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

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2010.11.2.4.6 Custody—Detection of

‘‘Free Riding’’

Custody departments should monitor account

activity to detect instances of ‘‘free-riding,’’ the

practice of offering the purchase of securities

without sufﬁcient capital and then using the

proceeds of the sale of the same securities to

cover the initial purchase. Free-riding poses sig-

niﬁcant risk to the institution and typically

occurs without the bank’s prior knowledge.

Free-riding also violates margin rules (Regula-

tions T, U, and X) governing the extension of

credit in connection with securities transactions.

(See SR-93-13 and section 2187.0.)

2010.11.2.5 Management Information

Systems

Management information systems (MIS) should

accumulate, interpret, and communicate infor-

mation on (1) the private-banking assets under

management, (2) proﬁtability, (3) business and

transaction activities, and (4) inherent risks. The

form and content of MIS for private-banking

activities will be a function of the size and

complexity of the private-banking organization.

Accurate, informative, and timely reports that

perform the following functions may be pre-

pared and reviewed by RMs and senior

management:

1. aggregate the assets under management

according to customer, product or service,

geographic area, and business unit

2. attribute revenue according to customer and

product type

3. identify customer accounts that are related to

or afﬁliated with one another through com-

mon ownership or common control

4. identify and aggregate customer accounts by

source of referral

5. identify beneﬁcial ownership of trust, PIC,

and similar accounts

To monitor and report transaction activity and to

detect suspicious transactions, management

reports may be developed to—

1. monitor a speciﬁc transaction criterion, such

as a minimum dollar amount or volume or

activity level;

2. monitor a certain type of transaction, such as

one with a particular pattern;

3. monitor individual customer accounts for

variations from established transaction and

activity proﬁles based on what is usual or

expected for that customer; and

4. monitor speciﬁc transactions for BSA and

SAR compliance.

In addition, reports prepared for private-banking

customers should be accurate, timely, and infor-

mative. Regular reports and statements prepared

for private-banking customers should

adequately and accurately describe the applica-

tion of their funds and should detail all transac-

tions and activity that pertain to the customers’

accounts.

Furthermore, MIS and technology play a role

in building new and more direct channels of

information between the institution and its

private-banking customers. Active and

sophisticated customers are increasing their

demand for data relevant to their investment

needs, which is fostering the creation of online

information services. Online information can

satisfy customers’ desire for convenience, real-

time access to information, and a seamless

delivery of information.

2010.11.2.6 Audit

An effective audit function is vital to ensuring

the strength of a private bank’s internal controls.

As a matter of practice, internal and external

auditors should be independently verifying and

conﬁrming that the framework of internal con-

trols is being maintained and operated in a man-

ner that adequately addresses the risks associ-

ated with the activities of the organization.

Critical elements of an effective internal audit

function are the strong qualiﬁcations and exper-

tise of the internal audit staff and a sound risk-

assessment process for determining the scope

and frequency of speciﬁc audits. The audit pro-

cess should be risk-focused and should ulti-

mately determine the risk rating of business

lines and client CDD procedures. Compliance

with CDD policies and procedures and the

detailed testing of ﬁles for CDD documentation

are also key elements of the audit function.

Finally, examiners should review and evaluate

management’s responsiveness to criticisms by

the audit function.

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 13

2010.11.2.7 Compliance

The responsibility for ensuring effective compli-

ance with relevant laws and regulations may

vary among different forms of institutions,

depending on their size, complexity, and avail-

ability of resources. Some institutions may have

a distinct compliance department with the cen-

tralized role of ensuring compliance institution-

wide, including private-banking activities. This

arrangement is strongly preferable to a situation

in which an institution delegates compliance to

speciﬁc functions, which may result in the man-

agement of private-banking operations being

responsible for its own internal review. Compli-

ance has a critical role in monitoring private-

banking activities; the function should be inde-

pendent of line management. In addition to

ensuring compliance with various laws and

regulations such as the Bank Secrecy Act and

those promulgated by the Ofﬁce of Foreign

Assets Control, compliance may perform its

own internal investigations and due diligence on

employees, customers, and third parties with

whom the bank has contracted in a consulting or

referral capacity and whose behavior, activities,

and transactions appear to be unusual or suspi-

cious. Institutions may also ﬁnd it beneﬁcial for

compliance to review and authorize account-

opening documentation and CDD adequacy for

new accounts. The role of compliance is a con-

trol function, but it should not be a substitute for

regular and frequent internal audit coverage of

the private-banking function. Following is a

description of certain regulations that may be

monitored by the compliance function.

2010.11.2.7.1 Ofﬁce of Foreign Assets

Control

The Ofﬁce of Foreign Assets Control (OFAC) of

the U.S. Department of the Treasury administers

and enforces economic and trade sanctions

based on U.S. foreign policy and national secu-

rity goals. Sanctions are imposed against tar-

geted foreign countries, terrorists, international

narcotics trafﬁckers, and those engaged in

activities related to the proliferation of weapons

of mass destruction. See 31 C.F.R. subtitle B,

chapter V, part 501. OFAC acts under presiden-

tial wartime and national emergency powers, as

well as under authority granted by speciﬁc legis-

lation, to impose controls on transactions and

freeze foreign assets under U.S. jurisdiction.

Many of the sanctions are based on United

Nations and other international mandates, are

multilateral in scope, and involve close coopera-

tion with allied governments. Under the Interna-

tional Emergency Economic Powers Act, the

President can impose sanctions, such as trade

embargoes, the freezing of assets, and import

surcharges, on certain foreign countries and the

‘‘specially designated nationals’’ of those

countries.

A ‘‘specially designated national’’ is a person

or entity who acts on behalf of one of the

countries under economic sanction by the

United States. Dealing with such nationals is

prohibited. Moreover, their assets or accounts in

the United States are frozen. In certain cases,

the Treasury Department can issue a license to a

designated national. This license can then be

presented by the customer to the institution,

allowing the institution to debit his or her

account. The license can be either general or

speciﬁc.

OFAC screening may be difﬁcult when trans-

actions are conducted through PICs, token

names, numbered accounts, or other vehicles

that shield true identities. Management must

ensure that accounts maintained in a name other

than that of the beneﬁcial owner are subject to

the same level of ﬁltering for OFAC specially

designated nationals and blocked foreign coun-

tries as other accounts. That is, the OFAC

screening process must include the account’s

beneﬁcial ownership as well as the ofﬁcial

account name.

Any violation of regulations implementing

designated national sanctions subjects the viola-

tor to criminal prosecution, including prison

sentences and ﬁnes to corporations and indi-

viduals, per incident. Any funds frozen because

of OFAC orders should be placed in a blocked

account. Release of those funds cannot occur

without a license from the Treasury Department.

2010.11.2.7.2 Bank Secrecy Act

Guidelines for compliance with the Bank

Secrecy Act (BSA) can be found in the FFIEC

BSA/AML Examination Manual. See also the

question-and-answer format interpretations (SR-

05-9) of the U.S. Department of the Treasury’s

regulation (31 C.F.R. 1010) for banking organi-

zations, which is based on section 326 of the

Patriot Act. In addition, the procedures for con-

ducting BSA examinations of foreign ofﬁces of

U.S. banks are detailed in the FFIEC BSA/AML

Examination Manual. The SAR ﬁling require-

ments for nonbank subsidiaries of bank holding

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 14

companies and state member banks are also set

forth in SR-10-8.

2010.11.3 PREPARATION FOR

INSPECTION

The following subsections provide examiners

with guidance on preparing for the on-site

inspection of private-banking operations,

including determination of the inspection scope

and drafting of the ﬁrst-day-letter questionnaire

that is provided to the institution.

2010.11.3.1 Pre-Inspection Review

To prepare the examiners for their assignments

and to determine the appropriate stafﬁng and

scope of the inspection, the following guidelines

should be followed during the pre-inspection

planning process:

1. Review the prior report of inspection and

workpapers for the inspection scope; struc-

ture and type of private-banking activities

conducted; and ﬁndings, conclusions, and

recommendations of the prior inspection.

The prior inspection report and inspection

plan should also provide insight to key con-

tacts at the institution and to the time frame

of the prior private-banking review.

2. Obtain relevant correspondence sent since

the prior inspection, such as management’s

response to the report of inspection, any

applications submitted to the Federal

Reserve, and any supervisory action.

3. Research press releases and published news

stories about the institution and its private-

banking activities.

4. Review internal and external audit reports

and any internal risk assessments performed

by the institution on its private-banking

activities. Such reports should include an

assessment of the internal controls and risk

proﬁle of the private-banking function.

5. Contact the institution’s management to

ascertain what changes have occurred since

the last inspection or are planned in the near

future. For example, examiners should deter-

mine if there have been changes to the strate-

gic plan; senior management; or the level

and type of private-banking activities, prod-

ucts, and services offered. If there is no men-

tion of private banking in the prior inspection

report, management should be asked at this

time if they have commenced or plan to

commence any private-banking activities.

6. Follow these inspection procedures and also

consider the core examination procedures in

the FFIEC BSA/AML Examination Manual

in order to establish the base scope for the

inspection of private-banking activities.

Review and follow the expanded procedures

for private banking and any other expanded

procedures that are deemed necessary.

2010.11.3.2 Inspection Stafﬁng and

Scope

Once the inspection scope has been established

and before beginning the new inspection, the

examiner-in-charge and key administrators of

the inspection team should meet to discuss the

private-banking inspection scope, the assign-

ments of the functional areas of private banking,

and the supplemental reviews of speciﬁc

private-banking products and services. If the

bank’s business lines and services overlap and if

its customer base and personnel are shared

throughout the organization, examiners may be

forced to go beyond a rudimentary review of

private-banking operations. They will probably

need to focus on the policies, practices, and

risks within the different divisions of a particu-

lar institution and throughout the institution’s

global network of afﬁliated entities.

2010.11.3.3 Reﬂection of Organizational

Structure

The review of private-banking activities should

be conducted on the basis of the bank holding

company’s organizational structure. These

structures may vary considerably depending on

the size and sophistication of the institution, its

country of origin and the other geographic mar-

kets in which it competes, and the objectives

and strategies of its management and board of

directors. To the extent possible, examiners

should understand the level of consolidated

private-banking activities an institution con-

ducts in the United States and abroad. This

broad view is needed to maintain the ‘‘big pic-

ture’’ impact of private banking for a particular

institution.

For bank holding company inspections,

examiners must consider the provisions of the

Gramm-Leach Bliley Act, which amended sec-

tion 5(c) of the Bank Holding Company Act,

that concern examinations and inspections. In

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 15

particular, examiners must adhere to those statu-

tory provisions that pertain to the inspections of

bank holding company nobank subsidiaries that

are supervised by functional regulators. See sec-

tion 1040.0.

2010.11.3.4 Risk-Focused Approach

Examiners reviewing the private-banking opera-

tions should implement the risk-focused inspec-

tion approach. The exam scope and degree of

testing of private-banking practices should

reﬂect the degree of risk assumed, prior exam

ﬁndings on the implementation of policies and

procedures, the effectiveness of controls, and an

assessment of the adequacy of the internal audit

and compliance functions. If initial inquiries

into the institution’s internal audit and other

assessment practices raise doubts about the

internal system’s effectiveness, expanded analy-

sis and review are required—and examiners

should perform more transaction testing. Exam-

iners will usually need to follow the core exami-

nation procedures in the FFIEC BSA/AML

Examination Manual, as well as the expanded

procedures for private banking. Other expanded

procedures should be followed if circumstances

dictate.

2010.11.3.5 First-Day Letter

As part of the inspection preparation, examiners

should customize the ﬁrst-day-letter question-

naire to reﬂect the structure and type of private-

banking activities of the institution and the

scope of the exam. The following is a list of

requests regarding private banking that examin-

ers should consider including in the ﬁrst-day

letter. Responses to these items should be

reviewed in conjunction with responses to the

BSA, ﬁduciary, audit, and internal control inqui-

ries:

1. organizational chart for the private bank on

both a functional and legal-entity basis

2. business or strategic plan

3. income and expense statements for the prior

ﬁscal year and current year to date, with

projections for the remainder of the current

and the next ﬁscal year, and income by

product division and marketing region

4. balance-sheet and total assets under man-

agement (list the most active and proﬁtable

accounts by type, customer domicile, and

responsible account ofﬁcer)

5. most recent audits for private-banking

activities

6. copies of audit committee minutes

7. copy of the CDD and SAR policies and

procedures

8. list of all new business initiatives intro-

duced last year and this year, relevant new-

product-approval documentation that

addresses the evaluation of the unique char-

acteristics and risk associated with the new

activity or product, and an assessment of

the risk-management oversight and control

infrastructures in place to manage the risks

9. list of all accounts in which an intermediary

is acting on behalf of clients of the private

bank, for example, as ﬁnancial advisers or

money managers

10. explanation of the methodology for follow-

ing up on outstanding account documenta-

tion and a sample report

11. description of the method for aggregating

client holdings and activities across busi-

ness units throughout the organization

12. explanation of how related accounts, such

as common control and family link, are

identiﬁed

13. name of a contact person for information on

compensation, training, and recruiting pro-

grams for relationship managers

14. list of all personal investment company

accounts

15. list of reports that senior management

receives regularly on private-banking

activities

16. description and sample of the management

information reports that monitor account

activity

17. description of how senior management

monitors compliance with global policies

for worldwide operations, particularly for

ofﬁces operating in secrecy jurisdictions

18. appropriate additional items from the core

and expanded procedures for private bank-

ing, as set forth in the FFIEC BSA/AML

Examination Manual, as well as any other

items from the expanded procedures that

are needed to gauge the adequacy of the

BSA/AML program for private-banking

activities.

2010.11.4 INSPECTION OBJECTIVES

1. To determine if the policies, practices, proce-

dures, and internal controls regarding

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 16

private-banking activities are adequate for

the risks involved.

2. To determine if the institution’s ofﬁcers and

employees are operating in conformance

with established guidelines for conducting

private-banking activities.

3. To assess the ﬁnancial condition and income-

generation results of the private-banking

activities.

4. To determine the scope and adequacy of the

audit function for private-banking activities.

5. To determine compliance with applicable

laws and regulations for private banking.

6. To initiate corrective action when policies,

practices, procedures, or internal controls are

deﬁcient, or when violations of laws or regu-

lations are found.

2010.11.5 INSPECTION PROCEDURES

The examiner-in-charge should supplement the

following procedures, as appropriate, with the

examination procedures for private banking, as

set forth in the FFIEC BSA/AML Examination

Manual.

2010.11.5.1 Private-Banking

Pre-Inspection Procedures

1. As the examiner-in-charge, conduct a meet-

ing with the lead members of the private-

banking inspection team and discuss—

a. the private-banking inspection scope (The

inspection may need to extend beyond a

rudimentary review of private-banking

operations if the institution’s business

lines and services overlap and if its cus-

tomer base and personnel are shared

throughout the organization. Examiners

will probably need to focus on the poli-

cies, practices, and risks within the differ-

ent divisions of each particular institution

and throughout each institution’s global

network of afﬁliated entities.);

b. examiner assignments of the functional

areas of private banking; and

c. the supplemental reviews of speciﬁc

private-banking products and services.

2. Review the prior report of inspection and the

previous inspection workpapers; description

of the inspection scope; structure and type of

private-banking activities conducted; and

ﬁndings, conclusions, and recommendations

of the prior inspection. The prior inspection

report and inspection plan should also pro-

vide information and insight on key contacts

at the institution and on the time frame of the

prior private-banking review.

3. Review relevant correspondence exchanged

since the prior inspection, such as manage-

ment’s response to the report of inspection,

any applications submitted to the Federal

Reserve, and any supervisory actions.

4. Research press releases and published news

stories about the institution and its private-

banking activities.

5. Review internal and external audit reports

and any internal risk assessments performed

by the institution’s internal or external audi-

tors on its private-banking activities. Review

information on any assessments of the inter-

nal controls and risk proﬁle of the private-

banking function.

6. Contact management at the institution to

ascertain what changes in private-banking

services have occurred since the last inspec-

tion or if there are any planned in the near

future.

a. Determine if the previous inspection or

examination report(s) mention private

banking; if not, ask management if they

have commenced or plan to commence

any private-banking activities within any

part of the bank holding company

organization.

b. Determine if there have been any changes

to the strategic plan; senior management;

or the level and type of private-banking

activities, products, and services offered.

c. During the entire inspection of private-

banking activities, be alert to the totality

of the client relationship, product by prod-

uct, in light of increasing client awareness

and use of derivatives, emerging-market

products, foreign exchange, and margined

accounts.

2010.11.5.2 Full-Inspection Phase

1. After reviewing the private-banking func-

tional areas, draw sound conclusions about

the quality and culture of management and

stated private-banking policies.

2. Evaluate the adequacy of risk-management

policies and practices governing private-

banking activities.

3. Assess the organization of the private-

banking function and evaluate the quality of

management’s supervision of private-

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 17

banking activities. An appraisal of manage-

ment covers the—

a. full range of functions (i.e., supervision

and organization, risk management, ﬁdu-

ciary standards, operational controls,

management information systems, audit,

and compliance) and activities related to

the operation of the private-banking

activities; and

b. discharge of responsibilities by the insti-

tution’s directors through a long-range

organizational plan that accommodates

the volume and business services

handled, local business practices and the

institution’s competition, and the growth

and development of the institution’s

private-banking business.

4. Determine if management has effective pro-

cedures for conducting ongoing reviews of

client-account activity to detect, and protect

the client from, any unauthorized activity

and any account activity that is inconsistent

with the client’s proﬁle (for example, fre-

quent or sizeable unexplained transfers

ﬂowing through the account).

5. Determine if the bank holding company has

initiated and maintained controls and proce-

dures that require each subsidiary private-

banking institution to have account-opening

procedures and documentation require-

ments that must be satisﬁed before an

account can be opened.

6. Determine if the bank holding company

requires its subsidiary institutions to main-

tain and adhere to well-structured CCD

procedures.

7. Determine if the bank holding company has

proper controls and procedures to ensure

each institution’s proper administration of

trust and estates, including strict controls

over assets, prudent investment and man-

agement of assets, and meticulous record-

keeping. Review previous trust examination

reports and consult with the designated Fed-

eral Reserve System trust examiners.

8. Ascertain whether the bank holding com-

pany adequately supervises the custody ser-

vices of its subsidiaries. The bank holding

company should ensure that each institution

has established and currently maintains pro-

cedures for the proper administration of

custody services, including the regular

review of the services on a preset schedule.

9. Determine whether subsidiary institutions

are required to and actually maintain strong

controls and supervision over funds

transfers.

10. Ascertain if institution management and

staff are required to perform due diligence,

that is, to verify and document that the

funds of its private-banking customers were

derived through legitimate means, and

when extending credit, to verify that the use

of loan proceeds was legitimate.

11. Review the institution’s use of deposit

accounts.

a. Assess the adequacy of the institution’s

controls and whether they are appropri-

ately used.

b. Determine if client monies ﬂow through

client deposit accounts and whether the

accounts function as the sole conduit and

paper trail for client transactions.

12. Determine and ensure that each institution’s

approach to Suspicious Activity Reports

(SARs) is proactive and that the bank hold-

ing company and each institution have well-

established procedures covering the SAR

process. Establish whether there is account-

ability within the organization for the analy-

sis and follow-up of internally identiﬁed

suspicious activity (this analysis includes a

sound decision on whether the bank holding

company or an institution needs to ﬁle, or is

required by regulation to ﬁle, a SAR).

Supervision of Subsidiaries (Private-Banking Functions and Activities) 2010.11

BHC Supervision Manual July 2012

Page 18

Fees Involving Investments of Fiduciary Assets in Mutual Funds

and Potential Conﬂicts of Interest Section 2010.12

Banking organizations, including trust institu-

tions, are increasingly encountering various

direct or indirect ﬁnancial incentives to place

trust assets with particular mutual funds. Such

incentives include the payment of fees to bank-

ing organizations for using nonafﬁliated fund

families as well as other incentives for using

those mutual funds that are managed by the

institution or an afﬁliate. The payment of such

fees, referred to variously as shareholder, subac-

counting, or administrative service fees, may be

structured as payments to reimburse the institu-

tion for performing standard recordkeeping and

accounting functions for the institution’s ﬁdu-

ciary accounts. Those functions may consist of

maintaining shareholder subaccounts and

records, transmitting mutual fund communica-

tions as necessary, and arranging mutual fund

transactions. These fees are typically based on a

percentage or basis point amount of the dollar

value of assets invested, or on transaction vol-

ume. Another form of compensation may con-

sist of a lump-sum payment based on assets

transferred into a mutual fund.

In all cases, decisions to place ﬁduciary assets

in particular investments must be consistent

with the underlying trust documents and must

be undertaken in the best interests of the trust

beneﬁciary. The primary supervisory concern is

that an institution may fail to act in the best

interest of beneﬁciaries if it stands to beneﬁt

independently from a particular investment. As

a result, an institution may expose itself to an

increased risk of legal action by account beneﬁ-

ciaries, as well as to potential violations of law

or regulation.

Nearly every state legislature has modiﬁed its

laws explicitly to allow ﬁduciaries to accept

fees from mutual funds under certain condi-

tions. As for the permissibility of other ﬁnancial

incentives, guidance under applicable law may

be less clear. Conditions involving fee payments

under state law often include compliance with

standards of prudence, quality, and appropriate-

ness for the account, and a determination of the

“reasonableness” of the fees received by the

institution. The Ofﬁce of the Comptroller of the

Currency (OCC) has also adopted these general

standards for national banks.

The Employee

Retirement Income Security Act of 1974

(ERISA), however, generally prohibits fee

arrangements between ﬁduciaries and third par-

ties, such as mutual fund providers, with limited

exceptions.

ERISA requirements supersede

state laws and guidelines put forth by the bank

regulatory agencies.

Similar conﬂict-of-interest concerns are

raised by the investment of ﬁduciary-account

assets in mutual funds for which the institution

or an afﬁliate acts as investment adviser

(referred to as “proprietary” funds). In this case,

the institution receives a ﬁnancial beneﬁt from

management fees generated by the mutual fund

investments. This activity can be expected to

become more prevalent as banking organiza-

tions more actively offer proprietary mutual

funds.

See SR-99-7.

2010.12.1 DUE-DILIGENCE REVIEW

NEEDED BEFORE ENTERING INTO

FEE ARRANGEMENTS

Although many state laws now explicitly autho-

rize certain fee arrangements in conjunction

with the investment of trust assets in mutual

funds, institutions nonetheless face heightened

legal and compliance risks from activities in

which a conﬂict of interest exists, particularly if

proper ﬁduciary standards are not observed and

documented. Even when the institution does not

exercise investment discretion, disclosure or

other requirements may apply. Therefore, insti-

tutions should ensure that they perform an

appropriate level of due diligence before enter-

ing into any fee arrangements similar to those

described earlier or placing ﬁduciary assets in

proprietary mutual funds. The following mea-

sures should be included in this process:

1. Reasoned legal opinion. The institution

should obtain a reasoned opinion of counsel

that addresses the conﬂict of interest inherent

1. In general, national banks may make these investments

and receive such fees if applicable law authorizes the practice

and if the investment is prudent and appropriate for ﬁduciary

accounts and consistent with established state law ﬁduciary

requirements. This includes a ‘‘reasonableness’’ test for any

fees received by the institution. See OCC Interpretive Letter

No. 704, February 1996.

2. ERISA section 406(b)(3). See Department of Labor,

Pension Welfare and Beneﬁts Administration Advisory Opin-

ion 97-15A and Advisory Opinion 97-16A.

3. A Federal Reserve Board interpretation of Regulation Y

addresses investment of ﬁduciary-account assets in mutual

funds for which the trustee bank’s holding company acts as

investment adviser. In general, such investments are prohib-

ited unless speciﬁcally authorized by the trust instrument,

court order, or state law. See 12 CFR 225.125.

BHC Supervision Manual November 2021

Page 1

in the receipt of fees or other forms of com-

pensation from mutual fund providers in con-

nection with the investment of ﬁduciary

assets. The opinion should address the per-

missibility of the investment and compensa-

tion under applicable state or federal laws,

the trust instrument, or a court order, as well

as any applicable disclosure requirements or

reasonableness standard for fees set forth in

the law.

2. Establishment of policies and procedures.

The institution should establish appropriate

policies and procedures governing the accep-

tance of fees or other compensation from

mutual fund providers as well as the use of

proprietary mutual funds. Policies and proce-

dures should generally address the following

issues: (1) designation of decision-making

authority; (2) analysis and documentation of

investment decisions; (3) compliance with

applicable statutes, regulations, and sound

ﬁduciary principles, including any disclosure

requirements or “reasonableness” standards

for fees; and (4) staff training and methods

for monitoring compliance with policies and

procedures by internal or external audit staff.

3. Analysis and documentation of investment

decisions. When fees or other compensation

are received in connection with ﬁduciary-

account investments over which the institu-

tion has investment discretion or when such

investments are made in the institution’s pro-

prietary mutual funds, the institution should

fully conduct appropriate analysis supporting

the investment decision. This analysis should

be performed regularly and would typically

include factors such as historical perfor-

mance comparisons with similar mutual

funds, management fees and expense ratios,

and ratings by recognized mutual fund rating

services. The institution should determine

whether the investment is, and continues to

be, (1) appropriate for the individual account,

(2) in the best interest of account beneﬁcia-

ries, and (3) in compliance with the provi-

sions of the “prudent investor” or “prudent

man rules,” as appropriate.

Fees Involving Investments of Fiduciary Assets in Mutual Funds and Potential Conﬂicts of Interest 2010.12

BHC Supervision Manual November 2021

Page 2

Supervision of Subsidiaries (Establishing Accounts for Foreign

Governments, Embassies, and Political Figures) Section 2010.13

On June 15, 2004, an interagency advisory con-

cerning the embassy banking business and

related banking matters was issued by the fed-

eral banking and thrift agencies

in coordination

with the U.S. Department of the Treasury’s

Financial Crimes Enforcement Network. The

purpose of the advisory is to provide general

guidance to ﬁnancial institutions regarding the

treatment of accounts for foreign governments,

foreign embassies, and senior foreign political

ﬁgures.

The joint interagency statement advises ﬁnan-

cial institutions

that the decision to accept or

reject an embassy or foreign government

account is theirs alone to make. Financial insti-

tutions should be aware, however, that there are

varying degrees of risk associated with such

accounts, depending on the customer and the

nature of the services provided. Financial insti-

tutions should take appropriate steps to manage

such risks, consistent with sound practices and

applicable anti-money-laundering laws and

regulations. The advisory also encourages ﬁnan-

cial institutions to direct questions about

embassy banking to their primary federal bank

regulators. See SR letter 04-10, “Banking

Accounts for Foreign Governments, Embassies,

and Political Figures.”

On March 24, 2011, another interagency

advisory was issued to supplement the 2004

interagency advisory. The 2011 advisory pro-

vides information to ﬁnancial institutions pro-

viding account services to foreign embassies,

consulates, and missions (“foreign missions”) in

a manner that fulﬁlls the needs of those foreign

governments while complying with the provi-

sions of the Bank Secrecy Act (BSA). It advises

that ﬁnancial institutions are expected to demon-

strate the capacity to conduct appropriate risk

assessments and implement the requisite con-

trols and oversight systems to effectively man-

age the risk identiﬁed in these relationships with

foreign missions. The 2011 advisory also con-

ﬁrms that it is the ﬁnancial institution’s decision

to accept or reject a foreign mission account.

See SR letter 11-6, “Guidance on Accepting

Accounts from Foreign Embassies, Consulates

and Missions.” See also the FFIEC Bank

Secrecy Act/ Anti-Money Laundering Examina-

tion Manual for examination and inspection pro-

cedures on embassy, foreign consulate, and for-

eign mission accounts.

2010.13.1 INTERAGENCY ADVISORY

ON ACCEPTING ACCOUNTS FOR

FOREIGN GOVERNMENTS,

EMBASSIES, AND POLITICAL

FIGURES

The 2004 and 2011 interagency advisories

answer questions on whether ﬁnancial institu-

tions should do business with foreign embassies

and whether institutions should establish

account services for foreign governments, for-

eign embassies, and senior foreign political ﬁg-

ures. As it would with any new account, an

institution should evaluate whether or not to

accept a new account for a foreign government,

embassy, or political ﬁgure. That decision

should be made by the institution’s manage-

ment, under standards and guidelines

established by the board of directors, and should

be based on the institution’s own business

objectives, its assessment of the risks associated

with particular accounts or lines of business,

and its capacity to manage those risks. The

agencies will not, in the absence of extraor-

dinary circumstances, direct or encourage any

institution to open, close, or refuse a particular

account or relationship.

Providing ﬁnancial services to foreign gov-

ernments and embassies and to senior foreign

political ﬁgures can, depending on the nature of

the customer and the services provided, involve

varying degrees of risk. Such services can range

from account relationships that enable an

embassy to handle the payment of operational

expenses—for example, payroll, rent, and

utilities—to ancillary services or accounts pro-

vided to embassy staff or foreign-government

ofﬁcials. Each of these relationships potentially

poses different levels of risk. Institutions are

expected to assess the risks involved in any such

relationships and to take steps to ensure both

that such risks are appropriately managed and

that the institution can do so in full compliance

with its obligations under the BSA, as amended

by the USA PATRIOT Act, and the regulations

promulgated thereunder.

1. The Board of Governors of the Federal Reserve Sys-

tem, the Federal Deposit Insurance Corporation, the Ofﬁce of

the Comptroller of the Currency, the Ofﬁce of Thrift Supervi-

sion, and the National Credit Union Administration (the

agencies).

2. The advisory is primarily directed to ﬁnancial institu-

tions located in the United States. The boards of directors of

bank holding companies, however, should consider whether

the advisory should be applied to their other U.S. subsidiaries’

ﬁnancial and other services.

BHC Supervision Manual September 2017

Page 1

When an institution elects to establish ﬁnan-

cial relationships with foreign governments,

embassies, or senior foreign political ﬁgures, the

agencies, consistent with their usual practice of

risk-based supervision, will make their own

assessment of the risks involved in such busi-

ness. As is the case with all accounts, the institu-

tion should expect appropriate scrutiny by

examiners that is commensurate with the level

of risk presented by the account relationship. As

in any case where higher risks are presented, the

institution should expect an increased level of

review by examiners to ensure that the institu-

tion has in place controls and compliance over-

sight systems that are adequate to monitor and

manage such risks, as well as personnel trained

in the management of such risks and in the

requirements of applicable laws and regulations.

Institutions that have or are considering tak-

ing on relationships with foreign governments,

embassies, or political ﬁgures should ensure that

such customers are aware of the requirements of

U.S. laws and regulations to which the institu-

tion is subject. Institutions should, to the maxi-

mum extent feasible, seek to structure such

relationships in order to conform them to con-

ventional U.S. domestic banking relationships

so as to reduce the risks that might be presented

by such relationships.

2010.13.2 RISK MITIGATION AND

SUPERVISORY EXPECTATIONS FOR

FOREIGN MISSIONS

A ﬁnancial institution should manage the risks

associated with transactions involving embassy,

foreign consulate, and foreign mission accounts,

and implement effective due diligence, monitor-

ing, and reporting systems as part of its BSA/

Anti-Money Laundering compliance program.

The ﬁnancial institution has the ﬂexibility to

manage its risk in a number of ways. A ﬁnancial

institution may reduce risk by ensuring custom-

ers are aware of the requirements of U.S. bank-

ing laws and regulations and monitoring those

accounts for compliance. When establishing a

customer relationship, a ﬁnancial institution

should assess the risks posed such as the volume

of activity, number of accounts, and country

risk.

A ﬁnancial institution may also mitigate risk

by entering into a written agreement with the

foreign mission that clearly deﬁnes the terms of

use for the account(s) setting forth available

services, acceptable transactions, and access

limitations. Similarly, the ﬁnancial institution

could offer limited purpose accounts, such as

those used to facilitate operational expense pay-

ments (e.g., payroll, rent and utilities, routine

maintenance), which are generally considered

lower risk and allow the foreign mission to

carry out its customary functions in the United

States. Account monitoring to ensure compli-

ance with account limitations and the terms of

any service agreements is essential to mitigate

risks associated with these accounts.

A ﬁnancial institution may also provide ancil-

lary services or accounts to foreign mission

personnel and their families. As with foreign

mission accounts, written agreements, which

clearly deﬁne the terms of use for these types of

services or accounts, may assist in mitigating

the varying degrees of risk.

As with any type of accountholder, the agen-

cies expect ﬁnancial institutions to demonstrate

the capacity to conduct appropriate risk assess-

ments and implement the requisite controls and

oversight systems to effectively manage varying

degrees of risks in ﬁnancial relationships with

foreign missions. The agencies, consistent with

their usual practice of risk-based supervision,

will evaluate the risks associated with the

account relationship and mitigating controls

implemented. The agencies will not direct or

require any ﬁnancial institution to close or

refuse a particular account or relationship,

except in extraordinary circumstances (for

example, when violations of law are identiﬁed

that warrant an administrative enforcement

action).

Supervision of Subsidiaries (Establishing Accounts for Foreign Governments, Embassies, and Political Figures)

2010.13

BHC Supervision Manual September 2017

Page 2

Intercompany Transactions

Section 2020.0

WHAT’S IN THIS SECTION

This section was revised as of January 2008 to

incorporate references to the Federal Reserve

Board’s Regulation W, primarily with regard to

the bank holding company (BHC) inspection

process. The section includes also a discussion

of the mandatory reporting of certain intercom-

pany transactions on the FR Y-8, The Bank

Holding Company Report of Insured Depository

Institutions’ Section 23A Transactions with

Afﬁliates, and its instructions. The mandatory

report is to be submitted quarterly to the Fed-

eral Reserve by (1) all top-tier BHCs, including

ﬁnancial holding companies, and (2) all foreign

banking organizations that directly own a U.S.

subsidiary bank. The examiner’s inspection

responsibilities are discussed.

2020.0.1 ANALYSIS OF

INTERCOMPANY TRANSACTIONS

The analysis of intercompany transactions

between a parent company, its nonbank sub-

sidiaries, and its bank subsidiaries is primarily

intended to assess the nature of the relation-

ships between these entities and the effect of the

relationships on the subsidiary insured deposi-

tory institutions (IDIs). IDIs include any state

bank, national bank, trust company, or banking

association and any institution that takes depos-

its that are insured by the Federal Deposit Insur-

ance Corporation, including savings associa-

tions. Both the legal and ﬁnancial ramiﬁcations

of such transactions are areas of concern.

Certain intercompany transactions are subject to

the provisions of section 23A or 23B (or both)

of the Federal Reserve Act and the Federal

Reserve Board’s Regulation W. Section 23A of

the Federal Reserve Act is one of the most

important statutes on limiting exposures to

individual institutions and protecting the fed-

eral safety net. Several types of intercompany

transactions and the primary regulatory

concerns of each are presented below.

Dividends paid by subsidiaries to the parent.

Dividends are a highly visible cash outﬂow by

subsidiaries. If the dividend payout ratio

exceeds the level at which the growth of

retained earnings can keep pace with the growth

of assets, the subsidiary’s capital ratios will

deteriorate. These dividends may also have a

negative effect on the subsidiary’s liquidity

position.

Transactions with afﬁliates. Transactions

between subsidiary IDI afﬁliates is another area

of potential abuse of subsidiary banks. Regula-

tory concern centers on the quantitative limits

and collateral restrictions on certain transactions

by subsidiary banks with their afﬁliates. These

restrictions are designed to protect subsidiary

IDIs from losses resulting from transactions

with afﬁliates.

Fees paid by subsidiaries. Management or ser-

vice fees are another cash outﬂow of bank

subsidiaries. These fees may be paid to the

parent, the nonbank subsidiaries, or, in some

cases, to the other bank subsidiaries. Regulatory

concern focuses on whether such fees are rea-

sonable in relation to the services rendered and

on the ﬁnancial impact of the fees on the bank

subsidiaries.

Tax allocation. How a bank holding company

organization determines to allocate taxes among

its component companies involves questions of

both the magnitude and timing of the cash-ﬂow

effects. Unreasonable or untimely tax payments

or refunds to the bank can have an adverse

effect on the ﬁnancial condition of the banking

subsidiaries.

Purchases or swaps of assets. Asset purchases

or swaps between a bank and its afﬁliates can

create the potential for abuse of subsidiary

banks. Regulatory concern focuses on the fair-

ness of such asset transactions and their ﬁnan-

cial impact and timing. Fairness and ﬁnancial

considerations include the quality and collect-

ibility and fair values of such assets and their

liquidity effects. IDIs generally are prohibited

from purchasing low-quality assets from afﬁli-

ates. Asset exchanges may be a mechanism to

avoid regulations designed to protect subsidiary

banks from becoming overburdened with non-

earning assets. Improper timing or certain struc-

turings of asset transactions also can cause them

to be regarded as extensions of credit to afﬁli-

ates. As such, these types of transactions could

potentially violate applicable regulations and

statutes.

BHC Supervision Manual January 2014

Page 1

Compensating balances. A subsidiary bank may

be required to maintain excess balances at a

correspondent bank that lends to other parts of

the holding company organization, possibly to

the detriment of the bank. The subsidiary bank

may be foregoing earnings on such excess

funds, which may adversely affect its ﬁnancial

condition.

Other expense allocations. In general, a subsidi-

ary bank should be adequately compensated for

its services or for the use of its facilities and

personnel by other parts of the holding company

organization. Furthermore, a subsidiary bank

should not pay for expenses for which it does

not receive a beneﬁt.

2020.0.2 ROLE OF THE EXAMINER

To properly assess intercompany transactions

and relationships between afﬁliates, the exam-

iner must make a thorough analysis of most

intercompany transactions and must have a

knowledge of applicable laws, regulations, and

rulings. In particular, the examiner should be

familiar with sections 23A and 23B of the Fed-

eral Reserve Act and the Board’s Regulation W.

The examiner should also be familiar with the

FR Y-8, The Bank Holding Company Report of

Insured Depository Institutions’ Section 23A

Transactions with Afﬁliates, and its instructions.

The mandatory report is to be submitted to the

Federal Reserve by (1) all top-tier bank holding

companies (BHCs), including ﬁnancial holding

companies, and (2) all foreign banking organiza-

tions that directly own a U.S. subsidiary bank.

The completed quarterly reports are used by the

Federal Reserve System to monitor bank expo-

sures to afﬁliates and to ensure banks’ compli-

ance with section 23A of the Federal Reserve

Act. With regard to the BHC’s inspection, the

examiner should review and verify, since the

previous inspection, the BHC’s accuracy and

comprehensiveness in its reporting based on the

FR Y-8 report form and instructions.

If a subsidiary IDI of a holding company is

not a state member bank, the bank’s primary

regulator should determine the bank’s compli-

ance with pertinent banking laws. In reviewing

the subsidiary bank’s examination report, any

violations of laws and regulations applicable to

intercompany transactions should be noted. If

the violation resulted from the actions of an

afﬁliate, the afﬁliate’s role should be identiﬁed

and be subject to criticism in the inspection

report.

Violations of banking laws discovered during

the inspection should be brought to manage-

ment’s attention and referred to the bank’s pri-

mary supervisor. However, any action or criti-

cism levied directly on the bank should come

from the bank’s primary supervisor.

Intercompany Transactions 2020.0

BHC Supervision Manual January 2014

Page 2

Intercompany Transactions (Transactions Between Member Banks and Their

Afﬁliates—Sections 23A and 23B of the Federal Reserve Act) Section 2020.1

2020.1.01 WHAT’S NEW IN THIS

REVISED SECTION

This section has been revised to discuss statu-

tory amendments of sections 23A and 23B of the

Federal Reserve Act resulting from the Dodd-

Frank Act. One amendment involved the deﬁni-

tion of an “afﬁliate,” with regard to an invest-

ment fund when an insured depository

institution (IDI) or one of its afﬁliates is an

investment adviser. Also, the deﬁnition of “cov-

ered transactions” was revised to include the

credit exposure resulting for derivative and

securities lending and borrowing transactions

between the IDI and its afﬁliates. In addition,

the Dodd-Frank Act removed the quantitative 10

percent exemption limit between ﬁnancial sub-

sidiaries. The retained earnings of a ﬁnancial

subsidiary are to be included as part of the

IDI’s investment. The amendments were effec-

tive July 21, 2012. (See sections 608(a)(1)(A),

608(a)(1)(B), and 609(a) of the Dodd-Frank

Act.)

Revised inspection objectives and inspection

procedures also are included.

2020.1.05 SECTIONS 23A AND 23B

OF THE FEDERAL RESERVE ACT,

AND REGULATION W

Section 23A of the Federal Reserve Act (FRA)

restricts the ability of insured depository insti-

tutions (IDIs)

to engage in certain covered

transactions with an afﬁliate. Transactions that

are subject to section 23A also are subject to

the provisions of section 23B of the FRA.

addition to these statutory provisions, the

Board issued Regulation W (the rule),

which

implements sections 23A and 23B of the FRA.

The rule provides several exemptions and com-

bines the statutory restrictions on transactions

between a member bank and its afﬁliates with

numerous previously issued Board inter-

pretations.

During a bank holding company inspection,

transactions between an IDI and an afﬁliate (for

example, a bank holding company parent or

other nonbank subsidiary) are reviewed for

compliance with sections 23A and 23B and

Regulation W, as well as other banking regula-

tions and statutes. Any violations of sec-

tions 23A and 23B of the FRA or Regulation W

involving a transaction between an IDI and its

afﬁliate that are disclosed or found during an

inspection should be brought to management’s

attention, may be discussed in the inspection

report as “Other Matters,” and referred to the

bank’s primary supervisor. However, any action

or criticism levied directly on the bank should

come from the bank’s primary supervisor. See

also SR-03-2.

2020.1.1 SECTION 23A OF THE

FEDERAL RESERVE ACT

Section 23A of the FRA (12 U.S.C. 371c) is the

primary statute governing transactions between

an IDI and its afﬁliates. Section 23A (1) desig-

nates the types of companies that are afﬁliates of

an IDI; (2) speciﬁes the types of transactions

covered by the statute; (3) sets the quantitative

limitations on an IDI’s covered transactions

with any single afﬁliate, and with all afﬁliates

combined; (4) sets forth collateral requirements

for certain transactions with afﬁliates; and

(5) requires all covered transactions to be con-

ducted on terms consistent with safe and sound

banking practices.

2020.1.1.1 Deﬁnition of an Afﬁliate

In general, companies that control or are under

common control with an IDI are deﬁned by

section 23A as ‘‘afﬁliates’’ of the bank. The

deﬁnition includes a bank subsidiary of a bank

and any company that a bank, or its subsidiaries

or afﬁliates, sponsors and advises on a

contractual basis.

Afﬁliates, for example, may

1. By their terms, sections 23A and 23B apply to banks

that are members of the Federal Reserve System (‘‘member

banks’’). Other federal laws subject FDIC-insured non-

member banks and FDIC-insured thrifts to sections 23A and

23B in the same manner and to the same extent as if

they were member banks. (See 12 U.S.C. 1828(j) and

12 U.S.C.1468(a)(4)). The statute also states that most subsid-

iaries of a member bank are to be treated as part of the

member bank itself for purposes of sections 23A and 23B.

Because the statute and regulation apply to all insured deposi-

tory institutions, this section will refer to the subject institu-

tions as insured depository institutions (IDIs).

2. Federally insured savings associations also are subject

to sections 23A and 23B as if they were banks.

3. In this section of the manual, Regulation W is referred

to as ‘‘the rule’’ or to a speciﬁc numbered section of the rule.

4. The Board has the authority to expand the deﬁnition of

afﬁliate to include a company that has a relationship with the

bank so that covered transactions between the company and

BHC Supervision Manual July 2014

Page 1

include banks, ﬁnancial holding companies,

savings and loan holding companies, and their

subsidiaries. Banks, savings associations, and

nonbanking companies that are under common

individual control or a group of individuals with

the bank also are afﬁliates for the purposes of

section 23A. Any investment fund with respect

to which a member bank or afﬁliate thereof is an

investment adviser. See section 608(a)(1)(A) of

the Dodd-Frank Act. In addition, any transaction

by an IDI with any person is deemed to be a

transaction with an afﬁliate to the extent that the

proceeds of the transaction are transferred to, or

used for the beneﬁt of, the afﬁliate. With respect

to any IDI within a holding company, its afﬁliates

include, among others, its parent, the parent’s

subsidiaries, and other companies directly or

indirectly controlled by the bank’s or holding

company’s shareholders. Speciﬁcally, Regula-

tion W deﬁnes

an afﬁliate as—

1. any company that controls

the IDI and any

other company that is controlled by the

company that controls the IDI;

2. any bank subsidiary of the IDI;

3. any company—

— that is controlled directly or indirectly,

by a trust or otherwise, by or for the

beneﬁt of shareholders who beneﬁcially

or otherwise control, directly or indi-

rectly, by trust or otherwise, the mem-

ber bank or any company that controls

the IDI; or

— in which a majority of its directors or

trustees constitute a majority of the per-

sons holding any such ofﬁce with the

IDI or any company that controls the

IDI;

4. any company (including a real estate invest-

ment trust) that is sponsored and advised on

a contractual basis by the IDI or any subsid-

iary or afﬁliate of the IDI;

5. any investment company, with respect to

which an IDI or any afﬁliate thereof is an

investment adviser as deﬁned in sec-

tion 2(a)(20) of the Investment Company

Act of 1940;

6. any investment fund for which the IDI or

any afﬁliate of the IDI serves as an invest-

ment adviser, if the IDI and its afﬁliates

own or control, in the aggregate, more than

5 percent of any class of voting securities or

of the equity capital of the fund;

7. a depository institution that is a subsidiary

of the IDI;

8. a ﬁnancial subsidiary of the member bank;

9. any company in which a holding company

of the IDI owns or controls, directly or

indirectly, or acting through one or more

other persons, 15 percent or more of the

equity capital pursuant to the merchant

banking authority in section 4(k)(4)(H) or

(I) of the Bank Holding Company Act

(12 U.S.C. 1843(k)(4)(H) or (I));

10. any partnership for which the IDI or any

afﬁliate of the IDI serves as a general part-

ner or for which the IDI or any afﬁliate of

the IDI causes any director, ofﬁcer, or

employee of the member bank or afﬁliate to

serve as a general partner;

11. any subsidiary of an afﬁliate described in

paragraphs (a)(1) through (10) of sec-

tion 223.2 of Regulation W; and

12. any company that the Board, or the appro-

priate federal banking agency for the IDI,

determines by regulation or order to have a

relationship with the IDI or any subsidiary

or afﬁliate of the member bank, such that

covered transactions by the member bank

or its subsidiary with that company may be

affected by the relationship, to the detri-

ment of the IDI or its subsidiary.

The following generally are not considered to

be afﬁliates of an IDI:

1. a nonbank subsidiary of the IDI (other than

a ﬁnancial subsidiary), unless the Board

determines not to exclude such a subsidiary;

2. a company engaged solely in holding the

IDI’s premises;

3. a company engaged solely in conducting a

safe deposit business;

4. a company engaged solely in holding obli-

gations of the United States or its agencies

or obligations fully guaranteed by the

United States or its agencies as to principal

and interest; and

5. a company in which control arises from the

exercise of rights arising out of a bona ﬁde

debt previously contracted (for the period

of time speciﬁed by section 23A).

the bank may be affected by the relationship to the detriment

of the bank.

5. See 12 C.F.R. 223.2.

6. By statute, ‘‘control’’ is deﬁned as the power to (1) vote

25 percent or more of the voting shares of a company,

excluding situations in which the stock is controlled in a

ﬁduciary capacity; (2) elect a majority of the directors of a

company; or (3) exercise a controlling inﬂuence over a com-

pany. Control is discussed in more detail at 2020.1.3.1.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 2

2020.1.1.2 Deﬁnition of Afﬁliates by

Type of Entity

2020.1.1.2.1 Investment Funds Advised

by the Member Bank or an Afﬁliate of the

Member Bank

Regulation W includes as an afﬁliate any com-

pany that is sponsored and advised on a contrac-

tual basis by the IDI or any of its afﬁliates as

well as any investment company for which the

IDI or its afﬁliate serves as an investment

adviser, as deﬁned in the Investment Company

Act of 1940 (the 1940 Act). In Regulation W,

the Board used its statutory authority to deﬁne

as an afﬁliate any investment fund—even if not

an investment company for purposes of the 1940

Act—for which the IDI or an afﬁliate of the IDI

serves as an investment adviser, if the IDI or an

afﬁliate of the IDI owns or controls more than

5 percent of any class of voting securities or

similar interests of the fund.

Many investment funds that are advised by an

IDI (or an afﬁliate of an IDI) are afﬁliates of the

IDI under section 23A because the funds either

are investment companies under the 1940 Act or

are sponsored by the IDI (or an afﬁliate of the

IDI). The IDI or its afﬁliate, in some instances,

however, may advise but not sponsor an invest-

ment fund that is not an investment company

under the 1940 Act.

The advisory relationship

of an IDI or afﬁliate with an investment fund

presents the same potential for conﬂicts of inter-

est regardless of whether the fund is an invest-

ment company under the 1940 Act.

The Dodd-

Frank Act treats any investment fund as an

afﬁliate if the IDI or an afﬁliate of the IDI serves

as an investment adviser to the fund.

2020.1.1.2.2 Financial Subsidiaries

In 1999, the Gramm-Leach-Bliley Act (the GLB

Act) authorized banks to own ‘‘ﬁnancial subsid-

iaries’’ that engage in activities not permissible

for the parent bank to conduct directly, such as

underwriting and dealing in bank-ineligible

securities. The GLB Act amended section 23A

to deﬁne a ﬁnancial subsidiary of a bank as an

afﬁliate of the bank and thus subjected covered

transactions between the bank and a ﬁnancial

subsidiary to the limitations of sections 23A and

23B.

Section 23A deﬁnes a ﬁnancial subsidiary as

a subsidiary of any bank (state or national) that

is engaged in an activity that is not permissible

for national banks to engage in directly (other

than a subsidiary that federal law speciﬁcally

authorizes national banks to own or control).

Speciﬁcally, a ‘‘ﬁnancial subsidiary’’ is deﬁned

as ‘‘any company that is a subsidiary of a bank

that would be a ﬁnancial subsidiary of a national

bank under section 5136A of the Revised Stat-

utes of the United States.’’

(See 12 U.S.C.

371c(e)(1).) Section 5136A, in turn, deﬁnes a

ﬁnancial subsidiary as any company that is con-

trolled by one or more member banks, other

than (1) a subsidiary that engages solely in

activities that national banks are permitted to

engage in directly (and subject to the terms and

conditions that apply to national banks) or (2) a

subsidiary that national banks are speciﬁcally

authorized to control by the express terms of a

federal statute (other than section 5136A of the

Revised Statutes), such as an Edge Act corpora-

tion or a small business investment company

(SBIC).

(See 12 U.S.C. 24a(g)(3).) Section

5136A also prohibits a ﬁnancial subsidiary of a

national bank from engaging in insurance under-

writing, real estate investment and development,

or merchant banking activities.

(See 12 U.S.C.

24a(a)(2).)

The Dodd-Frank Act amended section 23A as

it relates to ﬁnancial subsidiaries of a bank.

First, the 10 percent quantitative limit of sec-

tion 23A between a bank and any individual

afﬁliate applies to covered transactions between

a bank and a ﬁnancial subsidiary of the bank. In

addition, for purposes of section 23A, the

amount of a bank’s investment in its ﬁnancial

subsidiary includes the retained earnings of the

ﬁnancial subsidiary. See section 609(a) of the

Dodd-Frank Act.

Section 23A generally applies only to transac-

tions between (1) a bank and an afﬁliate of the

bank and (2) a bank and a third party in which

some beneﬁt of the transactions accrues to an

7. 12 U.S.C. 371c(b)(1)(E).

8. An investment fund typically escapes from the deﬁni-

tion of investment company under the 1940 Act because it

(1) sells interests only to a limited number of investors or only

to sophisticated investors or (2) invests primarily in ﬁnancial

instruments that are not securities. An IDI may face greater

risk from the conﬂicts of interest arising from its relationships

with an investment fund that is not registered than an invest-

ment company under the 1940 Act because the 1940 Act

restricts transactions between a registered investment com-

pany and entities afﬁliated with the company’s investment

adviser. (See 15 U.S.C. 80a-17).

9. 12 U.S.C. 24a(g)(3).

10. 12 U.S.C. 24a(a)(2).

11. 12 U.S.C. 371c(e)(1).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 3

afﬁliate of the bank. The statute generally does

not apply to transactions between two afﬁliates.

Section 23A establishes two special anti-evasion

provisions, however, that govern transactions

between a ﬁnancial subsidiary of a bank and

another afﬁliate of the bank. First, the FRA

provides that any purchase of, or investment in,

the securities of a bank’s ﬁnancial subsidiary by

an afﬁliate of the bank will be deemed to be a

purchase of, or investment in, such securities by

the bank itself. Second, the GLB Act authorizes

the Board to deem a loan or other extension of

credit made by a bank’s afﬁliate to any ﬁnancial

subsidiary of the bank to be an extension of

credit by the bank to the ﬁnancial subsidiary, if

the Board determines that such action is neces-

sary or appropriate to prevent evasion.

2020.1.1.2.2.1 Regulation W Provisions for

Financial Subsidiaries

Regulation W (1) deﬁnes a ﬁnancial subsidiary

of a bank, (2) exempts certain companies from

the deﬁnition, and (3) sets forth special valua-

tion and other rules for ﬁnancial subsidiaries.

(See sections 223.2(a)(8), 223.3(p), and 223.32

of the rule.) Regulation W also includes several

special rules that apply to transactions with

ﬁnancial subsidiaries.

Applicability of the 10 percent quantitative

limit to transactions with a ﬁnancial subsidiary.

The 10 percent quantitative limit in section 23A

applies with respect to covered transactions

between a member bank and any individual

ﬁnancial subsidiary of the bank.

Valuation of investments in securities issued

by a ﬁnancial subsidiary. Because ﬁnancial sub-

sidiaries of a member bank are considered afﬁli-

ates of the bank for purposes of section 23A, a

member bank’s purchases of, and investments

in, the securities of its ﬁnancial subsidiary are

covered transactions under the statute.

The

Dodd-Frank Act provides that a member bank’s

investment in its own ﬁnancial subsidiary, for

purposes of section 23A, shall include the

retained earnings of the ﬁnancial subsidiary.

In light of this statutory provision, sec-

tion 223.32(b) of the rule contains a special

valuation provision for investments by a mem-

ber bank in the securities of its own ﬁnancial

subsidiary.

Such investments must be valued

at the greater of (1) the price paid by the mem-

ber bank for the securities or (2) the carrying

value of the securities on the ﬁnancial state-

ments of the member bank (determined in accor-

dance with generally accepted accounting prin-

ciples (GAAP) but without reﬂecting the bank’s

pro rata share of any earnings retained, or losses

incurred by, the ﬁnancial subsidiary after the

bank’s acquisition of the securities).

This valuation rule differs from the general

valuation rule for investments in securities

issued by an afﬁliate in that the ﬁnancial subsid-

iary rule permits, consistent with the GLB Act,

that the carrying value of the investment be

computed without consideration of the retained

earnings or losses of the ﬁnancial subsidiary

since the time of the member bank’s investment.

As a result of this rule, the covered transaction

amount for a member bank’s investment in

securities issued by its ﬁnancial subsidiary gen-

erally would not increase after the investment

was made except if the member bank made an

additional capital contribution to the subsidiary

or purchased additional securities of the

subsidiary.

The following examples were designed to

assist banks in valuing investments in securities

issued by a ﬁnancial subsidiary of the bank.

Each example involves a securities underwriter

that becomes a ﬁnancial subsidiary of the bank

after the transactions described below.

1. Initial valuation.

a. Direct acquisition by a bank. A bank pays

$500 to acquire 100 percent of the shares

of a securities underwriter. The initial car-

rying value of the shares on the member

bank’s parent-only GAAP ﬁnancial state-

12. A member bank’s aggregate amount of covered trans-

actions with any individual ﬁnancial subsidiary of the bank

may not exceed 10 percent of the bank’s capital and surplus.

13. See section 609(a) of the Dodd-Frank Act. The Dodd-

Frank Act eliminated the 10 percent quantitative limit exemp-

tion for certain covered transactions with ﬁnancial subsidi-

aries and individual afﬁliates.

14. See section 609(a) of the Dodd-Frank Act.

15. The rule’s special valuation formula for investments by

a member bank in its own ﬁnancial subsidiary does not apply

to investments by a member bank in a ﬁnancial subsidiary of

an afﬁliated depository institution. Such investments must be

valued using the general valuation formula set forth in sec-

tion 223.23 for investments in securities issued by an afﬁliate

and, further, may trigger the anti-evasion rule contained in

section 223.32(c)(1) of the rule.

16. The rule also makes clear that if a ﬁnancial subsidiary

is consolidated with its parent bank under GAAP, the subsidi-

ary under the carrying value of the bank’s investment in the

ﬁnancial subsidiary shall be determined based on parent-only

ﬁnancial statements of the bank.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 4

ments is $500. The member bank initially

must value the investment at $500.

b. Contribution of a ﬁnancial subsidiary to a

member bank. The parent holding com-

pany of a bank acquires 100 percent of

the shares of a securities underwriter in a

transaction valued at $500 and immedi-

ately contributes the shares to the member

bank. The bank gives no consideration in

exchange for the shares. The bank ini-

tially must value the investment at the

carrying value of the shares on the bank’s

parent-only GAAP ﬁnancial statements.

Under GAAP, the bank’s initial carrying

value of the shares would be $500.

2. Carrying value not adjusted for earnings and

losses of the ﬁnancial subsidiary. A bank and

its parent holding company engage in a trans-

action whereby the member bank acquires

100 percent of the shares of a securities

underwriter in a transaction valued at $500.

The bank initially values the investment at

$500. In the following year, the securities

underwriter earns $25 in proﬁt, which is

added to its retained earnings. The bank’s

investment of the shares of the underwriter is

not adjusted for purposes of section 23A and

Regulation W, and the bank’s investment

continues to be valued at $500. If, however,

the member bank contributes $100 of addi-

tional capital to the securities underwriter,

the bank must value the aggregate invest-

ment at $600.

Anti-evasion rules as they pertain to ﬁnancial

subsidiaries. Section 23A generally applies only

to transactions between a bank and an afﬁliate

of the bank and transactions between a member

bank and a third party when some beneﬁt of the

transaction accrues to an afﬁliate of the bank.

The statute generally does not apply to transac-

tions between two afﬁliates. The GLB Act estab-

lishes two special anti-evasion rules, however,

that govern transactions between a ﬁnancial sub-

sidiary of a member bank and another afﬁliate

of the bank.

First, the GLB Act provides that

any purchase of, or investment in, securities

issued by a member bank’s ﬁnancial subsidiary

by an afﬁliate of the bank will be deemed to be a

purchase of, or investment in, such securities by

the bank itself. Second, the GLB Act authorizes

the Board to deem an extension of credit made

by a member bank’s afﬁliate to any ﬁnancial

subsidiary of the bank to be an extension of

credit by the bank to the ﬁnancial subsidiary, if

the Board determines that such action is neces-

sary or appropriate to prevent evasions of the

FRA or the GLB Act. Section 223.32(c) of the

rule incorporates both of these provisions.

The Board exercised its authority under the

second anti-evasion rule by stating that an

extension of credit to a ﬁnancial subsidiary of a

bank by an afﬁliate of the bank would be treated

as an extension of credit by the bank itself to the

ﬁnancial subsidiary if the extension of credit is

treated as regulatory capital of the ﬁnancial sub-

sidiary. An example of the kind of credit exten-

sion covered by this provision would be a subor-

dinated loan to a ﬁnancial subsidiary that is a

securities broker-dealer in which the loan is

treated as capital of the subsidiary under the

SEC’s net capital rules. Treating such an exten-

sion of credit as a covered transaction is appro-

priate because the extension of credit by the

afﬁliate has a similar effect on the subsidiary’s

regulatory capital as an equity investment by the

afﬁliate, which is treated as a covered transac-

tion by the terms of the GLB Act (as described

above). The rule generally does not prevent a

BHC or other afﬁliate of a member bank from

providing ﬁnancial support to a ﬁnancial subsid-

iary of the bank in the form of a senior or

secured loan.

2020.1.1.2.3 Partnerships

IDIs fund legitimate commercial transactions

through partnerships. Partnerships for which an

IDI or an afﬁliate(s) serves as a general partner

are afﬁliates. Regulation W also deﬁnes an afﬁli-

ate of an IDI as any partnership, if the IDI or an

afﬁliate of the IDI causes any director, ofﬁcer, or

employee of the IDI or afﬁliate to serve as a

general partner of the partnership (unless the

partnership is an operating subsidiary of the

bank.) Also, if a company, such as a bank hold-

ing company, controls more than 25 percent of

the equity through a partnership, that company

is an afﬁliate under Regulation W.

2020.1.1.2.4 Subsidiaries of Afﬁliates

Regulation W deems a subsidiary of an afﬁliate

as an afﬁliate of the IDI.

17. GLB Act section 121(b)(1), or 12 U.S.C. 371c(e)(3).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 5

2020.1.1.2.5 Companies Designated by

the Appropriate Federal Banking Agency

Under section 223.2(a)(12), the Board or the

appropriate federal banking agency for the rel-

evant IDI (under authority delegated by the

Board) can determine that any company that has

a relationship with an IDI or an afﬁliate of the

IDI, such that covered transactions by the IDI

with that company may be affected by the rela-

tionship to the detriment of the IDI, is an afﬁli-

ate of the IDI. The Board and the federal bank-

ing agencies can thus protect IDIs in their

transactions with associated companies. An IDI

may petition the Board to review any such afﬁli-

ate determination made by the institution’s

appropriate federal banking agency under the

general procedures established by the Board for

review of actions taken under delegated

authority.

2020.1.1.2.6 Merchant Banking

The GLB Act also amended the Bank Holding

Company Act (BHC Act) to permit BHCs and

foreign banks that qualify as ﬁnancial holding

companies (FHCs) to engage in merchant bank-

ing and insurance company investment activi-

ties.

If an FHC owns or controls more than

25 percent of a class of voting shares of a

company under the merchant banking or insur-

ance company investment authority, the com-

pany is an afﬁliate of any member bank con-

trolled by the FHC by operation of the statutory

deﬁnitions contained in section 23A. The GLB

Act also added paragraph (b)(11) to sec-

tion 23A, which creates a rebuttable presump-

tion that a company (‘‘portfolio companies’’) is

an afﬁliate of a member bank, for purposes of

section 23A, if the bank is afﬁliated with an

FHC and the FHC owns or controls 15 percent

or more of the equity capital of the other com-

pany pursuant to the FHC’s merchant banking

or insurance company investment authority

(section 4(k)(4)(H) or (I) of the BHC Act). (See

12 U.S.C. 371c(b)(11).)

The rule also provides three speciﬁc regula-

tory safe harbors from the 15 percent presump-

tion. These safe harbors apply in situations

where the holding company owns or controls

more than 15 percent of the total equity of the

company under the merchant banking or insur-

ance company investment authority (thereby

triggering the statutory presumption) and less

than 25 percent of any class of voting securities

of the company (thereby not meeting the statu-

tory deﬁnition of control). The three situations

are substantially identical to those listed in the

Board’s merchant banking regulation.

The ﬁrst exemption applies where no director,

ofﬁcer, or employee of the holding company

serves as a director (or individual exercising

similar functions) of the company. The second

exemption applies where an independent third

party controls a greater percentage of the equity

capital of the company than is controlled by the

holding company, and no more than one ofﬁcer

or employee of the holding company serves as a

director (or individual exercising similar func-

tions) of the company. The third exemption

applies where an independent third party con-

trols more than 50 percent of the voting shares

of the company, and ofﬁcers and employees of

the holding company do not constitute a major-

ity of the directors (or individuals exercising

similar functions) of the company.

These safe harbors do not require Board

review or approval of the exclusion from afﬁli-

ate status. Moreover, the safe harbors are not

intended to be a complete list of circumstances

in which the 15 percent presumption may be

rebutted. The rule also provides, consistent with

the GLB Act, that a holding company may rebut

the presumption with respect to a portfolio com-

pany by presenting information to the Board

that demonstrates, to the Board’s satisfaction,

that the holding company does not control the

portfolio company. The Board notes that a com-

pany that qualiﬁes as an afﬁliate under the

15 percent presumption and under another prong

of the regulation’s deﬁnition of afﬁliate cannot

avoid afﬁliate status through a rebuttal of the

15 percent presumption (either by qualifying for

18. See 12 C.F.R. 265.3.

19. GLB Act, section 103(a); 12 U.S.C. 1843(k)(4)(H) and

(I).

20. GLB Act, section 121(b)(2). As noted above, this

rebuttable presumption applies only if the afﬁliated FHC

owns or controls 15 percent or more of the company’s equity

capital under the merchant banking or insurance company

investment authorities. The Board noted, however, that under

existing Board precedents, a BHC may not own any shares of

a company in reliance on section 4(c)(6) or 4(c)(7) of the

BHC Act where the holding company owns or controls, in the

aggregate under a combination of authorities, more than 5 per-

cent of any class of voting securities of the company.

21. See 12 C.F.R. 225.176(b)(2) and (3).

22. For purposes of these safe harbors, the rule provides

that the term ‘‘holding company’’ includes any subsidiary of

the holding company, including any subsidiary bank of the

holding company. Accordingly, if a director of a subsidiary

bank or nonbank subsidiary of an FHC also serves as a

director of a portfolio company, the ﬁrst safe harbor, for

example, would be unavailable.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 6

one of the three regulatory safe harbors or by

obtaining an ad hoc rebuttal of the presumption

from the Board).

An FHC generally is considered to own or

control only those shares or other ownership

interests that are owned or controlled by itself or

by a subsidiary of the holding company. The

rule clariﬁes that, for purposes of applying the

presumption of afﬁliation described above, an

FHC that has an investment in a private equity

fund (as deﬁned in the Board’s merchant bank-

ing rule) will not be considered indirectly to

own the equity capital of a company in which

the fund has invested unless the FHC controls

the private equity fund (as described in the

Board’s merchant banking rule).

2020.1.1.2.7 Companies that are not

Afﬁliates

Under the terms of section 23A, subsidiaries of

an IDI generally are not treated as afﬁliates of

the member bank.

The statute contains two

speciﬁc exceptions to this general rule: ﬁnan-

cial subsidiaries of an IDI and IDI subsidiaries

of an IDI are treated as afﬁliates of the parent

IDI. The statute provides that the Board may

determine that other subsidiaries of an IDI

should be treated as afﬁliates in appropriate

circumstances.

Under section 223.2(b)(1)(iii) of the rule, cer-

tain joint venture subsidiary companies of an

IDI are treated as afﬁliates. A subsidiary of an

IDI is treated as an afﬁliate if one or more

afﬁliates of the IDI, or one or more controlling

shareholders of the IDI, directly control the joint

venture. For example, if an IDI controls 30 per-

cent of company A and an afﬁliate controls

70 percent of Company A, then Company A is

an afﬁliate. This provision also covers situations

in which a controlling natural-person share-

holder or group of controlling natural-person

shareholders of the IDI (who, as natural per-

sons, are not themselves section 23A afﬁliates

of the IDI) exercise direct control over the joint

venture company. The rule’s treatment of cer-

tain IDI-afﬁliate joint ventures as afﬁliates does

not apply to joint ventures between an IDI and

any afﬁliated IDIs. For example, if two afﬁliated

IDIs each own 50 percent of the voting common

stock of a company, the company would con-

tinue to qualify as a subsidiary and not an afﬁli-

ate of each IDI (despite the fact that an afﬁliate

of each IDI owned more than 25 percent of a

class of voting securities of the company). The

Board has retained its authority to treat such

joint ventures as afﬁliates under section 23A on

a case-by-case basis.

2020.1.1.2.8 Employee Beneﬁt Plans

Regulation W clariﬁes, under section

223.2(b)(1)(iv), that an employee stock option

plan (ESOP), of an IDI or an afﬁliate of the IDI

cannot itself avoid classiﬁcation as an afﬁliate

of the member bank by also qualifying as a

subsidiary of the member bank. Many, but not

all, ESOPs, trusts, or similar entities that exist to

beneﬁt shareholders, members, ofﬁcers, direc-

tors, or employees of an IDI or its afﬁliates are

treated as afﬁliates of the IDI for purposes of

sections 23A and 23B. The ESOP’s share own-

ership or the interlocking management between

the ESOP and its associated IDI (or BHC), in

many cases, exceeds the statutory thresholds for

determining that a company is an afﬁliate. For

example, if an ESOP controls more than 25 per-

cent of the voting shares of the member bank or

bank holding company, the ESOP is an afﬁliate.

The relationship between an IDI and its (or

its) afﬁliate’s ESOP generally warrants cover-

age by sections 23A and 23B. IDIs have made

unsecured loans to their ESOPs or their afﬁli-

ates’ ESOP or have guaranteed loans to such

ESOPs that were made by a third party. These

ESOPs, however, generally have no means to

repay the loans other than with funds provided

by the IDI. In addition, even if the ESOP’s

ownership control does not warrant treatment as

an afﬁliate, the issuance of holding company

shares to an ESOP that is funded by a loan from

the holding company’s subsidiary IDI could be

used as a vehicle by the IDI to provide funds to

its parent holding company when the IDI is

unable to pay dividends or is otherwise

restricted in providing funds to its holding com-

pany. The attribution rule (12 C.F.R. 223.16)

subjects such transactions to the restrictions of

sections 23A and 23B.

23. See 12 U.S.C. 371c(b)(1)(A) and (b)(2)(A). Section

23A deﬁnes a subsidiary of a speciﬁed company as a com-

pany that is controlled by the speciﬁed company. Under the

statute, a company controls another company if the ﬁrst

company owns or controls 25 percent or more of a class of

voting securities of the other company, controls the election of

a majority of the directors of the other company, or exercises

a controlling inﬂuence over the policies of the other company

(12 U.S.C. 371c(b)(3) and (4)).

24. 12 U.S.C. 371c(b)(2)(A).

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BHC Supervision Manual July 2014

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2020.1.2 QUANTITATIVE LIMITS

Section 23A(a)(1)(A) states that an IDI may

engage in a covered transaction with an afﬁliate

only if in the case of any afﬁliate

1. the IDI limits the aggregate amount of cov-

ered transactions to that particular afﬁliate to

not more than 10 percent of the IDI’s capital

stock and surplus and

2. the IDI limits the aggregate amount of all

covered transactions with all of its afﬁliates

to 20 percent of the IDI’s capital stock and

surplus.

The rule’s interpretation of the 10 percent limit

is consistent with the statutory language.

IDI that has crossed the 10 percent threshold

with one afﬁliate may still conduct additional

covered transactions with other afﬁliates, if

transactions with all afﬁliates would not exceed

20 percent of the IDI’s capital stock and surplus.

An IDI is prohibited from engaging in a new

covered transaction with that afﬁliate if the IDI’s

transactions would exceed the 10 percent thresh-

old with that afﬁliate or if the level of covered

transactions with all its afﬁliates exceeded the

20 percent threshold. The rule generally does

not require an IDI to unwind existing covered

transactions if the member bank exceeds the

10 percent or 20 percent limit because its capital

declined or a preexisting covered transaction

increased in value.

The Board strongly encourages IDIs with

covered transactions in excess of the 10 percent

threshold with any afﬁliate to reduce those trans-

actions before expanding the scope or extent of

the member bank’s relationships with other

afﬁliates.

2020.1.3 CAPITAL STOCK AND

SURPLUS

Under section 23A, the quantitative limits on

covered transactions are based on the ‘‘capital

stock and surplus’’ of the IDI. An IDI’s capital

stock and surplus for purposes of section 23A of

the FRA is—

1. the sum of tier 1 and tier 2 capital included in

an institution’s risk-based capital under the

capital guidelines of the appropriate federal

banking agency, based on the institution’s

most recent consolidated FFIEC Reports of

Condition and Income (Call Report) ﬁled

under 12 U.S.C. 1817(a)(3);

2. the balance of an institution’s allowance for

loan and lease losses not included in its tier 2

capital for purposes of the calculation of

risk-based capital by the appropriate federal

banking agency (based on the institution’s

most recent consolidated Call Report of Con-

dition and Income that is ﬁled under

12 U.S.C. 1817(a)(3)); and

3. the amount of any investment in a ﬁnancial

subsidiary that counts as a covered transac-

tion that is required to be deducted from the

IDI’s regulatory capital.

Examiners can determine the amount of the

quantitative limits.

2020.1.3.1 Determination of Control

The deﬁnition of ‘‘control’’ is similar to the

deﬁnition used in the BHC Act. Under the rule,

a company or shareholder shall be deemed to

have control over another company if—

• such company or shareholder, directly or indi-

rectly, or acting through one or more other

persons, owns, controls, or has power to vote

25 percent or more of any class of voting

securities of the other company;

• such company or shareholder controls in any

manner the election of a majority of the direc-

tors or trustees (or general partners or indi-

viduals exercising similar functions), of the

other company; or

• the Board determines, after notice and oppor-

tunity for hearing, that such company or

shareholder, directly or indirectly, exercises a

controlling inﬂuence over the management or

policies of the other company.

In addition, three additional presumptions of

control are provided under the rule. First, a

company will be deemed to control securities,

assets, or other ownership interests controlled

by any subsidiary of the company.

Second, a

company that controls instruments (including

options and warrants) that are convertible or

exercisable, at the option of the holder or owner,

25. Sections 223.11 and 223.12 of the rule set forth these

quantitative limits.

26. See section 223.3(d) of the rule (12 C.F.R. 223.3(d)).

27. Examiners should refer to the IDI’s most recent Call

Report.

28. See section 223.3(g) of the rule (12 C.F.R. 223.3(g)).

29. See 12 C.F.R. 225.2(e)(2)(i).

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BHC Supervision Manual July 2014

Page 8

into securities, will be deemed to control the

securities.

Third, a rebuttable presumption

provides that a company or shareholder that

owns or controls 25 percent or more of the

equity capital of another company controls the

other company, unless the company or share-

holder demonstrates otherwise to the Board

based on the facts and circumstances of the

particular case.

Such a presumption of control

is particularly appropriate in the section 23A

context because a BHC may have incentives to

divert the resources of a subsidiary IDI to any

company in which the holding company has a

substantial ﬁnancial interest, regardless of

whether the holding company owns any voting

securities of the company.

Section 23A and the rule provide that no

company shall be deemed to own or control

another company by virtue of its ownership or

control of shares in a ﬁduciary capacity except

(1) when a company that is controlled, directly

or indirectly, by a trust for the beneﬁt of share-

holders who beneﬁcially or otherwise control,

directly or indirectly, a member bank, or (2) if

the company owning or controlling such shares

is a business trust.

2020.1.4 COVERED TRANSACTIONS

The restrictions of section 23A do not apply to

every transaction between an IDI and its afﬁli-

ates; section 23A only applies to seven ‘‘cov-

ered transactions’’ between an IDI and its afﬁli-

ates.

A covered transaction under section 23A of

the FRA means—

1. a loan or extension of credit by an IDI to an

afﬁliate;

2. a purchase of, or an investment in, the securi-

ties issued by an afﬁliate of an IDI including

a purchase of assets subject to an agreement

to repurchase;

3. an IDI’s purchase of assets from an afﬁliate,

except for purchases of real and personal

property as may be speciﬁcally exempted by

the Board by order or regulation;

4. the acceptance by an IDI of securities or

other debt obligations issued by an afﬁliate

as collateral security for a loan or extension

of credit by the member bank to any person

or company;

5. the issuance by an IDI of a guarantee, accep-

tance, or letter of credit, including an

endorsement or standby letter of credit, on

behalf of an afﬁliate.

6. a transaction with an afﬁliate that involves

the borrowing or lending of securities, to the

extent that the transaction causes an IDI or a

subsidiary to have credit exposure to the

afﬁliate; or

7. a derivative transaction, as deﬁned in 12

U.S.C. 84(b), with an afﬁliate, to the extent

that the transaction causes an IDI or a subsid-

iary to have credit exposure to the afﬁliate.

If a transaction between an IDI and an afﬁliate is

not within one of the above categories, it is not a

covered transaction for the purposes of sec-

tion 23A and is not subject to its limitations. All

covered transactions must be made on terms and

conditions that are consistent with safe and

sound banking practices.

Among the transactions that generally are not

subject to section 23A are dividends paid by an

IDI to its holding company, sales of assets by an

IDI to an afﬁliate for cash, an afﬁliate’s pur-

chase of securities issued by an IDI, and many

service contracts between an IDI and an afﬁli-

ate.

Certain classes of transactions between a

member bank and an afﬁliate are discussed

below as to whether they are covered transac-

tions for purposes of section 23A. (See sec-

tion 223.3(h).)

2020.1.4.1 Attribution Rule

The ‘‘attribution rule,’’ found in section 223.16,

prevents an IDI from evading its restrictions of

30. See 12 C.F.R. 225.31(d)(1)(i). The rule refers more

generically to convertible ‘‘instruments.’’ It clariﬁes that the

convertibility presumption applies regardless of whether the

right to convert resides in a ﬁnancial instrument that techni-

cally qualiﬁes as a ‘‘security’’ under section 23A or the

federal securities laws.

31. See, for example, 12 C.F.R. 225.143 (Board Policy

Statement on Equity Investments in Banks and Bank Holding

Companies).

32. 12 U.S.C. 371c(b)(7).

33. The investment by an IDI or its afﬁliate in a ﬁnancial

subsidiary of the bank excludes the retained earnings of the

ﬁnancial subsidiary.

34. The acceptance of an afﬁliate’s securities for a loan

when proceeds are transferred to, or used for the beneﬁt of, an

afﬁliate is prohibited. (See section 223.3(h)(2).)

35. Board staff has taken the position that safety and

soundness requires that the transaction be conducted on mar-

ket terms.

36. A transaction when an IDI receives assets from an

afﬁliate and the IDI pays a dividend or returns capital to an

afﬁliate may result in a purchase of assets for the purposes of

section 23A. Although these transactions are not subject to

section 23A, they may be subject to section 23B or other laws.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 9

section 23A by using intermediaries, and it lim-

its the exposure that an IDI has to customers of

afﬁliates of the IDI. Section 223.16 provides

that any covered transaction by an IDI or its

subsidiary with any person is deemed to be a

transaction with an afﬁliate of the IDI if any of

the proceeds of the transaction are used for the

beneﬁt of, or are transferred to, the afﬁliate. For

example, an IDI’s loan to a customer for the

purpose of purchasing securities from the inven-

tory of a broker-dealer afﬁliate of the member

bank would be a covered transaction under sec-

tion 23A.

2020.1.4.2 Credit Transactions with an

Afﬁliate

2020.1.4.2.1 Extension of Credit to an

Afﬁliate or Other Credit Transaction with

an Afﬁliate

Section 23A includes a ‘‘loan or extension of

credit’’ to an afﬁliate as a covered transaction,

but does not deﬁne these terms. Section 223.3(o)

of the rule deﬁnes ‘‘extension of credit’’ to an

afﬁliate to mean the making or renewal of a loan

to an afﬁliate, the granting of a line of credit to

an afﬁliate, or the extending of credit to an

afﬁliate in any manner whatsoever, including on

an intraday basis. Transactions that are deﬁned

as extensions of credit include but are not lim-

ited to the following:

1. an advance to an afﬁliate by means of an

overdraft, cash item, or otherwise;

2. a sale of federal funds to an afﬁliate;

3. a lease that is the functional equivalent of an

extension of credit to an afﬁliate;

4. an acquisition by purchase, discount,

exchange, or otherwise of a note or other

obligation, including commercial paper or

other debt securities, of an afﬁliate;

5. any increase in the amount of, extension of

the maturity of, or adjustment to the interest-

rate term or other material term of, an exten-

sion of credit to an afﬁliate;

and

6. any other similar transaction as a result of

which an afﬁliate becomes obligated to pay

money (or its equivalent) to an IDI.

An IDI’s purchase of a debt security issued

by an afﬁliate is an extension of credit by the

IDI to the afﬁliate for purposes of section 23A

under the rule. An IDI that buys debt securities

issued by an afﬁliate has made an extension of

credit to an afﬁliate under section 23A and must

collateralize the transaction in accordance with

the collateral requirements of section 23A. An

exemption from the collateral requirements is

provided for situations in which an IDI pur-

chases an afﬁliate’s debt securities from a third

party in a bona ﬁde secondary-market

transaction.

2020.1.4.2.2 Valuation of Credit

Transactions with an Afﬁliate

A credit transaction between an IDI and an

afﬁliate initially must be valued at the amount of

funds provided by the IDI to, or on behalf of,

the afﬁliate plus any additional amount that the

IDI could be required to provide to, or on behalf

of, the afﬁliate. The section 23A value of a

credit transaction between an IDI and an afﬁli-

ate is the greater of (1) the principal amount of

the credit transaction; (2) the amount owed by

the afﬁliate to the member bank under the credit

transaction; or (3) the sum of (a) the amount

provided to, or on behalf of, the afﬁliate in the

transaction and (b) any additional amount that

the member bank could be required to provide

to, or on behalf of, the afﬁliate under the terms

of the member transaction. (See 223.21)

The ﬁrst prong of the rule’s valuation formula

for credit transactions (‘‘the principal amount of

the credit transaction’’) would likely determine

the valuation of a transaction in which an IDI

purchased a zero-coupon note issued by an

afﬁliate. An IDI should value such an extension

of credit at the principal, or face amount of the

note (that is, at the amount that the afﬁliate

ultimately must pay to the IDI) rather than at the

amount of funds initially advanced by the IDI.

For example, assume an IDI purchased from an

37. The Board would consider a full-payout, net lease

permissible for a national bank under 12 U.S.C. 24 (seventh)

and 12 C.F.R. 23 to be the functional equivalent of an exten-

sion of credit.

38. A ﬂoating-rate loan does not become a new covered

transaction whenever there is a change in the relevant index

(for example, LIBOR or the member bank’s prime rate) from

which the loan’s interest rate is calculated. If the member

bank and the borrower, however, amend the loan agreement to

change the interest-rate term from ‘‘LIBOR plus 100 basis

points’’ to ‘‘LIBOR plus 150 basis points,’’ the parties have

engaged in a new covered transaction.

39. The deﬁnition of extension of credit would cover,

among other things, situations in which an afﬁliate fails to pay

on a timely basis for services rendered to the afﬁliate by the

IDI or the afﬁliate fails to pay a tax refund to the IDI.

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BHC Supervision Manual July 2014

Page 10

afﬁliate for $50 a 10-year zero-coupon note

issued by the afﬁliate with a face amount of

$100. The rule’s valuation formula requires the

IDI to value this transaction at $100.

The second prong of the rule’s valuation for-

mula for credit transactions (‘‘the amount owed

by the afﬁliate’’) likely would determine the

valuation of a transaction in which an afﬁliate

fails to pay an IDI when due a fee for services

rendered by the IDI to the afﬁliate. This prong

of the valuation formula does not include

(within section 23A’s quantitative limits) items

such as accrued interest not yet due on an IDI’s

loan to an afﬁliate.

IDIs will be able to determine the section 23A

value for most credit transactions under the third

prong of the rule’s valuation formula. Under

this prong, for example, a $100 term loan is a

$100 covered transaction, a $300 revolving

credit facility is a $300 covered transaction

(regardless of how much of the facility the

afﬁliate has drawn down), and a guarantee back-

stopping a $500 debt issuance of the afﬁliate is a

$500 covered transaction.

Under section 23A and the rule, a member

bank has made an extension of credit to an

afﬁliate if the IDI purchases from a third party a

loan previously made to an afﬁliate of the IDI.

A different valuation formula is provided for

these indirect credit transactions: The IDI must

value the transaction at the price paid by the IDI

for the loan plus any additional amount that the

IDI could be required to provide to, or on behalf

of, the afﬁliate under the terms of the credit

agreement.

For example, if an IDI pays a third party $90

for a $100 term loan that the third party previ-

ously made to an afﬁliate of the IDI (because,

for example, the loan was at a ﬁxed rate and has

declined in value because of a rise in the general

level of interest rates), the covered-transaction

amount is $90 rather than $100. The lower

covered-transaction amount reﬂects the fact that

the IDI’s maximum loss on the transaction is

$90 rather than the original principal amount of

the loan. For another example, if an IDI pays a

third party $70 for a $100 line of credit to an

afﬁliate, of which $70 had been drawn down by

the afﬁliate, the covered-transaction amount

would be $100 (the $70 purchase price paid by

the IDI for the credit plus the remaining $30 that

the IDI could be required to lend under the

credit line).

In another example, an IDI makes a term loan

to an afﬁliate that has a principal amount of

$100. The afﬁliate pays $2 in up-front fees to

the member bank, and the afﬁliate receives net

loan proceeds of $98. The IDI must initially

value the covered transaction at $100.

Although the rule considers an IDI’s purchase

of, or investment in, a debt security issued by an

afﬁliate as an extension of credit to an afﬁliate,

these transactions are not valued like other

extensions of credit. See section 223.23 for the

valuation rules for purchases of, and invest-

ments in, the debt securities of an afﬁliate.

2020.1.4.2.3 Timing of a Credit

Transaction with an Afﬁliate

An IDI has entered into a credit transaction with

an afﬁliate at the time during the day that the

IDI becomes legally obligated to make the

extension of credit to, or issue the guarantee,

acceptance, or letter of credit on behalf of, the

afﬁliate. A covered transaction occurs at the

moment that the IDI executes a legally valid,

binding, and enforceable credit agreement or

guarantee and does not occur only when an IDI

funds a credit facility or makes payment on a

guarantee. Consistent with section 23A, the rule

only requires an IDI to compute compliance

with its quantitative limits when the IDI is about

to engage in a new covered transaction. The rule

does not require an IDI to compute compliance

with the rule’s quantitative limits on a continu-

ous basis. See section 223.21(b)(1) of the rule.

The burden of the timing rule is mitigated

signiﬁcantly by the exemption for intraday

extensions of credit found in section 223.42(l).

The intraday credit exemption generally applies

only to extensions of credit that an IDI expects

to be repaid, sold, or terminated by the end of its

U.S. business day. The IDI must have policies

and procedures to manage and minimize the

credit exposure. Any such extension of credit

that is outstanding at the end of the IDI’s busi-

ness day must be treated as an extension of

credit and must meet the regulatory quantitative

and collateral requirements.

2020.1.4.2.4 Leases

Lease transactions that constitute the functional

equivalent of a loan or an extension of credit may

be subject to section 23A. Such lease

arrangements, in effect, are equivalent to a loan

by the IDI and are essentially ﬁnancing

arrangements. Some of the characteristics that

would normally cause a lease to be construed as

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BHC Supervision Manual July 2014

Page 11

a loan equivalent include the lessee’s having

responsibility for the servicing, maintenance,

insurance, licensing, or risk of loss or damage,

and the lessee’s having the option to purchase the

equipment.

2020.1.4.2.5 Extensions of Credit Secured

by Afﬁliate Securities—General Valuation

Rule (Section 223.24(a) and (b))

Section 23A deﬁnes as a covered transaction an

IDI’s acceptance of securities issued by an afﬁli-

ate as collateral for a loan or extension of credit

to any person or company.

This type of cov-

ered transaction has two classes: one in which

the only collateral for the loan is solely afﬁliate

securities and another in which the loan is

secured by a combination of afﬁliate securities

and other collateral.

40a

Under the rule, if the credit extension is

secured exclusively by afﬁliate securities, then

the transaction is valued at the full amount of

the extension of credit. This approach reﬂects

the difﬁculty of measuring the actual value of

typically untraded and illiquid afﬁliate securities

and conservatively assumes that the value of the

securities is equal to the full value of the loan

that the securities collateralize. An exception is

provided to the general rule when the afﬁliate

securities held as collateral have a ready market

(as deﬁned by section 223.42 of the rule). In that

case, the transaction may be valued at the fair

market value of the afﬁliate securities. The

exception grants relief in those circumstances

when the value of the afﬁliate securities is inde-

pendently veriﬁable by reference to transactions

occurring in a liquid market.

Covered transactions of the second class, in

which the credit extension is secured by afﬁliate

securities and other collateral, are valued at the

lesser of (1) the total value of the extension of

credit minus the fair market value of the other

collateral or (2) the fair market value of the

afﬁliate securities (if the securities have a ready

market). The rule’s ready-market requirement

applies regardless of the amount of afﬁliate

collateral.

2020.1.4.2.6 Extensions of Credit Secured

by Afﬁliate Securities—Mutual Fund

Section 23A(b)(7)(D) of the FRA deﬁnes as a

covered transaction a member bank’s accep-

tance of securities issued by an afﬁliate as collat-

eral security for a loan or extension of credit to

any person or company.

Section 223.24(c) of the rule provides an

exemption for extensions of credit by a member

bank that are secured by shares of an afﬁliated

mutual fund. To qualify for the exemption, the

transaction must meet several conditions. First,

to ensure that the afﬁliate collateral is liquid and

trades at a fair price, the afﬁliated mutual fund

must be an open-end investment company that

is registered with the SEC under the 1940 Act.

Second, to ensure that the IDI can easily estab-

lish and monitor the value of the afﬁliate collat-

eral, the afﬁliated mutual fund’s shares serving

as collateral for the extension of credit must

have a publicly available market price. Third, to

reduce the IDI’s incentives to use these exten-

sions of credit as a mechanism to support the

afﬁliated mutual fund, the IDI and its afﬁliates

must not own more than 5 percent of the fund’s

shares (excluding certain shares held in a ﬁdu-

ciary capacity). Finally, the proceeds of the

extension of credit must not be used to purchase

the afﬁliated mutual fund’s shares serving as

collateral or otherwise used to beneﬁt an afﬁli-

ate. In such circumstances, the IDI’s extension

of credit would be covered by section 23A’s

attribution rule. For example, an IDI proposes to

lend $100 to a nonafﬁliate secured exclusively

by eligible afﬁliated mutual fund securities. The

IDI knows that the nonafﬁliate intends to use all

the loan proceeds to purchase the eligible afﬁli-

ated mutual fund securities that would serve as

collateral for the loan. Under the attribution rule

40. See 12 U.S.C. 371c(b)(7)(D). This covered transaction

only arises when the member bank’s loan is to a nonafﬁliate.

Under section 23A, the securities issued by an afﬁliate are not

acceptable collateral for a loan or extension of credit to any

afﬁliate. (See 12 U.S.C. 371(c)(4)) If the proceeds of a loan

that is secured by an afﬁliate’s securities are transferred to an

afﬁliate by the unafﬁliated borrower (for example, to purchase

assets or securities from the inventory of an afﬁliate), the loan

should be treated as a loan to the afﬁliate and the afﬁliates

securities cannot be used to meet the collateral requirements

of sections 23A. The loan must then be secured with other

collateral in an amount and of a type that meets the require-

ments of section 23A for loans by an IDI to an afﬁliate.

40a. The securities issued by an afﬁliate cannot be used as

collateral for a loan to any afﬁliate (12 U.S.C. 371c (c)(4)).

41. In either case, the transaction must comply with sec-

tion 23B; that is, the IDI must obtain the same amount of

afﬁliate securities as collateral on the credit extension that the

IDI would obtain if the collateral were not afﬁliate securities.

42. Under the rule, an IDI may use the higher of the two

valuation options for these transactions if, for example, the

IDI does not have the procedures and systems in place to

verify the fair market value of afﬁliate securities.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 12

in section 223.16, the IDI must treat the loan to

the nonafﬁliate as a loan to an afﬁliate, and

because securities issued by an afﬁliate are ineli-

gible collateral under section 223.14, the loan

would not be in compliance with section 223.14.

2020.1.4.3 Asset Purchases

2020.1.4.3.1 Purchase of Assets under

Regulation W

Regulation W provides that a purchase of assets

by an IDI from an afﬁliate initially must be

valued at the total amount of consideration

given by the IDI in exchange for the asset. (See

section 223.22.) This consideration can take any

form and includes an assumption of liabilities

by the IDI. An assumption of liabilities can

include a mortgage, other debt obligations, or

the cost associated with the transfer of employ-

ees, such as pension obligations, bonuses, or

accrued vacation.

Asset purchases are a covered transaction for

an IDI for as long as the IDI holds the asset. The

value of the covered transaction after the pur-

chase may be reduced to reﬂect amortization or

depreciation of the asset, to the extent that such

reductions are consistent with GAAP and are

reﬂected on the IDI’s ﬁnancial statements.

Certain asset purchases by an IDI from an

afﬁliate are not valued in accordance with the

general asset-purchase valuation formula. First,

if the IDI buys from one afﬁliate a loan made to

a second afﬁliate, the IDI must value the trans-

action as a credit transaction with the second

afﬁliate under section 223.21. Second, if the IDI

buys from one afﬁliate a security issued by a

second afﬁliate, the IDI must value the transac-

tion as an investment in securities issued by the

second afﬁliate under section 223.23. Third, if

the IDI acquires the shares of an afﬁliate that

becomes an operating subsidiary of the IDI after

the acquisition, the IDI must value the transac-

tion under section 223.31.

A special valuation rule applies to an IDI’s

purchase of a line of credit or loan commitment

from an afﬁliate. An IDI initially must value

such asset purchases at the purchase price paid

by the IDI for the asset plus any additional

amounts that the IDI is obligated to provide

under the credit facility.

This special valuation

rule ensures that there are limits on the amount

of risk a company can shift to an afﬁliated IDI.

Section 23A(d)(6) provides an exemption for

purchasing assets having a readily identiﬁable

and publically available market quotation. Sec-

tion 224.42(e) of the rule codiﬁed this exemp-

tion. Section 223.42(f) expands the statutory

(d)(6) exemption to allow an IDI to purchase

securities from an afﬁliate based on price quotes

obtained from certain electronic screens so long

as, among other things, (1) the selling afﬁliate is

a broker-dealer registered with the SEC, (2) the

securities are traded in a ready market and eli-

gible for purchase by state IDIs, (3) the securi-

ties are not purchased within 30 days of an

underwriting (if an afﬁliate of the IDI is an

underwriter of the securities), and (4) the securi-

ties are not issued by an afﬁliate. See sec-

tion 2020.1.10.2 for a further discussion of this

exemption.

In contrast with credit transactions, an asset

purchase from a nonafﬁliate that later becomes

an afﬁliate generally does not become a cov-

ered transaction for the purchasing IDI. How-

ever, if an IDI purchases assets from a nonaf-

ﬁliate in contemplation that the nonafﬁliate will

become an afﬁliate of the IDI, the asset pur-

chase becomes a covered transaction at the

time the nonafﬁliate becomes an afﬁliate. In

addition, the IDI must ensure that the aggregate

amount of the IDI’s covered transactions

(including any such asset purchase from the

nonafﬁliate) would not exceed the quantitative

limits of section 23A at the time the nonafﬁli-

ate becomes an afﬁliate.

The following examples are provided to assist

IDIs in valuing purchases of assets from an

afﬁliate. An IDI’s receipt of an encumbered

asset from an afﬁliate ceases to be a covered

transaction when, for example, the IDI sells the

asset.

• Cash purchase of assets. An IDI purchases a

pool of loans from an afﬁliate for $10 million.

The IDI initially must value the covered trans-

action at $10 million. Going forward, if the

borrowers repay $6 million of the principal

amount of the loans, the IDI may value the

covered transaction at $4 million.

• Purchase of assets through an assumption of

liabilities. An afﬁliate of an IDI contributes

43. A member bank would not be required to include

unfunded, but committed, amounts in the value of the covered

transaction if (1) the credit facility being transferred from the

afﬁliate to the bank is unconditionally cancelable (without

cause) at any time by the IDI and (2) the IDI makes a separate

credit decision before each drawing under the facility (see

12 C.F.R. 223.22).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 13

real property with a fair market value of

$200,000 to the IDI. The IDI pays the afﬁliate

no cash for the property, but assumes a

$50,000 mortgage on the property. The IDI

has engaged in a covered transaction with the

afﬁliate and initially must value the transac-

tion at $50,000. Going forward, if the IDI

retains the real property but pays off the mort-

gage, the IDI must continue to value the cov-

ered transaction at $50,000. If the IDI, how-

ever, sells the real property, the transaction

ceases to be a covered transaction at the time

of the sale (regardless of the status of the

mortgage).

2020.1.4.3.2 IDI’s Purchase of

Securities Issued by an Afﬁliate

Section 23A includes as a covered transaction

an IDI’s purchase of, or investment in, securi-

ties issued by an afﬁliate. Section 223.23 of the

rule requires an IDI to value a purchase of, or

investment in, securities issued by an afﬁliate

(other than a ﬁnancial subsidiary of the IDI) at

the greater of the IDI’s purchase price or carry-

ing value of the securities. An IDI that paid no

consideration in exchange for afﬁliate securities

has to value the covered transaction at no less

than the IDI’s carrying value of the securities. In

addition, if the IDI’s carrying value of the afﬁli-

ate securities increased or decreased after the

IDI’s initial investment (due to proﬁts or losses

at the afﬁliate), the amount of the IDI’s covered

transaction would increase or decrease to reﬂect

the IDI’s changing ﬁnancial exposure to the

afﬁliate. However, the amount of the IDI’s cov-

ered transaction cannot decline below the

amount paid by the IDI for the securities.

Several important considerations support the

general carrying-value approach of this valua-

tion rule. First, the approach would require an

IDI to reﬂect its investment in securities issued

by an afﬁliate at carrying value throughout the

life of the investment, even if the IDI paid no

consideration for the securities. Second, the

approach is supported by the terms of the stat-

ute, which deﬁnes both a ‘‘purchase of’’ and an

‘‘investment in’’ securities issued by an afﬁliate

as a covered transaction. The statute’s ‘‘invest-

ment in’’ language indicates that Congress was

concerned with an IDI’s continuing exposure to

an afﬁliate through an ongoing investment in the

afﬁliate’s securities.

Third, GLB Act amendments to section 23A

supported the approach. The GLB Act deﬁned a

ﬁnancial subsidiary of an IDI as an afﬁliate of

the IDI, but speciﬁcally provides that the sec-

tion 23A value of an IDI’s investment in securi-

ties issued by a ﬁnancial subsidiary did not

include retained earnings of the subsidiary. The

negative implication from this provision is that

the section 23A value of an IDI’s investment in

other afﬁliates includes the afﬁliates’ retained

earnings, which would be reﬂected in the IDI’s

carrying value of the investment under the rule.

Finally, the carrying-value approach is

consistent with the purposes of section 23A—

imiting the ﬁnancial exposure of IDIs to their

afﬁliates and promoting safety and soundness.

The valuation rule requires an IDI to revalue

upwards the amount of an investment in afﬁli-

ate securities only when the IDI’s exposure to

the afﬁliate increases (as reﬂected on the IDI’s

ﬁnancial statements) and the IDI’s capital

increases to reﬂect the higher value of the

investment. In these circumstances, the valua-

tion rule merely reﬂects the IDI’s greater ﬁnan-

cial exposure to the afﬁliate and enhances safety

and soundness by reducing the IDI’s ability to

engage in additional transactions with an afﬁli-

ate as the IDI’s exposure to that afﬁliate

increases.

The valuation rule also provides that the

covered-transaction amount of an IDI’s invest-

ment in afﬁliate securities can be no less than

the purchase price paid by the IDI for the

securities, even if the carrying value of the

securities declines below the purchase price.

This aspect of the valuation rule uses the IDI’s

purchase price for the securities as a ﬂoor for

valuing the covered transaction. First, it ensures

that the amount of the covered transaction never

falls below the amount of funds actually

transferred by the IDI to the afﬁliate in connec-

tion with the investment. In addition, the

purchase-price ﬂoor limits the ability of an IDI

to provide additional funding to an afﬁliate as

the afﬁliate approaches insolvency. If invest-

ments in securities issued by an afﬁliate were

valued strictly at carrying value, then the IDI

could lend more funds to the afﬁliate as the af-

ﬁliate’s ﬁnancial condition worsened. As the af-

ﬁliate declined, the IDI’s carrying value of the

afﬁliate’s securities would decline, the sec-

tion 23A value of the IDI’s investment likely

would decline, and, consequently, the IDI would

be able to provide additional funding to the

afﬁliate under section 23A. This type of increas-

ing support for an afﬁliate in distress is what

section 23A was intended to restrict.

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BHC Supervision Manual July 2014

Page 14

The following examples are designed to assist

IDIs in valuing purchases of, and investments

in, securities issued by an afﬁliate:

• Purchase of the debt securities of an afﬁliate.

The parent holding company of an IDI owns

100 percent of the shares of a mortgage com-

pany. The IDI purchases debt securities issued

by the mortgage company for $600. The ini-

tial carrying value of the securities is $600.

The IDI initially must value the investment at

$600.

• Purchase of the shares of an afﬁliate. The

parent holding company of an IDI owns

51 percent of the shares of a mortgage com-

pany. The IDI purchases an additional 30 per-

cent of the shares of the mortgage company

from a third party for $100. The initial carry-

ing value of the shares is $100. The IDI

initially must value the investment at $100.

Going forward, if the IDI’s carrying value of

the shares declines to $40, the IDI must con-

tinue to value the investment at $100.

• Contribution of the shares of an afﬁliate. The

parent holding company of an IDI owns

100 percent of the shares of a mortgage com-

pany and contributes 30 percent of the shares

to the IDI. The IDI gives no consideration in

exchange for the shares. If the initial carrying

value of the shares is $300, then the IDI

initially must value the investment at $300.

Going forward, if the IDI’s carrying value of

the shares increases to $500, the IDI must

value the investment at $500.

2020.1.4.5 Issuance of a Letter of Credit

or Guarantee

2020.1.4.5.1 Conﬁrmation of a Letter of

Credit Issued by an Afﬁliate

Section 23A includes as a covered transaction

the issuance by an IDI of a letter of credit on

behalf of an afﬁliate, including the conﬁrmation

of a letter of credit issued by an afﬁliate as a

covered transaction. (See section 223.3(h)(5).)

When an IDI conﬁrms a letter of credit, it

assumes the risk of the underlying transaction to

the same extent as if it had issued the letter of

credit.

Accordingly, a conﬁrmation of a letter

of credit issued by an afﬁliate is treated in the

same fashion as an issuance of a letter of credit

on behalf of an afﬁliate.

2020.1.4.5.2 Credit Enhancements

Supporting a Securities Underwriting

The deﬁnition of guarantee in section 23A does

not include an IDI’s issuance of a guarantee in

support of securities issued by a third party and

underwritten by a securities afﬁliate of the IDI.

Such a credit enhancement would not be issued

‘‘on behalf of’’ the afﬁliate. Although the guar-

antee does provide some beneﬁt to the afﬁliate

(by facilitating the underwriting), this beneﬁt is

indirect. The proceeds of the guarantee would

not be transferred to the afﬁliate for purposes of

the attribution rule of section 23A.

Section

23B would apply to the transaction and, where

an afﬁliate was issuer as well as underwriter, the

transaction would be covered by section 23A

because the credit enhancement would be on

behalf of the afﬁliate.

2020.1.4.5.3 Cross-Guarantee

Agreements and Cross-Afﬁliate Netting

Arrangements

A cross-guarantee agreement among an IDI, an

afﬁliate, and a nonafﬁliate in which the nonafﬁli-

ate may use the IDI’s assets to satisfy the obliga-

tions of a defaulting afﬁliate is a guarantee for

purposes of section 23A. The cross-guarantee

arrangements among IDIs and their afﬁliates are

subject to the quantitative limits and collateral

requirements of section 23A. (See sec-

tion 223.3(h)(5).)

As for cross-afﬁliate netting arrangements

(CANAs), such arrangements involve an IDI,

one or more afﬁliates of the IDI, and one or

more nonafﬁliates of the IDI, where a nonafﬁli-

ate is permitted to deduct obligations of an

afﬁliate of the IDI to the nonafﬁliate when set-

tling the nonafﬁliate’s obligations to the IDI.

These arrangements also would include agree-

ments in which an IDI is required or permitted

to add the obligations of an afﬁliate of the IDI to

a nonafﬁliate when determining the IDI’s obli-

gations to the nonafﬁliate. These types of

CANAs expose an IDI to the credit risk of its

afﬁliates because the IDI may become liable for

the obligations of its afﬁliates. Because the

exposure of an IDI to an afﬁliate in such an

arrangement resembles closely the exposure of

an IDI when it issues a guarantee on behalf of

44. See UCC 5-107(2).

45. See 62 Fed. Reg. 45295, August 27, 1997.

46. See 12 U.S.C. 371c(a)(2).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 15

an afﬁliate, the rule explicitly includes such

arrangements in the deﬁnition of covered trans-

action. Accordingly, the quantitative limits of

section 23A would prohibit an IDI from enter-

ing into such a CANA to the extent that the

netting arrangement does not cap the potential

exposure of the IDI to the participating afﬁliate

(or afﬁliates).

2020.1.4.5.4 Keepwell Agreements

In a keepwell agreement between an IDI and an

afﬁliate, the IDI typically commits to maintain

the capital levels or solvency of the afﬁliate. The

credit risk incurred by the IDI in entering into

such a keepwell agreement is similar to the

credit risk incurred by an IDI in connection with

issuing a guarantee on behalf of an afﬁliate. As

a consequence, keepwell agreements generally

should be treated as guarantees for purposes of

section 23A and, if unlimited in amount, would

be prohibited by the quantitative limits of sec-

tion 23A.

2020.1.4.5.5 Prohibition on the Purchase

of Low-Quality Assets

Section 23A generally prohibits the purchase by

an IDI of a low-quality asset from an afﬁliate.

In addition, an IDI and its subsidiaries cannot

purchase or accept as collateral a low-quality

asset from an afﬁliate. Section 23A deﬁnes a

low-quality asset to include (1) an asset classi-

ﬁed as ‘‘substandard,’’ ‘‘doubtful,’’ or ‘‘loss,’’ or

treated as ‘‘other loans specially mentioned,’’ in

the most recent report of examination or inspec-

tion by a federal or state supervisory agency (a

‘‘classiﬁed asset‘‘), (2) an asset in nonaccrual

status, (3) an asset on which payments are more

than 30 days past due in the payment of princi-

pal or interest, or (4) an asset whose terms have

been renegotiated or compromised due to the

deteriorating ﬁnancial condition of the obligor.

Any asset meeting one of the above four crite-

ria, including securities and real property, is a

low-quality asset.

Regulation W expands the deﬁnition of low-

quality assets in several respects. (See 12 C.F.R.

223.3(v).) First an asset may be identiﬁed by

examiners as a low-quality asset if they repre-

sent credits to countries that are not complying

with their external debt-service obligations but

are taking positive steps to restore debt service

through economic adjustment measures, gener-

ally as part of an International Monetary Fund

Program. Although such assets may not be con-

sidered classiﬁed assets, examiners are to con-

sider these assets in their assessment of an IDI’s

asset quality and capital adequacy.

Second, the rule considers a ﬁnancial institu-

tion’s use of its own internal asset-classiﬁcation

systems. The rule includes within the deﬁnition

of low-quality asset not only assets classiﬁed

during the last examination but also assets clas-

siﬁed or treated as special mention under the

institution’s internal classiﬁcation system (or

assets that received an internal rating that is

substantially equivalent to classiﬁed or special

mention in such an internal system).

The purchase by an IDI from an afﬁliate of

assets that have been internally classiﬁed raises

potentially signiﬁcant safety-and-soundness

concerns. The Board expects companies with

internal rating systems to use the systems con-

sistently over time and over similar classes of

assets and will view as an evasion of sec-

tion 23A any company’s deferral or alteration of

an asset’s rating to facilitate sale of the asset to

an afﬁliated institution.

Finally, the rule deﬁnes low-quality asset to

include foreclosed property designated ‘‘other

real estate owned’’ (OREO), until it is reviewed

by an examiner and receives a favorable classi-

ﬁcation. It further deﬁnes as a low-quality asset

any asset (not just real estate) that is acquired in

satisfaction of a debt previously contracted (not

just through foreclosure) if the asset has not yet

been reviewed in an examination or inspection.

Under the rule, if a particular asset is good

collateral taken from a bad borrower, the asset

should cease to be a low-quality asset upon

examination.

Section 23A provides a limited exception to

the general rule prohibiting purchase of low-

quality assets if the IDI performs an indepen-

dent credit evaluation and commits to the pur-

chase of the asset before the afﬁliate acquires

the asset.

Section 223.15 of the rule also pro-

vides an exception from the prohibition on the

purchase by an IDI of a low-quality asset from

an afﬁliate for certain loan renewals. The rule

allows an IDI that purchased a loan participa-

tion from an afﬁliate to renew its participation in

the loan, or provide additional funding under the

existing participation, even if the underlying

47. 12 U.S.C. 371c(a)(3). Section 23A does not prohibit an

afﬁliate from donating a low-quality asset to a member bank,

so long as the bank provides no consideration for the asset and

no liabilities are associated with the asset.

48. 12 U.S.C. 371c(a)(3).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 16

loan had become a low-quality asset, so long as

certain criteria were met. These renewals or

additional credit extensions may enable both the

afﬁliate and the participating IDI to avoid or

minimize potential losses. The exception is

available only if (1) the underlying loan was not

a low-quality asset at the time the IDI purchased

its participation and (2) the proposed transaction

would not increase the IDI’s proportional share

of the credit facility. The IDI must also obtain

the prior approval of its entire board of directors

(or its delegees) and it must give a 20 days’

post-consummation notice to its appropriate fed-

eral banking agency. An IDI is permitted to

increase its proportionate share in a restructured

loan by 5 percent (or by a higher percentage

with the prior approval of the IDI’s appropriate

federal banking agency). The scope of the

exemption includes renewals of participations in

loans originated by any afﬁliate of the IDI (not

just afﬁliated IDIs).

2020.1.5 COLLATERAL FOR CERTAIN

TRANSACTIONS WITH AFFILIATES

Section 23A requires a member bank’s use of

collateral for certain transactions between an

IDI and its afﬁliates.

Each loan or extension of

credit to an afﬁliate,

or guarantee, acceptance,

or letter of credit issued on behalf of an afﬁliate

by an IDI or its subsidiary, and any credit expo-

sure of an IDI or a subsidiary to an afﬁliate

resulting from a securities borrowing or lending

transaction, or a derivative transaction, shall be

secured at all times by collateral (“credit expo-

sure”) at the amounts required by the statute.

The required collateral varies,

depending on

the type of collateral used to secure the transac-

tion.

The speciﬁc collateral requirements are—

1. 100 percent of the amount of such loan or

extension of credit, guarantee, acceptance,

letter of credit or credit exposure, if the col-

lateral is composed of—

a. obligations of the United States or its

agencies;

b. obligations fully guaranteed by the United

States or its agencies as to principal and

interest;

c. notes, drafts, bills of exchange, or bank-

er’s acceptances that are eligible for redis-

count or purchase by a Federal Reserve

Bank;

d. a segregated, earmarked deposit account

with the member bank that is for the sole

purpose of securing credit transactions

between the member bank and its afﬁli-

ates and is identiﬁed as such.

2. 110 percent of the amount of such loan or

extension of credit, guarantee, acceptance, or

letter of credit if the collateral is composed

of obligations of any state or political subdi-

vision of any state;

3. 120 percent of the amount of such loan or

extension of credit, guarantee, acceptance, or

letter of credit if the collateral is composed

of other debt instruments, including receiv-

ables; or

4. 130 percent of the amount of such loan or

extension of credit, guarantee, acceptance, or

letter of credit if the collateral is composed

of stock, leases, or other real or personal

property.

For example, an IDI makes a $1,000 loan to

an afﬁliate. The afﬁliate posts as collateral for

the loan $500 in U.S. Treasury securities, $480

in corporate debt securities, and $130 in real

estate. The loan satisﬁes the collateral require-

ments of section 23A because $500 of the loan

is 100 percent secured by obligations of the

United States, $400 of the loan is 120 percent

secured by debt instruments, and $100 of the

loan is 130 percent secured by real estate. The

statute prohibits an IDI from counting a low-

quality asset toward section 23A’s collateral

requirements for credit transactions with afﬁli-

ates.

An IDI must maintain a perfected secu-

rity interest at all times in the collateral that

secures the credit transaction.

Each loan or extension of credit to an afﬁliate

or guarantee, acceptance, credit exposure or let-

ter of credit issued on behalf of an afﬁliate

(herein referred to as credit transactions) by an

IDI or its subsidiary must be secured at the time

of the transaction by collateral.

49. The IDI must perfect the security interest in the collat-

eral (Fitzpatrick v. FDIC, 765 F.2d 569 (6th Cir. 1985). A

purchase of assets from an afﬁliate does not require collateral.

50. 12 U.S.C. 371c(b)(7).

51. ‘‘Credit extended’’ means the loan or extension of

credit, guarantee, acceptance, or letter of credit.

52. 12 U.S.C. 371c(c)(1).

53. Regulation A includes a representative list of accept-

able government obligations (12 C.F.R. 201.108).

54. 12 U.S.C. 371c(c)(3).

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2020.1.5.1 Collateral Requirements in

Regulation W

The collateral requirements for credit transac-

tions are found in section 23A (c) of the statute.

Section 23A (c)(1) requires that an IDI meet the

collateral requirements of the statute at all times.

A low-quality asset cannot be used to satisfy the

statute’s or regulation’s collateral requirements,

but can be taken as additional collateral.

2020.1.5.1.1 Deposit Account Collateral

Under section 23A, an IDI may satisfy the col-

lateral requirements of the statute by securing a

credit transaction with an afﬁliate with a ‘‘segre-

gated, earmarked deposit account’’ maintained

with the IDI in an amount equal to 100 percent

of the credit extended.

IDIs may secure cov-

ered transactions with omnibus deposit accounts

so long as the IDI takes steps to ensure that the

omnibus deposit accounts fully secure the rel-

evant covered transactions. Such steps might

include substantial overcollateralization or the

use of subaccounts or other recordkeeping

devices to match deposits with covered transac-

tions. To obtain full credit for any deposit

accounts taken as section 23A collateral, IDIs

must ensure that they have a perfected, ﬁrst-

priority security interest in the accounts. (See

section 223.14(b)(1)(i)(D).)

2020.1.5.1.2 Ineligible Collateral

The purpose of section 23A’s collateral require-

ments is to ensure that IDIs that engage in credit

transactions with afﬁliates have legal recourse,

in the event of afﬁliate default, to tangible assets

with a value at least equal to the amount of the

credit extended.

The statute recognizes that certain types of

assets are not appropriate to serve as collateral

for credit transactions with an afﬁliate. In par-

ticular, the statute provides that low-quality

assets and securities issued by an afﬁliate are

not eligible collateral for such covered transac-

tions.

Under section 223.14(c) of the rule, intan-

gible assets also are not deemed acceptable to

meet the collateral requirements imposed by

section 23A.

Intangible assets, including ser-

vicing assets, are particularly hard to value, and

an IDI may have signiﬁcant difﬁculty in collect-

ing and selling such assets in a reasonable

period of time.

Section 23A(c) requires that credit transac-

tions with an afﬁliate be ‘‘secured’’ by collat-

eral. A credit transaction between an IDI and an

afﬁliate supported only by a guarantee or letter

of credit from a third party does not meet the

statutory requirement that the credit transac-

tion be secured by collateral. Guarantees and

letters of credit often are subject to material

adverse change clauses and other covenants that

allow the issuer of the guarantee or letter of

credit to deny coverage. Letters of credit and

guarantees are not balance-sheet assets under

GAAP and, accordingly, would not constitute

‘‘real or personal property’’ under sec-

tion 23A. There is a particularly signiﬁcant risk

that an IDI may have difﬁculty collecting on a

guarantee or letter of credit provided by a

nonafﬁliate on behalf of an afﬁliate of the IDI.

Accordingly, guarantees and letters of credit are

not acceptable section 23A collateral.

As noted above, section 23A prohibits an IDI

from accepting securities issued by an afﬁliate

as collateral for an extension of credit to any

afﬁliate. The rule clariﬁes that securities issued

by the IDI itself also are not eligible collateral to

secure a credit transaction with an afﬁliate.

Equity securities issued by a lending IDI, and

debt securities issued by a lending IDI that

count as regulatory capital of the IDI, are not

eligible collateral under section 23A. If an IDI

was forced to foreclose on a credit transaction

with an afﬁliate secured by such securities, the

IDI may be unwilling to liquidate the collateral

promptly to recover on the credit transaction

because the sale might depress the price of the

IDI’s outstanding securities or result in a change

in control of the IDI. In addition, to the extent

that an IDI is unable or unwilling to sell such

securities acquired through foreclosure, the

transaction would likely result in a reduction in

the IDI’s capital, thereby offsetting any poten-

tial beneﬁt provided by the collateral.

2020.1.5.1.3 Perfection and Priority

Under section 223.14(d) of the rule, an IDI’s

security interest in any collateral required by

section 23A must be perfected in accordance

with applicable law to ensure that an IDI has

55. 12 U.S.C. 371c(c)(1)(A)(iv).

56. The rule does not conﬁne the deﬁnition of intangible

assets by reference to GAAP.

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BHC Supervision Manual July 2014

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good access to the assets serving as collateral

for its credit transactions with afﬁliates. This

requirement ensures that the IDI has the legal

right to realize on the collateral in the case of

default, including a default resulting from the

afﬁliate’s insolvency or liquidation. An IDI also

is required to either obtain a ﬁrst-priority secu-

rity interest in the required collateral or deduct

from the amount of collateral obtained by the

IDI the lesser of (1) the amount of any security

interests in the collateral that are senior to that

obtained by the IDI or (2) the amount of any

credits secured by the collateral that are senior

to that of the IDI. For example, if an IDI lends

$100 to an afﬁliate and takes as collateral a

second lien on a parcel of real estate worth

$200, the arrangement would only satisfy the

collateral requirements of section 23A if the

afﬁliate owed the holder of the ﬁrst lien $70 or

less (a credit transaction secured by real estate

must be secured at 130 percent of the amount of

the transaction).

The rule includes the following example of

how to compute the section 23A collateral value

of a junior lien: An IDI makes a $2,000 loan to

an afﬁliate. The afﬁliate grants the IDI a second-

priority security interest in a piece of real estate

valued at $3,000. Another institution that previ-

ously lent $1,000 to the afﬁliate has a ﬁrst-

priority security interest in the entire parcel of

real estate. This transaction is not in compliance

with the collateral requirements of this section.

Because of the existence of the prior third-party

lien on the real estate, the effective value of the

real estate collateral for the IDI for purposes of

this section is only $2,000—$600 less than the

amount of real estate collateral required by this

section for the transaction ($2,000 × 130 percent

= $2,600).

2020.1.5.1.4 Unused Portion of an

Extension of Credit

Section 23A requires that the ‘‘amount’’ of an

extension of credit be secured by the statutorily

prescribed levels of collateral. Under the statute,

an IDI provides a line of credit to an afﬁliate, it

must secure the full amount of the line of credit

throughout the life of the credit. Section

223.14(f)(2) of the rule, however, provides an

exemption to the collateral requirements of sec-

tion 23A for the unused portion of an extension

of credit to an afﬁliate so long as the IDI does

not have any legal obligation to advance addi-

tional funds under the credit facility until the

afﬁliate has posted the amount of collateral

required by the statute with respect to the entire

used portion of the extension of credit.

In such

credit arrangements, securing the unused por-

tion of the credit line is unnecessary from a

safety-and-soundness perspective because the

afﬁliate cannot require the IDI to advance addi-

tional funds without posting the additional col-

lateral required by section 23A. If an IDI volun-

tarily advances additional funds under such a

credit arrangement without obtaining the addi-

tional collateral required under section 23A to

secure the entire used amount (despite its lack

of a legal obligation to make such an advance),

the Board views this action as a violation of the

collateral requirements of the statute. The entire

amount of the line counts against the IDI’s

quantitative limit, even if the line of credit does

not need to be secured.

2020.1.5.1.5 Purchasing Afﬁliate Debt

Securities in the Secondary Market

An IDI’s investment in the debt securities issued

by an afﬁliate is an extension of credit by the

IDI to the afﬁliate and thus is subject to sec-

tion 23A’s collateral requirements. Section

223.14(f)(3) of the rule provides an exemption

that permits IDIs in certain circumstances to

purchase debt securities issued by an afﬁliate

without satisfying the collateral requirements of

section 23A. The exemption is available where

an IDI purchases an afﬁliate’s debt securities

from a third party in a bona ﬁde secondary-

market transaction. When an IDI buys an afﬁli-

ate’s debt securities in a bona ﬁde secondary-

market transaction, the risk that the purchase is

designed to shore up an ailing afﬁliate is

reduced. Any purchase of afﬁliate debt securi-

ties that qualiﬁes for this exemption would still

remain subject to the quantitative limits of sec-

tion 23A and the market-terms requirement of

section 23B. In analyzing an IDI’s good faith

under this exemption transaction, examiners

should look at (1) the time elapsed between the

original issuance of the afﬁliate’s debt securities

and the IDI’s purchase, (2) the existence of any

relevant agreements or relationships between

the IDI and the third-party seller of the afﬁli-

ate’s debt securities, (3) any history of IDI

57. This does not apply to guarantees, acceptances, and

letters of credit issued on behalf of an afﬁliate. These instru-

ments must be fully collateralized at inception. Moreover,

these transactions are still subject to the 10 and 20 percent

limits of the statute.

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BHC Supervision Manual July 2014

Page 19

ﬁnancing of the afﬁliate, and (4) any other rel-

evant information.

2020.1.5.1.6 Credit Transactions with

Nonafﬁliates that Become Afﬁliates

IDIs sometimes lend money to, or issue guaran-

tees on behalf of, unafﬁliated companies that

later become afﬁliates of the IDI. Section

223.21(b)(2) provides transition rules that

exempt credit transactions from the collateral

requirements in situations in which the IDI

entered into the transactions with the nonafﬁli-

ate at least one year before the nonafﬁliate

became an afﬁliate of the IDI. For example, an

IDI with capital stock and surplus of $1,000 and

no outstanding covered transactions makes a

$120 unsecured loan to a nonafﬁliate. The IDI

does not make the loan in contemplation of the

nonafﬁliate becoming an afﬁliate. Nine months

later, the bank holding company purchases all

the stock of the nonafﬁliate, thereby making the

nonafﬁliate an afﬁliate of the IDI. The IDI is not

in violation of the quantitative limits of the

rule’s section 223.11 or 223.12 at the time of the

stock acquisition. The IDI is, however, prohib-

ited from engaging in any additional covered

transactions with the new afﬁliate at least until

such time as the value of the loan transaction

falls below 10 percent of the IDI’s capital stock

and surplus, and the transaction counts toward

the 20 percent limit for transactions with all

afﬁliates. In addition, the IDI must bring the

loan into compliance with the collateral require-

ments of section 223.14 promptly after the stock

acquisition. Transactions with nonafﬁliates in

contemplation of the nonafﬁliate becoming an

afﬁliate must meet the quantitative and collat-

eral requirements of the rule at the time of the

inception of the credit transaction and of the

afﬁliation.

2020.1.6 LIMITATIONS ON

COLLATERAL

IDIs may accept as collateral for covered trans-

actions receivables, leases, or other real or per-

sonal property.

The following are limitations

and collateral restrictions:

1. Any collateral that is subsequently retired or

amortized must be replaced by additional

eligible collateral. This is done to keep the

percentage of the collateral value relative to

the amount of the outstanding loan or exten-

sion of credit, guarantee, acceptance, or letter

of credit equal to the minimum percentage

that was required at the inception of the

transaction.

2. A low-quality asset is not acceptable as col-

lateral for a loan or extension of credit to, or

for a guarantee, acceptance, or letter of credit

issued on behalf of, an afﬁliate, or credit

exposure to an afﬁliate resulting from a secu-

rities borrowing or lending transaction, or

derivative transaction.

3. Securities or other debt obligations issued by

an afﬁliate of an IDI shall not be acceptable

as collateral for a loan or extension of credit

to, or for a guarantee, acceptance, or letter of

credit issued on behalf of, or credit exposure

from a securities borrowing or lending trans-

action, or derivative transaction to, that afﬁli-

ate or any other afﬁliate of the IDI.

The above collateral requirements are not appli-

cable to an acceptance that is already fully

secured either by attached documents or by

other property that is involved in the transaction

and has an ascertainable market value.

2020.1.7 DERIVATIVE

TRANSACTIONS WITH AFFILIATES

2020.1.7.1 Derivative Transactions

between Insured Depository Institutions

and Their Afﬁliates

Derivative transactions between an IDI and its

afﬁliates generally arise from the risk-

management needs of the institution or the afﬁli-

ate. Transactions arising from the institution’s

needs typically occur when an institution enters

into a swap or other derivative contract with a

customer but chooses not to hedge directly the

market risk generated by the derivative contract,

or when the institution is unable to hedge the

risk directly because it is not authorized to hold

the hedging asset. To manage the market risk,

the institution may have an afﬁliate acquire the

hedging asset. The institution would then do a

bridging derivative transaction between itself

and the afﬁliate maintaining the hedge.

Other derivative transactions between an IDI

and its afﬁliate are afﬁliate-driven. To accom-

plish its asset-liability-management goals, an

58. As noted above, letters of credit and mortgage-

servicing rights may not be accepted as collateral for purposes

of section 23A. See section 223.14(c)(4)(5) of the rule

(12 C.F.R. 223.14(c )(4) and (5).

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BHC Supervision Manual July 2014

Page 20

institution’s afﬁliate may enter into an interest-

rate or foreign-exchange derivative with the

institution. For example, an institution’s holding

company may hold a substantial amount of

ﬂoating-rate assets but issue ﬁxed-rate debt

securities to obtain cheaper funding. The hold-

ing company may then enter into a ﬁxed-to-

ﬂoating interest-rate swap with its subsidiary

member bank to reduce the holding company’s

interest-rate risk.

IDIs and their afﬁliates that seek to enter into

derivative transactions for hedging (or risk-

taking) purposes could enter into the desired

derivatives with unafﬁliated companies. IDIs

and their afﬁliates often choose to use each

other as their derivative counterparties, how-

ever, to maximize the proﬁts of, and manage

risks within, the consolidated ﬁnancial group.

2020.1.7.1.1 Section 23A on Derivatives

Transactions

The Dodd-Frank Act amended section 23A as it

relates to derivatives and now provides that a

derivative transaction, as deﬁned in paragraph

(3) of section 5200(b) of the Revised Statutes

(12 U.S.C. 84(b)) with an afﬁliate, is a covered

transaction to the extent that the transaction

causes an IDI or a subsidiary to have credit

exposure to the afﬁliate. The Dodd-Frank Act

also requires that any credit exposure must be

secured consistent with the collateral require-

ments of section 23A. This is a signiﬁcant

change and requires that all IDIs calculate the

relevant credit exposure and count that amount

towards the institution’s quantitative limits. The

Dodd-Frank Act requires the IDI to establish

and maintain policies and procedures designed

to manage the credit exposure arising from the

derivative. These policies and procedures

require, at a minimum, that the institution moni-

tor and control its exposure to its afﬁliates by

imposing appropriate credit controls and collat-

eral requirements. Regulation W provides that

credit derivatives between an institution and an

unafﬁliated third party that reference the obliga-

tions of an afﬁliate of the institution and that are

the functional equivalent of a guarantee by the

institution on behalf of an afﬁliate should be

treated as a guarantee by the institution on

behalf of an afﬁliate for the purposes of sec-

tion 23A. (The novation of a derivative between

an IDI and its afﬁliate is treated as a purchase

under the statute.)

2020.1.7.1.2 Section 23B and

Regulation W Regarding Derivative

Transactions

Derivative transactions between an IDI and an

afﬁliate also are subject to section 23B of the

FRA under the express terms of the statute.

Regulation W clariﬁes further that the trans-

actions are subject to the market-terms require-

ment of section 23B of the FRA (see sec-

tion 223.51). The rule requires IDIs to comply

strictly with section 23B in their derivative

transactions with afﬁliates. Section 23B requires

an institution to treat an afﬁliate no better than a

similarly situated nonafﬁliate. To comply with

section 23B of the FRA, each institution should

have in place credit limits on its derivatives

exposure to afﬁliates that are at least as strict as

the credit limits the institution imposes on unaf-

ﬁliated companies that are engaged in similar

businesses and are substantially equivalent in

size and credit quality. Similarly, each institu-

tion should monitor derivatives exposure to

afﬁliates at least as rigorously as it monitors

derivatives exposure to comparable unafﬁliated

companies. In addition, each institution should

price and require collateral in its derivative

transactions with afﬁliates in a way that is at

least as favorable to the institution as the way in

which it would price or require collateral in a

derivative transaction with comparable unafﬁli-

ated counterparties.

Section 23B generally does not allow an IDI

to use with an afﬁliate the terms and conditions

it uses with its most creditworthy unafﬁliated

customer unless the institution can demonstrate

that the afﬁliate is of comparable creditworthi-

ness as its most creditworthy unafﬁliated cus-

tomer. Instead, section 23B requires that an

afﬁliate be treated comparably (with respect to

terms, conditions, and credit limits) to the

majority of third-party customers engaged in the

same business, and having comparable credit

quality and size as the afﬁliate. Because an IDI

generally has the strongest credit rating within a

holding company, the Board generally would

not expect an afﬁliate to obtain better terms and

59. In addition to applying to covered transactions, as

deﬁned in section 23A of the FRA, the market-terms require-

ment of section 23B of the FRA applies broadly to, among

other things, ‘‘[t]he payment of money or the furnishing of

services to an afﬁliate under contract, lease, or otherwise’’

(12 U.S.C. 371c-1(a)(2)(C)). Institution-afﬁliate derivatives

generally involve a contract or agreement to pay money to the

afﬁliate or furnish risk-management services to the afﬁliate.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 21

conditions from an IDI than the institution

receives from its major unafﬁliated counterpar-

ties. In addition, market terms for derivatives

among major ﬁnancial institutions generally

include daily marks to market and two-way

collateralization above a relatively small expo-

sure threshold.

2020.1.7.1.3 Covering Derivatives That

Are the Functional Equivalent of a

Guarantee

Although most derivatives are not treated as

covered transactions, section 223.33 of the rule

provides that credit derivatives between an IDI

and a nonafﬁliate in which the IDI protects the

nonafﬁliate from a default on, or a decline in the

value of, an obligation of an afﬁliate of the IDI

are covered transactions under section 23A.

Such derivative transactions are viewed as guar-

antees by a member bank on behalf of an afﬁli-

ate (and, hence, are covered transactions) under

section 23A.

The rule provides that these credit derivatives

are covered transactions under section 23A and

gives several examples.

An IDI is not allowed

to reduce its covered transaction amount for

these derivatives to reﬂect hedging positions

established by the IDI with third parties. A

credit derivative is treated as a covered transac-

tion only to the extent that the derivative pro-

vides credit protection with respect to obliga-

tions of an afﬁliate of the IDI.

2020.1.8 INTRADAY EXTENSIONS OF

CREDIT

An extension of credit under section 23A of the

FRA includes the credit exposure arising from

intraday extensions of credit by IDIs to their

afﬁliates. IDIs regularly provide transaction

accounts to their afﬁliates in conjunction with

providing payment and securities clearing ser-

vices. As in the case of unafﬁliated commercial

customers, these accounts are occasionally sub-

ject to overdrafts during the day that are repaid

in the ordinary course of business.

Intraday extensions of credit by an IDI to an

afﬁliate are subject to the market-terms require-

ment of section 23B under the rule. The rule

also requires that, under section 23A, institu-

tions establish and maintain policies and

procedures that are reasonably designed to man-

age the credit exposure arising from an

institution’s intraday extensions of credit to

afﬁliates. The policies and procedures must, at a

minimum, provide for monitoring and control-

ling the institution’s intraday credit exposure to

each afﬁliate, and to all afﬁliates in the aggre-

gate, and ensure that the institution’s intraday

credit extensions to afﬁliates comply with sec-

tion 23B.

Section 223.42(l) of the rule provides that

intraday credit extensions by an IDI to an afﬁli-

ate are section 23A covered transactions but

exempts all such intraday credit extensions

from the quantitative and collateral require-

ments of section 23A if the IDI (1) maintains

policies and procedures for the management of

intraday credit exposure and (2) has no reason

to believe that any afﬁliate receiving intraday

credit would have difﬁculty repaying the credit

in accordance with its terms. The policies and

procedures are to be established and main-

tained for—

1. monitoring and controlling the credit expo-

sure arising at any one time from the IDI’s

intraday extensions of credit to each afﬁliate

and all afﬁliates in the aggregate and

2. ensuring that any intraday extensions of

credit by the IDI to an afﬁliate comply with

the market-terms requirement of sec-

tion 223.51 of the rule.

2020.1.8.1 Standard under Which the

Agencies May Grant Additional

Exemptions

The Dodd-Frank Act amended section 23A to

authorize the appropriate federal banking

agency to exempt transactions or relationships

by order if the exemption would be in the public

interest and consistent with the purposes of sec-

tion 23A. The exemption determination requires

the concurrence of the Board. The FDIC has a

60-day period to determine whether the

requested exemption presents an unacceptable

risk to the insurance fund. The request should

describe in detail the transaction or relation-

ship for which the member bank seeks exemp-

tion. The exemption request also should explain

why the Agency should exempt the transaction

or relationship, and why it meets the public

interest standard of the statute. The Board has

approved a number of exemptions, most of

60. In most instances, the covered-transaction amount for

such a credit derivative would be the notional principal

amount of the derivative.

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BHC Supervision Manual July 2014

Page 22

which involve corporate reorganizations. These

exemptions are available on the Board’s

website, www.federalreserve.gov/boarddocs/

legalint/FederalReserve Act.

2020.1.9 EXEMPTIONS FROM

SECTION 23A

Section 23A exempts seven transactions or rela-

tions from its quantitative limits and collateral

requirements.

Regulation W, subpart E, clari-

ﬁes these exemptions and exempts a number of

additional types of transactions. The Board

reserves the right to revoke or modify any addi-

tional exemption granted by the Board in Regu-

lation W, if the Board ﬁnds that the exemption is

resulting in unsafe or unsound banking prac-

tices. The Board also reserves the right to termi-

nate the eligibility of a particular IDI to use any

such exemption if the IDI’s use of the exemp-

tion is resulting in unsafe or unsound banking

practices.

2020.1.9.1 Covered Transactions Exempt

from the Quantitative Limits and

Collateral Requirements

Under the rule’s section 223.41, the quantitative

limits (sections 223.11 and 223.12) and the col-

lateral requirements (section 223.14) do not

apply to the following transactions. The transac-

tions are, however, subject to the safety-and-

soundness requirement (section 223.13) and the

prohibition on the purchase of a low-quality

asset (section 223.15).

2020.1.9.1.1 Parent Institution/Subsidiary

Institution Transactions

Transactions with an IDI are exempt from the

quantitative limits and collateral requirements

(section 223.14) if the member bank controls

80 percent or more of the voting securities of

the IDI or the depository institution controls

80 percent or more of the voting securities of

the IDI.

2020.1.9.1.2 Sister-Bank Exemption

(section 223.41(b))

Regulation W exempts transactions with an IDI

if the same company controls 80 percent or

more of the voting securities of the member

bank and the IDI.

In addition, the statute pro-

vides that covered transactions between sister

banks must be consistent with safe and sound

banking practices.

The sister-bank exemption generally applies

only to transactions between IDIs.

The rule’s

deﬁnition of afﬁliate excludes uninsured deposi-

tory institution subsidiaries of a member bank.

Covered transactions between a member bank

and a parent uninsured depository institution or

a commonly controlled uninsured depository

institution, under the rule, generally would be

subject to section 23A, whereas covered transac-

tions between a member bank and a subsidiary

uninsured depository institution would not be

subject to section 23A.

The sister-bank exemption, by its terms, only

exempts transactions by a member bank with a

sister-bank afﬁliate; hence, the sister-bank

exemption cannot exempt a member bank’s

extension of credit or other covered transaction

to an afﬁliate that is not a sister bank (even if the

extension of credit was purchased from a sister

bank). For example, an IDI purchases from

Sister-Bank Afﬁliate A a loan to Afﬁliate B in a

purchase that qualiﬁes for the sister-bank

exemption in section 23A. The IDI’s asset pur-

chase from Sister-Bank Afﬁliate A would be an

exempt covered transaction under sec-

tion 223.41(b), but the member bank also would

have acquired an extension of credit to Afﬁliate

B, which would be a covered transaction

between the IDI and Afﬁliate B under sec-

tion 223.3(h)(1) that does not qualify for the

sister-bank exemption.

61. See 12 U.S.C. 371c(d)

62. Banks that are afﬁliated in this manner are referred to

as ‘‘sister banks.’’ Sister banks can improve their efﬁciency

through intercorporate transfers under this exception. Also,

‘‘company’’ in this context is not limited to a bank holding

company. For example, if a retail corporation owns two credit

card banks, the two credit card banks would be sister banks,

and the sister-bank exception could be used for transactions

between two credit card banks.

63. 12 U.S.C. 371c(a)(4).

64. A member bank and its operating subsidiaries are

considered a single unit for purposes of section 23A. Under

the statute and the regulation, transactions between a member

bank (or its operating subsidiary) and the operating subsidiary

of a sister-insured depository institution generally qualify for

the sister-bank exemption.

65. The sister-bank exemption in section 23A does not

allow a member bank to avoid any restrictions on sister-bank

transactions that may apply to the bank under the prompt

corrective-action framework set forth in section 38 of the FDI

Act (12 U.S.C. 1831o) and regulations adopted by the bank’s

appropriate federal banking agency.

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BHC Supervision Manual July 2014

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2020.1.9.1.3 Purchase of Loans on a

Nonrecourse Basis from an Afﬁliated IDI

Banks that are commonly controlled (i.e., at

least 25 percent common ownership) can

purchase loans on a nonrecourse basis. This

allows chain banks and banks in companies that

are not owned 80 percent by the same com-

pany to achieve the same efﬁciency as sister

banks. The exemption only applies to the

purchase of loans; other covered transactions,

such as extensions of credit, are not exempt.

2020.1.9.1.4 Internal Corporate

Reorganizations

Section 223.41(d) of the rule provides an

exemption for asset purchases by an IDI from

an afﬁliate that is part of a one-time internal

corporate reorganization of a holding com-

pany.

The exemption includes purchases of

assets in connection with a transfer of securities

issued by an afﬁliate to an IDI, as described in

section 223.31(a).

Under this exemption, an IDI would be per-

mitted to purchase assets (other than low-quality

assets) from an afﬁliate (including in connection

with an afﬁliate share transfer that sec-

tion 223.31 of the rule treats as a purchase of

assets) that are exempt from the quantitative

limits of section 23A if the following conditions

are met.

First, the purchase must be part of an internal

corporate reorganization of a holding company

that involves the transfer of all or substantially

all of the shares or assets of an afﬁliate or of a

division or department of an afﬁliate. The asset

purchase must not be part of a series of periodic,

ordinary-course asset transfers from an afﬁliate

to an IDI.

Second, the IDI’s holding company

must provide the Board with contemporaneous

notice of the transaction and must commit to the

Board to make the IDI whole, for a period of

two years, for any transferred assets that become

low-quality assets.

Third, a majority of the

IDI’s directors must review and approve the

transaction before consummation. Fourth, the

section 23A value of the covered transaction

must be less than 10 percent of the IDI’s capital

stock and surplus (or up to 25 percent of the

IDI’s capital stock and surplus with the prior

approval of the appropriate federal banking

agency) for the IDI. Fifth, the holding company

and all its subsidiary depository institutions

must be well capitalized and well managed and

must remain well capitalized upon consumma-

tion of the transaction.

2020.1.9.2 Other Covered Transactions

Exempt from the Quantitative Limits,

Collateral Requirements, and

Low-Quality-Asset Prohibition

The quantitative limits (sections 223.11 and

223.12), the collateral requirements (sec-

tion 223.14), and the prohibition on the pur-

chase of a low-quality asset (section 223.15) do

not apply to the following exempted transac-

tions (see section 223.42) and certain condi-

tions. The transactions are, however, subject to

the safety-and-soundness requirement (sec-

tion 223.13). Detailed conditions or restrictions

pertaining to these exemptions are discussed

after this list.

1. Making correspondent banking deposits in

an afﬁliated depository institution (as

deﬁned in section 3 of the FDI Act

(12 U.S.C. 1813) or in an afﬁliated foreign

bank that represents an ongoing, working

balance maintained in the ordinary course

of correspondent business

2. Giving immediate credit to an afﬁliate for

uncollected items received in the ordinary

course of business

66. See 1998 Fed. Res. Bull. 985 and 1013-14.

67. The IDI must provide the Board, as well as the appro-

priate federal agency, a notice that describes the primary

business activities of the afﬁliate whose shares or assets are

being transferred to the IDI and must indicate the anticipated

date of the reorganization.

68. The holding company can meet these criteria by either

repurchasing the assets at book value plus any write-down

that has been taken or by making a quarterly cash contribution

to the bank equal to the book value plus any write-downs that

have been taken by the bank. The purchase or payment must

be made within 30 days of each quarter end. In addition, if a

cash payment is made, the IDI will hold an amount of risk-

based capital equal to the book value of any transferred assets

that become low-quality so long as the IDI retains ownership

or control of the transferred asset. For example, under this

dollar-for-dollar capital requirement, the risk-based capital

charge for each transferred low-quality loan asset would be

100 percent (equivalent to a 1250 percent risk weight), rather

than the 8 percent requirement (equivalent to a 100 percent

risk weight) that would apply to a similar defaulted loan asset

that is not a part of the transferred asset pool. See the Board’s

letter dated December 21, 2007, to Andres L. Navarette

(Capital One Financial Corp.). Once the capital pool has been

allocated to speciﬁc assets as described above, the capital

cannot be applied to other low-quality assets if the initial

low-quality asset returns to performing status. The IDI can

only apply the allocated capital pool to new assets if the initial

assets are fully paid or sold.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 24

3. Transactions secured by cash or U. S. gov-

ernment securities

4. Purchasing securities of a servicing afﬁliate,

as deﬁned by section 4(c)(1) of the BHC

Act

5. Purchasing certain liquid assets

6. Purchasing certain marketable securities

7. Purchasing certain municipal securities

8. Purchasing from an afﬁliate an extension of

credit subject to a repurchase agreement

that was originated by an IDI and sold to

the afﬁliate subject to a repurchase agree-

ment or with recourse

9. Asset purchases from an afﬁliate by a newly

formed IDI, if the appropriate federal bank-

ing agency for the IDI has approved the

asset purchase in writing in connection with

the review of the formation of the IDI

10. Transactions approved under the Bank

Merger Act that involve afﬁliated IDIs or an

IDI and the U.S. branches and agencies of a

foreign bank

11. Purchasing, on a nonrecourse basis, an

extension of credit from an afﬁliate under

certain conditions

12. Intraday extensions of credit

13. Riskless-principal transactions

2020.1.9.2.1 Correspondent Banking

Section 23A exempts from its quantitative lim-

its and collateral requirements a deposit by an

IDI in an afﬁliated IDI or afﬁliated foreign bank

that is made in the ordinary course of correspon-

dent business, subject to any restrictions that the

Board may impose.

Section 223.42(a) of the

rule further provides that such deposits must

represent ongoing, working balances maintained

by the IDI in the ordinary course of conducting

the correspondent business.

Although not

speciﬁed by section 23A or the Home Owners’

Loan Act (HOLA), the rule also provides that

correspondent deposits in an afﬁliated insured

savings association are exempt if they otherwise

meet the requirements of the exemption.

2020.1.9.2.2 Secured Credit Transactions

Section 23A and section 223.42(c) of the rule

exempt any credit transaction by an IDI with an

afﬁliate that is ‘‘fully secured’’ by obligations of

the United States or its agencies, or obliga-

tions that are fully guaranteed by the United

States or its agencies, as to principal and

interest.

A deposit account meets the ‘‘segregated,

earmarked’’ requirement only if the account

exists for the sole purpose of securing credit

transactions between the member bank and its

afﬁliates and is so identiﬁed. Under sec-

tion 23A, if U.S. government obligations or

deposit accounts are sufﬁcient to fully secure a

credit transaction, then the transaction is com-

pletely exempt from the quantitative limits of

the statute. If, however, the U.S. government

obligations or deposit accounts represent less

than full security for the credit transaction, then

the amount of U.S. government obligations or

deposits counts toward the collateral require-

ments of section 23A, but no part of the trans-

action is exempt from the statute’s quantitative

limits.

The exemption provides that a credit transac-

tion with an afﬁliate will be exempt ‘‘to the

extent that the transaction is and remains

secured’’ by appropriate (d)(4) collateral. If an

IDI makes a $100 nonamortizing term loan to

an afﬁliate that is secured by $50 of U.S. Trea-

sury securities and $75 of real estate, the value

of the covered transaction will be $50. If the

market value of the U.S. Treasury securities

falls to $45 during the life of the loan, the value

of the covered transaction would increase to

$55. The Board expects IDIs that use this

expanded (d)(4) exemption to review the market

value of their U.S. government obligations col-

lateral regularly to ensure compliance with the

exemption.

2020.1.10 ASSET PURCHASES FROM

AN AFFILIATE—EXEMPTIONS

2020.1.10.1 Purchase of a Security by an

Insured Depository Institution from an

Afﬁliate

Section 23A of the FRA restricts the ability of

a member bank to fund its afﬁliates through

asset purchases, loans, or certain other transac-

tions (referred to as ‘‘covered transactions’’).

69. 12 U.S.C. 371c(d)(2).

70. Unlike the sister-bank exemption, the exemption for

correspondent banking deposits applies to deposits placed by

a member bank in an uninsured depository institution or

foreign bank.

71. 12 U.S.C. 371c(d)(4). A partial list of such obligations

can be found in the rules’s section 201.108 (12 C.F.R.

201.108).

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BHC Supervision Manual July 2014

Page 25

Paragraph (d)(6) of section 23A contains an

exemption from the statute (the (d)(6) exemp-

tion) for ‘‘purchasing assets having a readily

identiﬁable and publicly available market quo-

tation,’’ if the purchase is at or below such

quotation.

2020.1.10.2 Purchases of Assets with

Readily Identiﬁable Market Quotes

Section 23A(d)(6) exempts the purchase of

assets by an IDI from an afﬁliate if the assets

have a ‘‘readily identiﬁable and publicly avail-

able market quotation’’ and are purchased at

their current market quotation. The rule (sec-

tion 223.42(e)) limits the availability of this

exemption (the (d)(6) exemption) to purchases

of assets with market prices that are recorded in

widely disseminated publications that are read-

ily available to the general public, such as news-

papers with a national circulation. Because as a

general matter only exchange-traded assets are

recorded in such publications, this test has

ensured that the qualifying assets are traded

actively enough to have a true ‘‘market quota-

tion’’ and that examiners can verify that the

assets are purchased at their current market quo-

tation. The rule applies if the asset is purchased

at or below the asset’s current market

quotation.

The (d)(6) exemption may apply to a pur-

chase of assets that are not traded on an

exchange. In particular, purchases of foreign

exchange, gold, and silver, and purchases of

over-the-counter (OTC) securities and deriva-

tive contracts whose prices are recorded in

widely disseminated publications, may qualify

for the (d)(6) exemption.

If an IDI purchases from one afﬁliate, the

securities issued by another afﬁliate, the IDI has

engaged in two types of covered transactions:

(1) the purchase of securities from an afﬁliate

and (2) the investment in securities issued by an

afﬁliate. Under the rule, although the

(d)(6) exemption may exempt the one-time

asset purchase from the ﬁrst afﬁliate, it would

not exempt the ongoing investment in securi-

ties being issued by a second afﬁliate.

2020.1.10.3 Purchasing Certain

Marketable Securities

Regulation W provided an additional exemp-

tion from section 23A for certain purchases of

securities by a member bank from an afﬁliate.

The rule expanded the statutory (d)(6) exemp-

tion to allow a member bank to purchase secu-

rities from an afﬁliate based on price quotes

obtained from certain electronic services so

long as, among other things, the selling afﬁliate

is a broker-dealer registered with the SEC, the

securities have a ready market and are eligible

for purchase by state member banks, the securi-

ties are not purchased within 30 days of an

underwriting (if an afﬁliate of the bank is an

underwriter of the securities), and the securities

are not issued by an afﬁliate.

2020.1.10.3.1 Broker-Dealer Requirement

and Securities Purchases from Foreign

Broker-Dealers

Under the Regulation W exemption, the selling

afﬁliate must be a broker-dealer securities

afﬁliate that is registered with the Securities and

Exchange Commission (SEC). Broker-dealers

that are registered with the SEC are subject to

supervision and examination by the SEC and

are required by SEC regulations to keep and

maintain detailed records concerning each

securities transaction conducted by the broker-

dealer. In addition, SEC-registered broker-

dealers have experience in determining whether

a security has a ‘‘ready market’’ under SEC

regulations. The rule does not expand the

exemption to include securities purchases from

foreign broker-dealers. The rule explicitly pro-

vides, however, that an IDI may request that the

Board exempt securities purchases from a par-

ticular foreign broker-dealer, and the Board

would consider these requests on a case-by-case

basis in light of all the facts and circumstances.

2020.1.10.3.2 Securities Eligible for

Purchase by a State Member Bank

The exemption requires that the IDI’s purchase

of securities be eligible for purchase by a state

member bank. For example, the Board deter-

mined that a member bank may purchase equity

securities from an afﬁliate, if the purchase is

72. 12 U.S.C. 371c(d)(6).

73. The rule provides that a U.S. government obligation is

an eligible (d)(6) asset only if the obligation’s price is quoted

routinely in a widely disseminated publication that is readily

available to the general public. Although all U.S. government

obligations have low credit risk, not all U.S. government

obligations trade in liquid markets at a publicly available

market quotation.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 26

made to hedge the member bank’s permissible

customer-driven equity derivative transaction.

The purchase must be treated as a purchase of a

security on the Call Report.

2020.1.10.3.3 No Purchases Within 30

Days of an Underwriting

The exemption generally prohibits an IDI from

using the exemption to purchase securities dur-

ing an underwriting, or within 30 days of an

underwriting, if an afﬁliate of the IDI is an

underwriter of the securities. This provision

applies unless the security is purchased as part

of an issue of obligations of, or obligations fully

guaranteed as to principal and interest by, the

United States or its agencies. The rule includes

the 30-day requirement because of the uncertain

and volatile market values of securities during

and shortly after an underwriting period and

because of the conﬂicts of interest that may

arise during and after an underwriting period,

especially if an afﬁliate has difﬁculty selling its

allotment.

2020.1.10.3.4 No Securities Issued by an

Afﬁliate

If an IDI purchases from one afﬁliate securities

issued by another afﬁliate, it would not exempt

the investment in securities issued by the sec-

ond afﬁliate, even though the exemption may

exempt the asset purchase from the ﬁrst afﬁli-

ate. The transaction would be treated as a pur-

chase of, or an investment in, securities issued

by an afﬁliate.

2020.1.10.3.5 Price-Veriﬁcation Methods

The exemption applies only in situations in

which the IDI is able to obtain price quotes on

the purchased securities from an unafﬁliated

electronic, real-time pricing service. The Board

reafﬁrmed its position that it would not be

appropriate to use independent dealer quotations

or economic models to establish a market price

for a security under the (d)(6) exemption. A

security that is not quoted routinely in a widely

disseminated news source or a third-party elec-

tronic ﬁnancial network may not trade in a

sufﬁciently liquid market to justify allowing an

IDI to purchase unlimited amounts of the secu-

rity from an afﬁliate.

2020.1.10.3.6 Record Retention

The rule expressly includes a two-year record-

retention and supporting information require-

ment that is sufﬁcient to enable the appropriate

federal banking agencies to ensure that the

IDI is in compliance with the terms of the

exemption.

2020.1.10.4 Purchasing Municipal

Securities

Section 223.42(g) of the rule exempts an IDI’s

purchase of municipal securities from an afﬁli-

ate if the purchase meets certain require-

ments.

First, the IDI must purchase the

municipal securities from a broker-dealer afﬁli-

ate that is registered with the SEC. Second, the

municipal securities must be eligible for pur-

chase by a state member bank, and the IDI

must report the transaction as a securities pur-

chase in its Call Report. Third, the municipal

securities should either be rated by a nationally

recognized statistical rating organization

(NRSRO) or be part of an issue of securities

that does not exceed $25 million in size. Fi-

nally, the price for the securities purchased

must be (1) quoted routinely on an unafﬁliated

electronic service that provides indicative data

from real-time ﬁnancial networks; (2) veriﬁed

by reference to two or more actual independent

dealer quotes on the securities to be purchased

or securities that are comparable to the securi-

ties to be purchased; or (3) in the case of secu-

rities purchased during the underwriting period,

veriﬁed by reference to the price indicated in

the syndicate manager’s written summary of

the underwriting.

Under any of the three pric-

ing options, the IDI must purchase the munici-

pal securities at or below the quoted or veriﬁed

price.

74. Municipal securities are deﬁned by reference to sec-

tion 3(a)(29) of the Securities Exchange Act. That Act deﬁnes

municipal securities as direct obligations of, or obligations

guaranteed as to principal or interest by, a state or agency,

instrumentality, or political subdivision thereof, and certain

tax-exempt industrial development bonds. (See 17 U.S.C.

78c(a)(29).)

75. Under the Municipal Securities Rulemaking Board’s

Rule G-11, the syndicate manager for a municipal bond

underwriting is required to send a written summary to all

members of the syndicate. The summary discloses the aggre-

gate par values and prices of bonds sold from the syndicate

account.

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BHC Supervision Manual July 2014

Page 27

2020.1.10.5 Purchase of Loans on a

Nonrecourse Basis

Section 223.41(c) of the rule exempts the pur-

chase of loans on a nonrecourse basis from an

afﬁliated depository institution. Under sec-

tions 23A(d)(6), a member bank may purchase

loans on a nonrecourse basis from an afﬁliated

‘‘bank’’ exempt from the quantitative limita-

tions of section 23A, even if the transactions

does not qualify for the sister-bank exemp-

tion.

The rule clariﬁes that the scope of the

exemption parallels that of the sister-bank

exemption by stating that this exemption

applies only to a member bank’s purchase of a

loan from an afﬁliated IDI.

2020.1.10.6 Purchases of Assets by

Newly Formed Institutions

Section 223.42(i) of the rule exempts a purchase

of assets by a newly formed IDI from an afﬁliate

if the appropriate federal banking agency for the

IDI has approved the purchase. This exemption

allows companies to charter a new IDI and to

transfer assets to the IDI free of the quantitative

limits and low-quality-asset prohibition of sec-

tion 23A.

2020.1.10.7 Transactions Approved under

the Bank Merger Act

The Bank Merger Act exemption applies to

transactions between an IDI and a certain IDI

afﬁliate. Section 223.42(j) exempts transactions

between IDIs that are approved pursuant to the

Bank Merger Act. The rule also makes the Bank

Merger Act exemption available for merger and

other related transactions between an IDI and a

U.S. branch or agency of an afﬁliated foreign

bank, if the transaction has been approved by

the responsible federal banking agency pursuant

to the Bank Merger Act. There is no regulatory

exemption for merger transactions between an

IDI and its nonbank afﬁliate. Any IDI merging

or consolidating with a nonbank afﬁliate may be

able to take advantage of the regulatory exemp-

tion for internal-reorganization transactions con-

tained in section 223.41(d) of the rule.

2020.1.11 PURCHASES OF

EXTENSIONS OF CREDIT—THE

PURCHASE EXEMPTION

Regulation W codiﬁed, with changes, the

exemption that was previously found at sec-

tion 250.250 (12 C.F.R. 250.250). In general,

1. The purchase of an extension of credit on a

nonrecourse basis from an afﬁliate is exempt

from section 23A’s quantitative limits pro-

vided that—

a. the extension of credit is originated by the

afﬁliate;

b. the IDI makes an independent evaluation

of the creditworthiness of the borrower

before the afﬁliate makes or commits to

make the extension of credit;

c. the IDI commits to purchase the exten-

sions of credit before the afﬁliate makes

or commits to the extensions of credit;

and

d. the IDI does not make a blanket advance

commitment to purchase extensions of

credit from the afﬁliate. (See sec-

tion 223.42(k) of the rule.)

2. The rule also includes a 50 percent limit on

the amount of loans an IDI may purchase

from an afﬁliate under the purchase exemp-

tion. When an IDI purchases more than half

of the extensions of credit originated by an

afﬁliate, the purchases represent the principal

ongoing funding mechanism for the afﬁliate.

The IDI’s status as the predominant source

of ﬁnancing for the afﬁliate calls into ques-

tion the availability of alternative funding

sources for the afﬁliate, places signiﬁcant

pressure on the IDI to continue to support the

afﬁliate through asset purchases, and reduces

the IDI’s ability to make independent credit

decisions with respect to the asset purchases.

3. ‘‘Substantial, ongoing funding’’ test. The rule

allows the appropriate federal banking

agency for an IDI to reduce the 50 percent

threshold prospectively, on a case-by-case

basis, in those situations in which the agency

believes that the IDI’s asset purchases from

an afﬁliate under the exemption may cause

harm to the IDI.

4. Independent credit review by the IDI. To

qualify for the purchase exemption under

section 223.42(k), an IDI must independently

review the creditworthiness of the borrower

before committing to purchase each loan.

Under established Federal Reserve guidance,

an IDI is required to have clearly deﬁned

policies and procedures to ensure that it per-

forms its own due diligence in analyzing the

76. See 12 U.S.C. 371c(d)(6).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 28

credit and other risks inherent in a proposed

transaction.

This function is not delegable

to any third party, including afﬁliates of the

IDI. Also, an IDI cannot rely on the stan-

dards of a government-sponsored enterprise.

Accordingly, to qualify for this exemption,

the IDI, independently and using its own

credit policies and procedures, must itself

review and approve each extension of credit

before giving a purchase commitment to its

afﬁliate.

5. Purchase of loans from an afﬁliate must be

without recourse. In connection with an IDI’s

purchase of loans from an afﬁliate, the afﬁli-

ate cannot retain recourse on the loans. The

rule (section 223.42(k)) speciﬁes that the

exemption does not apply in situations where

the afﬁliate retains recourse on the loans

purchased by the IDI. The rule also speciﬁes

that the purchase exemption only applies in

situations where the IDI purchases loans

from an afﬁliate that were originated by the

afﬁliate. The exemption cannot be used by an

IDI to purchase loans from an afﬁliate that

the afﬁliate purchased from another lender.

The exemption is designed to facilitate an

IDI’s using its afﬁliate as an origination

agent, not to permit an IDI to take loans off

an afﬁliate’s books that the afﬁliate pur-

chased from a third party.

2020.1.12 OTHER BOARD-

APPROVED EXEMPTIONS FROM

SECTION 23A

Section 23A gives the Board the authority to

grant exemptions from the statute’s restrictions

if such exemptions are ‘‘in the public interest

and consistent with the purposes of this section’’

(12 U.S.C. 371c(f)(2)). Regulation W includes

several exemptions that are available to qualify-

ing IDIs.

2020.1.12.1 Exemptions and

Interpretation from the Attribution Rule

of Section 23A

The attribution rule of section 23A provides that

‘‘a transaction by a member institution with any

person shall be deemed a transaction with an

afﬁliate to the extent that the proceeds of the

transaction are used for the beneﬁt of, or trans-

ferred to, that afﬁliate’’ (12 U.S.C.

371c(a)(2)). One respective interpretation and

three exemptions are discussed below.

2020.1.12.2 Interpretation—Loans to a

Nonafﬁliate that Purchases Securities or

Other Assets Through a Depository

Institution Afﬁliate Agent or Broker

In Regulation W, the Board issued an interpreta-

tion (12 C.F.R. 223.26(b)) regarding an IDI’s

loan to a nonafﬁliate that purchases assets

through an institution’s afﬁliate that is acting as

agent. This interpretation conﬁrms that sec-

tion 23A of the FRA does not apply to exten-

sions of credit an IDI grants to customers that

use the loan proceeds to purchase a security or

other asset through an afﬁliate of the depository

institution, so long as (1) the afﬁliate is acting

exclusively as an agent or broker in the transac-

tion and (2) the afﬁliate retains no portion of the

loan proceeds as a fee or commission for its

services.

Under this interpretation, the Board con-

cluded that when the afﬁliated agent or broker

retains a portion of the loan proceeds as a fee or

commission, the portion of the loan not retained

by the afﬁliate as a fee or commission would

still be outside the coverage of section 23A.

However, the portion of the loan retained by the

afﬁliate as a fee or commission would be subject

to section 23A because it represents proceeds of

a loan by a depository institution to a third party

that are transferred to, and used for the beneﬁt

of, an afﬁliate of the institution. The Board,

however, granted an exemption from sec-

tion 23A for that portion of a loan to a third

party that an afﬁliate retains as a market-rate

brokerage or agency fee. (See 12 C.F.R.

223.16(c )(2).)

The interpretation would not apply if the

securities or other assets purchased by the third-

party borrower through the afﬁliate of the

depository institution were issued or underwrit-

ten by, or sold from the inventory of, another

afﬁliate of the depository institution. In that

case, the proceeds of the loan from the deposi-

tory institution would be transferred to, and

used for the beneﬁt of, the afﬁliate that issued,

underwrote, or sold the assets on a principal

basis to the third party.

The above-mentioned transactions are subject

to the market-terms requirement of section 23B,

which applies to ‘‘any transaction in which an

afﬁliate acts as an agent or broker or receives a

77. See, for example, SR-97-21.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 29

fee for its services to the institution or any other

person’’ (12 U.S.C. 371c-1(a)(2)(D)). A market-

rate brokerage commission or agency fee refers

to a fee or commission that is no greater than

that prevailing at the same time for comparable

agency transactions the afﬁliate enters into with

persons who are neither afﬁliates nor borrowers

from an afﬁliated depository institution. (See

Regulation W at 12 C.F.R. 223.16(b).)

2020.1.12.3 Exemption—Loans to a

Nonafﬁliate that Purchases Securities

from a Depository Institution Securities

Afﬁliate that Acts as a Riskless Principal

The Board has granted an exemption in Regula-

tion W from section 23A of the FRA for exten-

sions of credit by an IDI to customers who use

the loan proceeds to purchase a security that is

issued by a third party through a broker-dealer

afﬁliate of the institution that acts as riskless

principal. The exemption for riskless-principal

transactions would not apply if the broker-dealer

afﬁliate sold to the third-party borrower securi-

ties that were issued or underwritten by, or sold

out of the inventory of, an afﬁliate of the deposi-

tory institution. Riskless-principal trades,

although the functional equivalent of securities

brokerage transactions, involve the purchase of

a security by the depository institution’s broker-

dealer afﬁliate. Accordingly, the broker-dealer

retains the loan proceeds at least for some

moment in time.

There is negligible risk that loans that a

depository institution makes to borrowers to

engage in riskless-principal trades through a

broker-dealer afﬁliate of the depository institu-

tion would be used to fund the broker-dealer.

For this reason, the Board adopted an exemption

from section 23A to cover riskless-principal

securities transactions engaged in by depository

institution borrowers through broker-dealer

afﬁliates of the depository institution. This

exemption is applicable even if the broker-

dealer retains a portion of the loan proceeds as a

market-rate markup for executing the riskless-

principal securities trade. (See Regulation W at

12 C.F.R. 223.16(c)(1) and (2).)

2020.1.12.4 Exemption—Depository

Institution Loan to a Nonafﬁliate Pursuant

to a Preexisting Line of Credit and the

Proceeds Are Used to Purchase Securities

from the Institution’s Broker-Dealer

Afﬁliate

The Board approved an exemption in Regula-

tion W from section 23A for loans by an IDI to

a nonafﬁliate pursuant to a preexisting line of

credit, in which the loan proceeds are used to

purchase securities from a broker-dealer afﬁli-

ate. In more detail, the Board exempted exten-

sions of credit by an IDI to its customers that

use the credit to purchase securities from a reg-

istered broker-dealer afﬁliate of the institution,

so long as the extension of credit is made pur-

suant to, and consistent with any conditions

imposed in, a preexisting line of credit. This

line of credit should not have been established

in expectation of a securities purchase from or

through an afﬁliate of the institution. The pre-

existing requirement is an important safeguard

to ensure that the depository institution did not

extend credit for the purpose of inducing a bor-

rower to purchase securities from or issued by

an afﬁliate. The preexisting line of exemption

may not be used in circumstances in which the

line has merely been preapproved. (See Regu-

lation W at 12 C.F.R. 223.16(c)(3).)

2020.1.12.5 Exemption—Credit Card

Transactions

Regulation W also provides an exemption from

section 23A’s attribution rule for general-

purpose credit card transactions that meet

certain criteria. (See section 223.16(c)(4).) The

rule deﬁnes a general-purpose credit card as a

credit card issued by a member institution that

is widely accepted by merchants that are not

afﬁliates of the institution (such as a Visa card

or Mastercard) if less than 25 percent of the

aggregate amount of purchases with the card are

purchases from an afﬁliate of the institution.

Extensions of credit to unafﬁliated borrowers

pursuant to special-purpose credit cards (that is,

credit cards that may only be used or are

substantially used to buy goods from an afﬁli-

ate of the member institution) are subject to the

rule.

The credit card exemption includes several

different methods that are provided for a mem-

ber institution to demonstrate that its credit card

meets the 25 percent test. First, if a member

institution has no commercial afﬁliates (other

than those permitted for an FHC under section 4

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 30

of the BHC Act), the institution would be

deemed to satisfy the 25 percent test if the

institution has no reason to believe that it would

fail the test. (A member institution could use

this method of complying with the 25 percent

test even if, for example, the institution’s FHC

controls, under section 4(a)(2), 4(c)(2), or

4(k)(4)(H) of the BHC Act, several companies

engaged in nonﬁnancial activities.) Such a mem-

ber institution would not be obligated to estab-

lish systems to verify strict, ongoing compliance

with the 25 percent test. Most BHCs and FHCs

should meet this test. If an IDI has commercial

afﬁliates (beyond those permitted for an FHC

under section 4 of the BHC Act), the institution

would be deemed to satisfy the 25 percent test

if—

1. the institution establishes systems to verify

compliance with the 25 percent test on an

ongoing basis and periodically validates its

compliance with the test or

2. the institution presents information to the

Board demonstrating that its card would

comply with the 25 percent test. (One way

that a member institution could demonstrate

that its card would comply with the 25 per-

cent test would be to show that the total sales

of the institution’s afﬁliates are less than

25 percent of the total purchases by

cardholders.)

Second, for those member institutions that

fall out of compliance with the 25 percent test,

there is a three-month grace period to return to

compliance before extensions of credit under

the card become covered transactions. Third,

member institutions that are required to validate

their ongoing compliance with the 25 percent

test have a ﬁxed method, time frames, and

examples for computing compliance.

Example of calculating compliance with the

25 percent test. A member institution seeks to

qualify a credit card as a general-purpose credit

card under section 223.16, paragraph

(c)(4)(ii)(A), of the rule. The member institu-

tion assesses its compliance under paragraph

(c)(4)(iii) of this section on the 15th day of

every month (for the preceding 12 calendar

months). The credit card qualiﬁes as a general-

purpose credit card for at least three consecu-

tive months. On June 15, 2008, however, the

member institution determines that, for the 12-

calendar-month period from June 1, 2007,

through May 31, 2008, 27 percent of the total

value of products and services purchased with

the card by all cardholders were purchases of

products and services from an afﬁliate of the

member institution. Unless the credit card

returns to compliance with the 25 percent limit

by the 12-calendar-month period ending

August 31, 2008, the card will cease to qualify

as a general-purpose credit card as of

September 1, 2008. Any outstanding exten-

sions of credit under the credit card that were

used to purchase products or services from an

afﬁliate of the member institution would

become covered transactions at such time.

2020.1.13 AN IDI’S ACQUISITION OF

AN AFFILIATE THAT BECOMES AN

OPERATING SUBSIDIARY

Section 223.31 (a)-(c) of the rule provides

guidance to an IDI that acquires an afﬁliate. The

ﬁrst situation is when an IDI directly purchases

or otherwise acquires the afﬁliate’s assets and

assumes the afﬁliate’s liabilities. In this case, the

transaction is treated as a purchase of assets, and

the covered-transaction amount is equal to the

amount of any consideration paid by the IDI for

the afﬁliate’s assets (if any) plus the amount of

any liabilities assumed by the IDI in the

transaction.

Regulation W provides that the acquisition by

an IDI of a company that was an afﬁliate of the

IDI before the acquisition is treated as a pur-

chase of assets from an afﬁliate if (1) as a result

of the transaction, the company becomes an

operating subsidiary of the IDI and (2) the com-

pany has liabilities, or the IDI gives cash or any

other consideration in exchange for the securi-

ties. The rule also provides that these transac-

tions must be valued initially at the sum of

(1) the total amount of consideration given by

the IDI in exchange for the securities and (2) the

total liabilities of the company whose securities

have been acquired by the IDI. In effect, the rule

requires IDIs to treat such share donations and

purchases in the same manner as if the IDI had

purchased the assets of the transferred company

at a purchase price equal to the liabilities of the

transferred company (plus any separate consid-

eration paid by the IDI for the shares). See

12 C.F.R. 223.31.

Similarly, when an afﬁliate donates a control-

ling block of an afﬁliate’s shares to an IDI, a

covered transaction occurs if the afﬁliate has

liabilities that the IDI assumes. For example, the

parent holding company of an IDI contributes

between 25 percent and 100 percent of the vot-

ing shares of a mortgage company to the IDI.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 31

The parent holding company retains no shares

of the mortgage company. The IDI gives no

consideration in exchange for the transferred

shares. The mortgage company has total assets

of $300,000 and total liabilities of $100,000.

The mortgage company’s assets do not include

any loans to an afﬁliate of the IDI or any other

asset that would represent a separate covered

transaction for the IDI upon consummation of

the share transfer. As a result of the transaction,

the mortgage company becomes an operating

subsidiary of the IDI. The transaction is treated

as a purchase of the assets of the mortgage

company by the IDI from an afﬁliate under

paragraph (a) of section 223.31. The IDI ini-

tially must value the transaction at $100,000,

the total amount of the liabilities of the mort-

gage company. Going forward, if the member

bank pays off the liabilities, the member bank

must continue to value the covered transaction

at $100,000. However, if the member bank sells

$15,000 of the transferred assets of the mort-

gage company or if $15,000 of the transferred

assets amortize, the IDI may value the covered

transaction at $85,000.

A similar situation is when an IDI acquires an

afﬁliate by merger. Because a merger with an

afﬁliate generally results in the IDI’s acquiring

all the assets of the afﬁliate and assuming all the

liabilities of the afﬁliate, this transaction is effec-

tively equivalent to the purchase and assump-

tion transaction described in the previous para-

graph. Accordingly, the merger transaction also

is treated as a purchase of assets, and the

covered-transaction amount is equal to the

amount of any consideration paid by the IDI for

the afﬁliate’s assets (if any) plus the amount of

any liabilities assumed by the IDI in the

transaction.

The assets and liabilities of an operating sub-

sidiary of an IDI are treated in the rule as

assets and liabilities of the IDI itself for pur-

poses of section 23A.

The rule only imposes

asset-purchase treatment on afﬁliate share

transfers when the company whose shares are

being transferred to the IDI was an afﬁliate of

the IDI before the transfer. If the transferred

company was not an afﬁliate before the trans-

fer, it would not be appropriate to treat the

share transfer as a purchase of assets from an

afﬁliate. Similarly, the rule only requires asset-

purchase treatment for afﬁliate share transfers

when the transferred company becomes a sub-

sidiary and not an afﬁliate of the IDI through

the transfer.

If an IDI purchases, or receives a donation, of

a partial interest in an entity that remains an

afﬁliate, that transaction is treated as a purchase

of, or investment in securities issued by an

afﬁliate. This type of transaction is valued

according to its purchase price or carrying value.

(See 12 C.F.R. 223.23.)

2020.1.14 STEP-TRANSACTION

EXEMPTION (SECTION 223.31(d)

AND (e))

Under section 223.31(d) of the rule, an exemp-

tion is provided for certain step transactions that

are treated as asset purchases under sec-

tion 223.31(a) when an afﬁliate owned the trans-

ferred company for a limited period of time.

Regulation W provides an exemption when a

company acquires the stock of an unafﬁliated

company and, immediately after consummation

of the acquisition, transfers the shares of the

acquired company to the holding company’s

subsidiary IDI. For example, a bank holding

company acquires 100 percent of the shares of

an unafﬁliated leasing company. At that time,

the subsidiary IDI of the holding company noti-

ﬁes its appropriate federal banking agency and

the Board of its intent to acquire the leasing

company from its holding company. On the day

after consummation of the acquisition, the hold-

ing company transfers all of the shares of the

leasing company to the IDI. No material change

in the business or ﬁnancial condition of the

leasing company occurs between the time of the

holding company’s acquisition and the IDI’s

acquisition. The leasing company has liabilities.

The leasing company becomes an operating sub-

sidiary of the IDI at the time of the transfer. This

transfer by the holding company to the IDI,

although deemed an asset purchase by the IDI

from an afﬁliate under paragraph (a) of sec-

tion 223.31, would qualify for the exemption in

paragraph (d) of section 223.31.

The rule exempts these ‘‘step’’ transactions

under certain conditions. First, the IDI must

acquire the target company immediately after

the company became an afﬁliate (by being

78. As noted, section 223.3(dd) of the rule makes explicit

the Board’s view that these merger transactions generally

involve the purchase of assets by a member bank from an

afﬁliate.

79. Because an IDI usually can merge a subsidiary into

itself, transferring all the shares of an afﬁliate to an IDI often

is functionally equivalent to a transaction in which the bank

directly acquires the assets and assumes the liabilities of the

afﬁliate. In a direct acquisition of assets and assumption of

liabilities, the covered-transaction amount would be equal to

the total amount of liabilities assumed by the IDI.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 32

acquired by the bank’s holding company, for

example). The IDI must acquire the entire

ownership position in the target company that

its holding company acquired. Also, there must

be no material change in the business or ﬁnan-

cial condition of the target company during the

time between when the company becomes an

afﬁliate of the IDI and when the IDI is in receipt

of the company. Finally, the entire transaction

must comply with the market-terms require-

ment of section 23B, and the IDI must notify its

appropriate federal banking agency and the

Board, at or before the time that the target com-

pany becomes an afﬁliate of the IDI, of its intent

ultimately to acquire the target company.

Regulation W requires that the IDI consum-

mate the step transaction immediately to ensure

the quality and fairness of the transaction. To

the extent that the IDI acquires the target com-

pany some time after the company becomes an

afﬁliate, the transaction looks less like a single

transaction in which the IDI acquires the target

company and more like two separate transac-

tions, the latter of which involves the IDI acquir-

ing assets from an afﬁliate.

The Board recognized, however, that bank-

ing organizations may need a reasonable

amount of time to address legal, tax, and busi-

ness issues relating to an acquisition. Regula-

tion W thus permits IDIs to avail themselves of

the step-transaction exemption if the IDI

acquires the target company within three

months after the target company becomes an

afﬁliate so long as the appropriate federal bank-

ing agency for the IDI has approved the longer

time period.

The 100 percent ownership requirement (that

the IDI must acquire the entire ownership posi-

tion in the target company that its holding com-

pany acquired) prevents a holding company

from keeping the good assets of the target com-

pany and transferring the bad assets to the hold-

ing company’s subsidiary IDI. If a banking

organization cannot meet the terms of the step-

transaction exemption, the organization may be

able to satisfy the conditions of the rule’s

internal-corporate-reorganization exemption or

may be able to obtain a case-by-case exemption

from the Board.

2020.1.14.1 Application of Sections 23A

and 23B of Subpart G to U.S. Branches

and Agencies of Foreign Banks

2020.1.14.1.1 Applicability of Sections

23A and 23B to Foreign Banks Engaged

in Underwriting Insurance, Underwriting

or Dealing in Securities, Merchant

Banking, or Insurance Company

Investment in the United States.

By its terms, sections 23A and 23B of the FRA

do not apply to the U.S. branches, agencies, or

commercial lending ofﬁces of foreign banks.

The Board, however, used the authority granted

to it by the Gramm-Leach-Bliley Act to impose

restrictions on transactions between the

branches, agencies, and lending ofﬁces and any

afﬁliate of the foreign bank that operates in the

United States in order to ensure that such trans-

actions met certain prudential standards and pro-

vided competitive equality with U.S. banking

organizations. The Board accomplished these

goals by imposing the deﬁnition of afﬁliates

within sections 23A and 23B on transactions

between the branches, agencies, and lending

ofﬁces and those afﬁliates if the company is also

1. directly engaged in the United States in cer-

tain activities. These activities are signiﬁcant

because a U.S. bank cannot engage in these

activities directly or through an operating

subsidiary and the 23A and 23B limitations

help ensure competitive equality between

U.S. banks and foreign banks. These activi-

ties are as follows:

• Insurance underwriting pursuant to sec-

tion 4(k)(4)(B) of the Bank Holding Com-

pany Act (12 U.S.C. 1843(k)(4)(B));

• Securities underwriting, dealing, or mar-

ket making pursuant to section 4(k)(4)(E)

of the Bank Holding Company Act (12

USC 1843(k)(4)(E));

• Merchant banking activities pursuant to

section 4(k)(4)(H) of the Bank Holding

Company Act (12 USC 1843(k)(4)(H))

(but only to the extent that the proceeds of

the transaction are used for the purpose of

funding the afﬁliate’s merchant banking

activities);

• Insurance company investment activities

pursuant to section 4(k)(4)(I) of the Bank

Holding Company Act (12 USC

1843(k)(4)(I)); or

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 33

• Any other activity designated by the

Board.

2. a portfolio company (as deﬁned in the mer-

chant banking subpart of Regulation Y (12

CFR 225.177(c)) controlled by the foreign

bank or an afﬁliate of the foreign bank or a

company that would be an afﬁliate of the

branch, agency, or commercial lending com-

pany of the foreign bank under paragraph

(a)(9) of section 223.2 if such branch,

agency, or commercial lending company

were a member bank; or

3. a subsidiary of an afﬁliate as described in

paragraph (b)(1) or (2) of section 223.61.

Regulation W also provides that for purposes of

subpart G, the “capital stock and surplus” of a

U.S. branch, agency, or commercial lending

company of a foreign bank will be determined

by reference to the capital of the foreign bank as

calculated under its home-country capital stan-

dards.

2020.1.15 SECTION 23B OF THE

FEDERAL RESERVE ACT

Section 23B of the FRA became law on

August 10, 1987, as part of the Competitive

Equality Banking Act of 1987. This section also

regulates transactions with afﬁliates. Section

23B applies to any covered transaction with an

afﬁliate, but excludes banks from the term

‘‘afﬁliate’’ as that term is deﬁned in section 23A.

Regulation W, subpart F, sets forth the princi-

pal restrictions of section 23B. These include

(1) a requirement that most transactions between

an IDI and its afﬁliates be on terms and circum-

stances that are substantially the same as those

prevailing at the time for comparable transac-

tions with nonafﬁliates; (2) a restriction on an

IDI’s purchase, as ﬁduciary, of assets from an

afﬁliate unless certain criteria are met; (3) a

restriction on an IDI’s purchase, during the exis-

tence of an underwriting syndicate, of any secu-

rity if a principal underwriter of the security is

an afﬁliate; and (4) a prohibition on publishing

an advertisement or entering into an agreement

stating that an IDI will be responsible for the

obligations of its afﬁliates. For the most part,

subpart F restates the operative provisions of

section 23B.

The following transactions with afﬁliates are

covered by section 23B:

1. Any covered transaction with an afﬁliate.

2. The sale of securities or other assets to an

afﬁliate, including assets subject to an agree-

ment to repurchase.

3. The payment of money or the furnishing of

services to an afﬁliate under contract, lease,

or otherwise.

4. Any transaction in which an afﬁliate acts as

an agent or broker or receives a fee for its

services to the institution or to any other

person.

5. Any transaction or series of transactions with

a nonafﬁliate if an afﬁliate

• has a ﬁnancial interest in the third party

• is a participant in the transaction or series

of transactions.

Any transaction by an IDI or its subsidiary with

any person is deemed to be a transaction with an

afﬁliate of the institution if any of the proceeds

of the transaction are used for the beneﬁt of, or

transferred to, the afﬁliate. An IDI and its sub-

sidiaries may engage in transactions covered by

section 23B of the FRA, but only on terms and

under certain circumstances, including credit

standards, that are substantially the same or at

least as favorable to the institution as those

prevailing at the time for comparable transac-

tions with or involving nonafﬁliated companies.

If comparable transactions do not exist, the

transaction must be on terms and under circum-

stances, including credit standards, that in good

faith would be offered to or applied to nonﬁnan-

cial companies.

Section 23B restricts the following transac-

tions with afﬁliates:

1. An IDI or its subsidiary cannot purchase as

ﬁduciary any securities or other assets from

any afﬁliate unless the purchase is permitted

(1) under the instrument creating the ﬁdu-

ciary relationship, (2) by court order, or

(3) by law of the jurisdiction creating the

ﬁduciary relationship.

2. An IDI or its subsidiary, whether acting as

principal or ﬁduciary, cannot knowingly pur-

chase or acquire, during the existence of any

underwriting or selling syndicate, any secu-

rity if a principal underwriter of that security

is an afﬁliate of the institution. This limita-

tion applies unless the purchase or acquisi-

tion of the security has been approved before

it is initially offered for sale to the public by

a majority of the directors of the institution.

The purchase should be based on a determi-

nation that it is a sound investment for the

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 34

institution, irrespective of the fact that an

afﬁliate is a principal underwriter of the

securities.

2020.1.15.1 Transactions Exempt from

Section 23B of the Federal Reserve Act

The market-terms requirement of section 23B

applies to, among other transactions, any ‘‘cov-

ered transaction’’ between an IDI and an afﬁli-

ate.

Section 23B(d)(3) makes clear that the

term ‘‘covered transaction’’ in section 23B has

the same meaning as the term ‘‘covered transac-

tion’’ in section 23A, but does not include any

transaction that is exempt under section 23A(d).

For example, transactions between sister banks

and IDIs that are part of a chain banking organi-

zation are exempt from section 23B;

Also

exempt are transactions that are fully secured by

a deposit account or U.S. government obliga-

tions, and purchases of assets from an afﬁliate at

a readily identiﬁable and publicly available mar-

ket quotation.

Consistent with the statute,

Regulation W’s section 223.52(a)(1) exempts

from section 23B any transaction that is exempt

under section 23A(d).

The rule also excludes from section 23B any

covered transaction that is exempt from sec-

tion 23A under section 223.42(i) or (j) (that is,

asset purchases by a newly formed IDI and

transactions approved under the Bank Merger

Act). The Board excluded from section 23B this

additional set of transactions because, in each

case, the appropriate federal banking agency for

the IDI involved in the transaction should ensure

that the terms of the transaction are not unfavor-

able to the IDI.

2020.1.15.2 Purchases of Securities for

Which an Afﬁliate Is the Principal

Underwriter

The GLB Act amended section 23B to permit an

IDI to purchase securities during an underwrit-

ing conducted by an afﬁliate if the following

two conditions are met. First, a majority of the

directors of the IDI (with no distinction drawn

between inside and outside directors) must

approve the securities purchase before the secu-

rities are initially offered to the public. Second,

such approval must be based on a determination

that the purchase would be a sound investment

for the IDI regardless of the fact that an afﬁliate

of the IDI is a principal underwriter of the

securities.

Section 223.53(b) includes this

standard and clariﬁes that if an IDI proposes to

make such a securities purchase in a ﬁduciary

capacity, then the directors of the IDI must base

their approval on a determination that the pur-

chase is a sound investment for the person on

whose behalf the IDI is acting as ﬁduciary.

An IDI may satisfy this director-approval

requirement by obtaining speciﬁc prior director

approval of each securities acquisition other-

wise prohibited by section 23B(b)(1)(B). The

rule clariﬁes, however, that an IDI also satisﬁes

this director-approval requirement if a majority

of the IDI’s directors approve appropriate stan-

dards for the IDI’s acquisition of securities oth-

erwise prohibited by section 23B(b)(1)(B), and

each such acquisition meets the standards ad-

opted by the directors. In addition, a majority

of the IDI’s directors must periodically review

such acquisitions to ensure that they meet the

standards and must periodically review the

standards to ensure they meet the ‘‘sound

investment’’ criterion of section 23B(b)(2). The

appropriate period of time between reviews

would vary depending on the scope and nature

of the IDI’s program, but such reviews should

be conducted by the directors at least annually.

Before the passage of the GLB Act, Board staff

informally allowed IDIs, based on the legisla-

tive history of section 23B, to meet the

director-approval requirement in this fashion,

and there is no indication that Congress in the

GLB Act intended to alter the procedures that a

member bank could use to obtain the requisite

director approval. The rule codiﬁes staff’s pre-

existing approach to the director-approval

requirement.

2020.1.15.3 Deﬁnition of Afﬁliate under

Section 23B

Section 23B states that the term ‘‘afﬁliate’’

under section 23B has the meaning given to

such terms in section 23A, except that the term

‘‘afﬁliate’’ under section 23B does not include a

80. 12 U.S.C. 371c-1(a)(2)(A).

81. Although transactions between banks are exempt from

section 23B, the safety-and-soundness provisions of sec-

tion 23A(a)(4) apply and generally require that transactions be

conducted on terms similar to those terms and standards

outlined in section 23B.

82. 12 U.S.C. 371c-1(d)(3).

83. Regulation W will again be subsequently referred to as

the ‘‘rule’’ or by its speciﬁed section-numbered discussion of

section 23B provisions.

84. See 12 U.S.C. 371c-1(b)(2).

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 35

‘‘bank,’’ as deﬁned in section 23A. In the case

of the sister-bank exemption, the rule’s sec-

tion 223.2(c) clariﬁes that the only companies

that qualify for the ‘‘bank’’ exception to sec-

tion 23B’s deﬁnition of afﬁliate are IDIs.

2020.1.15.4 Advertising and Guarantee

Restriction

In section 23B(c), the ‘‘advertising restriction’’

prohibits an IDI from publishing any advertise-

ment or entering into any agreement stating or

suggesting that the IDI shall in any way be

responsible for the obligations of its afﬁliates.

Regulation W clariﬁes this restriction to permit

such guarantees and similar transactions if the

transaction satisﬁes the quantitative and collat-

eral restrictions of section 23A. The rule also

clariﬁes that section 23B(c) does not prohibit an

IDI from making reference to such a guarantee,

acceptance, or letter of credit in a prospectus or

other disclosure document, for example, if oth-

erwise required by law.

2020.1.16 INSPECTION OBJECTIVES

1. To analyze and assess the ﬁnancial impact

of transactions (including loans and pur-

chases of assets) between the IDIs and their

subsidiaries and all afﬁliates.

2. To ascertain if all:

a. credit transactions are properly secured;

and

b. covered transactions are consistent with

the quantitative limits of section 23A.

3. To ascertain whether the IDIs are calculat-

ing credit exposure resulting from deriva-

tives and securities borrowing and lending

transactions. Also, to ascertain that any

credit exposure is secured.

4. To determine if an IDI has engaged in a

transaction with a third party when the pro-

ceeds are used for the beneﬁt of, or trans-

ferred to, an afﬁliate.

5. To determine if an IDI has procedures for

allowing intraday credit.

6. To determine whether covered transactions

between a subsidiary IDI (and its subsidi-

aries), its holding company, and other afﬁli-

ates are conducted consistent with the quan-

titative and collateral requirements of

sections 23A and 23B of the FRA and

Regulation W.

7. To determine if transactions between a sub-

sidiary IDI and its afﬁliates in the holding

company are on terms and conditions and

under circumstances, including credit stan-

dards, are consistent with safe and sound

banking practices and whether the terms

and conditions of the transactions are the

same as those that would be offered or

applied to nonafﬁliated companies.

8. To determine whether a subsidiary IDI or

its subsidiary

a. has purchased low-quality assets or

b. has purchased, as ﬁduciary, any securi-

ties or other assets from an afﬁliate in the

holding company.

9. To determine whether a subsidiary IDI, or

any subsidiary or afﬁliate of the IDI, has

published any advertisement or has entered

into any agreement that states or suggests

that it will, in any way, be responsible for

the obligations of afﬁliates.

10. To determine if securities were purchased

or acquired by the subsidiary IDI or its

subsidiaries from an underwriting or selling

syndicate afﬁliated with the IDI and, if so, if

the majority of outside directors of the IDI

approved the purchase or acquisition of

securities before they were offered for sale

to the public.

11. To conﬁrm that the subsidiary IDI or its

subsidiary has not purchased as ﬁduciary

any securities or other assets from a non-

bank afﬁliate in the holding company

unless the purchase was permitted in

accordance with the instrument creating

the ﬁduciary relationship, by court order,

or by the law governing the ﬁduciary

relationship.

12. To ascertain if any subsidiary IDI (or its

subsidiary) had knowingly purchased or

acquired any security from an afﬁliate in

which the principal underwriter of that

security was a nonbank afﬁliate within the

holding company organization.

13. To determine if the subsidiary IDI and its

subsidiaries have conducted transactions

with their parent holding company or any

other company afﬁliated in the holding

company organization that are not in

compliance with the restrictions in sec-

tions 23A and 23B of the FRA or Regula-

tion W.

2020.1.17 INSPECTION PROCEDURES

1. During the pre-inspection, perform the fol-

lowing activities:

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 36

a. Review examination reports of sub-

sidiary IDIs for comments on loans to

afﬁliates, intercompany transactions,

other transactions with afﬁliates, and

violations of the restrictions of sec-

tions 23A or 23B of the FRA, or Regula-

tion W.

b. Review the most current FR Y-8 (The

Bank Holding Company Report of

Insured Depository Institutions’ Section

23A Transactions with Afﬁliates).

2. In the ofﬁcer’s questionnaire, request a list

of subsidiary IDIs and their subsidiaries’

transactions with afﬁliates since the previ-

ous inspection, including the amounts,

types, and any collateral, consisting of—

a. loans or extensions of credit to an afﬁli-

ate, and purchases of extensions of credit

from an afﬁliate;

b. a purchase or sale of an investment in

securities issued by, or sold to, the afﬁli-

ate, or purchase or sale of other assets,

including assets subject to an agreement

to repurchase;

c. the acceptance of securities or other debt

instrument issued by the afﬁliate as col-

lateral security for a loan or extension of

credit;

d. the issuance of a guarantee, acceptance,

or letter of credit, including an endorse-

ment or standby letter of credit on behalf

of an afﬁliate;

e. a transaction with an afﬁliate that

involves the borrowing or lending of

securities, to the extent that the transac-

tion causes an IDI or a subsidiary to

have credit exposure to the afﬁliate;

f. a derivative transaction, as deﬁned in 12

U.S.C. 84(b), with an afﬁliate, to the

extent that the transaction causes an IDI

or a subsidiary to have credit exposure to

the afﬁliate.

g. the payment of money or the furnishing

of services to an afﬁliate under contract,

lease, or otherwise;

h. transactions in which an afﬁliate acts as

agent or broker or receives a fee for its

services to the bank or to any other

person;

i. any transaction or series of transactions

with a third party if—

(1) the afﬁliate has a ﬁnancial interest in

the third party or

(2) the afﬁliate is a participant in such

transactions; and

j. Any transaction by a subsidiary bank or

its subsidiary with any person, if the

proceeds of that transaction are used for

the beneﬁt of, or transferred to, the

afﬁliate.

3. During the BHC’s inspection, perform the

following activities:

a. Review the bank holding company’s

policies and procedures regarding inter-

company transactions of subsidiary

banks.

b. Determine if the substantive transactions

of the holding company organization

comply with the restrictions on transac-

tions with afﬁliates in sections 23A and

23B of the FRA and Regulation W.

c. Verify that covered transactions count

against Regulation W’s limits and are

collateralized when required.

(1) Ensure that covered transactions are

properly valued and adequately

collateralized;

(2) Review collateral documentation to

ensure that a lien is adequately per-

fected and prioritized.

(3) Review all related documentation,

terms, conditions, and circumstances

for each transaction, including any

resolutions for securities purchased

(or established standards for securi-

ties purchased from afﬁliates).

(4) Determine the purpose and use of

the transaction’s proceeds.

d. Review all outstanding guarantees,

endorsements, or pledge agreements by

the bank to support the afﬁliates’

borrowings.

e. Review, on a test-sample basis, adver-

tisements and written agreements to

ascertain whether the bank or any sub-

sidiary or afﬁliate of the bank has stated

or suggested that it shall be responsible

for the obligations of any afﬁliates in the

holding company organization.

f. If the BHC engages in derivative trans-

actions with afﬁliates, review the BHC’s

policies and procedures to determine if

credit limits, collateral restrictions, and

other limitations (each afﬁliate and all

afﬁliates combined) have been imposed

on interafﬁliate derivative transaction

(IDI) exposures to afﬁliates.

(1) Determine if the limits are similar to

those imposed on nonafﬁliated

counterparties.

g. Review the listed transactions of the

BHC or its subsidiary with the afﬁliates

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 37

that the IDI claims are exempt under

12 C.F.R. 223.42(k) provided in response

to the ofﬁcer’s questionnaire (item 2).

Determine if

(1) extensions of credit, and purchases

of extensions of credit, are supported

by independent credit evaluations

and if advance loan commitments

are provided before the afﬁliates

make loans;

(2) no blank advance purchase commit-

ments exist to purchase loans; and

(3) the purchases meet the quantitative

restrictions of the exemption.

4. Give additional attention to the following

problems involving the BHC and its

subsidiaries:

a. The subsidiary IDI would not have made

the loan or would not have made the

loan with such favorable terms and con-

ditions, or engaged in any other covered

transaction, except for the parent holding

company’s insistence due to the afﬁliate

relationship.

b. The IDI’s condition is weakened due to

the extension of credit or the nature of

the transaction with the afﬁliate.

c. The afﬁliate has not provided adequate

qualifying collateral to support the loan

or extension of credit provided by the

subsidiary IDI.

d. The IDI does not have a perfected secu-

rity interest in the collateral.

e. The loan, extension of credit, or transac-

tion with an afﬁliate is not in compliance

with the limits and restrictions in sec-

tions 23A or 23B of the FRA or Regula-

tion W.

f. Purchases of low-quality assets by a sub-

sidiary bank or its subsidiaries from an

afﬁliate, unless previously exempted by

the Board’s Regulation W, Board order,

or unless the IDI subsidiary or subsidiary

afﬁliate, pursuant to an independent

credit evaluation, had committed itself to

purchase the low-quality assets before

the time such asset was acquired by the

afﬁliate.

g. During the existence of any underwriting

or selling syndicate, a subsidiary IDI or

its subsidiary has purchased or acquired

a security from an IDI afﬁliate or bank

holding company afﬁliate, including an

afﬁliated broker-dealer, and the principal

underwriter of that security is an afﬁliate

of the IDI.

h. The purchase or acquisition of securities

(1) was not approved by a majority of

the outside board of directors before the

IDI’s securities were offered for sale to

the public and (2) was not, in the absence

of comparable transactions, on terms and

under circumstances, including credit

standards, that in good faith would have

been offered to, or would have applied

to, nonafﬁliated companies.

i. The existence of advertisements or

agreements that state or suggest that the

IDI, its subsidiaries, or afﬁliate will be

responsible for the obligations of its

afﬁliates.

5. Review any checking accounts and IDI

statements to check for overdrafts the par-

ent company or any of its nonbank subsidi-

aries may have with a subsidiary IDI.

6. Review the accounts payable to the sub-

sidiary IDI and other accounts payable

accounts for servicers, contractors, lessors,

and other afﬁliates to determine if they

arose as the equivalent of an extension of

credit, purchase of securities or other assets,

or as a liability to third parties. Ascertain

whether those transactions were listed in

response to the ofﬁcer’s questionnaire and

whether the transactions were in

accordance with the restrictions in sec-

tions 23A and 23B of the FRA and Regula-

tion W.

7. Review the accounts receivable from the

subsidiary IDI and other accounts receiv-

able of other afﬁliates for sales of securi-

ties or other assets and for the payment of

money or the furnishing of services.

Ascertain whether those transactions were

reported in response to an ofﬁcer’s

questionnaire and whether they are in

accordance with section 23A and 23B of

the FRA’s and Regulation W’s restrictions

placed on transactions with afﬁliates.

8. Ascertain if the IDI’s credit limits, collat-

eral requirements, and monitoring of its

exposures to afﬁliates are at least as strict as

those it imposes on unafﬁliated companies.

9. Determine if the IDI has policies and proce-

dures to monitor and control its intraday

credit exposure to each afﬁliate and to all

afﬁliates in the aggregate.

10. Determine if the IDI’s intraday extensions

of credit to afﬁliates are on comparable

market terms and if they comply with sec-

tion 23B of the FRA.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 38

11. Review all other transactions that the hold-

ing company organization has engaged in

with its afﬁliated IDIs and their subsidi-

aries, including lease arrangements, to

determine whether they are subject to the

restrictions in sections 23A and 23B and

Regulation W, and, if so, whether they are

in compliance.

12. Discuss the ﬁndings with appropriate senior

management and, if the ﬁndings are signiﬁ-

cant, the board of directors.

13. Determine management’s corrective actions

regarding any comments raised by the

bank’s primary regulator in an examination

report.

a. If violations are disclosed in a subsidiary

bank’s examination report or during an

inspection of the holding company, the

examiner may criticize management on

the “Examiner’s Comments and Matters

Requiring Special Board Attention” page

or section of the inspection report for

causing the bank to be in violation or for

engaging in unsafe and unsound prac-

tices.

b. If loans to or transactions with afﬁliates

within the holding company organiza-

tion appear to adversely affect a subsidi-

ary bank, request management’s assess-

ment of such effects and its rationale for

the transactions. Use of the “Examiner’s

Comments and Matters Requiring Spe-

cial Board Attention” report page or sec-

tion may be appropriate.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 39

2020.1.18 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

FRRS

Orders

Regulation W 223

Treatment of transactions

with ﬁnancial subsidiaries of

banks

371c(e), FRA

section 23A

208.73(d) 3-383.1

Limitations on amount—

loans secured by paper eli-

gible for rediscount or pur-

chase by a Federal Reserve

Bank

371c, FRA

section 23A(c)

223.14(b)(i)(C)

Applicability to FDIC-

insured banks

1828(j), FDIA

section 18(j)

1-398

Restrictions on transactions

with afﬁliates

371c-1, FRA

section 23B

3-1116

Market terms requirement—

derivative transactions with

afﬁliates

223.33

Intraday extensions of credit

by insured depository insti-

tutions to their afﬁliates

223.42(l)

Exemptions-loans and

extensions of credit by

member bank to a third

party

223.16(c)(3)

Securities issued by an

afﬁliate cannot be used as

collateral for a loan to any

afﬁliate

1813, Dodd-Frank

Act

371c(c)(4)

Credit exposure resulting

from a derivative transaction

with an afﬁliate is a covered

transaction

371c(b)(7)(G)

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Transactions Between Member Banks and Their Afﬁliates—Sections 23A and 23B 2020.1

BHC Supervision Manual July 2014

Page 40

Intercompany Transactions

(Loan Participations) Section 2020.2

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2010, this section was revised to

include a cross reference to section 2010.2.7 of

this manual, which discusses loan participa-

tions. References in the table of Laws, Regula-

tions, Interpretations, and Orders have also

been updated.

It is common practice for a bank to sell to or

place with other banks loans that the bank itself

has made to its customers. A loan participation

is a share or part of a loan which entitles the

holder to a pro rata share of the income deter-

mined by the extent of the holder’s contribution

to the original loan and a preference ordering

for repayment. Such loans may be sold outright

without liability to the selling bank in case of

default by the borrower, or they may be sold

with terms granting the purchasing bank

recourse to the selling bank should the loans

become uncollectible. Sales to or placement of

loans with other banks are for the accommoda-

tion of either the selling or purchasing bank and

are arranged for purposes of increasing the rate

of return when loan rates differ between banks,

achieving diversiﬁcation of loans by type, and

altering liquidity positions. It is also common

practice for banks to sell or place with other

banks those portions of individual loans that

would be in excess of the bank’s legal lending

limit (overlines) if the total loan were retained.

Participations of this type should be placed

without recourse as a matter of prudent banking

practice; otherwise, the purpose of compliance

with the legal lending limitations would be

defeated in the event of default. See section

2010.2.7 of this manual for supervisory and

accounting guidance regarding a BHC’s or

bank’s use, purchase, or sale of loan participa-

tion agreements.

Banks also sell or place loans or participa-

tions with their parent holding companies or

nonbank afﬁliates. A BHC’s purchase of loan

participations from its subsidiary bank(s) gener-

ally constitutes the making of a loan or exten-

sion of credit within the meaning of section

225.28(b)(1) of Regulation Y, and as such, a

BHC needs prior approval to purchase loan par-

ticipations from its subsidiary bank(s).

A bank may participate in or purchase a loan

originated by its parent holding company or one

of its nonbank subsidiaries. A subsidiary bank’s

purchase, or participation of a loan, note, or

other asset from an afﬁliate is considered a

purchase of an asset from an afﬁliate within the

meaning of section 23A of the Federal Reserve

Act and thus is a ‘‘covered transaction’’ that is

subject to the quantitative limitations and the

prohibition against purchasing of low-quality

assets. Subsidiary banks must make indepen-

dent judgments as to the quality of such partici-

pations before their purchase to avoid compro-

mising the asset quality of such banks for the

beneﬁt of other holding company entities. All

loans and participations must be purchased on

market terms.

A bank’s purchase of a loan or loan participa-

tion, on a nonrecourse basis from an afﬁliate,

may not be a covered transaction under section

23A that is subject to the quantitative limita-

tions (12 C.F.R. 223.11- 223.12)), collateral

requirements (12 C.F.R. 223.14), and low-

quality asset prohibition (12 C.F.R. 223.15) if

1. the extension of credit was originated by the

afﬁliate;

2. the member bank makes an independent

evaluation of the creditworthiness of the bor-

rower before the afﬁliate makes or commits

to make the extension of credit;

3. the member bank commits to purchase the

extension of credit before the afﬁliate makes

or commits to make the extension of credit;

4. the member bank does not make a blanket

advance commitment to purchase extensions

of credit from the afﬁliate; and

5. the dollar amount of the extension of credit,

when aggregated with the dollar amount of

all other extensions of credit purchased from

the afﬁliate during the preceding 12 calendar

months by the member bank and its deposi-

tory institution afﬁliates, does not represent

more than 50 percent (or such lower percent

as is imposed by the bank’s appropriate Fed-

eral banking agency) of the dollar amount of

extensions of credit originated by the afﬁliate

during the preceding 12 calendar months.

(See 12 C.F.R. 223.42(k).)

In some cases, a bank may renew a loan or a

participation that it purchased from another

afﬁliated bank even when the original participa-

tion has become a low-quality asset. In some

instances, a bank’s renewal of a low-quality

asset, such as a troubled agricultural loan, or an

extension of limited amounts of additional credit

to such a borrower may enable both the originat-

BHC Supervision Manual July 2010

Page 1

ing and participating banks to avoid or mini-

mize potential losses. It would be inconsistent

with the purposes of section 23A to bar a partici-

pating bank from using sound banking judg-

ment to take the steps that it may deem neces-

sary to protect itself from harm in such a

situation, so long as the loan was not a low-

quality asset at the time of the original participa-

tion and the participating bank does not assume

more than its original proportionate share of the

credit.

The following factors thus characterize the

situation where it would be reasonable to inter-

pret section 23A as not applying to the renewal

of an otherwise low-quality asset:

1. the original extension of credit was not a

low-quality asset at the time the afﬁliated

bank purchased its participation,

2. the renewal and/or the extension of addi-

tional credit has been approved by the board

of directors of the participating bank as nec-

essary to protect the bank’s investment by

enhancing the ultimate collection of the

original indebtedness, and

3. the participating bank’s share of the renewal

and/or additional loan will not exceed its

proportionate share of the original invest-

ment by more than 5 percent. In addition, it

is expected that, consistent with safe and

sound banking practices, the originating bank

would make its best efforts to obtain

adequate collateral for the loan(s) to further

protect the banks from loss. (See 12 C.F.R.

223.15.)

Loans and loan participations by the various

members of the holding company family to indi-

vidual borrowers or to the same or related inter-

ests may represent concentrations of credit

which are large in relation to the holding com-

pany’s consolidated capital position. These con-

centrations of credit should be assessed for

potentially harmful exposure to the holding

company’s ﬁnancial condition.

2020.2.1 INSPECTION OBJECTIVES

1. To determine the BHC’s loan participation

policy.

2. To assess the impact of a subsidiary bank’s

participation in loans with afﬁliates and to

ensure that the bank’s ﬁnancial condition is

not compromised and that the bank is not

providing the funding needs of the afﬁliates,

except within the parameters of sections 23A

and 23B of the Federal Reserve Act.

3. To assess the impact of any concentrations of

credit on the holding company’s overall

ﬁnancial position.

2020.2.2 INSPECTION PROCEDURES

1. During the preinspection process, review

each subsidiary bank’s examination report

for comments on participations with afﬁli-

ates.

2. In the ofﬁcer’s questionnaire to the holding

company, request the BHC’s policy on loan

participation. Request a list of any loan par-

ticipations the holding company or the non-

bank subsidiaries have with the subsidiary

bank(s).

3. During the inspection, review the policy

statements and each participation the holding

company or the nonbank subsidiaries have

with the subsidiary bank(s). The following

characteristics should be analyzed:

a. any repetitive transaction patterns which

may indicate policy;

b. the adequacy of credit information on ﬁle;

c. the extent to which the terms of the par-

ticipation including interest rates are

handled in an arm’s-length manner;

d. the degree that the bank is accommodat-

ing the funding needs of the nonbank sub-

sidiaries or its parent;

e. the impact of these transactions on the

subsidiary bank;

f. eligibility for exclusion from section 23A

restrictions and, if applicable, compliance

with such restrictions.

4. Review participations among the bank hold-

ing company, nonbank subsidiaries, and

the subsidiary banks to determine potentially

adverse concentrations of credit.

5. Discuss with management—

a. written and verbal policies regarding par-

ticipations both within the holding com-

pany and with nonafﬁliated third parties

and

b. any adverse ﬁndings on intercompany

participations.

6. Comment on policy on the appropriate page

of the inspection report (see section 5010.6).

If any adverse comments on participations

with afﬁliates are contained in a bank subsid-

iary’s examination report, comment on their

current status and the BHC’s efforts to rem-

edy the problem.

Intercompany Transactions (Loan Participations) 2020.2

BHC Supervision Manual July 2010

Page 2

2020.2.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Limitations and restrictions 371c, FRA

section 23A(c)

Purchase of extensions of

credit from afﬁliates

223.42(k) 3–1161

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Intercompany Transactions (Loan Participations) 2020.2

BHC Supervision Manual July 2010

Page 3

Intercompany Transactions

(Sale and Transfer of Assets) Section 2020.3

Sales and transfers of assets between subsidiary

banks and other entities in a bank holding com-

pany organization pose the potential of risk to

the subsidiary banks. Asset purchases are cov-

ered by Section 23A and Section 23B of the

Federal Reserve Act. The limitations state that

all covered transactions, including asset pur-

chases, by a bank with a single afﬁliate, may not

exceed 10 percent of a bank’s capital and sur-

plus, and transactions with all afﬁliates may not

exceed 20 percent of the bank’s capital and

surplus. In addition, all transactions must be

conducted on market terms.

A bank’s purchase of a loan or loan participa-

tion from a bank holding company or its subsid-

iary may not be a covered transaction under

Section 23A if:

1. the bank makes an independent credit

evaluation on each loan prior to the afﬁliate

making the loan;

2. the bank agrees to purchase the loan prior

to the afﬁliate making the loan; and

3. the bank’s purchase of the afﬁliate’s loans

is not the primary source of funding for the

afﬁliate.

Sale and transfer of assets can also occur

through swaps and spinoffs. Examples of such

transactions which may have an adverse effect

on a bank include the transfer of a proﬁtable

activity or subsidiary from the bank to the hold-

ing company, or the transfer of an unproﬁtable

activity or subsidiary from the holding company

to the bank. In addition, the transfer of a bank

holding company subsidiary to a bank, whereby

the bank assumes the liabilities of the afﬁliate

raises supervisory concerns and may violate

Sections 23A and 23B of the Federal Reserve

Act.

Another example is the transfer of a subsidi-

ary bank’s deferred taxes, together with an

equivalent amount of cash or earning assets, to

the parent. In such a transaction, a subsidiary

bank’s liquidity position is weakened. All such

transfers of deferred taxes must be reversed and

the bank’s asset and liability accounts restored

to their level prior to the transfer. For a detailed

discussion on transfers of a bank’s deferred tax

liability, see Manual section 2070.0.

A bank holding company may transfer a liqui-

dating asset from a subsidiary bank to a section

4(c)(1)(D) liquidating subsidiary of the holding

company. Also, pursuant to section 4(c)(3) of

the Act, a BHC may transfer from a subsidiary

bank an asset to be disposed of pursuant to the

request of the bank’s primary regulator. For

more information on the transfer of such assets

and the time parameters involved, refer to

Manual section 3030.0.

The purchase of low-quality assets is prohib-

ited by Section 23A of the Federal Reserve Act.

Refer to section 2020.1.1.5 for a listing of trans-

actions that are exempt from the limitations of

Section 23A of the Federal Reserve Act.

2020.3.1 INSPECTION OBJECTIVES

1. To review intercompany sale and transfer

of assets to assess the impact on the subsidiary

bank.

2. To initiate corrective action to reverse the

transaction, if necessary.

2020.3.2 INSPECTION PROCEDURES

1. During the preinspection process, review

all notes to ﬁnancial statements, the FR Y-8

report, and the examination reports of subsidi-

ary banks to ascertain whether any purchase or

transfer of assets has occurred between the sub-

sidiary banks and the parent holding company

or nonbank subsidiaries.

2. In the ofﬁcer’s questionnaire, request

information on any transfer or sale of assets

between the subsidiary bank and the parent

holding company or the nonbank subsidiaries.

3. During the inspection, review all facts

regarding any sale or transfer of assets transac-

tions and assess their impact on the subsidiary

bank. Examiners should determine:

a. Whether the transaction required and

received the approval of the bank’s primary

regulator; and

b. The quality of the assets transferred or

sold, and whether the sale of the assets was at a

price signiﬁcantly higher than would have been

realized in an arm’s-length transaction.

4. Discuss ﬁndings with management

including:

a. Apparent prejudicial transactions and

violations of regulations; and

b. Any unsound practices.

BHC Supervision Manual December 1992

Page 1

Intercompany Transactions

(Compensating Balances) Section 2020.4

A compensating balance is a deposit maintained

by a ﬁrm at a bank to compensate the bank for

loans and lines of credit granted to the ﬁrm.

Often, a commercial bank, when extending

credit, requires an average deposit balance equal

to a ﬁxed percentage of the outstanding loan

balance. Compensating balance requirements

vary from informal understandings to formal

contracts. Deposits maintained as compensating

balances may be demand or time, active or

dormant. Frequently, a lending bank will allow

compensating balances to be supplied by a

depositor other than the borrower itself. If com-

pensating balances are maintained by a BHC’s

subsidiary bank on behalf of its parent, the

practice is considered a diversion of bank

income (i.e., the bank loses the opportunity to

earn income on the balances that could be

invested elsewhere). In general, this practice is

inappropriate unless the bank is being compen-

sated at an appropriate rate of interest. If the

bank is not being appropriately reimbursed, the

practice should be criticized and action taken to

insure that the bank is compensated for the use

of its funds.

BHCs borrow directly from nonafﬁliated

banks, using the proceeds for both bank and

nonbank operations and investments. Also, bank

holding companies seek credit lines from banks

to back their borrowings in commercial paper

markets and for other liquidity purposes. Non-

bank subsidiaries of bank holding companies

borrow from banks to fund activities such as

mortgage banking, leasing and sales ﬁnance. In

some cases, when a bank holding company or

its nonbank subsidiaries borrow, the subsidiary

bank’s deposit at the lending institution may be

accepted as a compensating balance for the bor-

rowings of other members of the bank holding

company organization. Such transactions raise

questions under Section 23B of the Federal

Reserve Act regarding the bank’s compensation

for such services.

Often the distinction between correspondent

balances and compensating balances is not clear.

Occasionally, the rate of the required compen-

sating balance is written into the loan agree-

ment; however, informal understandings usually

appear to determine the amount of compensat-

ing balance maintained. At times, a balance may

be identiﬁed in the bank’s books as a compen-

sating balance. A compensating balance may

also be identiﬁed as an amount above a corre-

spondent balance historically maintained by the

bank. Compensating balances may also appear

as a dormant account or may be the aggregate

amount of a number of deposits of various sub-

sidiary banks.

The interest rate on the loan to the holding

company organization may also be helpful in

determining the existence of compensating bal-

ances. Loans below the lending bank’s normal

rate may indicate that the lending bank is receiv-

ing compensation in another form.

At times, excess correspondent balances are

maintained to encourage participation relation-

ships and for other goodwill reasons. Therefore,

the existence of excess balances may not always

indicate that there is a compensating balance

agreement.

Although a bank holding company may com-

pensate its subsidiary banks for the use of the

funds, the compensation may not equal the

opportunity cost associated with providing the

compensating balance. As a result, subsidiary

banks which maintain compensating balances

for holding company members may forego

proﬁt opportunities, and this practice may have

a negative impact on the bank’s earnings and

capital adequacy. The amount of such compen-

sation should be equal to a fair market rate.

If the lending bank has the right of offset to

compensating balances maintained by the sub-

sidiary bank in case of default by parent or

nonbank subsidiaries, the subsidiary bank’s

funds are jeopardized. Such potential loss of

funds should be commented on by the examiner.

2020.4.1 INSPECTION OBJECTIVES

1. To identify compensating balances main-

tained by a subsidiary bank for the parent hold-

ing company or any nonbank afﬁliate.

2. To determine whether the subsidiary bank

is adequately reimbursed for the maintenance of

any compensating balances.

2020.4.2 INSPECTION PROCEDURES

1. During the preinspection process:

a. Review the subsidiary bank examina-

tion reports or contact management to determine

whether the non-afﬁliated banks, lending to the

holding company organization, are correspon-

dents of the subsidiary banks. Where applicable,

request detailed loan information which could

BHC Supervision Manual December 1992

Page 1

provide information on the compensating bal-

ances’ terms required by the lending bank.

b. Review the notes to the ﬁnancial state-

ments and other available material, such as

10–K reports ﬁled with the SEC, which may

describe compensating balance agreements.

FR Y–8 reports should be reviewed for ques-

tions applicable to compensating balances.

2. Review interbank loan agreements to

determine whether compensating balances are

formally required. Assess the terms of the loan

to determine whether the loan appears to be at

fair market rates for this type of credit request.

3. Request and review the account balance

and monthly account statement provided by the

lending bank to identify the amount of compen-

sating balances. The statement should be avail-

able within the holding company or bank.

4. Request from management information

regarding compensating balances maintained by

subsidiary banks for the beneﬁt of other afﬁli-

ates.

5. Review the subsidiary bank’s historical

level of correspondent balances to assess trends.

Compare levels of balances prior to any loan

origination or interest rate changes.

6. Review intercompany accounts to deter-

mine the amount of compensation paid to the

subsidiary bank for maintaining compensating

balances. Assess adequacy of compensation.

Assess impact of practice on the bank’s ﬁnan-

cial condition.

7. Discuss with management the reasons for

any apparent excess balances, and whether com-

pensating balances are formally or informally

required.

Intercompany Transactions (Compensating Balances) 2020.4

BHC Supervision Manual December 1992

Page 2

Intercompany Transactions

(Dividends) Section 2020.5

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2012, this section was revised to

update the references within the table of Laws,

Regulations, Interpretations, and Orders.

Dividends are a means by which a corporation

distributes earnings or assets to its shareholders.

Although the word ‘‘dividends’’ usually applies

to funds paid out of net proﬁts or surplus and is

usually thought of in such a context, dividends

can also be made ‘‘in kind,’’ which means in

property or commodities. This section does not

discuss ‘‘stock dividends’’ which represent

transfers from retained earnings to paid-in capi-

tal rather than distributions of earnings. Divi-

dends from the subsidiaries, both bank and non-

bank, to the parent company are the means by

which a cash return is realized on the invest-

ment in subsidiaries, thus enabling the parent to

pay dividends to its shareholders and to meet its

debt service requirements and other obligations.

Dividends paid by any corporation are gener-

ally limited by certain State laws. Banks, how-

ever, are subject to further legal restrictions on

dividends by their chartering authority and other

regulators. Aside from the statutory limitations,

the primary consideration in this area is the

subsidiary’s level of capital and its ability to

meet future capital needs through earnings

retention.

Although there are no speciﬁc regulations

restricting dividend payments by bank holding

companies other than State corporate laws,

supervisory concern focuses on the holding

company’s capital position, its ability to meet its

ﬁnancial obligations as they come due, and its

capacity to act as a source of ﬁnancial strength

to its subsidiaries. Some one-bank holding com-

panies may be restricted in the amount of divi-

dends they may pay as a result of certain limita-

tions placed on future dividend distributions at

the time of the holding company’s formation.

(see Manual section 2090.2)

When analyzing the dividend practices of the

subsidiaries and the parent company the follow-

ing must be considered: the present level of

capital in relation to total assets, risk assets, and

classiﬁed assets; growth rates and additional

plans for expansion; past earnings performance

and projections; and the ability to service debt.

Aside from reasonable and timely fees for

services rendered, the most appropriate way for

funds to be paid by the bank to the parent is

through dividends. This principle applies, in

general, to bank payments of funds to service

holding company debt, even when the debt was

initially incurred to raise equity capital for the

subsidiary bank. It is not considered an appro-

priate banking practice for the subsidiary bank

to pay management fees for the purpose of

servicing holding company debt. Funds for ser-

vicing holding company debt should, as a

general rule, be upstreamed in the form of

dividends.

2020.5.1 POLICY STATEMENT ON

CASH DIVIDEND PAYMENTS

On November 14, 1985 the Board approved a

policy statement on the payment of cash divi-

dends by state member banks and bank holding

companies that are experiencing ﬁnancial difﬁ-

culties. The policy statement addresses the fol-

lowing practices of supervisory concern by

institutions that are experiencing earnings weak-

nesses, other serious problems, or that have

inadequate capital:

• The payment of dividends not covered by

earnings,

• The payment of dividends from borrowed

funds,

• The payment of dividends from unusual or

nonrecurring gains, such as the sale of prop-

erty or other assets.

It is the Federal Reserve’s view that an orga-

nization experiencing earnings weaknesses or

other ﬁnancial pressures should not maintain a

level of cash dividends that exceeds its net

income, that is inconsistent with the organiza-

tion’s capital position, or that can only be

funded in ways that may weaken the organiza-

tion’s ﬁnancial health. In some instances, it may

be appropriate to eliminate cash dividends alto-

gether. The policy statement is as follows:

2020.5.1.1 Policy Statement on the

Payment of Cash Dividends by State

Member Banks and Bank Holding

Companies

The Board of Governors of the Federal Reserve

System considers adequate capital to be critical

to the health of individual banking organiza-

BHC Supervision Manual July 2012

Page 1

tions and to the safety and stability of the bank-

ing system. A major determinant of a bank’s or

bank holding company’s capital adequacy is the

strength of its earnings and the extent to which

its earnings are retained and added to capital or

paid out to shareholders in the form of cash

dividends.

Normally, during proﬁtable periods, divi-

dends represent an appropriate return of a por-

tion of a banking organization’s net earnings to

its shareholders. However, the payment of cash

dividends that are not fully covered by earnings,

in effect, represents the return of a portion of an

organization’s capital at a time when circum-

stances may indicate instead the need to

strengthen capital and concentrate ﬁnancial

resources on resolving the organization’s

problems.

As a matter of prudent banking, therefore, the

Board believes that a bank or bank holding

company generally should not maintain its exist-

ing rate of cash dividends on common stock

unless 1) the organization’s net income avail-

able to common shareholders over the past year

has been sufﬁcient to fully fund the dividends

and 2) the prospective rate of earnings retention

appears consistent with the organization’s capi-

tal needs, asset quality, and overall ﬁnancial

condition. Any banking organization whose

cash dividends are inconsistent with either of

these criteria should give serious consideration

to cutting or eliminating its dividends. Such an

action will help to conserve the organization’s

capital base and assist it in weathering a period

of adversity. Once earnings have begun to

improve, capital can be strengthened by keeping

dividends at a level that allows for an increase

in the rate of earnings retention until an

adequate capital position has been restored.

The Board also believes it is inappropriate for

a banking organization that is experiencing seri-

ous ﬁnancial problems or that has inadequate

capital to borrow in order to pay dividends since

this can result in increased leverage at the very

time the organization needs to reduce its debt or

increase its capital. Similarly, the payment of

dividends based solely or largely upon gains

resulting from unusual or nonrecurring events,

such as the sale of the organization’s building or

the disposition of other assets, may not be pru-

dent or warranted, especially if the funds

derived from such transactions could be better

employed to strengthen the organization’s ﬁnan-

cial resources.

A fundamental principle underlying the Fed-

eral Reserve’s supervision and regulation of

bank holding companies is that bank holding

companies should serve as a source of manage-

rial and ﬁnancial strength to their subsidiary

banks. The Board believes, therefore, that a

bank holding company should not maintain a

level of cash dividends to its shareholders that

places undue pressure on the capital of bank

subsidiaries, or that can be funded only through

additional borrowings or other arrangements

that may undermine the bank holding com-

pany’s ability to serve as a source of strength.

Thus, for example, if a major subsidiary bank

is unable to pay dividends to its parent

company—as a consequence of statutory limi-

tations, intervention by the primary supervisor,

or noncompliance with regulatory capital

requirements—the bank holding company

should give serious consideration to reducing or

eliminating its dividends in order to conserve its

capital base and provide capital assistance to the

subsidiary bank. . . .

This statement of principles is not meant to

establish new or rigid regulatory standards;

rather, it reiterates what for most banks, and

businesses in general, constitutes prudent ﬁnan-

cial practice. Boards of directors should continu-

ally review dividend policies in light of their

organizations’ ﬁnancial condition and compli-

ance with regulatory capital requirements, and

should ensure that such policies are consistent

with the principles outlined above. Federal

Reserve examiners will be guided by these prin-

ciples in evaluating dividend policies and in

formulating corrective action programs for

banking organizations that are experiencing

earnings weaknesses, asset quality problems, or

that are otherwise subject to unusual ﬁnancial

pressures.

2020.5.2 INSPECTION OBJECTIVES

1. To assure compliance with statutes and the

Board’s November 1985, Policy Statement.

2. To determine reasonableness of dividend

payout at both the subsidiary and holding com-

pany levels.

Depending on the type of charter and mem-

bership in the Federal Reserve, all insured com-

mercial banks are subject to certain legal restric-

tions on dividends. In the case of nonbank

subsidiaries and holding companies, there are

no speciﬁc federal statutes, other than the policy

statements discussed, which apply to dividend

payments. State corporate laws would apply.

Intercompany Transactions (Dividends) 2020.5

BHC Supervision Manual July 2012

Page 2

One objective of the inspection process is to

check for compliance with these laws and to

follow-up on any violations.

In some cases dividends which comply with

the regulations still may not be in the best

interest of the bank. It is the examiner’s respon-

sibility to assess the reasonableness of dividend

payments in relation to each subsidiary’s capital

needs. Evaluation of the holding company’s

dividend policy and payment requires a review

at both the parent company and the consolidated

levels. On a consolidated basis the holding com-

pany’s capital level in relation to the quantity

and quality of total assets, earnings history and

potential, and growth rates are important in the

assessment of a reasonable dividend payout. At

the parent level, the method of funding divi-

dends should be reviewed. For example, a well

capitalized corporation with strong earnings

might pay dividends which could be considered

unreasonable if the organization were in a

strained liquidity position.

2020.5.3 INSPECTION PROCEDURES

1. Review dividend payments by subsidiaries

and the parent company. Check for compliance

with appropriate statutes and the Board’s

November 14, 1985 policy statement on the

Payment of Cash Dividends. Discuss violations

with management and comment on the ‘‘Exam-

iner’s Comments and Matters Requiring Special

Attention’’ page.

This step will often require a review of net

earnings and changes in the capital accounts in

the past years, as legal restrictions on dividends

often apply to cumulative income for several

years rather than just the year the dividend is

actually paid. For this reason detailed working

papers are important, as these can help to avoid

duplications of effort at future inspections. In

some situations the regulations provide that

dividends may be paid in excess of current

year’s earnings. If prior approval from the

bank’s primary regulator is necessary, verify

that it has been obtained. Any violations of

dividend statutes should be discussed with man-

agement and cited in the ‘‘Examiner’s Com-

ments and Matters Requiring Special Atten-

tion’’ page of the inspection report.

2. Analyze dividend payouts of subsidiaries

and the parent in terms of capital adequacy,

earnings and earnings potential.

Discuss excessive dividend payouts at any

level with management and comment on the

‘‘Examiner’s Comments and Matters Requiring

Special Attention’’ page of the inspection report.

In assessing the reasonableness of dividend pay-

ments by subsidiaries and the holding company,

the organization’s capital adequacy and future

capital needs must be judged with the following

in mind: the volume of total assets; asset quality

(the percentage of weighted classiﬁed assets to

gross capital could be used as an indicator of

quality); asset mix and liquidity; asset growth

rates and projections; and plans for expansion

and development of new areas. The subsidiary’s

or the holding company’s ability to augment

capital through earnings is also important. If a

bank, nonbank or holding company has a consis-

tently strong earnings record and its capital posi-

tion is healthy, a higher dividend payout may be

acceptable than would be otherwise. In analyz-

ing the strength of earnings both quantity and

quality must be considered. The actual quality

of earnings and earnings potential are related to

operating income rather than extraordinary

items, signiﬁcant capital or securities gains, or

substantial increases resulting from tax consid-

erations.

3. Review the funding of dividends paid by

the holding company. Analyze the parent’s cash

ﬂow and income statements in accordance with

section 4010.0 of this manual. Discuss any inap-

propriate funding with management and com-

ment on, based on their severity, either on the

‘‘Cash Flow Statement (Parent),’’ or the ‘‘Analy-

sis of Financial Factors’’ and the ‘‘Examiner’s

Comments and Matters Requiring Special

Attention’’ pages.

An analysis of the parent company’s cash

ﬂow statement supplemented by the income

statement will identify the source of cash for

dividend payments. The parent company has

cash inﬂow from various sources including:

dividends from subsidiaries, income from activi-

ties conducted for its own account, interest

income on advances to subsidiaries, manage-

ment and service fees, borrowings, and tax sav-

ings resulting from ﬁling a consolidated tax

return. Dividends should be internally funded

from dividends paid by the subsidiaries, the

parent company’s earnings from activities for

its own account or from interest income on

advances to subsidiaries. Should the analysis of

the cash ﬂow statement indicate that dividends

paid by the parent exceed cash inﬂow from

these sources, further attention to the area is

required to determine the actual underlying

source of dividend funding. As discussed in the

section on management and service fees, these

are properly assessed at market value or cost of

Intercompany Transactions (Dividends) 2020.5

BHC Supervision Manual July 2012

Page 3

services rendered. They are not to be charged

simply to divert income from subsidiaries in

order to pay dividends. Borrowing to fund divi-

dends is fundamentally an unsound practice.

When dividends paid by the holding com-

pany are funded by the bank subsidiary, it is

possible to control indirectly the holding com-

pany’s dividend payout level when it is deter-

mined to be detrimental to the bank subsidiary.

It is important to remember that the primary

responsibility of bank regulators is the promo-

tion of safe and sound banking operations. Other

than the mentioned policy statement there are

no speciﬁc federal laws restricting dividends

paid by bank holding companies; however, the

System’s cease and desist authority over bank

holding companies does afford the ability to

curb excessive dividend payouts.

Whenever the examiner determines that divi-

dend payments at the subsidiary level or parent

level are not reasonable, are not in the best

interest of the organization, or are not funded in

a proper manner, discussion with management

and a close look at its philosophy are essential.

Remarks on the matter should appear on the

‘‘Examiner’s Comments and Matters Requiring

Special Attention’’ page of the report.

2020.5.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Dividend limits for national

banks

5199(b)

Dividend limits 5204

Dividend limits for State

member banks

Section

9, F.R.

Act

Capital limitations and

earnings limitations

on the payment of

dividends by state

member banks

208.5 3–160

Board policy statement on

assessment of ﬁnancial

factors, one bank holding

companies (para. 4

dividend restrictions)

225 appendix C 4–868 1980 FRB 320

Board policy statement on

dividends for banking

organizations having

ﬁnancial difﬁculties

4–877 1986 FRB 26

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Intercompany Transactions (Dividends) 2020.5

BHC Supervision Manual July 2012

Page 4

Intercompany Transactions

(Management and Service Fees) Section 2020.6

A bank holding company is permitted to own

nonbank subsidiaries that furnish services to or

perform services for its other subsidiaries pursu-

ant to section 4(a)(2)(A), 4(c)(1)(C), or 4(c)(8)

of the BHC Act. Many bank holding companies

charge fees for providing to their subsidiaries

services such as management advice, personnel

services, data processing, marketing, supply

administration, investment advice, bookkeep-

ing, and trust services. The fees for these ser-

vices that are assessed against subsidiary banks

take many forms and are an area of potential

abuse. In addition to direct fees paid to an

afﬁliate, the compensation for providing these

services might take the form of salaries or direc-

tors’ fees paid to the bank holding company’s

management. A holding company should not,

directly or indirectly through other subsidiaries,

burden its bank subsidiaries with excessive

fees or charge for services unrelated to value

received in order to fund its debt service, divi-

dend payments, or support of other subsidiaries.

Examiners should review the fees charged by

a holding company’s bank and nonbank subsid-

iaries to any banking subsidiary and judge the

reasonableness of those fees by examining the

reasonableness of the services provided and the

basis for allocating fees. Fees charged nonbank

subsidiaries and independent third parties should

not be more favorable than fees charged bank-

ing subsidiaries. They should be reasonable and

justiﬁable and be based on the fair market value

of services provided or, when there is no market

established for a particular service, on actual

cost plus a reasonable proﬁt. The market value

of similar services is the preferred basis of fee

assessment. When fees are based on cost plus a

reasonable proﬁt, there is less incentive for the

efﬁcient and effective use of resources, because

a proﬁt margin is built in regardless of the costs

involved. In many situations, however, the cost

method is the only method possible.

Any method of pricing services provided to

bank subsidiaries that is based on anything other

than value received is inappropriate. The fee

mechanism should not be used to divert income

from any bank subsidiary to meet the parent’s

ﬁnancial needs if those needs are unrelated to

the provision of services to that subsidiary. In

addition, banks are prohibited from paying man-

agement fees* if it would cause the institution to

become undercapitalized (see title I, section 131

of the FDIC Improvement Act of 1991 or sec-

tion 38 of the FDIC Act).

Any fee for services to a banking subsidiary

should be supported by evidence that the parent

or other afﬁliate provided the service. Services

provided by bank holding companies should

serve the needs of the subsidiary bank; charges

for services that appear to duplicate existing

subsidiary-bank functions should be supported

by a detailed explanation of the net beneﬁt

derived by the subsidiary bank and by an analy-

sis of the reasonableness of the fee.

When it is impractical to allocate expenses on

a direct-charge basis, bank holding companies

frequently allocate overhead expenses to subsid-

iaries. Although this practice can be considered

acceptable with regard to nonbanking subsidi-

aries, allocating all bank holding company

expenses to bank subsidiaries is not permitted.

The parent company should bear a portion of

the costs connected with, for example, the hold-

ing company’s investor/shareholder relations,

regulatory reporting requirements, acquisitions,

formations, applications, board of directors, and

strategic planning. Bank holding companies are,

however, expected to support their subsidiary

banks, and expenses incurred to serve the needs

of the subsidiary banks, such as expenses

incurred in raising capital for subsidiary banks,

can appropriately be allocated to those subsidi-

ary banks that beneﬁt from the services pro-

vided, in proportion to the beneﬁt received from

the service.

All fees for services rendered should be sup-

ported by written agreements that describe the

service, the fees to be charged, and the method

of allocating the fees among the subsidiaries.

The absence of such contracts between the sub-

sidiaries of the holding company is considered

inappropriate and an unsafe and unsound bank-

ing practice. Supervisory action should be taken,

in a manner consistent with the ﬁnancial condi-

tion of the holding company and the subsidiary

bank, to eliminate the improper practices. The

practices should be criticized in the inspection

report and actions taken to see that the situation

is satisfactorily resolved. If the practices are

having a serious impact on the bank, or if they

might reasonably be expected to have a severe

impact given the bank’s ﬁnancial condition, for-

mal administrative action should be considered

in order to require the holding company to ter-

minate the practices and make restitution to the

subsidiary bank.

* ‘‘Management fees’’ does not include fees for such ser-

vices as electronic data processing or auditing.

BHC Supervision Manual December 1993

Page 1

A bank’s prepayment of service fees to the

parent company and payment of expenses

incurred primarily in conjunction with holding

company activities unconnected with the bank

also are cause for supervisory concern. In gen-

eral, prepayment for services is inappropriate

unless the bank holding company can demon-

strate that prepayment is standard industry prac-

tice for nonbanking companies acquiring the

same service. Prepayment of sums for services

that are not to be provided in the immediate

future (for example, prepayment of an entire

year’s fees for services to be rendered through-

out the year) can have an adverse impact on the

bank and is therefore inappropriate. These prac-

tices should be addressed by requiring timely

and reasonable payments for services and reim-

bursement to the banks for what are essentially

holding company expenses. If bank expenses

are incurred substantially in support of a hold-

ing company activity, the bank should be reim-

bursed for that portion of its cash outlay that

beneﬁts the holding company. Reimbursement

is necessary to ensure that bank resources are

not diverted to a holding company afﬁliate with

little or no beneﬁt to the bank.

Aside from reasonable and timely fees for

services rendered, the most appropriate way,

from a supervisory standpoint, for funds to be

paid to the parent company is through divi-

dends. This principle applies, in general, to bank

payment of funds to service holding company

debt, even when the debt was initially incurred

to raise equity capital for the subsidiary bank. It

is an inappropriate banking practice for the sub-

sidiary bank to pay management fees for the

purpose of servicing holding company debt.

Funds for servicing holding company debt

should, as a general rule, be upstreamed in the

form of dividends.

2020.6.1 TRANSACTIONS SUBJECT

TO FEDERAL RESERVE ACT

SECTION 23B

Section 23B of the FRA applies to any covered

transaction with an ‘‘afﬁliate,’’ as that term is

deﬁned in section 23A of the FRA. Section 23B

also applies to a number of transactions that are

not covered by section 23A, for example, trans-

actions that involve the payment of money or

the furnishing of services to an afﬁliate under

contract, lease, or otherwise, or transactions in

which an afﬁliate acts as an agent or a broker or

receives a fee for its services. Although transac-

tions between sister banks and banks that are

part of a chain banking organization are exempt

from section 23B, section 23A requires that

covered transactions between a bank and an

afﬁliate be conducted at arm’s length. See sec-

tion 2020.1.2 for other transactions that are cov-

ered by section 23B and the requirements that

pertain to all such transactions. For examples of

transactions that could violate section 23B, see

section 3700.10, dealing with an application to

provide armored car services through a bank

holding company’s nonbank subsidiary.

2020.6.2 INSPECTION OBJECTIVES

1. To determine whether the holding com-

pany and its subsidiaries charge fees to bank

subsidiaries based on value received and fair

market value.

2. To determine whether the subsidiaries are

actually receiving these services.

3. To determine that the timing of fee pay-

ments is appropriate.

4. To determine whether there is an agree-

ment between the entities relating to speciﬁc

services and fees charged.

5. To determine if any fees result in an

unsafe or unsound condition in any subsidiary

bank.

Once the management policy underlying the

fee structure is clearly understood, it is impor-

tant for the examiner to determine that practice

is consistent with policy. For example, if man-

agement indicates that fees charged are based

on the fair market value of services received but

the fee structure is actually geared to the bank

subsidiary’s asset size, an inconsistency exists.

Assuming either that all of the bank subsidiaries

have access to the same or similar markets for

the services being provided by the bank holding

company or that cost is used consistently to

determine pricing, the established pricing struc-

ture should be used for all subsidiaries. Devia-

tions from established policy intended to

channel a greater proportion of income from

ﬁnancially sound banks to ﬁnancially weak ones

should be noted.

When it has been established that the fee

structure is reasonable and is consistently fol-

lowed, a ﬁnal question remains. Are the bank

subsidiaries actually receiving the services for

which they are charged? This may be difﬁcult to

ascertain in many cases, but serious efforts must

be made.

It is important that the basic business prin-

ciples of an arm’s-length transaction be applied

Intercompany Transactions (Management and Service Fees) 2020.6

BHC Supervision Manual December 1993

Page 2

to all transactions between banks and their afﬁli-

ates. This approach provides protection for all

the interests involved. In addition, payment

should be made within a reasonable time of the

rendering of the services. It is inequitable for the

bank subsidiary to pay fees far in advance in

order to suit the parent’s cash needs. A clearly

understood agreement between the holding

company and its bank subsidiaries detailing the

duties and responsibilities of each party and the

method to be used for fee assessment is also

important to the servicing arrangement.

2020.6.3 INSPECTION PROCEDURES

1. Review and analyze the policy regarding

management and other services provided to

bank subsidiaries and the method of assessing

fees.

2. Determine the basis for valuation.

3. Review the actual pricing structure as it is

applied.

4. Verify the following:

a. Fees are charged in accordance with

pricing structure.

b. Pricing structure is consistently applied

for all bank subsidiaries.

c. Bank subsidiaries are actually receiving

services for which they are assessed. Determine

whether fee payments have caused the institu-

tion to become undercapitalized.

d. Payments are made in a timely manner.

5. Review examination reports on bank sub-

sidiaries for comments on fee assessment.

6. Analyze the parent company’s cash ﬂow

and income statements for intercompany fees.

7. Review recordkeeping.

A review of management’s written or stated

policy regarding services provided subsidiaries

and fee assessment is a logical starting point for

the analysis of this area. The policy should be

discussed with the holding company’s ofﬁcers

to ensure that the examiner has a clear under-

standing of the purpose and basic underlying

philosophy. Any policy that calls for fee assess-

ment based on standards other than fair market

value or the cost of providing the services

requires discussion with management and com-

ment on page 1 of the report.

The determination of fair market value or

cost of providing services is the responsibility

of the holding company. The examiner should

review the market or cost information used to

justify the pricing of services and be satisﬁed

that the data presented actually supports the fee

structure. Request a copy of the pricing sched-

ule as it is applied, and determine that it is

actually based on the valuation of the services

received and consistent with stated policy. Any

variations from the basic structure among the

bank subsidiaries would also require support

from the market or cost data furnished.

Once the holding company’s policy, valua-

tion data, and pricing structure are analyzed,

they should be veriﬁed. Check the service at the

bank-subsidiary level. The veriﬁcation process

can be modiﬁed as deemed appropriate by the

examiner.

Note the timing of payment for services. Fees

for services should be billed and paid as they are

received, just as they would be with an unafﬁli-

ated servicer. Prepayments are inappropriate in

most cases.

Written service agreements should be in

effect speciﬁcally detailing the types and extent

of services being rendered and the method of

pricing. Any signiﬁcant exceptions found dur-

ing the veriﬁcation process merit follow-up and

comments in the report.

Thus far, these inspection procedures for

management and service fees have emphasized

a review of management’s stated intent and the

actual fees charged on the individual bank-

subsidiary level and have been somewhat ori-

ented toward micro-level analysis. An overall

view of the parent company’s cash ﬂow and

income statements can also provide certain indi-

cators of appropriateness of fees. The parent

company should be servicing its debt and pay-

ing dividends from sources other than manage-

ment fees and service fees collected from bank

subsidiaries. If the ratio of management and

service fees to parent-company salaries and

other expenses signiﬁcantly exceeds 100 per-

cent, the holding company could be charging

fees that are unrelated to the value of the ser-

vice. This situation would call for further

investigation.

Intercompany Transactions (Management and Service Fees) 2020.6

BHC Supervision Manual December 1993

Page 3

2020.6.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Statement of practice and

procedure in reference to

unsound banking

practices; diversion-of-bank-

income practices (SR-79-533,

March 19, 1979)

4–876

Potential violations of

section 23B of the

Federal Reserve Act:

1993 FRB 352

1. Proposal by a bank holding

company to provide armored

car services to its banking

subsidiary through a de novo

nonbank subsidiary. The cost

of the service would be more

than the cost of armored car

services currently received

from an unafﬁliated provider.

2. Proposal whereby the bank

holding company’s de novo

nonbanking subsidiary would

pay a ﬂat fee based on a

percentage of its direct

operating expenses to cover

all the back-ofﬁce services

provided by the holding

company’s banking subsidiary.

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Intercompany Transactions (Management and Service Fees) 2020.6

BHC Supervision Manual December 1993

Page 4

Intercompany Transactions

(Transfer of Low-Quality Assets) Section 2020.7

The transfer of low-quality assets to an insured

depository institution can be reason for supervi-

sory concern. Such transfers may be made to

avoid detection and classiﬁcation during regula-

tory examinations, and may be accomplished

through participations, purchases/sales, and

asset swaps with other afﬁliated or nonafﬁliated

entities. The donation of an asset with liabilities

also is treated as a purchase of assets. An

insured depository institution may not purchase

a low-quality asset from an afﬁliate unless, pur-

suant to an independent credit evaluation, the

member bank had committed itself to purchase

the asset before the time the asset was acquired

by the afﬁliate. Examiners should be alert to

situations where an institution’s intention

appears to be the concealment of low-quality

assets for the purpose of avoiding examination

scrutiny and possible classiﬁcation.

During holding company inspections, exam-

iners should identify situations where low-

quality assets have been transferred between the

holding company and its subsidiaries and a

subsidiary-insured depository institution. Low-

quality assets are deﬁned in the Federal Reserve

Board’s Regulation W (12 CFR 223.3(v)). In

general, low-quality assets include assets that

are classiﬁed or specially mentioned, or if sub-

jected to review would most likely be classiﬁed

or specially mentioned, including assets classi-

ﬁed based on the institution’s internal rating

system. Low-quality assets also include past due

loans, nonaccrual loans, loans on which the

terms have been renegotiated because of a bor-

rower’s poor ﬁnancial condition, and any other

asset acquired through foreclosure, reposses-

sion, or otherwise in satisfaction of a debt previ-

ously contracted, if the asset has not yet been

reviewed in an examination or inspection. Other

assets of questionable quality would include

noninvestment grade securities and other real

estate owned (OREO). The transfer of assets to

avoid supervisory review is a highly improper

and unsound banking practice and may be a

violation of section 23A of the Federal Reserve

Act and the Federal Reserve Board’s Regula-

tion W that should be addressed through formal

supervisory enforcement action, if necessary.

Any situations involving the transfer of low-

quality assets to an insured depository institu-

tion should be brought to the attention of

Reserve Bank supervisory personnel who, in

turn, should notify the local ofﬁce of the pri-

mary federal supervisor(s) of the other deposi-

tory institution(s) involved in the transaction.

For example, Reserve Banks should notify the

primary federal supervisor of any depository

institution to whom a state member bank or

holding company is transferring or has trans-

ferred low-quality assets. Reserve Banks also

should notify the primary regulator of any

depository institution from which a state mem-

ber bank or holding company is acquiring or has

acquired low-quality loans. This procedure

applies to transfers involving savings and loan

associations and savings banks, as well as com-

mercial banking organizations.

Legitimate transfers of assets should be prop-

erly recorded on the books of the acquiring

institution at fair market value. If the transfer

was with the parent holding company or a non-

bank afﬁliate, determine that the transaction also

should be properly recorded on the books of the

afﬁliate.

2020.7.1 INSPECTION OBJECTIVES

1. To ensure that loan transfers involving

state member banks, bank holding companies,

savings and loan holding companies, and non-

bank afﬁliates are carefully evaluated to deter-

mine if they were carried out to avoid classiﬁca-

tion, and to determine the effect of the transfer

on the condition of the institution and to ascer-

tain whether the transfer was consistent with the

requirements of section 23A. Under section 23A

of the Federal Reserve Act, an asset purchase is

a “covered transaction.” All “covered transac-

tions” by a bank with a single afﬁliate and with

all afﬁliates combined may not exceed 10 per-

cent and 20 percent, respectively, of a bank’s

capital and surplus.

2. To ensure that the primary supervisor of

the other ﬁnancial institution involved in the

transfer of low-quality assets is notiﬁed.

2020.7.2 INSPECTION PROCEDURES

1. Determine whether assets were transferred

prior to the date of examination to avoid pos-

sible criticism during the examination.

2. Determine whether any of the loans trans-

ferred were nonperforming at the time of trans-

fer, classiﬁed at the previous examination, or for

any other reason were considered to be low-

quality assets.

BHC Supervision Manual February 2019

Page 1

3. Review the institution’s policies and pro-

cedures to determine whether assets or participa-

tions purchased are given an independent, com-

plete and adequate credit evaluation. If a bank is

a holding company subsidiary or a member of a

chain banking organization, review asset pur-

chases or participations from afﬁliates or other

known members of the organization to deter-

mine if the asset purchases are given an arms-

length and independent credit evaluation by the

purchasing bank.

4. Determine whether any purchases of assets

from an afﬁliate comply with section 23A,

which generally prohibits purchases of low-

quality assets from an afﬁliate and limits asset

purchases and all other “covered transactions”

by a bank from a single afﬁliate and all afﬁliates

combined to 10 percent and 20 percent, respec-

tively, of a bank’s capital and surplus.

5. Determine whether any assets purchased

are properly reﬂected at fair market value (while

fair market value may be difﬁcult to determine,

it should at a minimum reﬂect both the rate of

return being earned on such assets and an appro-

priate risk premium). Determine that appropri-

ate write-offs are taken on any assets sold at less

than book value.

6. Determine whether transactions involving

transfers of low-quality assets to the parent

holding company or a nonbank afﬁliate are

properly reﬂected at fair value on the books of

both the bank and the holding company afﬁliate.

7. If low-quality assets were transferred to or

from another ﬁnancial institution for which the

Federal Reserve is not the primary supervisor,

prepare a memorandum to be submitted to the

Reserve Bank supervisory personnel. The

Reserve Bank will then inform the local ofﬁce

of the primary federal supervisor of the other

institution involved in the transfer. The memo-

randum should include the following informa-

tion, as applicable:

• Name of originating and receiving institu-

tions.

• Type of assets involved and type of transfer

(i.e., participation, purchase/sale, swap).

• Date(s) of transfer.

• Total number and dollar amount of assets

transferred.

• Status of the assets when transferred (e.g.,

nonperforming, classiﬁed)

• Any other information that would be help-

ful to the other supervisor.

Intercompany Transactions (Transfer of Low-Quality Assets) 2020.7

BHC Supervision Manual February 2019

Page 2

Intercompany Transactions

(Split-Dollar Life Insurance) Section 2020.9

Split-dollar life insurance is a type of life insur-

ance in which the purchaser of the policy pays

at least part of the insurance premiums and is

entitled to only a portion of the cash surrender

value, or death beneﬁt, or both. See SR-93-37

and its attachments for further discussion of the

Federal Reserve’s position on such arrange-

ments between bank holding companies and

their subsidiary banks.

2020.9.1 SPLIT-DOLLAR LIFE

INSURANCE POLICY

ARRANGEMENTS

Certain split-dollar life insurance policy

arrangements involving banks and their parent

bank holding companies raise legal and safety-

and-soundness concerns. These arrangements

fall into two general categories: (1) those in

which the subsidiary bank owns the policy, pays

all or substantially all of the premiums and is

reimbursed for the premium payments (if at all)

at some time in the future (endorsement plans)

and (2) those in which the parent holding com-

pany owns the policy, and pays the premium,

but uses the insurance policy as collateral for

loans from its subsidiary bank (collateral assign-

ment plans).

2020.9.1.1 Split-Dollar Life Insurance

Endorsement Plan

Under an endorsement plan, the subsidiary bank

purchases a policy in which its parent bank

holding company or an ofﬁcer, director, or prin-

cipal shareholder thereof is the primary beneﬁ-

ciary, rather than the bank or one of its ofﬁcers

or directors. In this instance, the subsidiary bank

receives only a limited portion of the death

beneﬁt—usually an amount equal to its pre-

mium payments plus interest. The primary

beneﬁciary—the holding company or one of its

ofﬁcers, directors, or principal shareholders—

receives a majority of the insurance proceeds

but pays little or nothing for the beneﬁt. Many

of the policies in this category are single-

premium universal life policies, whereby the

subsidiary bank pays one large lump sum pre-

mium payment for the policy. Generally, a sub-

sidiary bank involved in an endorsement plan

records the cash surrender value of the policy as

an asset on its books; the bank holding company

does not record anything at the parent-only

level.

A variation of the endorsement plan is an

arrangement in which the bank pays an annual

premium towards the policy and the parent hold-

ing company reimburses the bank for a nominal

amount of the annual premium payments. These

amounts are substantially lower than the pre-

mium payments made by the subsidiary bank

and therefore do not accurately reﬂect the eco-

nomic beneﬁt derived by the holding company

as primary beneﬁciary of the insurance policy.

2020.9.1.2 Split-Dollar Life Insurance

Collateral Assignment Plan

Under a collateral assignment plan, the parent

bank holding company owns the policy and

pays the entire premium. The subsidiary bank

makes annual loans to the bank holding com-

pany in an amount equal to the annual increase

in the cash surrender value of the policy (or, in

some cases, in amounts equal to premiums paid)

with the policy itself serving as collateral for the

loan. The loans are repayable at either the termi-

nation of employment or the death of the insured

employee, and will be paid using the death

beneﬁts available from the policy.

2020.9.2 COMPLIANCE WITH

APPLICABLE LAWS

2020.9.2.1 Compliance with Sections

23A and 23B of the FRA

Both of the aforementioned types of split-dollar

life insurance policy arrangements may be inap-

propriate if they are inconsistent with sections

23A or 23B of the Federal Reserve Act (FRA).

Section 23A places quantitative restrictions and

other requirements on certain transactions,

including loans, between banks and their afﬁli-

ates. The statute also requires that loans between

banks and their afﬁliates be secured with col-

lateral having a speciﬁed market value that

depends on the type of collateral used to secure

the loan. Under an endorsement plan, where the

subsidiary bank pays all or substantially all of

the insurance premiums, an unsecured extension

of credit from the subsidiary bank to its parent

holding company generally results because the

subsidiary bank has paid the bank holding com-

pany’s portion of the premium, and the bank

BHC Supervision Manual December 1993

Page 1

will not be reimbursed fully for its payment

until sometime in the future.

Under a collateral assignment plan, if the

insurance policy held by the parent bank hold-

ing company serves as collateral to secure a

loan from its subsidiary bank, the loan may be a

violation of section 23A unless it meets the

quantitative requirements of section 23A and

the cash surrender value of the insurance policy

used as security is equal to 130 percent of the

amount of the loan. Thus, a bank loan to the

parent bank holding company that equals the

cash surrender value of the insurance policy that

is serving as collateral would not be adequately

secured under section 23A, unless additional

collateral was provided.

Both categories of split-dollar life insurance

policy arrangements may also lead to violations

of section 23B of the Federal Reserve Act,

which requires that certain transactions involv-

ing a bank and its afﬁliates be on terms and

under circumstances substantially the same or at

least as favorable to the bank as those prevailing

at the time for comparable transactions with or

involving nonafﬁliated companies. Because the

bank holding company is the beneﬁciary of the

life insurance policy, it is a participant in a

transaction between a bank and a third party;

therefore, the split-dollar life insurance transac-

tion must meet the standards of section 23B.

In order to conform to the statutory restrictions

of section 23B, the return to the bank from

ownership of the policy should be commensu-

rate with the size and nature of its ﬁnancial

commitment. In most split-dollar insurance

arrangements, the bank makes an investment in

the policy not for the purpose of insuring itself

against risk but for the purpose of obtaining

insurance for its holding company. The only

return that the bank will get from its participa-

tion in ownership of the policy is the return of

its initial investment and possibly some interest.

However, the insurance company deducts the

cost of maintaining the insurance coverage from

interest that would otherwise be credited to the

equity in the policy. These costs include policy

loads, surrender charges, and mortality costs.

The holding company should fully reimburse

the bank for all of these charges. Examiners

should carefully evaluate these arrangements

because, in many cases, the reimbursement the

bank receives from the holding company is

based on an implied value of the insurance

coverage received by the holding company that

is less than the assessments made to the policy

equity.

In the process of evaluating split-dollar insur-

ance arrangements, examiners should keep in

mind the fact that the advances made by a bank

to purchase the insurance are the equivalent of a

loan to the holding company. Therefore, to com-

ply with section 23B, the terms of the loan, such

as its duration and interest rate, must be on

market terms.

2020.9.2.2 Investment Authority Under

the National Bank Act

Participation by bank holding companies and

their state-chartered and national bank subsidi-

aries in split-dollar life insurance policy arrange-

ments may also raise concerns whether the poli-

cies are permissible bank investments under

section 24(7) of the National Bank Act. The

Ofﬁce of the Comptroller of the Currency’s

interpretation of this provision of the National

Bank Act (OCC Banking Circular 249, May 9,

1991).

In addition, under section 24 to the

Federal Deposit Insurance Act, a state-chartered

bank generally may not, without the FDIC’s

permission, engage in any activity that is imper-

missible for a national bank.

2020.9.3 SAFETY-AND-SOUNDNESS

CONCERNS

The purchase of a split-dollar life insurance

policy may also constitute an unsafe and

unsound banking practice involving the diver-

sion of bank income or assets. If a subsidiary

bank pays the entire insurance premium but is

not the beneﬁciary, it provides an economic

beneﬁt to its parent holding company or other

beneﬁciary for which it is not being adequately

reimbursed or compensated. In this instance, the

bank loses the opportunity to use its assets pro-

ductively. Generally, the bank pays the premium

in return for the insurance company’s payment

of the entire proceeds. When the bank receives

less than the entire proceeds, it has, in effect,

1. The Federal Deposit Insurance Corporation has taken

the same position in a published interpretive letter, FDIC

92-40, dated June 18, 1992.

2. National banks may not purchase life insurance as an

investment. See OCC Banking Circular 249, for the tests

under which life insurance may be purchased and held for

noninvestment purposes.

3. SR-92-97 (FIS) and SR-92-98 (FIS), dated December 16

and 21, 1992, respectively, describe the provisions of section

24 of the Federal Deposit Insurance Act.

Intercompany Transactions (Split-Dollar Life Insurance) 2020.9

BHC Supervision Manual December 1993

Page 2

paid a higher than market price for whatever

limited beneﬁt it may receive. This is also the

case when the primary beneﬁciary of the policy

is an ofﬁcer, director, or principal shareholder of

the parent holding company. Such an arrange-

ment is not consistent with safe and sound bank-

ing practices because the subsidiary bank is

conferring an economic beneﬁt on an insider of

the parent bank holding company without

receiving adequate compensation.

2020.9.4 EXAMINER REVIEW OF

SPLIT-DOLLAR LIFE INSURANCE

Examiners should be fully aware of the prob-

lems inherent in split-dollar life insurance pol-

icy arrangements between bank holding compa-

nies and their subsidiary banks. During the

course of all bank examinations and bank hold-

ing company inspections, examiners should

review corporate life insurance policy arrange-

ments for compliance with applicable banking

laws and safety-and-soundness standards.

If a

split-dollar life insurance policy arrangement

exists in either a bank holding company or a

state member bank, it should be reviewed and

modiﬁed if it does not comply fully with the law

and principles of safe and sound banking. If a

bank holding company or a state member bank

fails to take appropriate action to bring its split-

dollar life insurance policy arrangements into

compliance, then the Reserve Bank should con-

sider appropriate follow-up supervisory action

(including a formal enforcement action) against

the banking organization or its institution-

afﬁliated parties, or both.

2020.9.5 INSPECTION OBJECTIVES

1. To determine if split-dollar life insurance

arrangements between the parent holding com-

pany and its subsidiary banks are consistent

with the provisions of sections 23A and 23B of

the FRA.

2. To ascertain whether participation by bank

holding companies and their national bank or

state-chartered bank subsidiaries is consistent

with section 24(7) of the National Bank Act and

section 24 of the Federal Deposit Insurance Act.

3. To verify the cash surrender values of

split-dollar life insurance policies and to

establish whether those values have been

impaired by loans to, liens by, or assignments

to, third parties or by unauthorized borrowings

or cancellations.

2020.9.6 INSPECTION PROCEDURES

1. Review corporate life insurance policy

arrangements between the parent company and

its subsidiary banks.

a. Determine if there are split-dollar life

insurance arrangements between any subsidiary

bank and the parent company or ofﬁcers or

directors of the parent company.

b. If any such insurance arrangement

exists, establish if the plan is either an endorse-

ment plan or a collateral assignment plan.

c. Review arrangements involving a split-

dollar life insurance policy purchased by the

parent company.

(1) Review external documentation evi-

dencing the cash surrender value. If no docu-

mentation exists, ask the audit committee and its

internal auditors—

(a) to obtain external documentation

verifying its value and

(b) to verify that there are no out-

standing loans, liens, or assignments against the

insurance policies.

(2) Establish whether the parent com-

pany’s board of directors has established poli-

cies and implemented procedures for transac-

tions between the insurance carrier and the

parent company to prevent unauthorized bor-

rowing or cancellation of any insurance policy

that has a cash surrender value.

(3) Determine whether the corporate life

insurance policy arrangements are consistent

with applicable safety-and-soundness standards.

(4) Verify that the recorded value of the

respective asset is equal to the unimpaired cash

surrender value of the asset.

2. If an endorsement plan arrangement is pur-

chased by a subsidiary bank, establish whether

the bank holding company is the beneﬁciary. If

the parent company is the beneﬁciary, such an

arrangement may result in an unsecured exten-

4. Examiners conducting examinations of U.S. branches

and agencies of foreign banks and Edge corporations should

also be alerted to the problems associated with split-dollar life

insurance arrangements because these institutions could pur-

chase insurance for the beneﬁt of a parent foreign bank or

company, or one of the parent’s ofﬁcers or directors. In

addition, section 7(h) of the International Banking Act of

1978 prohibits state-licensed branches or agencies from

engaging in any activity that is impermissible for a federal

branch unless the Board determines that such activity is

consistent with ‘‘sound banking practice’’ and, in the case of

an FDIC-insured branch, the FDIC determines that the activ-

ity poses no signiﬁcant risk to the deposit insurance fund.

Intercompany Transactions (Split-Dollar Life Insurance) 2020.9

BHC Supervision Manual December 1993

Page 3

sion of credit when the subsidiary bank pays all

or substantially all of the insurance premiums

but is not reimbursed until some time in the

future. Ascertain if the investment return to the

bank from ownership of the policy is commen-

surate with the size and nature of its ﬁnancial

commitment.

3. If a collateral assignment plan (when the

insurance policy held by the parent company

serves as collateral to secure a loan from a

subsidiary bank), ascertain whether the cash sur-

render value of the insurance policy is equal to

130 percent of the amount of the loan.

4. For both types of split-dollar life

insurance:

a. Determine if the investment return from

ownership of the policy is commensurate with

the size and nature of the ﬁnancial commitment,

including all costs incurred for maintaining the

insurance coverage.

b. Determine if the terms (duration and

market interest rate) of the advances made to

purchase the insurance are on market terms.

c. If the bank holding company is the

beneﬁciary of a bank insurance policy and a

bank is a participant in the purchase of the

insurance from a third party, determine if the

transaction was on terms and under circum-

stances that were substantially the same as or at

least as favorable to the bank as those then

prevailing for comparable transactions with or

involving nonafﬁliated companies.

2020.9.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Split-dollar life

insurance:

1. Endorsement plan:

When a subsidiary

bank has paid all

the BHC’s portion

of the premium and

the bank will not be

reimbursed until

some time in the

future, a loan results

that must be secured.

371c, FRA

section 23A

2. Collateral assignment

plan securing a loan:

Cash surrender value

must be 130 percent

of the loan.

371c, FRA

section 23A

3. Both plans:

a. Transactions must

be on terms and

under circumstances

substantially the

same as those

prevailing for third-

party transactions.

371c, FRA

section 23B

Intercompany Transactions (Split-Dollar Life Insurance) 2020.9

BHC Supervision Manual December 1993

Page 4

2020.9.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

b. When the BHC is

the beneﬁciary, the

bank’s investment

return from the split-

dollar life insurance

policy should be

commensurate with

the size and nature

of the ﬁnancial

commitment.

371c-1, FRA

section 23B

Split-dollar life

insurance premiums

paid by a bank on behalf

of an executive ofﬁcer of

the bank are not deemed

an extension of credit for

purposes of Regulation O,

if the ofﬁcer reported the

premiums as taxable

compensation to the IRS.

Regulation O

staff opinion

3-1081.3

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Intercompany Transactions (Split-Dollar Life Insurance) 2020.9

BHC Supervision Manual December 1993

Page 5

Grandfather Rights—Retention and Expansion of Activities

Section 2030.0

The history of bank holding company legisla-

tion reﬂects a principle that banking and com-

merce should be separated in order to prevent

abuses in the distribution of credit. The 1956

Act generally required companies to divest their

nonbank activities and shares within two years.

In the 1970 Amendments, the same requirement

applied to companies formed in the future. How-

ever, one-bank holding companies in existence

at the time of these amendments were given a

‘‘grace period’’ to comply with divestiture

requirements of the legislation. Those compa-

nies whose bank and nonbank interests had been

combined on or before June 30, 1968, were

permitted to continue the existing combination

for an indeﬁnite period (indeﬁnite or permanent

grandfather privileges). But those BHCs which

existed at the time of the 1970 Amendments, but

whose bank was acquired or whose nonbank

activity was initiated after June 30, 1968, were

permitted to continue their nonbank activities

for only 10 years until December 31, 1980. An

exception to the divestiture deadline existed

with respect to certain real estate holdings.

Although indeﬁnitely grandfathered compa-

nies may continue to engage in nonbanking

activities, these grandfather privileges are sub-

ject to review by the Federal Reserve Board at

the time when a company’s banking assets

exceed $60 million.

2030.0.1 INDEFINITE GRANDFATHER

PRIVILEGES

Under the provisions of section 4(a)(2) of the

Act, as amended in 1970, relating to grandfather

privileges for certain nonbanking activities of

bank holding companies, the Reserve Banks

have been delegated the authority to determine

that termination of grandfathered activities of a

particular bank holding company is not war-

ranted; provided, the Reserve Bank is satisﬁed

that all of the following conditions are met:

1. The company or its successor is ‘‘a com-

pany covered in 1970;’’

2. The nonbanking activities for which

indeﬁnite grandfather privileges are being

sought do not present any signiﬁcant unsettled

policy issues; and

3. The bank holding company was lawfully

engaged in such activities as of June 30, 1968

and has been engaged in such activities continu-

ously thereafter.

A company covered in 1970 is deﬁned in

section 2(b) of the Act as ‘‘a company which

becomes a bank holding company as a result of

the enactment of the Bank Holding Company

Act Amendments of 1970 and which would

have been a bank holding company on June 30,

1968, if those amendments had been enacted on

that date.’’ The Board has also determined that

the company must have owned at least 25 per-

cent of the voting shares of the same subsidiary

bank on June 30, 1968, and December 31, 1970,

in order to qualify as a company covered in

1970. If a company was not actively engaged in

a nonbank activity prior to June 30, 1968, either

directly, or indirectly through a subsidiary, it

may still qualify for indeﬁnite grandfather privi-

leges if the company had entered into a binding

contract prior to June 30, 1968. The binding

contract must be a written document which

speciﬁes that the company (or its subsidiary) or

persons representing the company will purchase

another company which is already engaged in

the activity.

Within two years after the subsidiary bank of

an indeﬁnitely grandfathered company attains

banking assets in excess of $60 million, the

status of the company’s grandfather privileges is

subject to review to determine whether the

rights should remain in effect or be terminated.

The Board or Reserve Bank may also review

any company’s grandfather privileges and termi-

nate them if it determines that such action is

necessary to prevent (1) undue concentration of

resources, (2) decreased or unfair competition,

(3) conﬂicts of interests, or (4) unsound banking

practices. Moreover, when a company applies

for approval of an acquisition, it may expect the

Board or Reserve Bank to review the legitimacy

of its grandfather privileges.

2030.0.2 ACTIVITIES AND

SECURITIES OF NEW BANK

HOLDING COMPANIES

A company that becomes a bank holding com-

pany may, for a period of two years, engage in

1. Effective October 20, 1981 the Board amended its Rules

Regarding Delegation of Authority to delegate to the Reserve

Banks authority to make these determinations regarding

indeﬁnite grandfather privileges.

BHC Supervision Manual January 2010

Page 1

nonbanking activities and control voting securi-

ties or assets of a nonbank subsidiary, if the

bank holding company engaged in such activi-

ties or controlled such voting securities or assets

on the date it became a bank holding company.

The Board can grant requests for up to three

one-year extensions of the two-year period. This

is in accordance with a December 1983 revision

to Regulation Y (12 C.F.R. 225.22(e)). The

regulatory provision implements Section 4(a)(2)

of the BHC Act.

2030.0.3 LIMITATIONS ON

EXPANSION OF GRANDFATHER

RIGHTS FOR INSURANCE AGENCY

NONBANKING ACTIVITIES OF BANK

HOLDING COMPANIES

Refer to Manual section 3170.0.3.4.1.

2030.0.4 SUCCESSOR RIGHTS

When a bank holding company transfers its

bank shares to another company in a manner

that produces no substantial change in the con-

trol of the bank, the transferee qualiﬁes under

section 2(e) of the Act as a ‘‘successor.’’ The

‘‘successor’’ provision prevents a bank holding

company from transferring its bank to some

other organization. A successor is considered a

bank holding company from the date the trans-

feror became a bank holding company. Thus, it

may hold the same grandfather privileges as its

predecessor. By the same token, it becomes

subject to any conditions or restrictions, such as

divestiture requirements, imposed by the Sys-

tem upon its predecessor. For example, an irre-

vocable declaration ﬁled by the predecessor

would be binding upon the successor.

2030.0.5 EXPANSION OF

GRANDFATHER ACTIVITIES

Grandfather privileges apply to activities, not to

companies. As a general rule, these activities

are permitted to be expanded through internal

growth; however, there are a few exceptions.

See Appendix 1 in this section.

In Appendix 1 it is important to distinguish

between a purchase in the ordinary course of

business and a purchase, in whole or in part, of a

going concern. Each of the following conditions

must be satisﬁed in order for the transaction to

be in the ‘‘ordinary course of business,’’ which

is permissible: (1) less than a substantial amount

of the assets of the company to be acquired must

be involved; (2) the operations of the purchased

company must not be terminated or substan-

tially discontinued; (3) the assets acquired must

not be signiﬁcant in relation to the size of the

same line of nonbank activity already in the

holding company (an acquisition is deemed sig-

niﬁcant if the book value of the acquired non-

bank assets exceeds 50 percent of the book

value of the nonbank assets of the holding com-

pany or nonbank subsidiary comprising the

same line of activity); (4) if the transaction

involves the acquisition of assets for resale, the

sale must be a nominal business activity of the

acquiring company; and (5) the major purpose

of the transaction must not be to hire essentially

all of the seller’s principal employees who are

expert, skilled and experienced in the business

of the company being acquired. If any of these

ﬁve conditions is not satisﬁed, the transaction

may be considered to be an acquisition of a

going concern, which is not permissible without

prior approval. Refer to 12 C.F.R. 225.132.

2030.0.6 DIVESTITURES (also see

Manual section 2090.6)

The act speciﬁes the time in which a company

must divest of any impermissible activity. Any

company becoming a bank holding company

subsequent to the 1970 Amendments has two

years in which to divest its impermissible activ-

ity. The Act allowed a temporarily grandfath-

ered company ten years from December 31,

1970, to divest of its impermissible activities,

except certain real estate holdings discussed ear-

lier; and allows indeﬁnitely grandfathered com-

panies ten years from the date on which grand-

father privileges are terminated by the Board or

Reserve Bank, should they be terminated for

good cause.

As mentioned earlier, reviews of a company’s

grandfather privileges may be precipitated by

such circumstances as: (1) a subsidiary bank of

an indeﬁnitely grandfathered company attaining

assets in excess of $60 million (reviewed within

two years); (2) a company seeking approval to

engage in another activity or acquire another

bank; (3) a company which violates the Act; or

(4) a company operating in a manner which

results in an undue concentration of resources,

decreased or unfair competition, conﬂicts of

interests, or unsound banking practices.

Grandfather Rights—Retention and Expansion of Activities 2030.0

BHC Supervision Manual January 2010

Page 2

When a company has ﬁled an application

requiring the Board’s or Reserve Bank’s

approval, the Board or Reserve Bank may

approve the application subject to the condition

that the company divest of certain grandfathered

shares or assets within a speciﬁed time period.

The speciﬁed time period generally will be

shorter than the aforementioned time periods

stipulated in the Act.

The plan of divestiture should have provided

for the removal of any control relationship

between the company and its divested activities.

These control requirements, as outlined in

section 2(g) of the Act, include one or more of

the following: (1) no interlocking directorates;

(2) ownership of less than 25 percent of the

voting shares by the BHC and related parties;

(3) no interlocking management positions in

policymaking functions; (4) no indebtedness

between the transferor and the transferee; (5) no

agreement or understanding which restricts the

voting privileges of shares. Further discussion

of these and other control requirements and

issues is found in Manual sections 2090.1 and

2090.6.

2030.0.7 INSPECTION OBJECTIVES

1. To determine when the company acquired

its subsidiary bank.

2. To determine when the company com-

menced its nonbanking activities and whether

these activities were conducted continuously

thereafter.

3. To determine if the banking assets of a

bank controlled by a holding company with

indeﬁnite grandfather privileges have reached

$60 million.

4. To determine if a change of ownership

or control of the company has taken place,

and whether the transferee qualiﬁes as a ‘‘suc-

cessor.’’

5. To determine if expansions of grandfath-

ered activities occurred in accordance with the

Act.

2030.0.8 INSPECTION PROCEDURES

1. If necessary, examine the subsidiary

bank’s stock certiﬁcate book to determine when

the company acquired 25 percent or more of the

bank.

2. Review the minute books and historical

ﬁnancial records of the company and its subsid-

iaries for evidence of the date of commence-

ment of any nonbank activity and its continua-

tion thereafter. In particular, the ﬁnancial records

should reﬂect the activity’s impact as either an

asset and/or an income item. From these

records, also determine whether there has been

expansion of the activity and whether such

expansion complies with the Act.

3. If necessary, review the latest quarterly

Call Report of Condition for the subsidiary bank

to determine whether total assets exceeded

$60 million. If appropriate, advise management

that its grandfather status is subject to review.

4. If necessary, examine the stock certiﬁcate

records and minutes of the bank or BHC to

determine if the bank’s shares have been trans-

ferred from one bank holding company to

another in such a manner that the transferee

qualiﬁes as a successor.

5. Upon review of the aforementioned

records, discuss the status of the company’s

grandfather privileges with the Reserve Bank’s

management, if necessary.

6. If divestment is required, encourage its

execution as soon as possible during the divest-

ment period. Request a divestment plan which

speciﬁes the manner by which divestment will

be accomplished, the speciﬁc steps necessary to

effect the divestment, and the time schedule for

taking such steps. Advise management that fail-

ure to divest within the prescribed time period

will be viewed as a violation of the Act.

Grandfather Rights—Retention and Expansion of Activities 2030.0

BHC Supervision Manual January 2010

Page 3

2030.0.9 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Divestment of activities

which are temporarily

grandfathered

S-2346

February 15,

1977

Escrow agreements used

in divestiture

1976 FRB 151

Companies with

temporarily grandfathered

activities encouraged to

submit plans by June 30,

1978

1977 FRB 962

Divestment policies 4(a)(2) 1977 FRB 263

Denial of grandfather

rights for activities which

were shifted from

subsidiary bank to

nonbank subsidiary

Whitney

Holding

Corporation,

New Orleans,

Louisiana;

April 27, 1973

Denied continued

ownership of a savings

and loan association,

despite permanent

grandfather rights

D.H. Baldwin

Company,

Cincinnati,

Ohio;

February 22,

1977

Discussion of indeﬁnite

grandfather rights

acquired through the

indirect power to exercise

a controlling inﬂuence

Patagonia

Corporation,

Tucson,

Arizona;

February 24,

1977

Denial of grandfather

rights on additional stock

acquired after June 30,

1968, for lack of a

controlling inﬂuence over

the subsidiary as of June

30, 1968

Patagonia

Corporation,

Tucson,

Arizona;

July 6, 1973

Successor rights Republic of

Texas

Corporation,

Dallas, Texas;

October 25,

1973

Grandfather Rights—Retention and Expansion of Activities 2030.0

BHC Supervision Manual January 2010

Page 4

Subject Laws

Regulations

Interpretations

Orders

Interprets ‘‘Company

covered in 1970’’ and

‘‘Successor’’

American

Security

Corporation,

Washington,

D.C.; July 21,

1976

Review of grandfather

rights as a result of

subsidiary bank reaching

$60 million in total assets

Colorado

Funding

Company,

Denver,

Colorado;

September 9,

1977

Review of grandfather

rights as a result of

subsidiary bank reaching

$60 million in total

assets—charitable trust

involved

General

Education

Fund, Inc.,

Burlington,

Vermont;

September

13, 1977

Companies going out of

business are not going

concerns

Senate Report

90–1084,

page 5524

Failing companies are not

going concerns

1974 FRB 725

Ownership of less than 25

percent of a nonbanking

company represents an

investment rather than a

subsidiary

1973 FRB 539

Divestitures 225.138 and

225.140

Extension of divestiture

deadline for real estate

interests

Monetary

Control

Act of

1980

Section

701(b)

Delegation of authority to

Reserve Banks re:

Indeﬁnite Grandfathered

activities

265.2(f)(42) 1981 FRB 856

and 860

Grandfather Rights—Retention and Expansion of Activities 2030.0

BHC Supervision Manual January 2010

Page 5

Subject Laws

Regulations

Interpretations

Orders

Activities and securities

of new bank holding

companies

225.22(e)

Denial of a BHC

acquisition—‘‘successor’’

1984 FRB 667

Acquisition of assets 225.132

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

2030.0.10 APPENDIX 1—EXPANSION OF GRANDFATHERED ACTIVITIES

Permissible Type of Expansion Without Approval Requires Approval

FOR COMPANIES WITH AN INDEFINITELY

GRANDFATHERED NONBANK ACTIVITY

1. Opening of additional ofﬁces of existing

subsidiary X

2. Acquisition of assets in the ‘‘ordinary

course of business’’ as deﬁned X

3. Acquisition of a going concern:

a. Additional shares of the grandfathered

nonbanking subsidiary X

b. Additional shares of a nonbanking

company which is regarded as an

investment (generally companies in

which the holding company has an

interest of between 5 and 25 percent) X

c. Initial acquisition of shares of any

other company engaging in the

activity X

Grandfather Rights—Retention and Expansion of Activities 2030.0

BHC Supervision Manual January 2010

Page 6

Commitments to the Federal Reserve

Section 2040.0

Commitments to the Board arise most often

through the application process. Many commit-

ments are included within the text of accompa-

nying Board orders or letters transmitted to the

applicants. Commitments can also arise through

the supervisory process. Commitments should

be speciﬁc and furnished in written form.

The most common type involves a commit-

ment to inject capital (either equity or debt

capital) into the company or subsidiary to be

acquired or possibly into other subsidiaries of

the bank holding company. The required injec-

tions may be for a speciﬁc dollar amount or for

an unspeciﬁed amount necessary to achieve a

predetermined capital relationship. Determining

compliance with such commitments is generally

not difﬁcult since an agreed upon quantiﬁable

result must be achieved.

Types of commitments made to the Board in

the past include: divestiture of nonpermissible

stock holdings or activities; introduction of new

services; and reduction or elimination of divi-

dends or management fees from subsidiaries.

Several of the above forms of commitments

are rather difﬁcult to monitor due to their inex-

act nature. The examiner should determine in

such cases whether good faith compliance

efforts have been made. Where an order approv-

ing an application imposes speciﬁc conditions,

however, compliance is of the utmost impor-

tance since a conditional order is based on the

theory that such conditions were necessary to

eliminate or outweigh adverse factors. Willful

noncompliance in these cases might necessitate

the use of cease-and-desist powers to prevent

evasion of the purposes of the Act. Pursuant to

the Board’s request, each Reserve Bank reports

semi-annually on the status of all outstanding

commitments made by holding companies in its

District.

2040.0.1 INSPECTION OBJECTIVES

1. To determine that the bank holding com-

pany is taking the necessary steps to fulﬁll any

outstanding commitments as scheduled.

2. To determine whether additional commit-

ments or conditions should be imposed to

achieve complete compliance.

3. To determine whether a request for an

extension of time to fulﬁll any outstanding com-

mitment is warranted.

2040.0.2 INSPECTION PROCEDURES

1. Review semi-annual commitment reports

to the Board for commitments fulﬁlled since the

last inspection. Determine whether such com-

mitments were completed as required.

2. Review with management any actions

taken to comply with outstanding commitments

or plans to effect fulﬁllment.

3. If warranted, initiate action to consider

an extension for compliance on outstanding

commitments.

BHC Supervision Manual December 1992

Page 1

Extensions of Credit to BHC Ofﬁcials

Section 2050.0

WHAT’S NEW IN THIS REVISED

SECTION

This section was updated to discuss amendments

to the Federal Reserve Act regarding insider

lending. The deﬁnition of ‘‘extension of credit’’

was revised to include an insured depository

institution’s (IDI) credit exposure to a person

arising from a derivative transaction, repurchase

agreement, reverse repurchase agreement, secu-

rities lending transaction, or securities borrow-

ing transaction. See the Federal Reserve Act,

section 22(h)(9)(D)(i), as amended by the

Dodd-Frank Act, section 614(a).

The Federal Deposit Insurance Act was

amended to prohibit the purchase or sale of

assets between an IDI and an executive ofﬁcer,

director, or principal shareholder of the IDI,

and any related interest of such person, unless

the transaction is on market terms. In addition,

if the asset purchase or sale represents more

than 10 percent of the IDI’s capital stock and

surplus, the transaction must be approved in

advance by a majority of the members of the

board of directors of the IDI who do not have an

interest in the transaction. See section 615(1) of

the Dodd-Frank Act.

2050.0.1 BHC OFFICIAL AND

RELATED INTEREST

TRANSACTIONS BETWEEN THE

PARENT COMPANY OR ITS

NONBANK SUBSIDIARIES

Business transactions between a parent bank

holding company or its nonbank subsidiary and

a BHC ofﬁcial or a BHC ofﬁcial’s related inter-

ests require close supervisory review. ‘‘Bank

holding company ofﬁcial’’ is deﬁned as any

director, executive ofﬁcer, or principal share-

holder of the parent company or any of its

subsidiaries, excluding the subsidiary bank’s

nonbank subsidiaries.

Most of these transactions are soundly struc-

tured and have a legitimate business purpose

that result in equitable treatment for all parties.

However, examiners should pay close attention

to all extensions of credit by a BHC or its

nonbank subsidiary to a BHC ofﬁcial or related

interest to ensure that the terms of the credit,

particularly interest-rate and collateral terms,

are not preferential and that the credit does not

involve more than a normal risk of repayment.

An extension of credit by a BHC or nonbank

subsidiary may be considered abusive or self-

serving if its terms are unfavorable to the lender,

or if the credit would not have been extended on

the same terms absent the ofﬁcial relationship;

that is, it would be improbable that each party to

the credit would have entered into the credit

transaction under the same terms if the relation-

ship did not exist. When a transaction appears

questionable, a complete inquiry into the facts

and circumstances should be undertaken so that

a legal determination can be obtained.

In addition to the above supervisory consider-

ations, the Sarbanes-Oxley Act of 2002 (Pub. L.

No. 107-204) (the act) imposed certain insider

lending restrictions on public companies,

including BHCs that are public companies. A

BHC generally is considered a public company

for these purposes if it has a class of securities

registered under section 12 of the Securities

Exchange Act of 1934 (the 1934 act) or is

required to ﬁle reports with the Securities and

Exchange Commission (SEC) under section 15

of the 1934 act. The Sarbanes-Oxley Act

pro-

hibits a publicly owned BHC (public BHC) and

its subsidiaries from extending credit, or arrang-

ing for another entity to extend credit, in the

form of a personal loan to any director or execu-

tive ofﬁcer of the public BHC.

This prohibition

does not apply to any extension of credit made

before July 30, 2002, so long as the loan is not

renewed or materially modiﬁed after that date.

The Sarbanes-Oxley Act includes two excep-

tions to this loan prohibition. First and most

importantly, the prohibition does not apply to

any loan made by an insured depository institu-

tion that is subject to the insider lending restric-

tions of section 22(h) of the Federal Reserve

Act, as implemented by the Board’s Regulation

O. Thus, loans by the insured depository institu-

tion subsidiaries of a public BHC to a director

or executive ofﬁcer of the BHC likely are

exempt from the prohibition, although they

would be subject to Regulation O as discussed

below. The second exception permits the direc-

tors and executive ofﬁcers of a public BHC to

obtain home improvement and manufactured

home loans, consumer loans, and loans under

open-end credit plans or charge cards from the

public BHC or its subsidiaries, so long as the

1. See 15 U.S.C. 78m (section 402 of the act).

2. The act does not restrict lending by a subsidiary of a

public BHC to the subsidiary’s own directors and executive

ofﬁcers, so long as these persons are not also directors or

executive ofﬁcers of the public BHC.

BHC Supervision Manual January 2013

Page 1

credit (1) is extended in the ordinary course of

the company’s consumer credit business, (2) is a

kind of credit generally made available to the

public, and (3) is made on market terms or on

terms that are no more favorable than those

offered to the general public.

2050.0.2 TRANSACTIONS INVOLVING

OTHER PROPERTY

OR SERVICES

Other transactions involving BHC ofﬁcials, their

related interests, and the BHC and nonbank

subsidiary that should be reviewed by the exam-

iner include the—

1. purchase of assets or services from the BHC

or nonbank subsidiary, particularly if at a

discount or on preferential terms;

2. sale of assets or services to the BHC

or nonbank subsidiary, particularly if at a

premium;

3. lease of property to or from the BHC or

nonbank subsidiary; and

4. use of BHC or nonbank subsidiary property

or personnel by a BHC ofﬁcial or related

interest.

As with loans and other extensions of credit

to BHC ofﬁcials on preferential terms, abusive

or self-serving insider transactions involving

other property or services deprive the BHC or

nonbank subsidiary of higher returns or gains

that may have been achieved had the same

transaction been at a fair market price. A fair

market price would be that price charged or

received from an unafﬁliated party.

The Dodd-Frank Act amended the Federal

Deposit Insurance Act (FDIA) to impose a pro-

hibition on asset purchases and between an IDI

and an executive ofﬁcer, director, or principal

shareholder of the IDI, and any related interest

of such person, unless the transaction is on

market terms. In addition, if the asset purchase

or sale represents more than 10 percent of the

IDI’s capital stock and surplus, the transaction

must be approved in advance by a majority of

the members of the board of directors of the IDI

who do not have an interest in the transaction.

See section 18(z) of the FDIA, as amended by

the Dodd-Frank Act, section 615(a).

A fair market price is often difﬁcult to deter-

mine because the assets or services involved

may be unique to a given situation and individu-

als. In general, the fair market price of even

unique assets or services can be approximated

by the cost of the assets or services to the party

selling or furnishing them, if appropriate. The

value of services or properties provided by a

BHC or nonbank subsidiary should be estab-

lished and justiﬁed either by policy or on a

case-by-case basis, and appropriate documenta-

tion should be available to the examiner.

Services provided by a BHC ofﬁcial or a

related interest to a BHC or nonbank subsidiary,

while not unusual, may be most difﬁcult to

value. In part because of the problem of valua-

tion, this type of transaction is among the most

susceptible to abuse. The cost of providing ser-

vices is frequently derived by placing value on

the time of the individuals providing the ser-

vices. When services are provided by a BHC

ofﬁcial who normally places a very high billing

value on time provided, the beneﬁts to the BHC

must be assessed in order to form a basis for

determining a fair price. The BHC ofﬁcial may

be a highly regarded professional whose time

and services have great value to the organiza-

tion. However, when the BHC requires routine

clerical services, ofﬁcials should not charge the

BHC a professional-level rate for such services.

Under these or similar circumstances, the BHC

would be considered imprudent in paying such

rates and could be subject to critical comment.

2050.0.3 REGULATION O

For ease of reference, certain Regulation O deﬁ-

nitions and limitations, as revised by the Fed-

eral Deposit Insurance Corporation Improve-

ment Act of 1991 (FDICIA), are presented here,

some in abbreviated form. A thorough review of

the entire regulation (found at FRRS 3–960),

and the Board’s press releases pertaining to

Regulation O, is necessary for a complete

understanding of the regulation. (Note that sec-

tion 108 of the Financial Institutions Regulatory

Act of 1978 amended section 18(j) of the Fed-

eral Deposit Insurance Act to make section

22(h) of the Federal Reserve Act applicable to

nonmember insured banks.)

Purpose of Regulation O. Regulation O gov-

erns any extension of credit by a member bank

and its subsidiaries (based on amendments con-

tained in FDICIA, Regulation O also applies to

nonmember insured depository institutions) to

an executive ofﬁcer, director, or principal share-

holder of (1) the member bank, (2) a bank

holding company of which the member bank is

a subsidiary, and (3) any other subsidiary of that

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2013

Page 2

bank holding company. It also applies to any

extension of credit by a member bank to (1) a

company controlled by such a person and (2) a

political or campaign committee that beneﬁts or

is controlled by such a person.

Supervision of BHCs and their nonbank sub-

sidiaries. Regulation O deals exclusively with

extensions of credit by banks and their subsidi-

aries, not extensions of credit by BHCs and their

nonbank subsidiaries. However, because the

regulations curtail or eliminate abusive transac-

tions, they can be used as a guide or model in

providing standards for the supervisory review

of extensions of credit by BHCs and nonbank

subsidiaries. Although a direct extension of

credit by a BHC could not be determined to be a

violation of Regulation O, if the credit fails to

meet the requirements that Regulation O estab-

lishes for banks, it may be possible to conclude

that the BHC is engaging in either an unsafe or

unsound practice that exposes the entire banking

organization to undue risk and exposure to loss.

Regulation O limits credit extensions by a bank

to ofﬁcials of that bank and their related inter-

ests; therefore, examiners should be especially

alert to credit extensions from BHCs and non-

bank subsidiaries. If credit extensions appear to

circumvent the intent of Regulation O, they

should be identiﬁed and discussed with manage-

ment and noted in the inspection report for

follow-up review and possible formal corrective

action by regulatory authorities.

2050.0.3.1 FDICIA and BHC Inspection

Guidance for Regulation O

On April 22, 1992, the Board adopted amend-

ments to Regulation O, effective May 18, 1992,

to implement the changes required by section

306 of FDICIA. Section 306 amended section

22(h) of the Federal Reserve Act and replaced

the language of section 22(h) with the provi-

sions of the Board’s Regulation O. Section 306

also made several substantive modiﬁcations to

section 22(h) that required revisions to Regula-

tion O. These changes are outlined in the

Board’s press release and Federal Register

notice of May 28, 1992 (57 Fed. Reg. 22,417).

The following are some of the more signiﬁ-

cant changes that were made effective May 18,

1992:

1. Aggregate lending limit (section 215.4(d)).

The aggregate limit on the total amount that a

bank can lend to its insiders and their related

interests as a class was changed. In general, this

amount is equal to the bank’s unimpaired capi-

tal and unimpaired surplus. The Board also

decided as a one-year interim measure to permit

banks with deposits under $100 million to adopt

a higher limit, not to exceed 200 percent of the

bank’s unimpaired capital and unimpaired sur-

plus. (This interim period was extended twice

by the Board, extending the higher limit through

February 18, 1994, when the higher limit

became permanent. The board of directors must

provide an annual resolution authorizing the use

of this higher limit. Other conditions also apply.)

2. Lending limits for directors and related

interests (section 215.4(c)). Loans to directors

(and their related interests) are subject to the

same lending limit that is applicable to execu-

tive ofﬁcers and principal shareholders (and

their related interests).

3. Credit standards (section 215.4(a)). When

lending to an insider

a bank must follow credit

underwriting procedures that are as stringent as

those applicable to comparable transactions by

the bank with persons outside the bank.

4. Deﬁnition of ‘‘principal shareholder’’ (sec-

tion 215.2(m)(1)). The deﬁnition of principal

shareholder was tightened for banks located in

small communities. The previously existing

10 percent limitation was made applicable to all

banks, regardless of the size of the communities

in which they were located.

5. Deﬁnition of ‘‘member bank’’ (section

215.2(j)). The term member bank was redeﬁned

to include any subsidiary of the member bank.

This revision clariﬁed that an extension of credit

from a subsidiary of a member bank is subject

2a. The Regulation O cites are to the February 18, 1994,

amendment.

2b. The term insider refers to an executive ofﬁcer, director,

or principal shareholder, and includes any related interest of

such a person.

3. The Board amended the deﬁnition of principal share-

holder of a member bank, effective December 17, 1992, so

that it does not include a company of which a member bank is

a subsidiary. This amendment excludes from Regulation O

loans to a company that owns, controls, or exercises a control-

ling inﬂuence over a member bank, as those relationships are

deﬁned in section 2(d) of the Bank Holding Company Act, as

well as the related interests of such a parent bank holding

company. The deﬁnition of principal shareholder for pur-

poses of reporting obligations under section 215.11 of Regula-

tion O was not changed as a result of the Housing and

Community Development Act of 1992 because those portions

of Regulation O implement provisions of law in addition to

section 22(h) of the Federal Reserve Act.

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Page 3

to the same insider restrictions as an extension

of credit from a member bank itself.

6. Coverage of all companies that own banks

(section 215.2(b)). All companies that own

banks became subject to Regulation O, regard-

less of whether they are technically bank hold-

ing companies.

7. Prohibition on knowingly receiving unau-

thorized extensions of credit (section 215.6).

Insiders are prohibited from knowingly receiv-

ing (or permitting their related interests to

receive) any extension of credit not authorized

by section 22(h) of the Federal Reserve Act.

8. Reporting requirement for certain credit

(section 215.12). Executive ofﬁcers and direc-

tors of member banks that do not have publicly

traded stock are required to report annually to

their institutions the outstanding amount of

any credit secured by shares of the insider’s

institution.

In a February 18, 1994, press release, the

Federal Reserve Board announced its approval

of a ﬁnal rule that further amended several

provisions of Regulation O, effective on that

date. Some of the provisions carried out or

further reﬁned provisions of FDICIA. The

amendments were designed to increase the abil-

ity of banks to make extensions of credit that

pose minimal risk of loss, to eliminate record-

keeping requirements that impose a paperwork

burden, and to remove certain transactions from

the regulation’s coverage consistent with bank

safety and soundness. The amendments were

expected to increase the availability of credit,

particularly in communities served by small

banks. The following is a discussion of some of

the rule’s primary provisions.

1. Aggregate lending limit—exception for

small, adequately capitalized banks (section

215.4(d)). This revision of Regulation O made

permanent an interim rule increasing the aggre-

gate lending limit for small, adequately capital-

ized banks from 100 percent of the bank’s unim-

paired capital surplus to 200 percent, provided

the bank satisﬁes three conditional criteria.

2. Exceptions to the general limits on lend-

ing (section 215.4(d)(3)). The Board adopted

certain exceptions to the general restrictions on

lending to insiders. The exceptions apply to

loans fully secured by—

a. obligations of the United States or other

obligations fully guaranteed as to principal and

interest by the United States;

b. commitments or guarantees of a depart-

ment or agency of the United States; or

c. a segregated deposit account with the

lending bank.

An exception is also made for loans arising

from the discount of installment consumer paper

by an insider with full or partial recourse

endorsement or guarantee by the insider, if the

maker of the paper is not an insider and the

loan was made relying primarily on the maker

and this is properly documented. Such loans

continue to be subject to the prohibitions against

preferential lending.

3. Including closing costs in the reﬁnancing

of home mortgage loans (section 215.5(c)(2)).

Section 22(g) of the Federal Reserve Act allows

a bank to make a loan to its executive ofﬁcer,

without restrictions on the amount, if the loan is

secured by a ﬁrst lien on a dwelling that is

owned and used by the executive ofﬁcer as a

residence after the loan is made. The Board’s

amendment includes the reﬁnancing of home

mortgage loans in this category only if the pro-

ceeds are used to pay off the previous home

mortgage loan or for the other purposes listed in

this section. The regulation states that closing

costs can be included as part of the exempt

portion of a home mortgage reﬁnancing.

4. Alternative recordkeeping procedures

(section 215.8). Banks are permitted to follow

alternative recordkeeping procedures on loans

to insiders of afﬁliates. The amendment allows a

bank to decide on its own how to gather infor-

mation on related interests, so long as its method

is effective. For example, a nonbank credit card

bank or other bank that does not make commer-

cial loans could decide not to keep records on

related interests. For banks that make commer-

cial loans, one of two acceptable methods is

required, unless a bank can demonstrate that

another method is equally effective: (a) the ‘‘sur-

vey’’ method or (b) the ‘‘borrower inquiry’’

method. Every bank, regardless of the record-

keeping method it selects, must conduct an

annual survey to identify its own insiders, but

not those of its holding company afﬁliates.

Every bank is expected to check this short list

before extending credit, even if it is using the

borrower-inquiry method of recordkeeping for

afﬁliates in lieu of the survey method.

5. Tangible-economic-beneﬁt rule (section

215.3(f)). This rule was similar to a provision

in section 23A of the Federal Reserve Act

and was adopted at a time when the Board was

required by section 22(h) of the Federal Reserve

Act to use the deﬁnition of ‘‘extension of credit’’

found in section 23A. However, the deﬁnition of

extension of credit in section 22(h) is no longer

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BHC Supervision Manual January 2013

Page 4

tied to section 23A. The Board has therefore

revised the tangible-economic-beneﬁt rule to

clarify that it does not reach certain transactions

that may beneﬁt an insider. The Board explicitly

provided that the rule does not apply to an

arm’s-length extension of credit by a bank to a

third party where the proceeds of the credit are

used to ﬁnance the bona ﬁde acquisition of

property, goods, or services from an insider or

an insider’s related interest.

2050.0.3.2 Deﬁnitions in Regulation O

(abbreviated listing)

Note: Regulation O deﬁnitions, prohibitions,

exceptions, and exemptions are particularly

detailed and complex. Therefore, inspection staff

should consult with Reserve Bank or Board

supervisory or legal staff before discussing with

management or presenting in an inspection

report any BHC inspection ﬁndings that rely

upon Regulation O.

(a) ‘‘Afﬁliate’’ means any company of which

a member bank is a subsidiary or any other

subsidiary of that company.

(b) ‘‘Company’’ means any corporation, part-

nership, trust (business or otherwise), associa-

tion, joint venture, pool syndicate, sole propri-

etorship, unincorporated organization, or any

other form of business entity. The term, how-

ever, does not include (1) an insured bank (as

deﬁned in 12 U.S.C. 1813) or (2) a corporation

the majority of the shares of which are owned

by the United States or by any state.

(c)(1) ‘‘Control of a company or bank’’

means that a person directly or indirectly, or

acting through or in concert with one or more

persons (i) owns, controls, or has the power to

vote 25 percent or more of any class of voting

securities of the company or bank; (ii) controls

in any manner the election of a majority of the

directors of the company or bank; or (iii) has the

power to exercise a controlling inﬂuence over

the management or policies of the company or

bank. (Note: If a company does not have voting

securities (that is, a partnership), review the

degree of interest in the company to determine

control.)

(2) A person is presumed to have control,

including the power to exercise a controlling

inﬂuence over the management or policies, of a

company or bank if (i) the person is an execu-

tive ofﬁcer or director of the company or bank

and directly or indirectly owns, controls, or has

the power to vote more than 10 percent of any

class of voting securities of the company or

bank or (ii) the person directly or indirectly

owns, controls, or has the power to vote more

than 10 percent of any class of voting securi-

ties of the company or bank, and no other

person owns, controls, or has the power to vote

a greater percentage of that class of voting

securities.

(3) An individual is not considered to have

control, including the power to exercise a con-

trolling inﬂuence over the management or poli-

cies, of a company or bank solely by virtue of

the individual’s position as an ofﬁcer or director

of the company or bank.

(d) ‘‘Director’’ of a company or bank means

any director of the company or bank, whether or

not receiving compensation.

An advisory

director is not considered a director if the advi-

sory director (1) is not elected by the sharehold-

ers of the bank or company, (2) is not authorized

to vote on matters before the board of directors,

and (3) provides solely general policy advice to

the board of directors.

(e)(1) ‘‘Executive ofﬁcer’’ of a company or

bank means a person who participates or has

authority to participate (other than in the capac-

ity of a director) in major policymaking func-

tions of the company or bank, whether or not

the ofﬁcer has an ofﬁcial title; the title desig-

nates the ofﬁcer an assistant; or the ofﬁcer is

serving without salary or other compensation.

3a. Extensions of credit to a director of an afﬁliate of a

bank are not subject to the general prohibitions (section

215.4), the prohibitions on knowingly receiving unauthorized

extensions of credit (section 215.6), and the alternative record-

keeping procedures (section 215.8) if—

(1) the director of the afﬁliate is excluded, by resolution of

the board of directors or by the bylaws of the bank, from

participation in major policymaking functions of the bank,

and the director does not actually participate in those

functions;

(2) the afﬁliate does not control the bank; and

(3) as determined annually, the assets of the afﬁliate do not

constitute more than 10 percent of the consolidated assets of

the company that controls the bank and is not controlled by

any other company, and the director of the afﬁliate is not

otherwise subject to sections 215.4, 215.6, and 215.8 of

Regulation O.

If the director of the afﬁliate is excluded, by resolution of

the board of directors or by the bylaws of the bank, from

participation in major policymaking functions of the bank, a

resolution of the board of directors or a corporate bylaw may

(1) include the director (by name or by title) in a list of

persons excluded from participation in such functions or

(2) not include the director in a list of persons authorized (by

name or by title) to participate in such functions.

4. The term ‘‘executive ofﬁcer’’ is not intended to include

persons who may have ofﬁcial titles and may exercise a

certain measure of discretion in the performance of their

duties, including discretion in the making of loans, but who

do not participate in determining major policies of the bank or

company and whose decisions are limited by policy standards

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Page 5

The chairman of the board, the president, every

vice president, the cashier, the secretary, and the

treasurer of a company or bank are considered

executive ofﬁcers, unless the ofﬁcer is excluded,

by resolution of the board of directors or by the

bylaws of the bank or company, from participa-

tion (other than in the capacity of a director) in

major policymaking functions of the bank or

company, and the ofﬁcer does not actually par-

ticipate therein.

(2) Extensions of credit to an executive

ofﬁcer of an afﬁliate of a member bank (other

than a company that controls the bank) are not

subject to sections 215.4, 215.6, and 215.8 of

Regulation O if—

(i) the executive ofﬁcer of the afﬁliate is

excluded, by resolution of the board of directors

or by the bylaws of the bank, from participation

in major policymaking functions of the bank,

and the executive ofﬁcer does not actually par-

ticipate in those functions;

(ii) the afﬁliate does not control the

bank; and

(iii) as determined annually, the assets

of the afﬁliate do not constitute more than

10 percent of the consolidated assets of the

company that controls the bank and is not con-

trolled by any other company, and the execu-

tive ofﬁcer of the afﬁliate is not otherwise

subject to sections 215.4, 215.6, and 215.8 of

Regulation O.

If the executive ofﬁcer of the afﬁliate is

excluded, by resolution of the board of directors

or by the bylaws of the bank, from participation

in major policymaking functions of the bank, a

resolution of the board of directors or a corpo-

rate bylaw may (i) include the executive ofﬁcer

(by name or by title) in a list of persons

excluded from participation in such functions or

(ii) not include the executive ofﬁcer in a list of

persons authorized (by name or by title) to

participate in such functions.

(f) ‘‘Immediate family’’ means the spouse of

an individual, the individual’s minor children,

and any of the individual’s children (including

adults) residing in the individual’s home.

(g) ‘‘Insider’’ means an executive ofﬁcer,

director, principal shareholder, and any related

interest of such person.

(h) The ‘‘lending limit’’ for a member bank

is an amount equal to the limit on loans to a

single borrower established by section 5200 of

the Revised Statutes,

12 U.S.C. 84. This

amount is 15 percent of the bank’s unimpaired

capital and unimpaired surplus in the case of

loans that are not fully secured, and an addi-

tional 10 percent of the bank’s unimpaired capi-

tal and unimpaired surplus in the case of loans

that are fully secured by readily marketable

collateral having a market value, as determined

by reliable and continuously available price

quotations, at least equal to the amount of the

loan. The lending limit also includes any higher

amounts that are permitted by section 5200 of

the Revised Statutes for the types of obligations

listed therein as exceptions to the limit.

A member bank’s unimpaired capital and

unimpaired surplus equals the (1) member

bank’s tier 1 and tier 2 capital included in the

bank’s risk-based capital, under the capital

guidelines of the appropriate federal banking

agency, and (2) balance of the member bank’s

allowance for loan and lease losses that was not

included in the bank’s tier 2 capital. This com-

putation is based on the bank’s risk-based capi-

tal under the capital guidelines of the appropri-

ate federal banking agency, based on the bank’s

most recent consolidated report of condition

ﬁled under 12 U.S.C. 1817(a)(3).

(i) ‘‘Member bank’’ means any banking insti-

tution that is a member of the Federal Reserve

System, including any subsidiary of a member

bank. The term does not include any foreign

bank that maintains a branch in the United

States, whether or not the branch is insured

(within the meaning of 12 U.S.C. 1813(s)) and

regardless of the operation of 12 U.S.C. 1813(h)

and 12 U.S.C. 1828(j)(3)(B).

(j) ‘‘Person’’ means an individual or a

company.

(k) ‘‘Principal shareholder’’

means an indi-

vidual or a company (other than an insured

bank) that directly or indirectly, or acting

through or in concert with one or more persons,

ﬁxed by the senior management of the bank or company. For

example, the term does not include a manager or assistant

manager of a branch of a bank unless that individual partici-

pates, or is authorized to participate, in major policymaking

functions of the bank or company.

5. Where state law establishes a lending limit for a state

member bank that is lower than the amount permitted in

section 5200 of the Revised Statutes, the lending limit estab-

lished by the applicable state laws shall be the lending limit

for the state member bank.

6. On October 28, 1992, in section 955 of the Housing and

Community Development Act of 1992, Congress amended

section 22(h) of the Federal Reserve Act to exclude from the

deﬁnition of principal shareholder a company of which a

member bank is a subsidiary. Regulation O was amended,

effective December 17, 1992, to implement this change. As a

result of the amendment, extensions of credit by a bank to its

holding company and to any related interests of its subsidiary

are governed solely by sections 23A and 23B of the Federal

Reserve Act.

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Page 6

owns, controls, or has the power to vote more

than 10 percent of any class of voting securities

of a member bank or company. Shares owned or

controlled by a member of an individual’s

immediate family are considered to be held by

the individual. A principal shareholder of a

member bank includes (1) a principal share-

holder of a company of which the member bank

is a subsidiary and (2) a principal shareholder of

any other subsidiary of that company, exclusive

of nonbank subsidiaries of member banks.

(l) ‘‘Related interest’’ means (1) a company

that is controlled by a person or (2) a political or

campaign committee that is controlled by a per-

son or the funds or services of which will bene-

ﬁt a person.

(m) ‘‘Subsidiary’’ has the meaning given in

section 2(d) of the BHC Act, but does not

include a subsidiary of a member bank.

2050.0.3.2.1 Extension of Credit

For the purposes of Regulation O, an ‘‘exten-

sion of credit’’ is

(a) a making or renewal of any loan, a grant-

ing of a line of credit, or an extending of

credit in any manner whatsoever and

includes:

(1) a purchase under repurchase agree-

ment of securities, other assets, or obligations;

(2) an advance by means of an overdraft,

cash item, or otherwise;

(3) issuance of a standby letter of credit

(or other similar arrangement regardless of name

or description) or an ineligible acceptance;

(4) an acquisition by discount, purchase,

exchange, or otherwise of any note, draft, bill of

exchange, or other evidence of indebtedness

upon which an insider may be liable as maker,

drawer, endorser, guarantor, or surety;

(5) an increase of an existing indebted-

ness, but not if the additional funds are

advanced by the bank for its own protection for

(i) accrued interest or (ii) taxes, insurance, or

other expenses incidental to the existing

indebtedness;

(6) an advance of unearned salary or other

unearned compensation for a period in excess of

30 days; and

(7) any other similar transaction as a result

of which a person becomes obligated to pay

money (or its equivalent) to a bank, whether

the obligation arises directly or indirectly, or

because of an endorsement on an obligation or

otherwise, or by any means whatsoever.

The Dodd-Frank Act added to the deﬁnition of

an ‘‘extension of credit’’ an insured depository

institution’s (IDI) credit exposure to a person

arising from a derivative transaction, repurchase

agreement, reverse repurchase agreement, secu-

rities lending transaction, or securities borrowing

transaction.

An extension of credit does not include—

(1) an advance against accrued salary or

other accrued compensation, or an advance for

the payment of authorized travel or other

expenses incurred or to be incurred on behalf

of the bank;

(2) a receipt by a bank of a check depos-

ited in or delivered to the bank in the usual

course of business unless it results in the carry-

ing of a cash item for or the granting of an

overdraft (other than an inadvertent overdraft in

a limited amount that is promptly repaid under

terms that are not more favorable than those

offered to the general public).

(3) an acquisition of a note, draft, bill of

exchange, or other evidence of indebtedness

through (i) a merger or consolidation of banks

or a similar transaction by which a bank

acquires assets and assumes liabilities of another

bank or similar organization or (ii) foreclosure

on collateral or similar proceeding for the pro-

tection of the bank, provided that such indebted-

ness is not held for a period of more than three

years from the date of the acquisition, subject to

extension by the appropriate federal banking

agency for good cause;

(4)(i) an endorsement or guarantee for the

protection of a bank of any loan or other asset

previously acquired by the bank in good faith or

(ii) any indebtedness to a bank for the purpose

of protecting the bank against loss or of giving

ﬁnancial assistance to it;

(5) indebtedness of $15,000 or less arising

by reason of any general arrangement by which

a bank (i) acquires charge or time credit

accounts or (ii) makes payments to or on behalf

of participants in a bank credit card plan, check

credit plan, or similar open-end credit plan,

provided—

(A) the indebtedness does not involve

prior individual clearance or approval by the

bank other than for the purposes of determining

authority to participate in the arrangement and

compliance with any dollar limit under the

arrangement and

(B) the indebtedness is incurred under

terms that are not more favorable than those

offered to the general public;

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Page 7

(6) indebtedness of $5,000 or less arising

by reason of an interest-bearing overdraft credit

plan (see Regulation O, section 215.4(e)); or

(7) a discount of promissory notes, bills of

exchange, conditional sales contracts, or similar

paper, without recourse.

Non-interest-bearing deposits to the credit of

a bank are not considered loans, advances, or

extensions of credit to the bank of deposit. Also,

the giving of immediate credit to a bank upon

collected items received in the ordinary course

of business is not considered to be a loan,

advance, or extension of credit to the depositing

bank.

An extension of credit by a member bank (for

the purposes of section 215.4 of Regulation O)

is considered to have been made at the time the

bank enters into a binding commitment to make

the extension of credit. A participation without

recourse is considered to be an extension of

credit by the participating bank, not by the origi-

nating bank.

Tangible-economic-beneﬁt rule. In general, an

extension of credit is considered made to an

insider to the extent that the proceeds are trans-

ferred to the insider or are used for the tangible

economic beneﬁt of the insider. An extension of

credit is not considered made to an insider if—

(1) the credit is extended on terms that

would satisfy the standard set forth in section

215.4(a) of Regulation O for extensions of credit

to insiders and

(2) the proceeds of the extension of credit

are used in a bona ﬁde transaction to acquire

property, goods, or services from the insider.

2050.0.3.2.2 Insider Use of a

Bank-Owned Credit Card

Board staff issued a May 22, 2006, legal opinion

in response to an FDIC request for clariﬁcation

on the application of the Board’s Regulation O

(12 C.F.R. 215) to credit cards that are issued to

bank insiders for the bank’s business purposes.

The FDIC asked whether, and under what cir-

cumstances, an insider’s use of a bank-owned

credit card would be deemed an extension of

credit by the bank to the insider for purposes of

Regulation O.

The FDIC indicated that insiders of a bank

often use a bank-owned credit card to purchase

goods and services for the bank’s business pur-

poses. A bank-owned credit card is a credit card

that is issued by a third-party ﬁnancial institu-

tion to a bank to enable the bank (through its

employees) to ﬁnance the purchase of goods

and services for the bank’s business. Board staff

commented that it was understood that (1) a

bank that provides a bank-owned credit card to

its employees typically forbids or discourages

use of the card by employees for their personal

purposes and that an employee who uses the

card for personal purposes is obligated to

promptly reimburse the bank and (2) a bank is

liable to the card-issuing institution for all

extensions of credit made under the card

(whether for the bank’s business purposes or for

an employee’s personal purposes)

Although section 215.3(a) of Regulation O

broadly deﬁnes an extension of credit to include

‘‘a making or renewal of a loan, a granting of a

line of credit, or an extending of credit in any

manner whatsoever,’’ the rule also provides sev-

eral important exceptions to the deﬁnition that

are relevant to the FDIC’s inquiry. Section

215.3(b)(1) of Regulation O excludes from the

deﬁnition of extension of credit any advance by

a bank to an insider for the payment of autho-

rized or other expenses incurred or to be

incurred on behalf of the bank. Also, section

215.3(b)(5) of Regulation O excludes from the

deﬁnition of extension of credit indebtedness of

up to $15,000 incurred by an insider with a bank

under an ordinary credit card.

Considering the provisions of Regulation O

and the purposes of the insider lending restric-

tions in the Federal Reserve Act, Board legal

staff opined that a bank does not make an exten-

sion of credit to an insider for purposes of

Regulation O at the time of issuance of a bank-

owned credit card to the insider (regardless of

whether the line of credit associated with the

card is greater than $15,000). The opinion states

also that a bank does not extend credit to an

insider for the purposes of Regulation O when

the insider uses the card to purchase goods or

services for the bank’s business purposes. How-

ever, when an insider uses the card to purchase

goods or services for the insider’s personal pur-

poses, the bank may be making an extension of

7. The provisions of Regulation O apply to a bank holding

company of which a member bank is a subsidiary, and any

other subsidiary of that bank holding company. (See

2050.0.3.)

8. In the responding letter, Board legal staff notes that it

was understood that some banks directly issue credit cards to

their employees to enable the employees to ﬁnance the pur-

chase of goods and services for the bank’s business (bank-

issued credit cards). Also, the letter states that the principles

set forth with regard to bank-owned credit cards also would

apply to bank-issued credit cards.

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 8

credit to the insider. The opinion states that an

extension of credit would occur for the purposes

of Regulation O if—and to the extent that—the

amount of outstanding personal charges made to

the card, when aggregated with all other indebt-

edness of the insider that qualiﬁes for the credit

card exception in section 215.3(b)(5) of Regula-

tion O, exceeds $15,000.

The FDIC also asked whether incidental per-

sonal expenses charged by an insider to a bank-

owned credit card are per se violations of the

market-terms requirement in section 215.4(a) of

Regulation O because non-insiders do not have

access to this form of credit from the bank. In

response, Board staff stated that section 215.4(a)

requires extensions of credit by a bank to its

insiders to (1) be on substantially the same

terms (including interest rates and collateral) as,

and subject to credit underwriting standards that

are not less stringent than, those prevailing at

the time for comparable transactions with non-

insiders and (2) not involve more than the nor-

mal risk of repayment or other features unfavor-

able to the bank.

The opinion states that a bank may be able to

satisfy the market-terms requirement, however,

if the bank approves an insider for use of a

bank-owned credit card only (1) if the insider

meets the bank’s normal credit underwriting

standards and (2) the card does not have prefer-

ential terms (or the card does not have preferen-

tial terms in connection with uses of the card for

personal purposes). Nonetheless, use of a bank-

owned credit card by an insider for personal

purposes may violate the market- terms require-

ment of Regulation O if the card carries a lower

interest rate or permits a longer repayment

period than comparable consumer credit offered

by the bank.

The Board staff’s legal opinion applies only

to the speciﬁc issues and circumstances

described in the letter and does not address any

other issues or circumstances.

2050.0.3.3 General Prohibitions and

Limitations of Regulation O

(a) Terms and creditworthiness. No member

bank may extend credit to any insider of the

bank or insider of its afﬁliates unless the exten-

sion of credit (1) is made on substantially the

same terms (including interest rates and collat-

eral) as, and following credit-underwriting pro-

cedures that are not less stringent than, those

prevailing at the time for comparable transac-

tions by the bank with other persons that are not

covered by Regulation O and who are not

employed by the bank and (2) does not involve

more than the normal risk of repayment or pres-

ent other unfavorable features.

Nothing stated above (as to ‘‘terms and cred-

itworthiness’’) should prohibit any extension of

credit made in accordance with a beneﬁt or

compensation program that—

1. is widely available to employees of the

member bank, and in the case of extensions of

credit to an insider of its afﬁliates, is widely

available to employees of the afﬁliates at which

that person is an insider and

2. does not give preference to any insider

of the member bank over other employees of the

member bank and, in the case of extensions of

credit to an insider of its afﬁliates, does not give

preference to any insider of its afﬁliates over

other employees of the afﬁliates of which that

person is an insider.

(b) Prior approval. A member bank may not

extend credit (including granting a line of credit)

to any insider of the bank or insider of its

afﬁliates in an amount that, when aggregated

with the amount of all other extensions of credit

to that person and to all related interests of that

person, exceeds the higher of $25,000 or 5 per-

cent of the member bank’s unimpaired capital

and unimpaired surplus, but in no event can it

exceed $500,000. This provision applies unless

(1) the extension of credit or line of credit has

been approved in advance by a majority of the

entire board of directors of that bank and (2) the

interested party has abstained from participating

directly or indirectly in the voting.

The board of directors’ approval is not

required for an extension of credit that is made

pursuant to a line of credit that was approved by

the board of directors within 14 months of the

date of the extension of credit. Participation in

the discussion, or any attempt to inﬂuence the

voting, by the board of directors regarding an

extension of credit constitutes indirect participa-

tion in the voting by the board of directors on an

extension of credit.

may not extend credit to any insider of the bank

or insider of its afﬁliates in an amount that,

when aggregated with the amount of all other

extensions of credit by the member bank to that

person and to all related interests of that person,

exceeds the lending limit described above in

section 2050.0.3.2 (paragraph h). This prohibi-

tion does not apply to an extension of credit by a

member bank to a company of which the mem-

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 9

ber bank is a subsidiary or to any other subsidi-

ary of that company.

(d) Aggregate lending limit.

(1) General limit. A member bank may

not extend credit to any insider of the bank or

insider of its afﬁliates unless the extension of

credit is in an amount that, when aggregated

with all outstanding extensions of credit to all

such insiders, would exceed the bank’s unim-

paired capital and unimpaired surplus as deﬁned

in section 215.2(i) of Regulation O (see section

2050.0.3.2, paragraph h).

(2) A member bank with deposits of less

than $100,000,000 may, by an annual resolution

of its board of directors, increase the general

limit (speciﬁed above) to a level that does not

exceed two times the bank’s unimpaired capital

and unimpaired surplus if the board of directors

determines that such higher limit is consistent

with prudent, safe, and sound banking practices

in light of the bank’s experience in lending to its

insiders and is necessary to attract or retain

directors or to prevent the restriction of the

availability of credit in small communities.

The board of directors’ resolution must

set forth the facts and reasoning on which it

bases its ﬁnding, including the amount of the

bank’s lending to its insiders as a percentage of

the bank’s unimpaired capital and unimpaired

surplus as of the date of the resolution. In addi-

tion, the bank must meet or exceed, on a fully

phased-in basis, all applicable capital require-

ments established by the appropriate federal

banking agency. The bank would also have had

to receive a satisfactory composite rating in its

most recent bank examination report.

If a member bank has adopted a resolu-

tion authorizing a higher limit and subsequently

fails to meet the above-listed requirements, the

member bank cannot extend any additional

credit (including a renewal of any existing

extension of credit) to any insider of the bank or

its afﬁliates unless the extension or renewal is

consistent with the general limit.

(3) Exceptions to the general limit. Effec-

tive May 3, 1993, the general limit, described in

manual section 2050.0.3.3 (paragraph d) and

speciﬁed in section 215.4(d)(1) of the Board’s

Regulation O does not apply to—

(i) extensions of credit secured by a per-

fected security interest in bonds, notes, certiﬁ-

cates of indebtedness, or Treasury bills of the

United States or in other such obligations fully

guaranteed as to principal and interest by the

United States;

(ii) extensions of credit to or secured by

unconditional takeout commitments or guaran-

tees of any department, agency, bureau, board,

commission, or establishment of the United

States or any corporation wholly owned directly

or indirectly by the United States;

(iii) extensions of credit secured by a

perfected security interest in a segregated

deposit account in the lending bank; or

(iv) extensions of credit arising from the

discount of negotiable installment consumer

paper that is acquired from an insider and

carries a full or partial recourse endorsement or

guarantee by the insider,

provided that—

(A) the ﬁnancial condition of each

maker of such consumer paper is reasonably

documented in the bank’s ﬁles or known to its

ofﬁcers;

(B) an ofﬁcer of the bank designated

for that purpose by the board of directors of the

bank certiﬁes in writing that the bank is relying

primarily upon the responsibility of each maker

for the payment of the obligation and not upon

any endorsement or guarantee by the insider;

and

an insider.

(e) Overdrafts. A member bank may not pay

an overdraft of an executive ofﬁcer or director

of the bank

on an account at the bank, unless

the payment of funds is made in accordance

with (1) a written, preauthorized, interest-

bearing extension of credit plan that speciﬁes a

method of repayment or (2) a written, preautho-

rized transfer of funds from another account of

the account holder at the bank.

The prohibition above does not apply to

payment of inadvertent overdrafts on an account

in an aggregate amount of $1,000 or less, pro-

vided (1) the account is not overdrawn for more

than ﬁve business days and (2) the member

bank charges the executive ofﬁcer or director

the same fee charged any other customer of the

bank in similar circumstances.

9. The exceptions to the aggregate lending limit pertaining

to extensions of credit secured in the manner described above

(i through iii) apply only to the amounts of such extensions of

credit that are secured in such manner.

10. This prohibition does not apply to the payment by a

member bank of an overdraft of a principal shareholder of the

member bank, unless the principal shareholder is also an

executive ofﬁcer or director. This prohibition also does not

apply to the payment by a member bank of an overdraft of a

related interest of an executive ofﬁcer, director, or principal

shareholder of the member bank.

11. The requirement that the member bank charge the

executive ofﬁcer or director the same fee charged any other

customer of the bank in similar circumstances does not pro-

hibit the member bank from charging a fee provided for in a

beneﬁt or compensation program that satisﬁes the require-

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 10

2050.0.3.4 Additional Restrictions

on Loans to Executive Ofﬁcers

of Member Banks

The following restrictions on extensions of

credit by a member bank to any of its executive

ofﬁcers are in addition to any restrictions on

extensions of credit by a member bank to insid-

ers of itself or its afﬁliates. The restrictions

listed below apply only to the executive ofﬁcers

of the member bank and not to the executive

ofﬁcers of its afﬁliates.

A member bank may not extend credit to any

of its executive ofﬁcers, and no executive ofﬁcer

of a member bank can borrow from or otherwise

become indebted to the bank, except in the

amounts, for the purposes, and upon the condi-

tions speciﬁed in items 3 and 4 below.

A member bank is authorized to extend credit

to any executive ofﬁcer of the bank—

(1) in any amount to ﬁnance the education of

the executive ofﬁcer’s children;

(2) in any amount to ﬁnance or reﬁnance

the purchase, construction, maintenance, or

improvement of a residence of the executive

ofﬁcer, provided—

(i) the extension of credit is secured by a

ﬁrst lien on the residence and the residence is

owned (or expected to be owned after the exten-

sion of credit) by the executive ofﬁcer; and

(ii) in the case of reﬁnancing, that only the

amount used to repay the original extension of

credit, together with the closing costs of the

reﬁnancing, and any additional amount thereof

used for any of the purposes enumerated in

item 2 above, are included within this category

of credit;

(3) in any amount, if the extension of credit

is secured in a manner described in the ﬁrst

three exceptions to the general limit of the

aggregate lending limit (see section 2050.0.3.3,

paragraph d, subparagraphs i to iii); and

(4) for any other purpose (not speciﬁed in

items 1 through 3 above), if the aggregate

amount of loans to that executive ofﬁcer does

not exceed, at any one time, the higher of

2.5 percent of the bank’s unimpaired capital and

unimpaired surplus or $25,000, but in no event

more than $100,000.

Any extension of credit by a member bank to

any of its executive ofﬁcers must be—

(1) promptly reported to the member bank’s

board of directors,

(2) in compliance with the general prohibi-

tions of section 215.4 of Regulation O (manual

section 2050.0.3.3),

(3) preceded by the submission of a current

detailed ﬁnancial statement of the executive

ofﬁcer, and

(4) made subject to the condition in writing

that the extension of credit will, at the option of

the member bank, become due and payable at

any time that the ofﬁcer is indebted to any other

bank or banks in an aggregate amount greater

than the amount speciﬁed for a category of

credit that may be made available by a member

bank to any of its executive ofﬁcers.

No member bank may extend credit in an

aggregate amount greater than the amount per-

mitted for general-purpose loans to an executive

ofﬁcer (section 215.5(c)(4) of Regulation O) to

a partnership in which one or more of the bank’s

executive ofﬁcers are partners and, either indi-

vidually or together, hold a majority interest.

The total amount of credit extended by a mem-

ber bank to such partnership is considered to be

extended to each executive ofﬁcer of the mem-

ber bank who is a member of the partnership.

Prohibition on knowingly receiving unauthor-

ized extensions of credit. Insiders are prohibited

from knowingly receiving (or permitting their

related interests to receive) any extensions of

credit not authorized by section 22(h) of the

Federal Reserve Act and by Regulation O.

2050.0.3.5 Grandfathering Provisions

(a) Under FDICIA. FDICIA provided that

the amendments to Regulation O would not

affect extensions of credit entered into on or

before the effective date of the regulation.

Therefore, extensions of credit, including lines

of credit, made on or before May 18, 1992,

are not required to comply with either the

individual-borrower limit made applicable to

directors and their related interests, or with the

aggregate limit on all loans to insiders. All

extensions of credit, loan renewals, and loan

rollovers made after May 18, 1992, must com-

ply with all of the provisions of Regulation O.

In other words, banks cannot make new loans or

renew outstanding extensions of credit in

amounts that, when aggregated with all other

outstanding loans to insiders, would exceed

either of the new limits.

(b) Extensions of credit outstanding on

March 10, 1979. Any extension of credit that

was outstanding on March 10, 1979, and that

would have, if made on or after March 10, 1979,

violated the individual lending limit, had to be

ments detailed in section 2050.0.3.3, item (a).

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 11

reduced in amount by March 10, 1980, to be in

compliance with the aggregate lending limit of

Regulation O. Any renewal or extension of such

a credit extension on or after March 10, 1979,

must have been made only on terms that would

have brought it into compliance with the aggre-

gate lending limit by March 10, 1980. However,

any extension of credit made before March 10,

1979, that bears a speciﬁc maturity date of

March 10, 1980, or later, had to be repaid in

accordance with the repayment schedule in

existence on or before March 10, 1979.

2050.0.3.6 Reports by Executive Ofﬁcers

Each executive ofﬁcer of a member bank who

becomes indebted to any other bank or banks in

an aggregate amount greater than the amount

speciﬁed for a category of credit in section

215.5(c) of Regulation O (manual section

2050.0.3.4) must make a written report to the

board of directors of the ofﬁcer’s bank within

10 days of the date the indebtedness reaches

such a level. The report must state the lender’s

name, the date and amount of each extension of

credit, any security for it, and the purposes for

which the proceeds have been or are to be used.

Report on credit secured by BHC stock. In

addition to the report required above, each

executive ofﬁcer or director of a member bank

the shares of which are not publicly traded must

report annually to the bank’s board of directors

the outstanding amount of any credit that was

extended to the executive ofﬁcer or director that

is secured by shares of the member bank. (See

also Regulation Y section 225.4(f) for the iden-

tical restriction on executive ofﬁcers and direc-

tors of a bank holding company with loans

secured by shares of the bank holding company.)

2050.0.3.7 Report on Credit

to Executive Ofﬁcers

Each member bank must include with (but not

as part of) each report of condition (and copy

thereof) ﬁled pursuant to 12 U.S.C. 1817(a)(3) a

report of all extensions of credit made by the

member bank to its executive ofﬁcers since the

date of the bank’s previous report of condition.

2050.0.3.8 Disclosure of Credit from

Member Banks to Executive Ofﬁcers and

Principal Shareholders

(a) Deﬁnitions. For the purposes of this sec-

tion, the following deﬁnitions apply:

(1) ‘‘Principal shareholder of a member

bank’’ means a person (individual or a com-

pany), other than an insured bank, or branch or

representative ofﬁce of a foreign bank as deﬁned

in 12 U.S.C. 3101(7)

that, directly or indi-

rectly, or acting through or in concert with one

or more persons, owns, controls, or has power to

vote more than 10 percent of any class of voting

securities of the member bank or company. The

term includes an individual or company that

controls a principal shareholder (for example, a

person that controls a bank holding company).

Shares of a bank (including a foreign bank),

bank holding company, or other company

owned or controlled by a member of an indi-

vidual’s immediate family are considered to be

held or controlled by the individual for the

purposes of determining principal shareholder

status.

(2) ‘‘Related interest’’ means (i) any com-

pany controlled by a person; or (ii) any political

or campaign committee the funds or services of

which will beneﬁt a person or that is controlled

by a person. A related interest does not include

a bank or a foreign bank (as deﬁned in 12 U.S.C.

3101(7)).

(b) Public disclosure. Upon receipt of a writ-

ten request from the public, a member bank

shall make available the names of each of its

executive ofﬁcers (with the exception of any

executive ofﬁcer of a bank holding company of

which the member bank is a subsidiary or of any

other subsidiary of that bank holding company

unless the executive ofﬁcer is also an executive

ofﬁcer of the member bank) and each of its

principal shareholders to whom, or to whose

related interests, the member bank had outstand-

ing at the end of the latest previous quarter of

the year, an extension of credit that, when aggre-

gated with all other outstanding extensions of

credit at that time from the member bank to

such person and to all related interests of such

12. A foreign bank means any company organized under

the laws of a foreign country, a territory of the United States,

Puerto Rico, Guam, American Samoa, or the Virgin Islands

that engages in the business of banking, or any subsidiary or

afﬁliate, organized under such laws, of any such company.

This includes foreign commercial banks, foreign merchant

banks, and other foreign institutions that engage in banking

activities usual in connection with the business of banking in

the countries where such foreign institutions are organized or

operating.

13. See footnote 3.

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 12

person, equaled or exceeded 5 percent of the

member bank’s capital and unimpaired surplus

or $500,000, whichever amount is less. No dis-

closure under this paragraph is required if the

aggregate amount of all extensions of credit

outstanding at that time from the member bank

to the executive ofﬁcer or principal shareholder

of the member bank and to all related interests

of such a person does not exceed $25,000.

A member bank is not required to disclose

the speciﬁc amounts of individual extensions of

credit.

is required to maintain records of all requests

for the information described above and the

disposition of the requests. These records may

be disposed of two years after the date of the

request.

2050.0.3.9 Civil Penalties of

Regulation O

Any member bank, or any ofﬁcer, director,

employee, agent, or other person participating in

the conduct of the affairs of the bank, that

violates any provision of Regulation O is sub-

ject to a civil penalty, as speciﬁed in section 29

of the Federal Reserve Act.

2050.0.3.10 Records of Member Banks

(and BHCs)

To help inspection and examination personnel

identify BHC ofﬁcials, Regulation O requires

each member bank to maintain records neces-

sary to monitor compliance with this regulation.

BHCs and nonbank subsidiaries should be

given access to the records identifying ‘‘bank

ofﬁcials.’’ Each state member bank is required

to (1) identify, through an annual survey, all

insiders of the bank itself; and (2) maintain

records of all extensions of credit to insiders of

the bank itself, including the amount and terms

of each such extension of credit.

2050.0.3.10.1 Recordkeeping for Insiders

of the Member Bank’s Afﬁliates

A member bank is required to maintain records

of extensions of credit to insiders of the member

bank’s afﬁliates by—

(1) a ‘‘survey’’ method, which identiﬁes,

through an annual survey, each of the insiders of

the member bank’s afﬁliates. Under the survey

method, the member bank must maintain

records of the amount and terms of each exten-

sion of credit by the member bank to such

insiders or

(2) a ‘‘borrower inquiry’’ method, which

requires, as part of each extension of credit, the

borrower to indicate whether the borrower is an

insider of an afﬁliate of the member bank.

Under this method, the member bank must

maintain records that identify the amount and

terms of each extension of credit by the member

bank to borrowers so identifying themselves.

Alternative recordkeeping method for insid-

ers of afﬁliates. A member bank may use a

recordkeeping method other than those identi-

ﬁed above if the appropriate federal banking

agency determines that the bank’s method is at

least as effective.

2050.0.3.10.2 Special Rule for

Noncommercial Lenders

A member bank that is prohibited by law or by

an express resolution of the bank’s board of

directors from making an extension of credit to

any company, or other entity that is covered by

Regulation O as a company, is not required to

maintain any records of the related interests of

the insiders of the bank or its afﬁliates. The

bank is also not required to inquire of borrowers

whether they are related interests of the insiders

of the bank or its afﬁliates.

2050.0.3.11 Section 23A Ramiﬁcations

Loans to a holding company parent and its

afﬁliates are governed by section 23A of the

Federal Reserve Act and are not subject to

Regulation O.

2050.0.4 REMEDIAL ACTION

Self-serving and abusive transactions deprive a

BHC of opportunities and beneﬁts that may

otherwise have been available and may strip a

BHC of its ability to serve as a source of ﬁnan-

cial and managerial strength to its subsidiary

banks. Even if not extended on preferential

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual January 2007

Page 13

terms, self-serving loans and other extensions of

credit to insiders may be an imprudent business

practice and may reduce the lender’s liquidity or

otherwise overextend the BHC. In such situa-

tions, formal or informal remedial measures by

the Federal Reserve may be necessary. Formal

enforcement action is provided for in the 1974

amendments to the Financial Institutions Super-

visory Act of 1966 (12 U.S.C. 1818), which

grant the Board authority to issue cease-and-

desist orders in appropriate situations. For com-

plete details on formal corrective actions, see

section 2110.0.

2050.0.5 INSPECTION OBJECTIVES

1. To determine if any transactions between

BHC ofﬁcials, their related interests, and the

BHC or its nonbank subsidiaries are based

on preferential treatment.

2. To determine if any transactions between

BHC ofﬁcials, their related interests, and the

BHC or its nonbank subsidiaries result in

any undue loss exposure to the BHC or its

subsidiaries.

3. To determine if any BHC or nonbank

extension of credit to a BHC ofﬁcial or

related interest is in the spirit of Regulation

O’s requirements or whether it is an attempt

to circumvent Regulation O’s prohibition on

various bank extensions of credit to similar

parties.

4. To determine that BHC ofﬁcials are aware of

Regulation O’s limitations and prohibitions

and have established internal policies and

procedures for the bank subsidiaries to

ensure compliance by the banks.

5. To determine that the BHC has arranged to

make available, upon request, a listing or

some other form of information sufﬁcient to

identify all ‘‘BHC ofﬁcials’’ and to make

certain that such information is available to

the bank subsidiaries in particular.

2050.0.6 INSPECTION PROCEDURES

1. Review the balance sheets and other records

of the parent-only and nonbank subsidiaries

to determine if there are any loans or other

extensions of credit to BHC ofﬁcials.

2. Review the income statements and support-

ing records of the parent-only and nonbank

subsidiaries to determine if any interest

income, other income, or expense is associ-

ated with a transaction with a BHC ofﬁcial or

a related interest.

3. Ask management to identify all such

transactions and to provide supporting

documentation.

4. Review management’s familiarity with

Regulation O’s limitations and the steps they

have taken to establish policies for the inter-

nal administration of their subsidiary banks’

extensions of credit to BHC ofﬁcials.

5. Review any information prepared by man-

agement that presents a listing of all BHC

ofﬁcials and their related interests.

6. Review any corporate resolutions declaring

an individual not to be an ‘‘executive ofﬁ-

cer’’ for purposes of Regulation O and, if

necessary, conﬁrm the individual’s nonpar-

ticipation in the formulation of corporate pol-

icy.

7. As the provision of Regulation O apply to

the BHC and its subsidiaries, determine if

the BHC provides employees or other insid-

ers with extensions of credit, including BHC-

owned or BHC-issued credit cards. Find out

if any of the credit cards are used to conduct

the BHC’s business.

a. Verify that the BHC has a written policy

that forbids or discourages an employee

or other insider from using a BHC-owned

or BHC-issued credit card for the insid-

er’s personal purposes and that the policy

obligates the insider to promptly make

reimbursement to the BHC.

b. Determine the BHC’s compliance with

Regulation O regarding its extensions of

credit (including BHC-owned or BHC-

issued credit card loans) to insiders.

Verify that the BHC monitors the amount

of personal charges outstanding on its

BHC-owned or BHC-issued credit cards

that are held by insiders so that the out-

standing charges, when aggregated with

all of an insider’s other indebtedness

owed to the BHC, do not exceed $15,000.

c. Verify the BHC’s compliance with the

market-terms requirement of Regulation

O. Determine if—

• the BHC requires employees and other

insiders who have extensions of credit,

or use BHC-owned or BHC-issued

credit cards for personal purposes, to

meet the BHC’s normal credit under-

writing standards and

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual July 2007

Page 14

• the BHC has veriﬁed that the insiders’

extensions of credit (or BHC-owned

or BHC-issued credit cards) do not

have more preferential terms (for

example, a lower interest rate or a

longer repayment period) than the con-

sumer credit cards offered by the BHC.

2050.0.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Loans and extensions

of credit to executive

ofﬁcers, directors, and

principal shareholders

375a and

375b

(sections 22(g)

and 22(h) of

F.R. Act)

215.4

215.5

(Reg. O)

Granting of below-

market interest rate

mortgage loans to

executives of BHC

subsidiaries as

compensation

1972(2) 4–514

3–1094

Restrictions on

loans to insiders

of a bank or its

correspondent

bank

1972 (2)

Board staff interpretation

on the use of bank-

owned or bank-issued

credit cards by bank

insiders

3–1081.5

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Extensions of Credit to BHC Ofﬁcials 2050.0

BHC Supervision Manual July 2007

Page 15

Management Information Systems

(General) Section 2060.0

Management Information Systems refers to the

policies and operating procedures, including

systems of internal control, that the board of

directors of a bank holding company initiates to

monitor and ensure control of its operations and

activities, while maintaining and improving the

ﬁnancial strength and objectives of the overall

organization. These policies should focus on the

overall organizational structure with respect to

identifying, monitoring, and managing risks.

Subsequent sections of the manual focus on the

essential elements of various management infor-

mation systems. Included are inspection objec-

tives and procedures to be used by Federal

Reserve Bank examiners when conducting

inspections of bank holding companies.

See 2060.05 Internal Audit Function

and Its Outsourcing

2060.1 Audit

2060.2 Budget

2060.3 Records and Statements

2060.4 Reporting

2060.5 Insurance

5052.0 Targeted MIS Inspection

BHC Supervision Manual December 1998

Page 1

Policy Statement on the Internal Audit Function and Its

Outsourcing (Management Information Systems) Section 2060.05

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2014, this section was revised

to include new and revised inspection objectives

and inspection procedures for both the 2003

interagency guidance, ‘‘Policy Statement on the

Internal Audit Function and its Outsourcing,’’

and the January 23, 2013, Federal Reserve

‘‘Supplemental Policy Statement on Internal

Audit Function and its Outsourcing.’’ Refer to

SR-03-5 and SR 13-1/CA 13-1 and Manual sec-

tion 2060.07.

2060.05.01 AN EFFECTIVE SYSTEM

OF INTERNAL CONTROLS

Effective internal control

is a foundation for the

safe and sound operation of a ﬁnancial institu-

tion (institution).

The board of directors and

senior management of an institution are respon-

sible for ensuring that the system of internal

control operates effectively. Their responsibility

cannot be delegated to others within the institu-

tion 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, inter-

nal audit provides directors and senior manage-

ment with vital information about weaknesses in

the system of internal control so that manage-

ment can take prompt, remedial action. The

federal banking agencies’

(agencies) long-

standing inspection policies call for examiners

to review an institution’s internal audit function

and recommend improvements, if needed. In

addition, pursuant to section 39 of the Federal

Deposit Insurance Act (FDI Act) (12 U.S.C.

1831p-1), the agencies have adopted Inter-

agency Guidelines Establishing Standards for

Safety and Soundness that apply to insured

depository institutions.

Under these guidelines

and policies, each institution should have an

internal audit function that is appropriate to its

size and the nature and scope of its activities.

In addressing various quality and resource

issues, many institutions have been engaging

independent public accounting ﬁrms and other

outside professionals (outsourcing vendors) in

recent years to perform work that traditionally

has been done by internal auditors. These

arrangements are often called ‘‘internal audit

outsourcing,’’ ‘‘internal audit assistance,’’ ‘‘audit

co-sourcing,’’ and ‘‘extended audit services’’

(hereafter, collectively referred to as outsourc-

ing). Typical outsourcing arrangements are

more fully illustrated in part II below.

Outsourcing may be beneﬁcial to an institu-

tion if it is properly structured, carefully con-

ducted, and prudently managed. However, the

agencies have concerns that the structure, scope,

and management of some internal audit out-

sourcing arrangements do not contribute to the

institution’s safety and soundness. Furthermore,

the agencies want to ensure that these arrange-

ments with outsourcing vendors do not leave

directors and senior management with the erro-

neous impression that they have been relieved

of their responsibility for maintaining an effec-

tive system of internal control and for oversee-

ing the internal audit function.

The Sarbanes-Oxley Act of 2002 (the act)

became law on July 30, 2002.

The act addresses

weaknesses in corporate governance and the

1. In summary, internal control is a process designed to

provide reasonable assurance that the institution will achieve

the following internal control objectives: efﬁcient and effec-

tive 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 communi-

cation, 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 essen-

tial to achieving the internal control objectives. This descrip-

tion of internal control is consistent with the Committee of

Sponsoring Organizations of the Treadway Commission

(COSO) report Internal Control—Integrated Framework. In

addition, under the COSO framework, ﬁnancial reporting is

deﬁned in terms of published ﬁnancial statements, which, for

purposes of this policy statement, encompass both ﬁnancial

statements prepared in accordance with generally accepted

accounting principles and regulatory reports (such as the

Reports of Condition and Income). Institutions are encour-

aged to evaluate their internal control against the COSO

framework.

2. The term ‘‘institution’’ includes depository institutions

insured by the Federal Deposit Insurance Corporation (FDIC),

U.S. ﬁnancial holding companies and bank holding companies

supervised by the Federal Reserve System, thrift holding

companies supervised by the Ofﬁce of Thrift Supervision

(OTS), and the U.S. operations of foreign banking

organizations.

3. The Board of Governors of the Federal Reserve System

(FRS), Federal Deposit Insurance Corporation (FDIC), Ofﬁce

of the Comptroller of the Currency (OCC), and Ofﬁce of

Thrift Supervision (OTS).

4. For national banks, appendix A to part 30; for state

member banks, appendix D-1 to part 208; for insured state

nonmember banks and insured state-licensed branches of for-

eign banks, appendix A to part 364; for savings associations,

appendix A to part 570.

5. Pub. L. No. 107-204.

BHC Supervision Manual January 2014

Page 1

accounting and auditing professions, and

includes provisions addressing audits, ﬁnancial

reporting and disclosure, conﬂicts of interest,

and corporate governance at publicly owned

companies. The act, among other things,

requires public companies to have an audit com-

mittee composed entirely of independent direc-

tors. Public banking organizations that are listed

on the New York Stock Exchange (NYSE) and

Nasdaq must also comply with those exchanges’

listing requirements, which include audit com-

mittee requirements.

The act also established a Public Company

Accounting Oversight Board (PCAOB) that has

the authority to set and enforce auditing, attesta-

tion, quality control, and ethics (including inde-

pendence) standards for auditors of public com-

panies, subject to SEC review. (See SR-02-20.)

Accounting ﬁrms that conduct audits of public

companies (i.e., registered accounting ﬁrms)

must register with the PCAOB and be subject to

its supervision. The PCAOB is also empowered

to inspect the auditing operations of public

accounting ﬁrms that audit public companies, as

well as impose disciplinary and remedial sanc-

tions for violations of its rules, securities laws,

and professional auditing and accounting

standards.

[Sections 2060.05.02–2060.05.04 are

reserved.]

2060.05.05 APPLICATION OF THE

SARBANES-OXLEY ACT TO

NONPUBLIC BANKING

ORGANIZATIONS

In May 2003, the Federal Reserve, the Ofﬁce of

the Comptroller of the Currency, and the Ofﬁce

of Thrift Supervision announced that they did

not expect to take actions to apply the corporate-

governance and other requirements of the

Sarbanes-Oxley Act generally to nonpublic

banking organizations that are not otherwise

subject to them.

(See SR-03-08.) The agen-

cies, however, encouraged nonpublic banking

organizations to periodically review their poli-

cies and procedures relating to corporate-

governance and auditing matters. This review

should ensure that such policies and procedures

are consistent with applicable law, regulations,

and supervisory guidance and remain appropri-

ate in light of the organization’s size, opera-

tions, and resources. Furthermore, the agencies

stated that a banking organization’s policies and

procedures for corporate governance, internal

controls, and auditing will be assessed during

the supervisory process, and the agencies may

take appropriate supervisory action if there

are deﬁciencies or weaknesses in these areas

that are inconsistent with sound corporate-

governance practices or safety-and-soundness

considerations.

2060.05.06 INTERAGENCY POLICY

STATEMENT ON THE INTERNAL

AUDIT FUNCTION AND ITS

OUTSOURCING

The Federal Reserve and other federal banking

agencies

adopted on March 17, 2003, an inter-

agency policy statement addressing the internal

audit function and its outsourcing (See SR

03-5). The policy statement revises and replaces

the former 1997 policy statement and incorpo-

rates recent developments in internal auditing.

In addition, the revised policy incorporates guid-

ance on the independence of accountants who

provide institutions with both internal and exter-

nal audit services in light of the Sarbanes-Oxley

Act of 2002 and associated SEC rules. (See also

sections 2124.0.2.4, 2060.1, 3230.0.10.2.5,

5010.7, and 5030.0 [page 7] pertaining to inter-

nal and external audits.)

The act prohibits an accounting ﬁrm from

acting as the external auditor of a public com-

pany during the same period that the ﬁrm pro-

vides internal audit services to the company.

The policy statement discusses the applicability

of this prohibition to institutions that are public

companies, insured depository institutions with

assets of $500 million or more that are subject

to the annual audit and reporting requirements

of section 36 of the Federal Deposit Insurance

Act, and also nonpublic institutions that are not

subject to section 36.

5a. As discussed below, some aspects of the auditor-

independence rules established by the Sarbanes-Oxley Act

apply to all federally insured depository institutions with $500

million or more in total assets. See part 363 of the FDIC’s

regulations.

6. The FDIC, OCC, and OTS.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 2

2060.05.1 INTERNAL AUDIT

FUNCTION (PART I)

2060.05.1.1 Director and Senior

Management Responsibilities for Internal

Audit

The board of directors and senior management

are responsible for having an effective system of

internal control and an effective internal audit

function in place at their institution. They are

also responsible for ensuring that the impor-

tance of internal control is understood and

respected throughout the institution. This over-

all responsibility cannot be delegated to anyone

else. They may, however, delegate the design,

implementation, and monitoring of speciﬁc

internal controls to lower-level management and

the testing and assessment of internal controls to

others. Accordingly, directors and senior man-

agement should have reasonable assurance that

the system of internal control prevents or detects

signiﬁcant inaccurate, incomplete, or unauthor-

ized transactions; deﬁciencies in the safeguard-

ing of assets; unreliable ﬁnancial reporting

(which includes regulatory reporting); and

deviations from laws, regulations, and the insti-

tution’s policies.

Some institutions have chosen to rely on

so-called management self-assessments or con-

trol self-assessments, wherein business-line

managers and their staff evaluate the perfor-

mance of internal controls within their purview.

Such reviews help to underscore management’s

responsibility for internal control, but they are

not impartial. Directors and members of senior

management who rely too much on these

reviews may not learn of control weaknesses

until they have become costly problems, particu-

larly if directors are not intimately familiar with

the institution’s operations. Therefore, institu-

tions generally should also have their internal

controls tested and evaluated by units without

business-line responsibilities, such as internal

audit groups.

Directors should be conﬁdent that the internal

audit function addresses the risks and meets the

demands posed by the institution’s current and

planned activities. To accomplish this objective,

directors should consider whether their institu-

tion’s internal audit activities are conducted in

accordance with professional standards, such as

the Institute of Internal Auditors’ (IIA) Stan-

dards for the Professional Practice of Internal

Auditing. These standards address indepen-

dence, 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 matters are

reﬂected in their institution’s internal audit

function.

2060.05.1.1.1 Internal Audit Placement

and Structure Within the Organization

Careful thought should be given to the place-

ment of the audit function in the institution’s

management structure. The internal audit func-

tion should be positioned so that the board has

conﬁdence that the internal audit function will

perform its duties with impartiality and not be

unduly inﬂuenced by managers of day-to-day

operations. The audit committee,

using objec-

tive criteria it has established, should oversee

the internal audit function and evaluate its per-

7. As noted above, under section 36 of the FDI Act, as

implemented by part 363 of the FDIC’s regulations (12 C.F.R.

363), FDIC-insured depository institutions with total assets of

$500 million or more must submit an annual management

report signed by the chief executive ofﬁcer (CEO) and chief

accounting or chief ﬁnancial ofﬁcer. This report must contain

the following: (1) a statement of management’s responsibili-

ties for preparing the institution’s annual ﬁnancial statements,

for establishing and maintaining an adequate internal control

structure and procedures for ﬁnancial reporting, and for com-

plying with designated laws and regulations relating to safety

and soundness, including management’s assessment of the

institution’s compliance with those laws and regulations; and

(2) for an institution with total assets of $1 billion or more at

the beginning of the institution’s most recent ﬁscal year, the

report should include an assessment by management of the

effectiveness of such internal control structure and procedures

as of the end of such ﬁscal year. (See 12 C.F.R. 363.2(b) and

70 Fed. Reg. 71,232, November 28, 2005.)

8. Depository institutions subject to section 36 of the FDI

Act and part 363 of the FDIC’s regulations must maintain an

independent audit committee (i.e., consisting of directors who

are not members of management). For institutions with

between $500 million and $1 billion in assets, only a majority,

rather than all, of the members of the audit committee—who

must be outside directors—must be independent of manage-

ment. For insured institutions having total assets of more than

$3 billion, the audit committee must (1) have members with

banking or related ﬁnancial management expertise, (2) have

access to outside legal counsel, and (3) not include any large

customers of the institution. The audit committee also may be

required to satisfy other audit committee membership criteria

(see 12 U.S.C. 831m(g)(1)(c) and section 363.5(b)(12 C.F.R.

363.5(b)). Consistent with the 1999 Interagency Policy State-

ment on External Auditing Programs of Banks and Savings

Associations, the agencies also encourage the board of direc-

tors of each depository institution that is not otherwise

required to do so to establish an audit committee consisting

entirely of outside directors. Where the term ‘‘audit commit-

tee’’ is used in this policy statement, the board of directors

may fulﬁll the audit committee responsibilities if the institu-

tion is not subject to an audit committee requirement.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual July 2008

Page 3

formance.

The audit committee should assign

responsibility for the internal audit function to a

member of management (that is, the manager of

internal audit or internal audit manager) who

understands the function and has no responsibil-

ity for operating the system of internal control.

The ideal organizational arrangement is for this

manager to report directly and solely to the

audit committee regarding both audit issues and

administrative matters (e.g., resources, budget,

appraisals, and compensation). Institutions are

encouraged to consider the IIA’s Practice Advi-

sory 2060-2: Relationship with the Audit Com-

mittee, which provides more guidance on the

roles and relationships between the audit com-

mittee and the internal audit manager.

Many institutions place the manager of inter-

nal audit under a dual reporting arrangement:

functionally accountable to the audit committee

on issues discovered by the internal audit func-

tion, while reporting to another senior manager

on administrative matters. Under a dual report-

ing relationship, the board should consider the

potential for diminished objectivity on the part

of the internal audit manager with respect to

audits concerning the executive to whom he or

she reports. For example, a manager of internal

audit who reports to the chief ﬁnancial ofﬁcer

(CFO) for performance appraisal, salary, and

approval of department budgets may approach

audits of the accounting and treasury operations

controlled by the CFO with less objectivity than

if the manager were to report to the chief execu-

tive ofﬁcer. Thus, the chief ﬁnancial ofﬁcer,

controller, or other similar ofﬁcer should ideally

be excluded from overseeing the internal audit

activities even in a dual role. The objectivity

and organizational stature of the internal audit

function are best served under such a dual

arrangement if the internal audit manager

reports administratively to the CEO.

Some institutions seek to coordinate the inter-

nal audit function with several risk-monitoring

functions (for example, loan review, market-risk

assessment, and legal compliance departments)

by establishing an administrative arrangement

under one senior executive. Coordination of

these other monitoring activities with the inter-

nal audit function can facilitate the reporting of

material risk and control issues to the audit

committee, increase the overall effectiveness of

these monitoring functions, better use available

resources, and enhance the institution’s ability

to comprehensively manage risk. Such an

administrative reporting relationship should be

designed so as to not interfere with or hinder the

manager of internal audit’s functional reporting

to and ability to directly communicate with the

institution’s audit committee. In addition, the

audit committee should ensure that efforts to

coordinate these monitoring functions do not

result in the manager of internal audit conduct-

ing control activities nor diminish his or her

independence with respect to the other risk-

monitoring functions. Furthermore, the internal

audit manager should have the ability to inde-

pendently audit these other monitoring

functions.

In structuring the reporting hierarchy, the

board should weigh the risk of diminished inde-

pendence against the beneﬁt of reduced admin-

istrative burden in adopting a dual reporting

organizational structure. The audit committee

should document its consideration of this risk

and mitigating controls. The IIA’s Practice

Advisory 1110-2: Chief Audit Executive Report-

ing Lines provides additional guidance regard-

ing functional and administrative reporting

lines.

2060.05.1.1.2 Internal Audit

Management, Stafﬁng, and Audit Quality

In managing the internal audit function, the

manager of internal audit is responsible for con-

trol risk assessments, audit plans, audit pro-

grams, and audit reports.

1. A control risk assessment (or risk-assessment

methodology) documents the internal audi-

tor’s understanding of the institution’s sig-

niﬁcant business activities and their associ-

ated 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 institu-

tion. They should be updated regularly to

reﬂect changes to the system of internal con-

trol or work processes and to incorporate

new lines of business.

2. An internal audit plan is based on the control

risk assessment and typically includes a sum-

mary of key internal controls within each

signiﬁcant business activity, the timing and

frequency of planned internal audit work,

and a resource budget.

3. An internal audit program describes the

objectives of the audit work and lists the

9. For example, the performance criteria could include the

timeliness of each completed audit, comparison of overall

performance to plan, and other measures.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual July 2008

Page 4

procedures that will be performed during

each internal audit review.

4. An audit report generally presents the pur-

pose, scope, and results of the audit, includ-

ing ﬁndings, conclusions, and recommenda-

tions. Workpapers that document the work

performed and support the audit report

should be maintained.

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 gov-

ernance processes. Internal auditors increas-

ingly have taken a consulting role within institu-

tions on new products and services and on

mergers, acquisitions, and other corporate reor-

ganizations. This role typically includes helping

design controls and participating in the imple-

mentation of changes to the institution’s control

activities. The audit committee, in its oversight

of the internal audit staff, should ensure that the

function’s consulting activities do not interfere

or conﬂict with the objectivity it should have

with respect to monitoring the institution’s sys-

tem of internal control. In order to maintain its

independence, the internal audit function should

not assume a business-line management role

over control activities, such as approving or

implementing operating policies or procedures,

including those it has helped design in connec-

tion with its consulting activities. The agencies

encourage internal auditors to follow the IIA’s

standards, including guidance related to the

internal audit function acting in an advisory

capacity.

The internal audit function should be compe-

tently supervised and staffed by people with

sufﬁcient expertise and resources to identify the

risks inherent in the institution’s operations and

assess whether internal controls are effective.

The manager of internal audit should oversee

the staff assigned to perform the internal audit

work and should establish policies and proce-

dures to guide the audit staff. The form and

content of these policies and procedures should

be consistent with the size and complexity of

the department and the institution. Many poli-

cies and procedures may be communicated

informally in small internal audit departments,

while larger departments would normally

require more formal and comprehensive written

guidance.

2060.05.1.1.3 Internal Audit Frequency

and Scope

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. At least

annually, the audit committee should review and

approve internal audit’s control risk assessment

and the scope of the audit plan, including how

much the manager relies on the work of an

outsourcing vendor. It should also periodically

review internal audit’s adherence to the audit

plan. The audit committee should consider

requests for expansion of basic internal audit

work when signiﬁcant issues arise or when sig-

niﬁcant changes occur in the institution’s envi-

ronment, structure, activities, risk exposures, or

systems.

2060.05.1.1.4 Communication of Internal

Audit Findings to the Directors, Audit

Committee, and Management

To properly carry out their responsibility for

internal control, directors and senior manage-

ment should foster forthright communications

and critical inspection of issues to better under-

stand the importance and severity of internal

control weaknesses identiﬁed by the internal

auditor and operating management’s solutions

to these weaknesses. Internal auditors should

report internal control deﬁciencies to the appro-

priate level of management as soon as they are

identiﬁed. Signiﬁcant matters should be

promptly reported directly to the board of direc-

tors (or its audit committee) and senior manage-

ment. In periodic meetings with management

and the manager of internal audit, the audit

committee should assess whether management

is expeditiously resolving internal control weak-

nesses and other exceptions. Moreover, the audit

committee should give the manager of internal

audit the opportunity to discuss his or her ﬁnd-

ings without management being present.

10. Major changes in an institution’s environment and

conditions may compel changes to the internal control system

and also warrant additional internal audit work. These include

(1) new management; (2) areas or activities experiencing

rapid growth or rapid decline; (3) new lines of business,

products, or technologies or disposals thereof; (4) corporate

restructurings, mergers, and acquisitions; and (5) expansion

or acquisition of foreign operations (including the impact

of changes in the related economic and regulatory

environments).

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual July 2008

Page 5

Furthermore, each audit committee should

establish and maintain procedures for employ-

ees of their institution to submit conﬁdentially

and anonymously concerns to the committee

about questionable accounting, internal account-

ing control, or auditing matters.

In addition,

the audit committee should set up procedures

for the timely investigation of complaints

received and the retention for a reasonable time

period of documentation concerning the com-

plaint and its subsequent resolution.

2060.05.1.1.5 Contingency Planning

As with any other function, the institution

should have a contingency plan to mitigate any

signiﬁcant discontinuity in audit coverage, par-

ticularly for high-risk areas. Lack of contin-

gency planning for continuing internal audit

coverage may increase the institution’s level of

operational risk.

2060.05.1.2 U.S. Operations of Foreign

Banking Organizations

The internal audit function of a foreign banking

organization (FBO) should cover its U.S. opera-

tions in its risk assessments, audit plans, and

audit programs. Its U.S.-domiciled audit func-

tion, head-ofﬁce internal audit staff, or some

combination thereof normally performs the

internal audit of the U.S. operations. Internal

audit ﬁndings (including internal control deﬁ-

ciencies) should be reported to the senior man-

agement of the U.S. operations of the FBO and

the audit department of the head ofﬁce. Signiﬁ-

cant adverse ﬁndings also should be reported to

the head ofﬁce’s senior management and the

board of directors or its audit committee.

2060.05.1.3 Internal Audit Systems and

the Audit Function for Small Financial

Institutions

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. Each institu-

tion should have an internal audit function that

is appropriate to its size and the nature and

scope of its activities. The procedures assigned

to this function should include adequate testing

and review of internal controls and information

systems.

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 costs 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 outweigh the cost. For small institutions

with few employees and less complex opera-

tions, however, these costs may outweigh the

beneﬁts. Nevertheless, a small institution with-

out an internal auditor can ensure that it main-

tains an objective internal audit function by

implementing a comprehensive set of indepen-

dent 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 proce-

dures and arrange for their implementation. The

person responsible 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.

2060.05.2 INTERNAL AUDIT

OUTSOURCING ARRANGEMENTS

(PART II)

2060.05.2.1 Examples of Internal Audit

Outsourcing Arrangements

An outsourcing arrangement is a contract

between an institution and an outsourcing ven-

dor to provide internal audit services. Outsourc-

ing arrangements take many forms and are used

by institutions of all sizes. 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 con-

trol systems. The internal audit services under

contract can be limited to helping internal audit

staff in an assignment for which they lack exper-

tise. Such an arrangement is typically under the

control of the institution’s manager of internal

11. Where the board of directors fulﬁlls the audit commit-

tee responsibilities, the procedures should provide for the

submission of employee concerns to an outside director.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual June 2003

Page 6

audit, and the outsourcing vendor reports to him

or her. Institutions often use outsourcing ven-

dors for audits of areas requiring more technical

expertise, such as electronic data processing and

capital-markets activities. Such uses are often

referred to as ‘‘internal audit assistance’’ or

‘‘audit co-sourcing.’’

Some outsourcing arrangements may require

an outsourcing vendor to perform virtually all

the procedures or tests of the system of internal

control. Under such an arrangement, a desig-

nated manager of internal audit oversees the

activities of the outsourcing vendor and typi-

cally is supported by internal audit staff. The

outsourcing vendor may assist the audit staff in

determining risks to be reviewed and may rec-

ommend testing procedures, but the internal

audit manager is responsible for approving the

audit scope, plan, and procedures to be per-

formed. Furthermore, the internal audit manager

is responsible for the results of the outsourced

audit work, including ﬁndings, conclusions, and

recommendations. The outsourcing vendor may

report these results jointly with the internal audit

manager to the audit committee.

2060.05.2.2 Additional Inspection and

Examination Considerations for Internal

Audit Outsourcing Arrangements

Even when outsourcing vendors provide inter-

nal audit services, the board of directors and

senior management of an institution are respon-

sible for ensuring that both the system of inter-

nal control and the internal audit function oper-

ate effectively. In any outsourced internal audit

arrangement, the institution’s board of directors

and senior management must maintain owner-

ship of the internal audit function and provide

active oversight of outsourced activities. When

negotiating the outsourcing arrangement with an

outsourcing vendor, an institution should care-

fully consider its current and anticipated busi-

ness 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.

To clearly distinguish its duties from those of

the outsourcing vendor, the institution should

have a written contract, often taking the form of

an engagement letter.

Contracts between the

institution and the vendor typically include pro-

visions that—

1. deﬁne the expectations and responsibilities

under the contract for both parties;

2. set the scope and frequency of, and the fees

to be paid for, the work to be performed by

the vendor;

3. set the responsibilities for providing and

receiving information, such as the type and

frequency of reporting to senior manage-

ment and directors about the status of con-

tract work;

4. establish the process for changing the terms

of the service contract, especially for expan-

sion of audit work if signiﬁcant issues are

found, and stipulations for default and ter-

mination of the contract;

5. state that internal audit reports are the prop-

erty of the institution, that the institution

will be provided with any copies of the

related workpapers it deems necessary, and

that employees authorized by the institution

will have reasonable and timely access to

the workpapers prepared by the outsourcing

vendor;

6. specify the locations of internal audit

reports and the related workpapers;

7. specify the period of time (for example,

seven years) that vendors must maintain the

workpapers;

8. state that outsourced internal audit services

provided by the vendor are subject to regu-

latory review and that examiners will be

granted full and timely access to the inter-

nal audit reports and related workpapers

prepared by the outsourcing vendor;

9. prescribe a process (arbitration, mediation,

or other means) for resolving disputes and

for determining who bears the cost of con-

sequential damages arising from errors,

omissions, and negligence; and

10. state that the outsourcing vendor will not

perform management functions, make man-

agement decisions, or act or appear to act

in a capacity equivalent to that of a member

of management or an employee and, if

12. The engagement letter provisions described are compa-

rable to those outlined by the American Institute of Certiﬁed

Public Accountants (AICPA) for ﬁnancial statement audits

(see AICPA Professional Standards, AU section 310). These

provisions are consistent with the provisions customarily

included in contracts for other outsourcing arrangements,

such as those involving data processing and information tech-

nology. Therefore, the federal banking agencies consider these

provisions to be usual and customary business practices.

13. If the workpapers are in electronic format, contracts

often call for the vendor to maintain proprietary software that

enables the bank and examiners to access the electronic

workpapers for a speciﬁed time period.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual June 2003

Page 7

applicable, will comply with AICPA,

SEC, PCAOB, or regulatory independence

guidance.

2060.05.2.2.1 Management of the

Outsourced Internal Audit Function

Directors and senior management should ensure

that the outsourced internal audit function is

competently managed. For example, larger insti-

tutions should employ sufﬁcient competent staff

members in the internal audit department to

assist the manager of internal audit in oversee-

ing the outsourcing vendor. Small institutions

that do not employ a full-time audit manager

should appoint a competent employee who ide-

ally has no managerial responsibility for the

areas being audited to oversee the outsourcing

vendor’s performance under the contract. This

person should report directly to the audit com-

mittee for purposes of communicating internal

audit issues.

2060.05.2.2.2 Communication of

Outsourced Internal Audit Findings to

Directors and Senior Management

Communication between the internal audit func-

tion and the audit committee and senior manage-

ment should not diminish because the institution

engages an outsourcing vendor. All work by the

outsourcing vendor 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 deci-

sion of the internal audit manager and the out-

sourcing 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 indica-

tor of which control weakness to report. For

example, when evaluating an institution’s com-

pliance with laws and regulations, any excep-

tion may be important.

2060.05.2.2.3 Competence of Outsourced

Internal Audit Vendor

Before entering an outsourcing arrangement, the

institution should perform due diligence to sat-

isfy itself that the outsourcing vendor has sufﬁ-

cient staff qualiﬁed to perform the contracted

work. The staff’s qualiﬁcations may be demon-

strated, for example, through prior experience

with ﬁnancial institutions. Because the outsourc-

ing arrangement is a personal-services contract,

the institution’s internal audit manager should

have conﬁdence in the competence of the staff

assigned by the outsourcing vendor and receive

timely notice of key stafﬁng changes. Through-

out the outsourcing arrangement, management

should ensure that the outsourcing vendor main-

tains sufﬁcient expertise to effectively perform

its contractual obligations.

2060.05.2.2.4 Contingency Planning to

Avoid Discontinuity of Internal Audit

Coverage

When an institution enters into an outsourcing

arrangement (or signiﬁcantly changes the mix of

internal and external resources used by internal

audit), it may increase its operational risk.

Because the arrangement may be terminated

suddenly, the institution should have a contin-

gency plan to mitigate any signiﬁcant disconti-

nuity in audit coverage, particularly for high-

risk areas.

2060.05.3 INDEPENDENCE OF THE

INDEPENDENT PUBLIC

ACCOUNTANT (PART III)

The following discussion applies only when a

ﬁnancial institution is considering using a pub-

lic accountant to provide both external audit

and internal audit services to the institution.

When one accounting ﬁrm performs both the

external audit and the outsourced internal audit

function, the ﬁrm risks compromising its inde-

pendence. These concerns arise because, rather

than having two separate functions, this out-

sourcing arrangement places the independent

public accounting ﬁrm in the position of appear-

ing to audit, or actually auditing, its own work.

For example, in auditing an institution’s ﬁnan-

cial statements, the accounting ﬁrm will con-

sider the extent to which it may rely on the

internal control system, including the internal

audit function, in designing audit procedures.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual July 2008

Page 8

2060.05.3.1 Applicability of the SEC’s

Auditor Independence Requirements

2060.05.3.1.1 Institutions That Are Public

Companies

To strengthen auditor independence, Congress

passed the Sarbanes-Oxley Act of 2002 (the

act). Title II of the act applies to any public

company—that is, any company that has a class

of securities registered with the SEC or the

appropriate federal banking agency under sec-

tion 12 of the Securities Exchange Act of 1934

or that is required to ﬁle reports with the SEC

under section 15(d) of that act.

The act prohib-

its an accounting ﬁrm from acting as the exter-

nal auditor of a public company during the same

period that the ﬁrm provides internal audit out-

sourcing services to the company.

In addition,

if a public company’s external auditor will be

providing auditing services and permissible non-

audit services, such as tax services, the com-

pany’s audit committee must preapprove each

of these services.

According to the SEC’s ﬁnal rules (effective

May 6, 2003) implementing the act’s nonaudit

service prohibitions and audit committee preap-

proval requirements, an accountant is not inde-

pendent if, at any point during the audit and

professional engagement period, the accountant

provides internal audit outsourcing or other pro-

hibited nonaudit services to the public company

audit client. The SEC’s ﬁnal rules generally

become effective May 6, 2003, although a one-

year transition period is provided if the accoun-

tant is performing prohibited nonaudit services

and actual audit services for a public company

pursuant to a contract in existence on May 6,

2003. The services provided during this transi-

tion period, however, must not have impaired

the auditor’s independence under the preexist-

ing independence requirements of the SEC, the

Independence Standards Board, and the AICPA.

Although the SEC’s pre-Sarbanes-Oxley inde-

pendence requirements (issued November 2000

(effective August 2002)) did not prohibit the

outsourcing of internal audit services to a public

company’s independent public accountant, they

did place conditions and limitations on internal

audit outsourcing.

2060.05.3.1.2 Depository Institutions

Subject to the Annual Audit and

Reporting Requirements of Section 36 of

the FDI Act

Under section 36, as implemented by part 363

of the FDIC’s regulations, each FDIC-insured

depository institution with total assets of

$500 million or more is required to have an

annual audit performed by an independent pub-

lic accountant.

The part 363 guidelines address

the qualiﬁcations of an independent public

accountant engaged by such an institution by

stating that ‘‘[t]he independent public accoun-

tant should also be in compliance with the

AICPA’s Code of Professional Conduct and

meet the independence requirements and inter-

pretations of the SEC and its staff.’’

Thus, the guidelines provide for each FDIC-

insured depository institution with $500 million

or more in total assets, whether or not it is a

public company, and its external auditor to com-

ply with the SEC’s auditor independence

requirements that are in effect during the period

covered by the audit. These requirements

include the nonaudit-service prohibitions and

audit committee preapproval requirements

implemented by the SEC’s January 2003 audi-

tor independence rules, once the rules come into

effect.

14. 15 U.S.C. 78l and 78o(d).

15. In addition to prohibiting internal audit outsourcing,

the Sarbanes-Oxley Act (15 U.S.C. 78j-1) also identiﬁes other

nonaudit services that an external auditor is prohibited from

providing to a public company whose ﬁnancial statements it

audits. The legislative history of the act indicates that three

broad principles should be considered when determining

whether an auditor should be prohibited from providing a

nonaudit service to an audit client. These principles are that an

auditor should not (1) audit his or her own work, (2) perform

management functions for the client, or (3) serve in an advo-

cacy role for the client. To do so would impair the auditor’s

independence. Based on these three broad principles, the other

nonaudit services . . . referred to in this section . . . that an

auditor is prohibited from providing to a public company

audit client include bookkeeping or other services related to

the client’s accounting records or ﬁnancial statements; ﬁnan-

cial information systems design and implementation; appraisal

or valuation services, fairness opinions, or contribution-in-

kind reports; actuarial services; management functions or

human resources; broker or dealer, investment adviser, or

investment banking services; legal services and expert ser-

vices unrelated to the audit; and any other service determined

to be impermissible by the PCAOB.

16. 12 C.F.R. 363.3(a). (See FDIC Financial Institutions

Letter, FIL-17-2003 (Corporate Governance, Audits, and

Reporting Requirements), Attachment II, March 5, 2003.)

17. Appendix A to part 363, Guidelines and Interpreta-

tions, paragraph 14, Independence.

18. If a depository institution subject to section 36 and

part 363 satisﬁes the annual independent audit requirement by

relying on the independent audit of its parent holding com-

pany, once the SEC’s January 2003 regulations prohibiting an

external auditor from performing internal audit outsourcing

services for an audit client take effect May 6, 2003, or May 6,

2004, depending on the circumstances, the holding company’s

external auditor cannot perform internal audit outsourcing

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual July 2008

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2060.05.3.1.3 Institutions Not Subject to

Section 36 of the FDI Act That Are

Neither Public Companies Nor

Subsidiaries of Public Companies

The agencies have long encouraged each institu-

tion not subject to section 36 of the FDI Act that

is neither a public company nor a subsidiary of a

public company

to have its ﬁnancial state-

ments audited by an independent public accoun-

tant.

The agencies also encourage each such

institution to follow the internal audit outsourc-

ing prohibition in the Sarbanes-Oxley Act, as

discussed above for institutions that are public

companies. As previously mentioned, some

institutions seek to enhance the quality of their

control environment by obtaining the services of

an outsourcing vendor who can critically assess

their internal control system and recommend

improvements. The agencies believe that a small

nonpublic institution with less complex opera-

tions and limited staff can, in certain circum-

stances, use the same accounting ﬁrm to per-

form both an external audit and some or all of

the institution’s internal audit activities. These

circumstances include, but are not limited to,

situations where—

1. splitting the audit activities poses signiﬁcant

costs or burden,

2. persons with the appropriate specialized

knowledge and skills are difﬁcult to locate

and obtain,

3. the institution is closely held and investors

are not solely reliant on the audited ﬁnancial

statements to understand the ﬁnancial posi-

tion and performance of the institution, and

4. the outsourced internal audit services are lim-

ited in either scope or frequency.

In circumstances such as these, the agencies

view an internal audit outsourcing arrangement

between a small nonpublic institution and its

external auditor as not being inconsistent with

their safety-and-soundness objectives for the

institution.

When a small nonpublic institution decides to

hire the same ﬁrm to perform internal and exter-

nal audit work, the audit committee and the

external auditor should pay particular attention

to preserving the independence of both the inter-

nal and external audit functions. Furthermore,

the audit committee should document both that

it has preapproved the internal audit outsourcing

to its external auditor and has considered the

independence issues associated with this

arrangement.

In this regard, the audit commit-

tee should consider the independence standards

described in parts I and II of the policy state-

ment, the AICPA guidance discussed below,

and the broad principles that the auditor should

not perform management functions or serve in

an advocacy role for the client.

Accordingly, the agencies will not consider

an auditor who performs internal audit outsourc-

ing services for a small nonpublic audit client to

be independent unless the institution and its

auditor have adequately addressed the associ-

ated independence issues. In addition, the insti-

tution’s board of directors and management

must retain ownership of and accountability for

the internal audit function and provide active

oversight of the outsourced internal audit

relationship.

A small nonpublic institution may be required

by another law or regulation, an order, or

another supervisory action to have its ﬁnancial

statements audited by an independent public

accountant. In this situation, if warranted for

safety-and-soundness reasons, the institution’s

primary federal regulator may require that the

institution and its independent public accountant

comply with the auditor independence require-

ments of the Act.

2060.05.3.1.4 AICPA Guidance

As noted above, the independent public accoun-

tant for a depository institution subject to sec-

tion 36 of the FDI Act also should be in compli-

ance with the AICPA’s Code of Professional

Conduct. This code includes professional ethics

standards, rules, and interpretations that are

binding on all certiﬁed public accountants

(CPAs) who are members of the AICPA in order

work for that holding company or the subsidiary institution.

19. FDIC-insured depository institutions with less than

$500 million in total assets are not subject to section 36 of the

FDI Act. Section 36 does not apply directly to holding compa-

nies, but it provides that, for an insured depository institution

that is a subsidiary of a holding company, its audited ﬁnancial

statements requirement and certain of its other requirements

may be satisﬁed by the holding company.

20. See, for example, the 1999 Interagency Policy State-

ment on External Auditing Programs of Banks and Savings

Institutions.

21. If a small nonpublic institution is considering having

its external auditor perform other nonaudit services, its audit

committee may wish to discuss the implications of the perfor-

mance of these services on the auditor’s independence.

22. 15 U.S.C. 78j-1.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual June 2003

Page 10

for the member to remain in good standing.

Therefore, this code applies to each member

CPA who provides audit services to an institu-

tion, regardless of whether the institution is

subject to section 36 or is a public company.

The AICPA has issued guidance indicating

that a member CPA would be deemed not inde-

pendent of his or her client when the CPA acts

or appears to act in a capacity equivalent to a

member of the client’s management or as a

client employee. The AICPA’s guidance

includes illustrations of activities that would be

considered to compromise a CPA’s indepen-

dence. Among these are activities that involve

the CPA authorizing, executing, or consummat-

ing transactions or otherwise exercising author-

ity on behalf of the client. For additional details,

refer to Interpretation 101-3, Performance of

Other Services, and Interpretation 101-13,

Extended Audit Services, in the AICPA’s Code

of Professional Conduct.

2060.05.4 INSPECTION GUIDANCE

(PART IV)

2060.05.4.1 Review of the Internal Audit

Function and Outsourcing Arrangements

Examiners should have full and timely access to

an institution’s internal audit resources, includ-

ing personnel, workpapers, risk assessments,

work plans, programs, reports, and budgets. A

delay may require examiners to widen the scope

of their inspection work and may subject the

institution to follow-up supervisory actions.

Examiners should assess the quality and

scope of an institution’s internal audit function,

regardless of whether it is performed by the

institution’s employees or by an outsourcing

vendor. Speciﬁcally, examiners should consider

whether—

1. the internal audit function’s control risk

assessment, audit plans, and audit programs

are appropriate for the institution’s

activities;

2. the internal audit activities have been

adjusted for signiﬁcant changes in the insti-

tution’s environment, structure, activities,

risk exposures, or systems;

3. the internal audit activities are consistent

with the long-range goals and strategic

direction of the institution and are respon-

sive to its internal control needs;

4. the audit committee promotes the internal

audit manager’s impartiality and indepen-

dence by having him or her directly report

audit ﬁndings to it;

5. the internal audit manager is placed in the

management structure in such a way that

the independence of the function is not

impaired;

6. the institution has promptly responded to

signiﬁcant identiﬁed internal control

weaknesses;

7. the internal audit function is adequately

managed to ensure that audit plans are met,

programs are carried out, and results of

audits are promptly communicated to senior

management and members of the audit

committee and board of directors;

8. workpapers adequately document the inter-

nal audit work performed and support the

audit reports;

9. management and the board of directors use

reasonable standards, such as the IIA’s

Standards for the Professional Practice of

Internal Auditing, when assessing the per-

formance of internal audit; and

10. the audit function provides high-quality

advice and counsel to management and the

board of directors on current developments

in risk management, internal control, and

regulatory compliance.

The examiner should assess the competence

of the institution’s internal audit staff and man-

agement by considering the education, profes-

sional background, and experience of the princi-

pal internal auditors. In addition, when

reviewing outsourcing arrangements, examiners

should determine whether—

1. the arrangement maintains or improves the

quality of the internal audit function and the

institution’s internal control;

2. key employees of the institution and the out-

sourcing vendor clearly understand the lines

of communication and how any internal con-

trol problems or other matters noted by the

outsourcing vendor are to be addressed;

3. the scope of the outsourced work is revised

appropriately when the institution’s environ-

ment, structure, activities, risk exposures, or

systems change signiﬁcantly;

4. the directors have ensured that the out-

sourced internal audit activities are effec-

tively managed by the institution;

5. the arrangement with the outsourcing vendor

satisﬁes the independence standards

described in this policy statement and

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual June 2003

Page 11

thereby preserves the independence of the

internal audit function, whether or not the

vendor is also the institution’s independent

public accountant; and

6. the institution has performed sufﬁcient due

diligence to satisfy itself of the vendor’s

competence before entering into the out-

sourcing arrangement and has adequate pro-

cedures for ensuring that the vendor main-

tains sufﬁcient expertise to perform

effectively throughout the arrangement.

2060.05.4.2 Inspection Concerns About

the Adequacy of the Internal Audit

Function

If the examiner concludes that the institution’s

internal audit function, whether or not it is out-

sourced, does not sufﬁciently meet the institu-

tion’s internal audit needs; does not satisfy the

Interagency Guidelines Establishing Standards

for Safety and Soundness, if applicable; or is

otherwise inadequate, he or she should deter-

mine whether the scope of the inspection should

be adjusted. The examiner should also discuss

his or her concerns with the internal audit man-

ager or other person responsible for reviewing

the system of internal control. If these discus-

sions do not resolve the examiner’s concerns, he

or she should bring these matters to the attention

of senior management and the board of directors

or audit committee. Should the examiner ﬁnd

material weaknesses in the internal audit func-

tion or the internal control system, he or she

should discuss them with appropriate agency

staff in order to determine the appropriate

actions the agency should take to ensure that the

institution corrects the deﬁciencies. These

actions may include formal and informal

enforcement actions.

The institution’s management and composite

ratings should reﬂect the examiner’s conclu-

sions regarding the institution’s internal audit

function. The report of inspection should con-

tain comments concerning the adequacy of this

function, signiﬁcant issues or concerns, and rec-

ommended corrective actions.

2060.05.4.3 Concerns About the

Independence of the Outsourcing Vendor

An examiner’s initial review of an internal audit

outsourcing arrangement, including the actions

of the outsourcing vendor, may raise questions

about the institution’s and its vendor’s adher-

ence to the independence standards described in

parts I and II of the policy statement, whether or

not the vendor is an accounting ﬁrm, and in

part III if the vendor provides both external and

internal audit services to the institution. In such

cases, the examiner ﬁrst should ask the institu-

tion and the outsourcing vendor how the audit

committee determined that the vendor was inde-

pendent. If the vendor is an accounting ﬁrm, the

audit committee should be asked to demonstrate

how it assessed that the arrangement has not

compromised applicable SEC, PCAOB, AICPA,

or other regulatory standards concerning auditor

independence. If the examiner’s concerns are

not adequately addressed, the examiner should

discuss the matter with appropriate agency staff

prior to taking any further action.

If the agency staff concurs that the indepen-

dence of the external auditor or other vendor

appears to be compromised, the examiner will

discuss his or her ﬁndings and the actions the

agency may take with the institution’s senior

management, board of directors (or audit com-

mittee), and the external auditor or other vendor.

In addition, the agency may refer the external

auditor to the state board of accountancy, the

AICPA, the SEC, the PCAOB, or other authori-

ties for possible violations of applicable inde-

pendence standards. Moreover, the agency may

conclude that the institution’s external auditing

program is inadequate and that it does not com-

ply with auditing and reporting requirements,

including sections 36 and 39 of the FDI Act and

related guidance and regulations, if applicable.

2060.05.5 INSPECTION OBJECTIVES

1. To determine with reasonable assurance

whether the institution

has an adequate

system of internal controls that ensures efﬁ-

cient and effective operations, including the

safeguarding of assets, reliable ﬁnancial

reporting, and compliance with applicable

laws and regulations.

2. To determine if the internal audit function

and the internal audit outsourcing arrange-

ments of the banking organizations are

adequately and competently managed by

the board of directors and senior manage-

ment.

23. The term ‘‘institution’’ is used to maintain consistency

with the interagency policy statement, but these inspection

objectives and procedures apply to ﬁnancial holding compa-

nies, bank holding companies, and their bank and nonbank

subsidiaries.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 12

3. To ascertain that the banking organization’s

internal audit function monitors, reviews,

and ensures the continued existence and

maintenance of sound and adequate internal

controls over the management process: the

control environment, risk assessment, con-

trol activities, information and communica-

tion, and monitoring activities.

4. To make an overall determination as to

whether an institution’s internal audit func-

tion and its processes are effective or inef-

fective based on the 2003 interagency pol-

icy statement and the FR supplemental

policy guidance.

5. To determine whether the internal audit

function reports vital information about

weaknesses in the system of internal control

to the board of directors (or its audit com-

mittee) and senior management and that

expeditious remedial action is taken to

resolve the internal control weaknesses as

well as any other exceptions.

6. To determine if

a. the audit committee has established and

maintains procedures for employees of

the institution to conﬁdentially and

anonymously submit concerns to the

committee about questionable account-

ing, internal control, or auditing matters;

and

b. the audit committee has procedures for

the timely investigation of complaints

received and the retention, for a reason-

able time period, of documentation con-

cerning the complaint and its subsequent

resolution.

7. To determine the adequacy of the internal

audit function (including its use of out-

sourced internal audit vendors) as to organi-

zational structure, prudent management,

staff having sufﬁcient expertise, audit qual-

ity, and the ability of auditors to directly

and freely communicate internal audit ﬁnd-

ings to the board of directors, its audit com-

mittee, and senior management.

8. To review and evaluate internal audit out-

sourcing arrangements and the actions of

the outsourcing vendor, under standards

established in the 2003 ‘‘Interagency Policy

Statement on the Internal Audit Function

and Its Outsourcing’’ and the 2013 Federal

Reserve’s ‘‘Supplemental Policy Statement

on the Internal Audit Function and its Out-

sourcing.’’

9. To determine whether the internal audit

function and its processes can be relied

upon for the current supervisory review

period.

10. For high risk areas, to make a determination

as to whether additional inspection work is

needed even when the internal audit may be

deemed effective and its work reliable.

2060.05.6 INSPECTION PROCEDURES

Examiners should obtain assurances from the

audit committee and senior management that

they will have full and timely access to an

institution’s internal audit resources, including

personnel, work papers, risk assessments, work

plans, programs, reports, and budgets. Examin-

ers should consider widening the scope of their

inspection work when such assurances are not

provided or if there are any signiﬁcant delays in

gaining access to the internal audit resources.

Such a delay may subject the institution to

follow-up supervisory action.

This inspection program should include a

review of audit function and audit outsourcing,

which would include a review of the holding

company’s internal and external audits and the

audit procedures they encompass. The audit

guidelines are general and all sections or ques-

tions may not be applicable to every entity

within the consolidated organization.

Before reviewing any speciﬁc audit proce-

dures, the examiner should ﬁrst determine the

independence and competence of the auditors. If

the examiner believes the auditors to be both

competent and independent, he or she should

then determine the effectiveness and adequacy

of their work, and whether the auditors made an

assessment as to whether the institution’s inter-

nal audit function incorporated the enhanced

practices outlined in the FR’s ‘‘Supplemental

Policy Statement on Internal Audit Function

and its Outsourcing’’ (Supplemental Guidance).

Based on a review of the audit function and

on the auditor’s work, the examiner must then

determine the scope of the inspection. The pro-

gram and related supporting documentation

should be completed in an organized manner

and should be retained as part of the inspection

work papers.

Upon completion of the review of the internal

audit program, the examiner should be able to

formulate a conclusion on the effectiveness of

audit processes and coverage. Conclusions

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BHC Supervision Manual January 2014

Page 13

about any weaknesses in the internal or external

audit work performed for the FR supervised

bank or savings and loan holding company

should be summarized and included in the

inspection report. Matters Requiring Immediate

Attention (MRIA) or Matters Requiring Atten-

tion (MRA) to be included in the inspection

report should be discussed with the audit com-

mittee and board of directors, the Chief Audit

Executive, (CAE) and senior bank management.

2060.05.6.1 Internal Audit Function

The following inspection procedures should

encompass a review of the structure of the inter-

nal audit organization and function:

1. Organizational structure of the audit

department. Review the internal audit’s

charter and its organization chart for direct

and indirect reporting lines of the CAE, and

the minutes of the board’s audit or examin-

ing committee to determine how effectively

the CAE and board of directors are dis-

charging their responsibility. If the CAE

reports to someone other than the chief

executive ofﬁcer (CEO), determine if the

audit committee has documented its ratio-

nale for the reporting structure, including

any mitigating controls for situations that

could adversely impact the objectivity of

the CAE. Determine if the audit committee

has quarterly, but at least annually, evalu-

ated whether (1) the CAE is impartial and

not unduly inﬂuenced by the administrative

reporting line and (2) any conﬂicts of inter-

est for the CAE and other audit staff are

accompanied by appropriate restrictions to

mitigate those conﬂicts.

2. Independence of the audit function. Inter-

view the CAE and observe the operation of

the audit department to determine its func-

tional responsibilities.

3. CAE’s qualiﬁcations. Review biographical

data and interview the CAE to determine

his or her ability to manage the institution’s

internal audit function and his or her

responsibility within the institution (i.e.,

bank holding or savings and loan holding

company).

4. Audit staff qualiﬁcations. Review the bio-

graphical data and interview the manage-

ment staff of the audit department to deter-

mine their qualiﬁcations commensurate

with their delegated responsibilities com-

pared to the institution’s strategy and opera-

tions. Review the educational background,

professional certiﬁcations and relevant

banking and audit experience of staff to

assess overall staff qualiﬁcations and to

identify any knowledge gaps.

5. Skills gap assessments. Review how often

they are performed, and how gaps in cover-

age are addressed (e.g. targeted staff hires;

training; business- line rotation programs,

and co-sourcing/ outsourcing arrange-

ments).

6. Training. Ensure there is a process in place

to determine and monitor the annual train-

ing, typically 40 hours minimum, for each

staff member based on their needs.

7. Content and use of the audit frequency and

scope schedule. Review the methodology

utilized to determine the audit universe and

frequency of coverage per auditable entity.

8. Audit department participation in systems

design projects. Determine through inter-

views and documentation reviews, internal

audit’s role in assessing systems change

control processes.

9. Internal audit charter. Review the internal

audit charter to determine its current

adequacy. Determine whether the CAE

periodically reviews the current adequacy

of the charter and makes recommendations

to the audit committee for improving inter-

nal audit function and whether outsourcing

to external experts may be needed.

10. Audit manual. Review the audit manual to

ensure that it includes all applicable audit

processes, practices, and procedures, and

applicable references to Institute of Internal

Auditor (IIA) standards.

11. Maintenance of audit records. Review a

sample of the audit reports and associated

work papers to determine compliance with

prescribed procedures and proper documen-

tation, including appropriate distribution to

senior managers.

12. Audit department’s formal reporting proce-

dures. Review CAE presentations and MIS

reporting to the audit or examining commit-

tee to ensure the committee is providing

effective oversight of the internal audit

function.

13. Issue Tracking Follow-up Processes.

Review processes utilized to validate clo-

sure of internal audit ﬁndings. Review a

sample of closed issues to ensure that inter-

nal audit maintains sufﬁcient documenta-

tion to validate issue closure.

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BHC Supervision Manual January 2014

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14. Use and effectiveness of audit computer

programs. Interview the CAE and/or the

appropriate staff members regarding the use

of the computer and access to the ﬁles for

audit purposes. Obtain a walkthrough of

automated auditing systems and methodolo-

gies.

2060.05.6.2 Other Internal Audit

Function Inspection Procedures

1. Broaden the scope of the inspection if the

institution’s internal audit function, whether

or not it is outsourced, does not sufﬁciently

meet its internal audit needs, does not sat-

isfy the Interagency Guidelines Establish-

ing Standards for Safety and Soundness, or

is otherwise inadequate.

2. Discuss supervisory concerns and outstand-

ing internal-external audit report comments

with the CAE or other person responsible

for reviewing the system of internal control.

If these discussions do not resolve the

examiner’s comments and concerns, bring

these matters to the attention of senior man-

agement and the board of directors or audit

committee.

3. If material weaknesses in the internal audit

function or the internal control system exist,

discuss them with appropriate Federal

Reserve Bank supervisory staff to deter-

mine the appropriate actions that should be

taken to ensure that the institution corrects

the deﬁciencies (including formal and infor-

mal enforcement actions).

4. Incorporate conclusions about the institu-

tion’s internal audit function into its man-

agement and composite supervisory ratings.

5. Include in the inspection report comments

concerning the adequacy of the internal

audit function, signiﬁcant issues or con-

cerns, and recommended corrective actions.

2065.05.6.3 Additional Aspects of the

Examiner’s Review of an Outsourcing

Arrangement

1. Review the internal audit outsourcing

arrangement and determine if the institution

has a written contract or an engagement

letter with the vendor.

2. Determine whether the written contract or

engagement letter includes provisions

that—

a. deﬁne the expectations and responsibili-

ties under the contract for both parties;

b. set the scope and frequency of, and the

fees to be paid for, the work to be per-

formed by the vendor;

c. set the responsibilities for providing and

receiving information, such as the type

and frequency of reporting to senior

management and directors about the sta-

tus of contract work;

d. establish the process for changing the

terms of the service contract, especially

for expansion of audit work if signiﬁcant

issues are found, and establish stipula-

tions for default and termination of the

contract;

e. state that internal audit reports are the

property of the institution, that the insti-

tution will be provided with any copies

of the related work papers it deems nec-

essary, and that employees authorized by

the institution will have reasonable and

timely access to the work papers pre-

pared by the outsourcing vendor;

f. specify the locations of internal audit

reports and the related work papers;

g. specify the period of time (for example,

seven years) that vendors must maintain

the work papers;

h. state that outsourced internal audit ser-

vices provided by the vendor are subject

to regulatory review and that examiners

will be granted full and timely access to

the internal audit reports and related

work papers prepared by the outsourcing

vendor;

i. prescribe a process (arbitration, media-

tion, or other means) for resolving dis-

putes and for determining who bears the

cost of consequential damages arising

from errors, omissions, and negligence;

and

j. state that the outsourcing 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, SEC, PCAOB, or regulatory

independence guidance.

3. Determine whether—

a. the outsourcing arrangement maintains

or improves the quality of the internal

24. If the work papers are in electronic format, contracts

often call for the vendor to maintain proprietary software that

enables the banking organization and examiners to access the

electronic work papers for a speciﬁed time period.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 15

audit function and the institution’s inter-

nal control;

b. key employees of the institution and the

outsourcing vendor clearly understand

the lines of communication and how any

internal control problems or other mat-

ters noted by the outsourcing vendor are

to be addressed;

c. the scope of work is revised appropri-

ately when the institution’s environment,

structure, activities, risk exposures, or

systems change signiﬁcantly;

d. the directors have ensured that the out-

sourced internal audit function is effec-

tively managed by the institution;

e. the arrangement with the outsourcing

vendor satisﬁes the independence stan-

dards described in the Policy Statement

on the Internal Audit Function and Its

Outsourcing and thereby preserves the

independence of the internal audit func-

tion, whether or not the vendor is also

the institution’s independent public

accountant;

f. the institution has performed sufﬁcient

due diligence to satisfy itself of the ven-

dor’s competence before entering into

the outsourcing arrangement and

whether there are adequate procedures

for ensuring that the vendor maintains

sufﬁcient expertise to perform effectively

throughout the arrangement; and

g. the institution has a contingency plan to

ensure continuity in audit coverage,

especially for high-risk areas.

4. Adjust the scope of the inspection if the

outsourcing arrangement has diminished the

quality of the institution’s internal audit. If

the quality of the internal audit is dimin-

ished, inform senior management and the

board of directors and consider it in the

institution’s management and composite

ratings.

2060.05.6.4 Assessment of Auditor

Independence

1. The initial review of an internal audit out-

sourcing arrangement, including the actions

of the outsourcing vendor, may raise ques-

tions about the institution’s and its vendor’s

adherence to the independence standards

discussed in parts I, II, and III of the ‘‘Inter-

agency Policy Statement on the Internal

Audit Function and Its Outsourcing’’ (2003

Policy Statement) and the Federal Reserve’s

2013 Supplemental Guidance. If the vendor

provides both external and internal audit

services to the institution—

a. question the bank or savings and loan

holding company’s CAE and audit com-

mittee how they determined that the ven-

dor was independent; and

b. if the vendor is an accounting ﬁrm, ask

the CAE or audit committee how they

assessed that the arrangement had not

compromised applicable SEC, PCAOB,

AICPA, or other regulatory standards

concerning auditor independence.

2. If the answers to the above raise supervi-

sory concern, or are not adequately

addressed, discuss the matter with appropri-

ate Reserve Bank management and supervi-

sory staff.

3. If the Reserve Bank management and super-

visory staff concurs that the independence

of the external auditor or other vendor

appears to be compromised, discuss the

inspection ﬁndings and what appropriate

supervisory actions the Federal Reserve

may take with the bank holding or savings

and loan holding company’s senior manage-

ment, board of directors (or audit commit-

tee), and the external auditor or other ven-

dor.

2060.05.6.5 Supplemental Procedures to

Evaluate the Effectiveness of the Internal

Audit Function

1. Determine whether the internal audit func-

tion and its processes are effective or inef-

fective and whether internal audit’s work

can be potentially relied upon as part of the

supervisory review process. An institution’s

internal audit function generally would be

considered effective if the institution’s

internal audit function structure and prac-

tices are consistent with the 2003 inter-

agency policy statement and the Federal

Reserve’s 2013 supplemental guidance

(supplemental guidance).

2. To determine if the institution has incorpo-

rated the Federal Reserve’s Supplemental

Guidance, evaluate whether the factors and

requirements underpinning the following

characteristics and processes are in place:

Attributes

• Independence

• Competent internal audit staff

• Objectivity and ethics

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 16

Governance

• Role of board of directors

• Role of audit committee

• Role of Chief Audit Executive (CAE)

Audit Processes

• Audit methodology—Review the inter-

nal audit’s risk-assessment methodol-

ogy that drives its risk-assessment pro-

cess and determine if it represents the

audit universe. Determine if the meth-

odology included a documented analy-

sis of cross-institutional risk and the-

matic control issues and the processes

and procedures for evaluating the

effectiveness of risk-management, con-

trol, and governance processes. Evalu-

ate internal audit’s plan for continuous

monitoring and in determining and

evaluating risk. Assess internal audit’s

process for incorporating other risk

identiﬁcation techniques (i.e., risk and

control self-assessment) that the insti-

tution’s management utilizes.

• Audit universe—Determine if internal

audit has effective processes to identify

all auditable entities within the audit

universe. Review the documentation of

the audit universe and verify whether it

has been reviewed periodically (e.g.,

during the annual audit planning pro-

cess) and when signiﬁcant organiza-

tional changes have occurred.

• Risk assessment—Review internal

audit’s documentation of its under-

standing of the institution’s signiﬁcant

business activities and their associated

risks. Verify that internal audit

includes, at least annually, a review of

critical risk-management functions as

well as changes in the system of inter-

nal controls, infrastructure, work pro-

cesses, new or changed business lines,

or laws and regulations. Review the

disposition of the results of the overall

risk assessment summary and deter-

mine if internal audit gave consider-

ation to key performance or risk indica-

tors and the most signiﬁcant risks

facing the institution, including how

the risks are addressed within the inter-

nal audit plan.

• Audit plan—Verify that internal audit

develops and periodically revises its

comprehensive audit plan. Determine

if it veriﬁes that the plan includes audit

coverage for all identiﬁed, auditable

entities within the audit universe appro-

priate for the size and complexity of

the institution’s activities.

• Continuous monitoring— Supplement

inspection procedures with continuous

monitoring and an assessment of key

elements of internal audit, including:

— the adequacy and independence

of the audit committee;

— the independence, professional

competence, and quality of the

internal audit function;

— the quality and scope of the audit

methodology, audit plan, and risk

assessment; and

— the adequacy of audit programs

and work paper standards.

1) Review these key elements at least

annually to determine whether there

have been signiﬁcant changes in the

internal audit infrastructure or

whether there are potential concerns

regarding their adequacy.

2) Make a determination on whether

the work of internal audit can be

relied upon when internal audit’s

overall function and related pro-

cesses are effective and when recent

work was performed by internal

audit in an area where examiners

are performing inspection proce-

dures.

3) Evaluate and determine whether

additional inspection work is

needed in high risk areas even

where internal audit has been

deemed effective and its work reli-

able.

Audit Performance and Monitoring

• Scope—Adjust the scope of the inspec-

tion if the bank holding or savings and

loan holding company’s internal audit

function does not sufﬁciently meet the

institution’s internal audit needs

(whether or not the audit function is

outsourced), or is otherwise ineffec-

tive.

• Work papers—Determine whether the

internal audit work papers adequately

document the work program, the work

performed and work paper standards,

including documentation of any obser-

vations and analysis made, the conclu-

sions, and audit results.

• Audit reports:

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 17

1) Ascertain whether internal audit has

effective audit reporting processes

that communicate audit report

issues throughout the institution and

they are addressed in a timely man-

ner.

2) Review the inspection period’s

audit reports and verify that they

contain an executive summary

describing the auditable area, its

conclusions, rationale, key issues,

and management’s documented

action plans to address audit ﬁnd-

ings.

• Audit issues tracking

1) Verify that internal audit has effec-

tive processes in place to track,

monitor, and follow up on open

audit issues.

2) Determine if the institution con-

ducts independent quality assurance

reviews of internal audit work per-

formed.

3) Verify that the CAE implements

appropriate improvements in inter-

nal audit processes or staff training

through the quality assurance and

improvement programs.

4) Determine whether the institution

conducts an internal quality assess-

ment at least annually and if the

CAE reports the results and status

of internal assessments to senior

management and the audit commit-

tee at least annually.

5) Discuss supervisory concerns and

outstanding internal-external audit

report comments with the CAE or

other person responsible for review-

ing the system of internal control. If

these discussions do not resolve the

examiner’s comments and concerns,

bring these matters to the attention

of senior management and the board

of directors or the audit committee.

• Retrospective review processes.

1) Determine if management has con-

ducted a post-mortem and ‘‘lessons

learned’’ analysis when adverse

events (fraud or a signiﬁcant loss)

have occurred.

2) Find out if internal audit function

veriﬁed that a review took place and

that appropriate action was taken to

remediate identiﬁed issues.

3) Ascertain if internal audit function

evaluated management’s analysis of

the reasons for the event and if the

adverse event was the result of a

control break down or failure, and

whether management identiﬁed

measures to be put in place to pre-

vent a similar event from occurring

in the future.

Quality Assurance

— Internal Quality Assurance. Ensure

that the internal audit function pro-

cess is documented in the audit

manual. Review samples of work,

overall results and status of any

action plans.

— External Quality Assurance. Deter-

mine whether an independent assess-

ment had been performed within the

ﬁve-year requirement. Review results

and action plan status to remediate

issues.

1) Assess the quality and scope of

the internal audit work, regardless

of whether it is performed by the

institution’s employees or by an

outsourcing vendor. Consider

whether—

a. the internal audit function’s

risk assessment, plans, and pro-

grams are appropriate for the

institution’s activities;

b. the internal audit function is

adequately managed to ensure

that audit plans are accom-

plished, programs are carried

out, and results of audits are

promptly communicated to the

managers and directors;

c. the internal audit plan and pro-

gram have been adjusted for

signiﬁcant changes in the insti-

tution’s environment, structure,

activities, risk exposures, or

systems;

d. the activities of internal audit

are consistent with the long-

range goals of the institution

and are responsive to its inter-

nal control needs; and

e. the audit function provides

high-quality advice and coun-

sel to management and the

board of directors on current

developments in risk manage-

ment, internal control, and

regulatory compliance.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 18

3. If there are deﬁciencies in any internal audit

characteristics, use your judgment to:

• evaluate the signiﬁcance of the deﬁcien-

cies and their relevance to the institu-

tion’s safety and soundness or compli-

ance with laws and regulations, and

• determine whether these deﬁciencies

would preclude overall audit processes

from being deemed effective.

While the internal audit function’s overall

processes could be deemed effective, some

elements of the internal audit function may

require enhancements or improvements,

such as documentation with respect to spe-

ciﬁc audit processes (for example, risk

assessments or work papers).

4. If examiners ﬁnd the key elements of the

internal audit function to be insufﬁcient, the

overall effectiveness of the internal audit

function should come into question. Such

ﬁndings may be include:

• Lack of an appropriate risk-assessment

process

• Lack of sufﬁcient and competent

resources

• Lack of audit coverage in key areas

• Inappropriate classiﬁcation of audit ﬁnd-

ings

• Insufﬁcient root cause analyses

• Numerous work paper deﬁciencies

• A large number of unresolved control-

related issues

5. Internal audit processes may be considered

ineffective if there are signiﬁcant, unre-

solved supervisory matters requiring imme-

diate attention (MRIAs) and/or matters

requiring attention (MRAs) pertaining to

internal audit, or if other supervisory con-

cerns exist relating to the effectiveness of

the internal audit function.

2060.05.6.6 Continuous Monitoring

between Inspections of Internal Audit

1. Supplement the inspection procedures

through continuous monitoring. Include an

assessment of key elements of internal audit

during the period following the institution’s

most recent inspection. The assessment of

key elements of internal audit should

include:

• The adequacy and independence of the

audit committee;

• The independence, professional compe-

tence, and quality of the internal audit

function;

• The quality and scope of the audit meth-

odology, audit plan, and risk assessment;

and

• The adequacy of audit programs and

work paper standards.

2. Review, at least annually, the above key

elements and determine whether there have

been signiﬁcant changes to the internal

audit infrastructure or whether there are

potential concerns regarding their adequacy.

2060.05.6.7 Evaluating the Ability to

Rely on Internal Audit

1. Consider relying on internal audit at a

supervised institution based on whether:

a. an internal audit was deemed effective at

the most recent supervisory inspection of

internal audit;

b. internal audit’s overall function and

related processes are considered effec-

tive and when recent work was per-

formed by internal audit in a area where

examiners are performing inspection

procedures and the examiners can evalu-

ation whether they may rely on the work

of internal audit;

c. an evaluation was performed of the sig-

niﬁcance and degree of risk of particular

activities, business lines or other areas or

business and if a determination was

made as to the existence of appropriate

internal controls over such risks; and

d. the extent of continuous monitoring

activities that did not identify any sig-

niﬁcant deﬁciencies or discover any

adverse changes in audit processes or the

quality of internal audit’s work.

2. Leverage off an internal audit function’s

assessment of how emerging risks and high-

risk areas are mitigated within the institu-

tion, including whether appropriate internal

controls are in place over such risks;

3. For emerging risks and high-risk areas,

determine if additional inspection work is

needed, even when internal audit has been

deemed effective and its work considered

reliable.

4. Document the results of the supervisory

review, supporting the basis for a conclu-

sion as to whether the examiners can rely

upon internal audit and whether there are

any speciﬁc auditable areas (that is, func-

tion or business line) or elements of internal

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 19

audit (e.g. open audit issues) on which the

examiners cannot rely.

2060.05.6.8 Considerations for

Consolidated Supervision

1. Tailor the nature and scope of the Federal

Reserve’s supervisory and inspection work

to the organization’s legal entity and regula-

tory structure and also the risks associated

with the organization’s activities. Promote

effective consolidated supervision by foster-

ing strong, cooperative relationships among

the Federal Reserve, relevant domestic and

foreign supervisors, and functional regula-

tors. Achieve this objective while limiting

the potential for duplication of effort or

undue burden on the institution under

review.

2. Focus on the scope and depth of the other

supervisor’s or regulator’s internal audit

review. Determine the Federal Reserve’s

ability to rely on the work of the relevant

supervisor or functional regulator:

• Rely to the fullest extent possible on

assessments and information developed

by other relevant domestic and foreign

supervisors and functional regulators;

• Focus Federal Reserve supervisory atten-

tion on material risks from activities that

are not supervised by another supervisor

or regulator, or that cut across legal enti-

ties; and

• Participate in the exchange of informa-

tion among domestic and foreign super-

visors and functional regulators, consis-

tent with applicable laws and

information-sharing arrangements, pro-

viding for the comprehensive, consoli-

dated supervision of each banking orga-

nization’s global activities.

3. The Federal Reserve’s conduct of consoli-

dated supervision is central to and depen-

dent on the coordination with, and reliance

on, the work of other relevant primary

supervisors and functional regulators. The

Federal Reserve’s direction for achieving

these objectives is closely integrated into

the supervisory framework for consolidated

bank holding companies and the combined

U.S. operations of foreign banking organi-

zations.

4. When the Federal Reserve is not the pri-

mary supervisor or functional regulator of

all entities consolidated under the holding

company, the Federal Reserve will evaluate

whether, and the degree to which, the major

subsidiaries of the holding company imple-

mented the supplemental guidance.

Policy Statement on the Internal Audit Function and Its Outsourcing 2060.05

BHC Supervision Manual January 2014

Page 20

Supplemental Policy Statement on the Internal Audit Function

and Its Outsourcing Section 2060.07

The Federal Reserve issued this January 23,

2013, policy statement to supplement the guid-

ance in the 2003 ‘‘Interagency Policy Statement

on the Internal Audit Function and Its Outsourc-

ing’’ (referred to as the 2003 Policy Statement).

Federal Reserve staff has identiﬁed areas for

improving regulated institutions’ internal audit

functions. This supplemental policy statement

addresses the characteristics, governance, and

operational effectiveness of an institution’s

internal audit function. Further, this statement

reﬂects certain changes in banking regulations

that have occurred since the issuance of the

2003 Policy Statement. The Federal Reserve is

providing this supplemental guidance to

enhance regulated institutions’ internal audit

practices and to encourage them to adopt profes-

sional audit standards and other authoritative

guidance, including those issued by the Institute

of Internal Auditors (IIA).

This supplemental statement applies to super-

vised institutions with greater than $10 billion

in total consolidated assets, including state

member banks, domestic bank and savings and

loan holding companies, and U.S. operations of

foreign banking organizations.

This supple-

mental guidance is also consistent with the

objectives of the Federal Reserve’s consolidated

supervision framework for large ﬁnancial insti-

tutions with total consolidated assets of $50 bil-

lion or more, which promotes an independent

internal audit function as an essential element

for enhancing the resiliency of supervised

institutions.

Assessment of the effectiveness of the internal

audit function. The degree to which an institu-

tion implements the internal audit practices out-

lined in this policy statement will be considered

in the Federal Reserve’s supervisory assessment

of the effectiveness of an institution’s internal

audit function as well as its safety and sound-

ness and compliance with consumer laws and

regulations. Moreover, the overall effectiveness

of an institution’s internal audit function will

inﬂuence the ability of the Federal Reserve to

rely upon the work of an institution’s internal

audit function.

This supplemental policy statement builds

upon the 2003 Policy Statement, which remains

in effect, and follows the same organizational

structure, with a new section entitled ‘‘Enhanced

Internal Audit Practices’’ and updates to Parts

I-IV of the 2003 Policy Statement. Refer to

SR-13-1/CA13-1 and its attachment. To avoid

historical references and duplication some intro-

ductory paragraphs and other small phrases are

omitted from the policy statement here, as indi-

cated by a line of asterisks.

* * * * * *

2060.07.1 SUPPLEMENTAL POLICY

GUIDANCE

2060.07.1.1 Enhanced Internal Audit

Practices

An institution’s internal audit function should

incorporate the following enhanced practices

into their overall processes:

2060.07.1.1.1 Risk Analysis

Internal audit should analyze the effectiveness

of all critical risk-management functions both

with respect to individual risk dimensions (for

example, credit risk), and an institution’s overall

risk-management function. The analysis should

focus on the nature and extent of monitoring

compliance with established policies and pro-

cesses and applicable laws and regulations

within the institution as well as whether moni-

toring processes are appropriate for the institu-

tion’s business activities and the associated

risks.

2060.07.1.1.2 Thematic Control Issues

Internal audit should identify thematic macro

control issues as part of its risk-assessment pro-

1. Refer to SR-03-5, ‘‘Amended Interagency Guidance on

the Internal Audit Function and Its Outsourcing.’’

2. In this guidance, references have been provided to the

IIA’s International Standards for the Professional Practice of

Internal Auditing (Standards). Refer to the IIA website at

https://na.theiia.org/standards-guidance/pages/standards-and-

guidance-ippf.aspx.

3. Section 4 of this document, however, clariﬁes certain

changes to the Federal Deposit Insurance Corporation regula-

tion (12 CFR part 363) on independence standards for inde-

pendent public accountants at insured depository institutions

with total assets of $500 million or more, which were adopted

pursuant to 2009 amendments to section 36 of the FDI Act.

4. Refer to SR-12-17/CA letter 12-14, ‘‘Consolidated

Supervision Framework for Large Financial Institutions.’’

BHC Supervision Manual July 2013

Page 1

cesses and determine the overall impact of such

issues on the institution’s risk proﬁle. Addi-

tional audit coverage would be expected in busi-

ness activities that present the highest risk to the

institution. Internal audit coverage should reﬂect

the identiﬁcation of thematic macro control

issues across the ﬁrm in all auditable areas.

Internal audit should communicate thematic

macro control issues to senior management and

the audit committee.

In addition, internal audit should identify pat-

terns of thematic macro control issues, deter-

mine whether additional audit coverage is

required, communicate such control deﬁciencies

to senior management and the audit committee,

and ensure management establishes effective

remediation mechanisms.

2060.07.1.1.3 Challenging Management

and Policy

Internal audit should challenge management to

adopt appropriate policies and procedures and

effective controls. If policies, procedures, and

internal controls are ineffective or insufﬁcient in

a particular line of business or activity, internal

audit should report speciﬁc deﬁciencies to

senior management and the audit committee

with recommended remediation. Such recom-

mendations may include restricting business

activity in affected lines of business until effec-

tive policies, procedures, and controls are

designed and implemented. Internal audit should

monitor management’s corrective action and

conduct a follow-up review to conﬁrm that the

recommendations of both internal audit and the

audit committee have been addressed.

2060.07.1.1.4 Infrastructure

When an institution designs and implements

infrastructure enhancements, internal audit

should review signiﬁcant changes and notify

management of potential internal control issues.

In particular, internal audit should ensure that

existing, effective internal controls (for exam-

ple, software applications and management

information system reporting) are not rendered

ineffective as a result of infrastructure changes

unless those controls are compensated for by

other improvements to internal controls.

2060.07.1.1.5 Risk Tolerance

Internal audit should understand risks faced by

the institution and conﬁrm that the board of

directors and senior management are actively

involved in setting and monitoring compliance

with the institution’s risk tolerance limits. Inter-

nal audit should evaluate the reasonableness of

established limits and perform sufﬁcient testing

to ensure that management is operating within

these limits and other restrictions.

2060.07.1.1.6 Governance and Strategic

Objectives

Internal audit should evaluate governance at all

management levels within the institution,

including at the senior management level, and

within all signiﬁcant business lines. Internal

audit should also evaluate the adequacy and

effectiveness of controls to respond to risks

within the organization’s governance, opera-

tions, and information systems in achieving the

organization’s strategic objectives. Any con-

cerns should be communicated by internal audit

to the board of directors and senior

management.

2060.07.1.2 Internal Audit Function (Part

I of the 2003 Policy Statement)

The primary objectives of the internal audit

function are to examine, evaluate, and perform

an independent assessment of the institution’s

internal control system, and report ﬁndings back

to senior management and the institution’s audit

committee. An effective internal audit function

within a ﬁnancial institution is a vital means for

an institution’s board of directors to maintain

the quality of the internal control environment

and risk-management systems.

The guidance set forth in this section supple-

ments the existing guidance in the 2003 Policy

Statement by strongly encouraging internal

auditors to adhere to professional standards,

such as the IIA guidance. Furthermore, this sec-

tion clariﬁes certain aspects of the IIA guidance

and provides practices intended to increase the

safety and soundness of institutions.

2060.07.1.2.1 Attributes of Internal Audit

Independence. Internal audit is an independent

function that supports the organization’s busi-

ness objectives and evaluates the effectiveness

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 2

of risk management, control, and governance

processes. The 2003 Policy Statement addressed

the structure of an internal audit function, not-

ing that it should be positioned so that an institu-

tion’s board of directors has conﬁdence that the

internal audit function can be impartial and not

unduly inﬂuenced by managers of day-to-day

operations. Thus, the member of management

responsible for the internal audit function (here-

after referred to as the chief audit executive or

CAE)

should have no responsibility for operat-

ing the system of internal control and should

report functionally to the audit committee. A

reporting arrangement may be used in which the

CAE is functionally accountable and reports

directly to the audit committee on internal audit

matters (that is, the audit plan, audit ﬁndings,

and the CAE’s job performance and compensa-

tion) and reports administratively to another

senior member of management who is not

responsible for operational activities reviewed

by internal audit. When there is an administra-

tive reporting of the CAE to another member of

senior management, the objectivity of internal

audit is served best when the CAE reports

administratively to the chief executive ofﬁcer

(CEO).

If the CAE reports administratively to some-

one other than the CEO, the audit committee

should document its rationale for this reporting

structure, including mitigating controls avail-

able for situations that could adversely impact

the objectivity of the CAE. In such instances,

the audit committee should periodically (at least

annually) evaluate whether the CAE is impartial

and not unduly inﬂuenced by the administrative

reporting line arrangement. Further, conﬂicts of

interest for the CAE and all other audit staff

should be monitored at least annually with

appropriate restrictions placed on auditing areas

where conﬂicts may occur.

For foreign banking organizations (FBOs),

the internal audit function for the U.S. opera-

tions of an FBO should have appropriate inde-

pendent oversight for the total assets of U.S.

operations.

When there is a resident U.S. audit

function, the CAE of the U.S. audit function

should report directly to senior ofﬁcials of the

internal audit department at the head ofﬁce such

as the global CAE. If the FBO has separate U.S.

subsidiaries, oversight may be provided by a

U.S. based audit committee that meets U.S. pub-

lic company standards for independence or by

the foreign parent company’s internal audit

function.

Professional competence and stafﬁng. Internal

audit staff should have the requisite collective

skill levels to audit all areas of the institution.

Therefore, auditors should have a wide range of

business knowledge, demonstrated through

years of audit and industry-speciﬁc experience,

educational background, professional certiﬁca-

tions, training programs, committee participa-

tion, professional associations, and job rota-

tional assignments. Internal audit should assign

staff to audit assignments based on areas of

expertise and, when feasible, rotate staff within

the audit function.

Internal audit management should perform

knowledge-gap assessments at least annually to

evaluate whether current staff members have the

knowledge and skills commensurate with the

institution’s strategy and operations. Manage-

ment feedback surveys and internal or external

quality assurance ﬁndings are useful tools to

identify and assess knowledge gaps. Any identi-

ﬁed knowledge gaps should be ﬁlled and may

be addressed through targeted staff hires, train-

ing, business line rotation programs, and out-

sourcing arrangements. The internal audit func-

tion should have an effective staff training

program to advance professional development

and should have a process to evaluate and moni-

tor the quality and appropriateness of training

provided to each auditor. Internal auditors gen-

erally receive a minimum of forty hours of

training in a given year.

Objectivity and ethics. Internal auditors should

be objective, which means performing assign-

ments free from bias and interference. A major

characteristic of objectivity is that the CAE and

all internal audit professional staff avoid any

conﬂicts of interest.

For their ﬁrst year in the

internal audit function, internally recruited

internal auditors should not audit activities for

which they were previously responsible. More-

over, compensation schemes should not provide

incentives for internal auditors to act contrary to

the attributes and objectives of the internal audit

5. More recently, this title is used to refer to the person in

charge of the internal audit function. An institution may not

have a person at the management level of CAE and instead

may have an internal audit manager.

6. This is deﬁned as the combined total assets of U.S.

operations, net of all intercompany assets and claims on

U.S.-domiciled afﬁliates.

7. IIA standards deﬁne conﬂict of interest as a situation in

which an internal auditor, who is in a position of trust, has a

competing professional or personal interest. Such competing

interests can make it difﬁcult for the individual to fulﬁll his or

her duties impartially.

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BHC Supervision Manual July 2013

Page 3

function.

While an internal auditor may recom-

mend internal control standards or review man-

agement’s procedures before implementation,

objectivity requires that the internal auditor not

be responsible for the design, installation, proce-

dures development, or operations of the institu-

tion’s internal control systems.

An institution’s internal audit function should

have a code of ethics that emphasizes the prin-

ciples of objectivity, competence, conﬁdential-

ity, and integrity, consistent with professional

internal audit guidance such as the code of

ethics established by the IIA.

Internal audit charter. Each institution should

have an internal audit charter that describes the

purpose, authority, and responsibility of the

internal audit function. An audit charter should

include the following critical components:

• The objectives and scope of the internal audit

function;

• The internal audit function’s management

reporting position within the organization, as

well as its authority and responsibilities;

• The responsibility and accountability of the

CAE; and

• The internal audit function’s responsibility to

evaluate the effectiveness of the institution’s

risk management, internal controls, and gov-

ernance processes.

The charter should be approved by the audit

committee of the institution’s board of directors.

The charter should provide the internal audit

function with the authorization to access the

institution’s records, personnel, and physical

properties relevant to the performance of inter-

nal audit procedures, including the authority to

examine any activities or entities. Periodically,

the CAE should evaluate whether the charter

continues to be adequate, requesting the

approval of the audit committee for any revi-

sions. The charter should deﬁne the criteria for

when and how the internal audit function may

outsource some of its work to external experts.

2060.07.1.2.2 Corporate Governance

Considerations

Board of directors and senior management

responsibilities. The board of directors and

senior management are responsible for ensuring

that the institution has an effective system of

internal controls. As indicated in the 2003 Pol-

icy Statement, this responsibility cannot be del-

egated to others within the institution or to

external parties. Further, the board of directors

and senior management are responsible for

ensuring that internal controls are operating

effectively.

Audit committee responsibilities. An institu-

tion’s audit committee is responsible for estab-

lishing an appropriate internal audit function

and ensuring that it operates adequately and

effectively. The audit committee should be con-

ﬁdent that the internal audit function addresses

the risks and meets the demands posed by the

institution’s current and planned activities.

Moreover, the audit committee is expected to

retain oversight responsibility for any aspects of

the internal audit function that are outsourced to

a third party.

The audit committee should provide

oversight to the internal audit function. Audit

committee meetings should be on a frequency

that facilitates this oversight and generally

should be held four times a year at a minimum,

with additional meetings held by audit commit-

tees of larger ﬁnancial institutions. Annually,

the audit committee should review and approve

internal audit’s charter, budget and stafﬁng

levels, and the audit plan and overall risk-

assessment methodology. The committee

approves the CAE’s hiring, annual performance

evaluation, and compensation.

The audit committee and its chairperson

should have ongoing interaction with the CAE

separate from formally scheduled meetings to

remain current on any internal audit department,

organizational, or industry concerns. In addi-

tion, the audit committee should have executive

sessions with the CAE without members of

senior management present as needed.

The audit committee should receive appropri-

ate levels of management information to fulﬁll

its oversight responsibilities. At a minimum, the

audit committee should receive the following

data with respect to internal audit:

• Audit results with a focus on areas rated less

than satisfactory;

• Audit plan completion status and compliance

with report issuance timeframes;

8. IIA standards have additional examples of ‘‘conﬂict of

interest’’ for consideration.

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 4

• Audit plan changes, including the rationale

for signiﬁcant changes;

• Audit issue information, including aging,

past-due status, root-cause analysis, and the-

matic trends;

• Information on higher-risk issues indicating

the potential impact, root cause, and remedia-

tion status;

• Results of internal and external quality assur-

ance reviews;

• Information on signiﬁcant industry and insti-

tution trends in risks and controls;

• Reporting of signiﬁcant changes in audit staff-

ing levels;

• Signiﬁcant changes in internal audit pro-

cesses, including a periodic review of key

internal audit policies and procedures;

• Budgeted audit hours versus actual audit

hours;

• Information on major projects; and

• Opinion on the adequacy of risk-management

processes, including effectiveness of manage-

ment’s self-assessment and remediation of

identiﬁed issues (at least annually).

Role of the chief audit executive. In addition to

communicating and reporting to the audit com-

mittee on audit-related matters, the CAE is

responsible for developing and maintaining a

quality assurance and improvement program

that covers all aspects of internal audit activity,

and for continuously monitoring the effective-

ness of the audit function. The CAE and/or

senior staff should effectively manage and moni-

tor all aspects of audit work on an ongoing

basis, including any audit work that is

outsourced.

2060.07.1.2.3 The Adequacy of the

Internal Audit Function’s Processes

Internal audit should have an understanding of

the institution’s strategy and operating processes

as well as the potential impact of current market

and macroeconomic conditions on the ﬁnancial

institution. Internal audit’s risk-assessment

methodology is an integral part of the evalua-

tion of overall policies, procedures, and controls

at the institution and the development of a plan

to test those processes.

Audit methodology. Internal audit should ensure

that it has a well-developed risk-assessment

methodology that drives its risk-assessment pro-

cess. The methodology should include an analy-

sis of cross-institutional risk and thematic con-

trol issues and address its processes and

procedures for evaluating the effectiveness of

risk management, control, and governance pro-

cesses. The methodology should also address

the role of continuous monitoring in determin-

ing and evaluating risk, as well as internal

audit’s process for incorporating other risk iden-

tiﬁcation techniques that the institution’s man-

agement utilizes such as a risk and control self-

assessment (RCSA). The components of an

effective methodology should support the inter-

nal audit function’s assessment of the control

environment, beginning with an evaluation of

the audit universe.

Audit universe. Internal audit should have effec-

tive processes to identify all auditable entities

within the audit universe. The number of audit-

able entities will depend upon whether entities

are captured at individual department levels or

at other aggregated organizational levels. Inter-

nal audit should use its knowledge of the institu-

tion to determine whether it has identiﬁed all

auditable entities and may use the general led-

ger, cost centers, new product approval pro-

cesses, organization charts, department listings,

knowledge of the institution’s products and ser-

vices, major operating and application systems,

signiﬁcant laws and regulations, or other data.

The audit universe should be documented and

reviewed periodically as signiﬁcant organiza-

tional changes occur or at least during the

annual audit planning process.

Internal audit risk assessment. A risk assess-

ment should document the internal audit staff’s

understanding of the institution’s signiﬁcant

business activities and the associated risks.

These assessments typically analyze the risks

inherent in a given business line or process, the

mitigating control processes, and the resulting

residual risk exposure to the institution.

A comprehensive risk assessment should

effectively analyze the key risks (and the critical

risk-management functions) within the institu-

tion and prioritize audit entities within the audit

universe. The risk-assessment process should be

well documented and dynamic, reﬂecting

changes to the system of internal controls, infra-

structure, work processes, and new or changed

9. The ongoing review of audit work should include risk

assessments of audit entities and elements, scope documents,

audit programs, detailed audit procedures and steps (including

sampling methodologies), audit work papers, audit ﬁndings,

and monitoring of the timely and effective resolution of audit

issues.

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BHC Supervision Manual July 2013

Page 5

business lines or laws and regulations. The risk

assessments should also consider thematic con-

trol issues, risk tolerance, and governance

within the institution. Risk assessments should

be revised in light of changing market condi-

tions or laws and regulations and updated dur-

ing the year as changes are identiﬁed in the

business activities of the institution or observed

in the markets in which the institution operates,

but no less than annually. When the risk assess-

ment indicates a change in risk, the audit plan

should be reviewed to determine whether the

planned audit coverage should be increased or

decreased to address the revised assessment of

risk.

Risk assessments should be formally docu-

mented and supported with written analysis of

the risks.

There should be risk assessments for

critical risk-management functions within the

institution. Risk assessments may be quantita-

tive or qualitative and may include factors such

as the date of the last audit, prior audit results,

the impact and likelihood of an event occurring,

and the status of external vendor relationships.

A management RCSA, if performed, may be

considered by the internal audit function in

developing its independent risk assessment. The

internal audit risk assessment should also

include a speciﬁc rationale for the overall audit-

able entity risk score. The overall disposition of

the risk assessment should be summarized with

consideration given to key performance or risk

indicators and prior audit results. A high-level

summary or discussion of the risk-assessment

results should be provided to the audit commit-

tee and include the most signiﬁcant risks facing

the institution as well as how these risks have

been addressed in the internal audit plan.

Internal audit plan. Internal audit should develop

and periodically revise its comprehensive audit

plan and ensure that audit coverage for all

identiﬁed, auditable entities within the audit

universe is appropriate for the size and

complexity of the institution’s activities. This

should be accomplished either through a

multiyear plan approach, with the plan revised

annually, or through an approach that utilizes a

framework to evaluate risks annually focusing on

the most signiﬁcant risks. In the latter approach,

there should be a mechanism in place to identify

when a signiﬁcant risk will not be audited in the

speciﬁed timeframe and a requirement to notify

the audit committee and seek its approval of any

exception to the framework. Generally, common

practice for institutions with deﬁned audit cycles

is to follow either a three- or four-year audit

cycle; high-risk areas should be audited at least

every twelve to eighteen months.

The internal audit plan should consider the

risk assessment and internal audit’s approach to

audit coverage should be appropriate based on

the risk assessment. An effective plan covers

individual business areas and risk disciplines as

well as cross-functional and cross-institutional

areas.

The audit planning process should be

dynamic, allowing for change when necessary.

The process should include a process for modi-

fying the internal audit plan to incorporate sig-

niﬁcant changes that are identiﬁed either

through continuous monitoring or during an

audit. Any signiﬁcant changes should be clearly

documented and included in quarterly commu-

nications to the audit committee. Critical data to

be reported to the audit committee should

include deferred or cancelled audits rated high-

risk and other signiﬁcant additions or deletions.

Signiﬁcant changes to audit budgets and timeli-

ness for the completion of audits should be

reported to the audit committee with docu-

mented rationale.

Internal audit continuous monitoring. Internal

audit is encouraged to utilize formal continuous

monitoring practices as part of the function’s

risk-assessment processes to support adjust-

ments to the audit plan or universe as they

occur. Continuous monitoring can be conducted

by an assigned group or individual internal audi-

tors. An effective continuous monitoring pro-

cess should include written standards to ensure

consistent application of processes throughout

the organization.

Continuous monitoring results should be

documented through a combination of metrics,

management reporting, periodic audit summa-

ries, and updated risk assessments to substanti-

ate that the process is operating as designed.

Critical issues identiﬁed through the monitoring

process should be communicated to the audit

committee. Computer-assisted auditing tech-

niques are useful tools to highlight issues that

10. For example, risks include credit, market, operational,

liquidity, compliance, IT, fraud, political, legal, regulatory,

strategic, and reputational.

11. Regardless of the institution’s practice, particular care

should be taken to ensure that higher-risk elements are

reviewed with an appropriate frequency, and not obscured due

to their inclusion in a lower risk-rated audit entity.

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 6

warrant further consideration within a continu-

ous monitoring process.

2060.07.1.2.4 Internal Audit Performance

and Monitoring Processes

Performance. Detailed guidance related to the

performance of an internal audit should be docu-

mented in the audit manual

and work pro-

grams to ensure that audit execution is consis-

tent across the audit function. Internal audit

policies and procedures should be designed to

ensure that audits are executed in a high-quality

manner, their results are appropriately commu-

nicated, and issues are monitored and appropri-

ately resolved. In performing internal audit

work, an institution should consider the

following.

• Internal audit scope: During the audit plan-

ning process, internal audit should analyze the

auditable entity’s speciﬁc risks, mitigating

controls, and level of residual risk. The infor-

mation gathered during the audit planning

phase should be used to determine the scope

and speciﬁc audit steps that should be per-

formed to test the adequacy of the design and

operating effectiveness of control processes.

• Internal audit work papers: Work papers

document the work performed, observations

and analyses made, and support for the con-

clusions and audit results. The work papers

should contain sufﬁcient information regard-

ing any scope or audit program modiﬁcations

and waiver of issues not included in the ﬁnal

report. Work papers also should document the

speciﬁc sampling methodology, including

minimum sample sizes, and the rationale for

such methodology. The work papers should

contain information that reﬂects all phases of

the audit process including planning, ﬁeld-

work, reporting, and issues tracking and

follow-up. On an ongoing basis, a comprehen-

sive supervisory review should be performed

on all audit work, including any outsourced

internal audit procedures.

• Audit report: Internal audit should have effec-

tive processes to ensure that issues are com-

municated throughout the institution and audit

issues are addressed in a timely manner. The

audit report should include an executive sum-

mary that describes the auditable area, audit’s

conclusions, the rationale for those conclu-

sions, and key issues. Most audit reports also

include management’s action plans to address

audit ﬁndings. To ensure that identiﬁed issues

are addressed in a timely manner, reports

should be issued to affected business areas,

senior management, and the audit committee

within an appropriate timeframe after the

completion of ﬁeld work. Compliance with

issuance timeframes should be monitored and

reported periodically to the audit committee.

At a minimum, internal audit should ensure

that management considers the level and sig-

niﬁcance of the risk when assigning resources

to address and remediate issues. Management

should appropriately document the action

plans either within the audit report or

separately.

• Internal audit issues tracking: Internal audit

should have effective processes in place to

track and monitor open audit issues and to

follow-up on such issues. The timely remedia-

tion of open audit issues is an essential com-

ponent of an organization’s risk reduction

efforts. Internal audit and the responsible

management should discuss and agree to an

appropriate resolution date, based on the level

of work necessary to complete remediation

processes. When an issue owner indicates that

work to close an issue is completed, the inter-

nal audit function should perform validation

work prior to closing the issue. The level of

validation necessary may vary based on the

issue’s risk level. For higher-risk issues, inter-

nal audit should perform and document sub-

stantive testing to validate that the issue has

been resolved. Issues should be tested over an

appropriate period of time to ensure the sus-

tainability of the remediation.

Retrospective review processes. When an

adverse event occurs at an institution (for exam-

ple, fraud or a signiﬁcant loss), management

should conduct a post-mortem and ‘‘lessons

learned’’ analysis. In these situations, internal

audit should ensure that such a review takes

place and appropriate action is taken to remedi-

ate identiﬁed issues. The internal audit function

should evaluate management’s analysis of the

reasons for the event and whether the adverse

12. To facilitate effective, efﬁcient, and consistent practice

within the internal audit department, an institution should

develop an audit manual that includes comprehensive policies

and procedures and is made available to all internal audit

staff. The manual should be updated as needed.

13. An experienced audit manager should perform this

review.

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 7

event was the result of a control breakdown or

failure, and identify the measures that should be

put in place to prevent a similar event from

occurring in the future. In certain situations, the

internal audit function should conduct its own

post-mortem and a ‘‘lessons learned’’ analysis

outlining the remediation procedures necessary

to detect, correct, and/or prevent future internal

control breakdowns (including improvements in

internal audit processes).

Quality assurance and improvement program.

A well-designed, comprehensive quality assur-

ance program should ensure that internal audit

activities conform to the IIA’s professional stan-

dards and the institution’s internal audit policies

and procedures. The program should include

both internal and external quality assessments.

The internal audit function should develop

and document its internal assessment program

to promote and assess the quality and consis-

tency of audit work across all audit groups with

respect to policies, procedures, audit perfor-

mance, and work papers. The quality assurance

review should be performed by someone inde-

pendent of the audit work being reviewed. Con-

clusions reached and recommendations for

appropriate improvement in internal audit pro-

cess or staff training should be implemented by

the CAE through the quality assurance and

improvement program. Action plan progress

should be monitored and subsequently closed

after a period of sustainability. Each institution

should conduct an internal quality assessment

annually and the CAE should report the results

and status of internal assessments to senior man-

agement and the audit committee at least

annually.

The IIA recommends that an external quality

assessment of internal audit be performed by a

qualiﬁed independent party at least once every

ﬁve years. The review should address compli-

ance with the IIA’s deﬁnition of internal audit-

ing, code of ethics, and standards, as well as

with the internal audit function’s charter, poli-

cies and procedures, and any applicable legisla-

tive and regulatory requirements. The CAE

should communicate the results, planned

actions, and status of remediation efforts to

senior management and the audit committee.

2060.07.1.3 Internal Audit Outsourcing

Arrangements (Part II of the 2003 Policy

Statement)

As stated in the 2003 Policy Statement, an insti-

tution’s board of directors and senior manage-

ment are charged with the overall responsibility

for maintaining an effective system of internal

controls. Responsibility for maintaining an

effective system of internal controls cannot be

delegated to a third party. An institution that

chooses to outsource audit work should ensure

that the audit committee maintains ownership of

the internal audit function. The institution’s

audit committee and CAE should provide active

and effective oversight of outsourced activities.

Institutions should carefully consider the over-

sight responsibilities that are consequential to

these types of arrangements in determining

appropriate stafﬁng levels.

To distinguish its duties from those of the

outsourcing vendor, the institution should have

a written contract, which may take the form of

an engagement letter or similar services agree-

ment. Contracts between the institution and the

vendor should include a provision stating that

work papers and any related non-public conﬁ-

dential information and personal information

must be handled by the vendor in accordance

with applicable laws and regulations. An institu-

tion should periodically conﬁrm that the vendor

continues to comply with the agreed-upon conﬁ-

dentiality requirements, especially for long-term

contracts. The audit committee should approve

all signiﬁcant aspects of outsourcing arrange-

ments and should receive information on audit

deﬁciencies in a manner consistent with that

provided by the in-house audit department.

2060.07.1.3.1 Vendor Competence

An institution should have appropriate policies

and procedures governing the selection and

oversight of internal audit vendors, including

whether to continue with an existing outsourced

arrangement. The audit committee and the CAE

are responsible for the selection and retention of

internal audit vendors and should be aware of

factors that may impact vendors’ competence

and ability to deliver high-quality audit services.

2060.07.1.3.2 Contingency Planning

An institution’s contingency plan should take

into consideration the extent to which the insti-

tution relies upon outsourcing arrangements.

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 8

When an institution relies signiﬁcantly on the

resources of an internal audit service provider,

the institution should have contingency proce-

dures for managing temporary or permanent

disruptions in the service in order to ensure that

the internal audit function can meet its intended

objectives.

2060.07.1.3.3 Quality of Audit Work

The quality of audit work performed by the

vendor should be consistent with the institu-

tion’s standards of work expected to be per-

formed by an in-house internal audit depart-

ment. Further, information supplied by the

vendor should provide the board of directors, its

audit committee, and senior management with

an accurate report on the control environment,

including any changes necessary to enhance

controls.

2060.07.1.4 Independence Guidance for

the Independent Public Accountant (Part

III of the 2003 Policy Statement)

The following discussion supplements the dis-

cussion in Part III of the 2003 Policy Statement

and addresses additional requirements regarding

auditor independence for depository institutions

subject to section 36 of the FDI Act (as amended

in 2009).

2060.07.1.4.1 Depository Institutions

Subject to the Annual Audit and

Reporting Requirements of Section 36 of

the FDI Act

The July 2009 amendments to section 36 of the

FDI Act (applicable to insured depository insti-

tutions with total assets of $500 million or more)

require an institution’s external auditor to fol-

low the more restrictive of the independence

rules issued by the AICPA, SEC, and PCAOB.

In March 2003, the SEC prohibited a registered

public accounting ﬁrm that is responsible for

furnishing an opinion on the consolidated or

separate ﬁnancial statements of an audit client

from providing internal audit services to that

same client.

Therefore, by following the more

restrictive independence rules, a depository

institution’s external auditor is precluded from

performing internal audit services, either on a

co-sourced or an outsourced basis, even if the

institution is not a public company.

2060.07.1.5 Examination Guidance (Part

IV of the 2003 Policy Statement)

The following discussion supplements the exist-

ing guidance in Part IV of the 2003 Policy

Statement on examination guidance and dis-

cusses the overall effectiveness of an institu-

tion’s internal audit function and the examiner’s

reliance on internal audit.

2060.07.1.5.1 Determining the Overall

Effectiveness of Internal Audit

An effective internal audit function is a vehicle

to advance an institution’s safety and soundness

and compliance with consumer laws and regula-

tions and is therefore considered as part of the

supervisory review process. Federal Reserve

examiners will make an overall determination as

to whether the internal audit function and its

processes are effective or ineffective and

whether examiners can potentially rely upon

internal audit’s work as part of the supervisory

review process. If internal audit’s overall pro-

cesses are deemed effective, examiners may be

able to rely on the work performed by internal

audit depending on the nature and risk of the

functions subject to examination.

The supervisory assessment of internal audit

and its effectiveness will consider an institu-

tion’s application of the 2003 Policy Statement

and this supplemental guidance. An institution’s

internal audit function generally would be con-

sidered effective if the institution’s internal audit

function structure and practices are consistent

with the 2003 Policy Statement and this guid-

ance.

Conversely, an institution’s internal audit

function that does not follow the enhanced prac-

tices and supplemental guidance outlined in this

policy letter generally will be considered inef-

fective. In such a case, examiners will not rely

on the institution’s internal audit function.

Examiners will inform the CAE as to whether

the function is deemed to be effective or ineffec-

tive. Internal audit’s overall processes could be

deemed effective even though some aspects of

the internal audit function may require

enhancements or improvements such as addi-

tional documentation with respect to speciﬁc

14. See SEC ﬁnal rule, ‘‘Strengthening the Commission’s

Requirements Regarding Auditor Independence,’’ at 17 CFR

parts 210, 240, 249 and 274.

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 9

audit processes (for example, risk assessments

or work papers). In these situations, the required

enhancements or improvements generally

should not be a critical part of the overall inter-

nal audit function, or the function should be

deemed to be ineffective.

2060.07.1.5.2 Relying on the Work

Performed by Internal Audit

Examiners may rely on internal audit at super-

vised institutions if internal audit was deemed

effective at the most recent examination of inter-

nal audit. In examining an institution’s internal

audit function, examiners will supplement their

examination procedures through continuous

monitoring and an assessment of key elements

of internal audit, including (1) the adequacy and

independence of the audit committee; (2) the

independence, professional competence, and

quality of the internal audit function; (3) the

quality and scope of the audit methodology,

audit plan, and risk assessment; and (4) the

adequacy of audit programs and work paper

standards. On at least an annual basis, examin-

ers should review these key elements to deter-

mine whether there have been signiﬁcant

changes in the internal audit infrastructure or

whether there are potential concerns regarding

their adequacy.

Examiners may choose to rely on the work of

internal audit when internal audit’s overall func-

tion and related processes are effective and

when recent work was performed by internal

audit in an area where examiners are performing

examination procedures. For example, if an

internal audit department performs internal audit

work in an area where examiners might also

review controls, examiners may evaluate

whether they can rely on the work of internal

audit (and either eliminate or reduce the testing

scheduled as part of the regulatory examination

processes). In high-risk areas, examiners will

consider whether additional examination work

is needed even where internal audit has been

deemed effective and its work reliable.

* * * * * * * * * * *

(End of the January 23, 2013, Supplemental

Policy Statement)

Supplemental Policy Statement on the Internal Audit Function and Its Outsourcing 2060.07

BHC Supervision Manual July 2013

Page 10

Audit

(Management Information Systems) Section 2060.1

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2016, this section has been

revised to incorporate the January 15, 2016

“Interagency Advisory on External Audits of

Internationally Active U.S. Financial Institu-

tions.” The federal banking agencies issued the

interagency advisory to communicate their sup-

port for the principles and expectations set forth

in parts 1 and 2 of the Basel Committee on

Banking Supervision’s March 2014 guidance on

“External audits of banks.” “Internationally

Active Banks” is deﬁned in the advisory. Refer

to subsection 2060.1.8 and SR-16-2 and its

attachment.

2060.1.1 INTERNAL AND EXTERNAL

AUDIT PROGRAMS AND ACTIVITIES

Audit is an independent appraisal activity that

serves as a managerial control within an organi-

zation. The primary responsibility for the main-

tenance of sound systems of internal controls

and an adequate internal audit program rests

with the directorate of the bank holding com-

pany. Included among the objectives of a com-

prehensive audit program are the detection of

irregularities; the determination of compliance

with applicable laws and regulations; and the

appraisal of the soundness and adequacy of

accounting, operating, and administrative con-

trols designed to ensure prompt and accurate

recording of transactions and proper safeguard-

ing of assets. At a minimum, an audit program

should ensure that adequate systems of checks

and balances are in effect to deter fraud and

detect control deﬁciencies.

The size and complexity of a bank holding

company operation are major determinants in

the scope and extent of the audit program that is

developed. In the smaller, less sophisticated

organizations, such as holding company shells

for small banks, it may not be feasible to employ

an auditor or implement an audit program. In

some cases, such as those in which banking

assets represent virtually all of the parent com-

pany’s assets and a comprehensive, effective

audit program is being implemented in the vari-

ous subsidiaries, neither an internal nor an exter-

nal audit program may be necessary at the par-

ent company level.

The development and implementation of an

internal audit program should be delegated to a

qualiﬁed staff large enough to meet the func-

tional requirements of the job under the guid-

ance and leadership of the auditor. When evalu-

ating the effectiveness of an internal audit

program, the examiner may want to consider the

size of audit staffs of banking organizations of a

similar size and complexity. To ensure freedom

of access to corporate records and complete

independence and objectivity in administering

the audit program, the auditor should report

directly to the directorate or a committee

thereof. Administratively, the internal auditor is

usually responsible to an ofﬁcer at a major poli-

cymaking level.

To supplement the internal audit activities,

external accountants-auditors may be engaged

to certify or audit the ﬁnancial statements or

speciﬁed activities of the bank holding company

and its subsidiaries. Each top-tier bank holding

company with total consolidated assets of $500

million or more must engage independent pub-

lic accountants to perform audits and report on

its annual ﬁnancial statements in accordance

with generally accepted accounting principles.

The scope of the audit engagement must be

sufﬁcient to permit such accountant to deter-

mine and report whether the ﬁnancial statements

are presented fairly and in accordance with gen-

erally accepted accounting principles. Bank

holding companies do not have to submit

audited ﬁnancial statements as part of the

requirements for the FR Y-6 annual report. The

Federal Reserve may request audited consoli-

dated ﬁnancial statements from any bank hold-

ing company with total consolidated assets of

less than $500 million if deemed warranted for

supervisory purposes.

The internal and external auditors should

work together in establishing the scope and fre-

quency of audits to be performed. In addition to

performing some of the basic functions of the

internal auditor, the external auditor should

review the internal auditing program to assess

its scope and adequacy. When a bank holding

company is perhaps too small to employ an

internal audit staff, but when the complexities

and activities of the organization suggest the

need for an audit, the holding company should

consider hiring an external auditor. Indepen-

dence and objectivity are mandatory in any audit

program, and these are difﬁcult to maintain if

the audit function is a part-time responsibility.

When external auditors are employed to per-

form the internal audit function, they should be

BHC Supervision Manual January 2016

Page 1

permitted to establish the scope of their audits

and schedule surprise audits. They also should

be given responsibility for suggesting systems

and organizational duty assignments for maxi-

mum control consistent with the size of the

organization.

2060.1.2 EXTERNAL AUDITORS AND

THE RELEASE OF REQUIRED

INFORMATION

The enactment of the Financial Institutions

Reform, Recovery, and Enforcement Act

(FIRREA) on August 9, 1989, requires that

FDIC-insured depository institutions that are

being audited provide their independent auditors

with information concerning their ﬁnancial con-

dition and any supervisory actions being taken

against them. Speciﬁcally, section 36(h)(1) of

the Federal Deposit Insurance Act (12 U.S.C.

1831m(h)(1)) (the FDI Act) requires an insured

depository institution that has engaged the ser-

vices of an independent auditor to perform an

audit within the past two years to provide the

auditor with—

1. a copy of the most recent report of condition

made by the institution (pursuant to the FDI

Act or any other provision of law) and a

copy of the most recent report of examina-

tion received by the institution;

2. a copy of any supervisory memorandum of

understanding with such institution and any

written agreement between a federal or state

banking agency and the depository institu-

tion that is in effect during the period cov-

ered by the audit; and

3. a report of any action initiated or taken by a

federal banking agency during the period

covered by the audit under subsection (a),

(b), (c), (e), (g), (i), (s), or (t) of section 8 of

the FDI Act or of any similar action taken by

a state banking agency under state law, or

any other civil money penalty assessed under

any other provision of law with respect to the

depository institution or any afﬁliated party.

External auditors who are serving as agents

of a bank holding company may, with the

approval of the organization, review examina-

tion or inspection reports and supervisory corre-

spondence received and communicate with

examiners. Examiners should remind external

auditors of their responsibility to maintain the

conﬁdentiality of the reports and other supervi-

sory communications reviewed as part of their

engagement. See also the Board’s rules on the

release of conﬁdential supervisory information

(12 C.F.R. 261, subpart C).

2060.1.3 EXTERNAL AUDITOR

INQUIRIES

In some situations, examiners may not be able

to fully respond to external auditors’ inquiries

on certain matters relating to examinations still

in progress. The examiners’ ﬁndings may be

incomplete or may be under review by higher

supervisory authorities within the Federal

Reserve System. In addition, as a general prac-

tice, examiners will normally only discuss with

external auditors issues and inspection ﬁndings

that have been presented to the bank holding

company’s management. These situations relate

primarily to the timing of the auditors’ inquiries

in relation to the stage of inspection work and,

thus, should not automatically preclude an audi-

tor from expressing an opinion on the organiza-

tion’s ﬁnancial statements.

2060.1.4 UNSAFE AND UNSOUND

USE OF LIMITATION-OF-LIABILITY

PROVISIONS IN EXTERNAL AUDIT

ENGAGEMENT LETTERS

On February 9, 2006, the Federal Reserve and

the other ﬁnancial institution regulatory agen-

cies (the agencies)

issued an interagency advi-

sory (the advisory) to address safety-and-

soundness concerns that may arise when

ﬁnancial institutions enter into external audit

contracts (typically referred to as engagement

letters) that limit the auditors’ liability for audit

services.

The advisory informs ﬁnancial institu-

tions’

boards of directors, audit committees,

management, and external auditors of the safety-

and-soundness implications that may arise when

the ﬁnancial institution enters into engagement

letters that contain provisions to limit the audi-

tors’ liability.

1. The Board of Governors of the Federal Reserve System

(Board), the Ofﬁce of the Comptroller of the Currency (OCC),

the Federal Deposit Insurance Corporation (FDIC), and the

National Credit Union Administration (NCUA).

2. The advisory is effective for audit engagement letters

issued on or after February 9, 2006.

3. As used in this advisory, the term ﬁnancial institutions

includes bank holding companies, banks, savings associa-

tions, and savings and loan holding companies.

Audit 2060.1

BHC Supervision Manual January 2016

Page 2

The advisory does not apply to previously

executed engagement letters. However, any

ﬁnancial institution subject to a multiyear audit

engagement letter containing unsafe and

unsound limitation-of-liability provisions should

seek an amendment to its engagement letter to

be consistent with the advisory for periods end-

ing in 2007 or later. (See SR-06-4.)

Limits on external auditors’ liability may

weaken the external auditors’ objectivity, impar-

tiality, and performance and, thus, reduce the

agencies’ ability to rely on audits. Therefore,

certain limitation-of-liability provisions

(described in the advisory and its appendix A;

see section 2060.1.4.7) are unsafe and unsound.

In addition, such provisions may not be consis-

tent with the auditor-independence standards of

the U.S. Securities and Exchange Commission

(SEC), the Public Company Accounting Over-

sight Board (PCAOB), and the American Insti-

tute of Certiﬁed Public Accountants (AICPA).

2060.1.4.1 Scope of the Advisory on

Engagement Letters

The advisory applies to engagement letters

between ﬁnancial institutions and external audi-

tors with respect to ﬁnancial-statement audits,

audits of internal control over ﬁnancial report-

ing, and attestations on management’s assess-

ment of internal control over ﬁnancial reporting

(collectively, audit or audits).

The advisory does not apply to—

1. nonaudit services that may be performed by

ﬁnancial institutions’ external auditors,

2. audits of ﬁnancial institutions’ 401(k) plans,

pension plans, and other similar audits,

3. services performed by accountants who are

not engaged to perform ﬁnancial institutions’

audits (e.g., outsourced internal audits or

loan reviews), and

4. other service providers (e.g., software con-

sultants or legal advisers).

While the agencies have observed several

types of limitation-of-liability provisions in

external audit engagement letters, this advisory

applies to any agreement that a ﬁnancial institu-

tion enters into with its external auditor that

limits the external auditor’s liability with respect

to audits in an unsafe and unsound manner.

2060.1.4.2 External Audits and Their

Engagement Letters

A properly conducted audit provides an inde-

pendent and objective view of the reliability of a

ﬁnancial institution’s ﬁnancial statements. The

external auditor’s objective in an audit is to

form an opinion on the ﬁnancial statements

taken as a whole. When planning and perform-

ing the audit, the external auditor considers the

ﬁnancial institution’s internal control over

ﬁnancial reporting. Generally, the external audi-

tor communicates any identiﬁed deﬁciencies in

internal control to management, which enables

management to take appropriate corrective

action. In addition, certain ﬁnancial institutions

are required to ﬁle audited ﬁnancial statements

and internal control audit or attestation reports

with one or more of the agencies. The agencies

encourage ﬁnancial institutions not subject to

mandatory audit requirements to voluntarily

obtain audits of their ﬁnancial statements. The

FFIEC’s September 1999 Interagency Policy

Statement on External Auditing Programs of

Banks and Savings Associations

notes, ‘‘[a]n

institution’s internal and external audit pro-

grams are critical to its safety and soundness.’’

The policy also states that an effective external

auditing program ‘‘can improve the safety and

soundness of an institution substantially and

lessen the risk the institution poses to the insur-

ance funds administered by the FDIC.’’

Typically, a written engagement letter is used

to establish an understanding between the exter-

nal auditor and the ﬁnancial institution regard-

ing the services to be performed in connection

with the ﬁnancial institution’s audit. The

engagement letter commonly describes the

objective of the audit, the reports to be prepared,

the responsibilities of management and the

external auditor, and other signiﬁcant arrange-

ments (for example, fees and billing). Boards of

directors, audit committees, and management

are encouraged to closely review all of the pro-

visions in the audit engagement letter before

agreeing to sign. As with all agreements that

affect a ﬁnancial institution’s legal rights, the

ﬁnancial institution’s legal counsel should care-

fully review audit engagement letters to help

ensure that those charged with engaging the

external auditor make a fully informed decision.

The advisory describes the types of objection-

able limitation-of-liability provisions and pro-

4. See 64 Fed. Reg. 52,319 (September 28, 1999).

Audit 2060.1

BHC Supervision Manual January 2016

Page 3

vides examples.

Financial institutions’ boards

of directors, audit committees, and management

should also be aware that certain insurance poli-

cies (such as error and omission policies and

directors’ and ofﬁcers’ liability policies) might

not cover losses arising from claims.

2060.1.4.3 Limitation-of-Liability

Provisions

The provisions of an external audit engagement

letter that the agencies deem to be unsafe and

unsound can be generally categorized as fol-

lows: a provision within an agreement between

a client ﬁnancial institution and its external

auditor that effectively—

1. indemniﬁes the external auditor against

claims made by third parties;

2. holds harmless or releases the external audi-

tor from liability for claims or potential

claims that might be asserted by the client

ﬁnancial institution, other than claims for

punitive damages; or

3. limits the remedies available to the client

ﬁnancial institution, other than punitive

damages.

Collectively, these categories of provisions

are referred to in this advisory as limitation-of-

liability provisions.

Provisions that waive the right of ﬁnancial

institutions to seek punitive damages from their

external auditor are not treated as unsafe and

unsound under the advisory. Nevertheless,

agreements by clients to indemnify their audi-

tors against any third-party damage awards,

including punitive damages, are deemed unsafe

and unsound under the advisory. To enhance

transparency and market discipline, public

ﬁnancial institutions that agree to waive claims

for punitive damages against their external audi-

tors may want to disclose annually the nature of

these arrangements in their proxy statements or

other public reports.

Many ﬁnancial institutions are required to

have their ﬁnancial statements audited, while

others voluntarily choose to undergo such

audits. For example, federally insured banks

with $500 million or more in total assets are

required to have annual independent audits.

Furthermore, ﬁnancial institutions that are pub-

lic companies

must have annual independent

audits. Certain savings associations (for exam-

ple, those with a CAMELS rating of 3, 4, or 5)

and savings and loan holding companies are

also required by OTS’s regulations to have

annual independent audits.

The agencies rely

on the results of audits as part of their assess-

ment of a ﬁnancial institution’s safety and

soundness.

For audits to be effective, the external audi-

tors must be independent in both fact and

appearance, and they must perform all neces-

sary procedures to comply with auditing and

attestation standards established by either the

AICPA or, if applicable, the PCAOB. When

ﬁnancial institutions execute agreements that

limit the external auditors’ liability, the external

auditors’ objectivity, impartiality, and perfor-

mance may be weakened or compromised, and

the usefulness of the audits for safety-and-

soundness purposes may be diminished.

By their very nature, limitation-of-liability

provisions can remove or greatly weaken exter-

nal auditors’ objective and unbiased consider-

ation of problems encountered in audit engage-

ments and may diminish auditors’ adherence to

the standards of objectivity and impartiality

required in the performance of audits. The exis-

tence of such provisions in external audit

engagement letters may lead to the use of less

extensive or less thorough procedures than

would otherwise be followed, thereby reducing

the reliability of audits. Accordingly, ﬁnancial

institutions should not enter into external audit

arrangements that include unsafe and unsound

limitation-of-liability provisions identiﬁed in the

advisory, regardless of (1) the size of the ﬁnan-

cial institution, (2) whether the ﬁnancial institu-

tion is public or not, or (3) whether the external

audit is required or voluntary.

5. In the majority of external audit engagement letters

reviewed, the agencies did not observe provisions that limited

an external auditor’s liability. However, for those reviewed

external audit engagement letters that did have external audi-

tor limited-liability provisions, the agencies noted a signiﬁ-

cant increase in the types and frequency of the provisions. The

provisions took many forms, which made it impractical for

the agencies to provide an all-inclusive list. Examples of

auditor limitation-of-liability provisions are illustrated in the

advisory’s appendix A. See section 2060.1.4.7.

6. For banks and savings associations, see section 36 of the

FDI Act (12 U.S.C. 1831m) and part 363 of the FDIC’s

regulations (12 C.F.R. 363).

7. Public companies are companies subject to the reporting

requirements of the Securities Exchange Act of 1934.

8. See OTS regulation at 12 C.F.R. 563.4.

Audit 2060.1

BHC Supervision Manual January 2016

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2060.1.4.4 Auditor Independence

Currently, auditor-independence standard-setters

include the SEC, PCAOB, and AICPA. Depend-

ing on the audit client, an external auditor is

subject to the independence standards issued by

one or more of these standard-setters. For all

nonpublic ﬁnancial institutions that are not

required to have annual independent audits, the

FDIC’s rules, pursuant to part 363 (or section

562.4 of the OTS’s regulations) require only

that an external auditor meet the AICPA inde-

pendence standards. The rules do not require the

ﬁnancial institution’s external auditor to comply

with the independence standards of the SEC and

the PCAOB.

In contrast, for ﬁnancial institutions subject to

the audit requirements in part 363 of the FDIC’s

regulations (or in section 562.4 of the OTS

regulations), the external auditor should be in

compliance with the AICPA’s Code of Profes-

sional Conduct and meet the independence

requirements and interpretations of the SEC and

its staff.

In this regard, in a December 13, 2004,

frequently asked question (FAQ) on the applica-

tion of the SEC’s auditor-independence rules,

the SEC staff reiterated its long-standing posi-

tion that when an accountant and his or her

client enter into an agreement that seeks to

provide the accountant immunity from liability

for his or her own negligent acts, the accountant

is not independent. The SEC’s FAQ also stated

that including in engagement letters a clause

that would release, indemnify, or hold the

auditor harmless from any liability and costs

resulting from knowing misrepresentations by

management would impair the auditor’s

independence. The FAQ is consistent with the

SEC’s Codiﬁcation of Financial Reporting Poli-

cies, section 602.02.f.i, ‘‘Indemniﬁcation by Cli-

ent.’’ (See section 2060.1.4.8.)

On the basis of the SEC guidance and the

agencies’ existing regulations, certain limits on

auditors’ liability are already inappropriate in

audit engagement letters entered into by—

1. public ﬁnancial institutions that ﬁle reports

with the SEC or with the agencies,

2. ﬁnancial institutions subject to part 363,

and

3. certain other ﬁnancial institutions that are

required to have annual independent audits.

In addition, certain of these limits on audi-

tors’ liability may violate the AICPA indepen-

dence standards. Notwithstanding the potential

applicability of auditor-independence standards,

the limitation-of-liability provisions discussed

in the advisory present safety-and-soundness

concerns for all ﬁnancial institution audits.

2060.1.4.5 Alternative Dispute-Resolution

Agreements and Jury-Trial Waivers

The agencies observed that a review of the

engagement letters of some ﬁnancial institutions

revealed that they had agreed to submit disputes

over external audit services to mandatory and

binding alternative dispute resolution, binding

arbitration, or other binding nonjudicial dispute-

resolution processes (collectively, mandatory

ADR) or to waive the right to a jury trial. By

agreeing in advance to submit disputes to man-

datory ADR, ﬁnancial institutions may waive

the right to full discovery, limit appellate

review, or limit or waive other rights and pro-

tections available in ordinary litigation

proceedings.

Mandatory ADR procedures and jury-trial

waivers may be efﬁcient and cost-effective tools

for resolving disputes in some cases. Accord-

ingly, the agencies believe that mandatory ADR

or waiver of jury-trial provisions in external

audit engagement letters do not present safety-

and-soundness concerns, provided that the

engagement letters do not also incorporate

limitation-of-liability provisions. Institutions are

encouraged to carefully review mandatory ADR

and jury-trial provisions in engagement letters,

as well as review any agreements regarding

rules of procedure, and to fully comprehend the

ramiﬁcations of any agreement to waive any

available remedies. Financial institutions should

ensure that any mandatory ADR provisions in

audit engagement letters are commercially rea-

sonable and—

1. apply equally to all parties,

2. provide a fair process (for example, neutral

decision makers and appropriate hearing pro-

cedures), and

3. are not imposed in a coercive manner.

9. See part 363 of the FDIC’s regulation (12 C.F.R. 363),

Appendix A—Guidelines and Interpretations, Guideline 14,

‘‘Role of the Independent Public Accountant-Independence.’’

10. See also the OTS’s regulation (12 C.F.R. 562.4).

Audit 2060.1

BHC Supervision Manual January 2016

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2060.1.4.6 The Advisory’s Conclusion

Financial institutions’ boards of directors, audit

committees, and management should not enter

into any agreement that incorporates limitation-

of-liability provisions with respect to audits. In

addition, ﬁnancial institutions should document

their business rationale for agreeing to any other

provisions that limit their legal rights.

The inclusion of limitation-of-liability provi-

sions in external audit engagement letters and

other agreements that are inconsistent with the

advisory will generally be considered an unsafe

and unsound practice. Examiners will consider

the policies, processes, and personnel surround-

ing a ﬁnancial institution’s external auditing

program in determining whether (1) the engage-

ment letter covering external auditing activities

raises any safety-and-soundness concerns and

(2) the external auditor maintains appropriate

independence regarding relationships with the

ﬁnancial institution under relevant professional

standards. The agencies may take appropriate

supervisory action if unsafe and unsound

limitation-of-liability provisions are included in

external audit engagement letters or other agree-

ments related to audits that are executed

(accepted or agreed to by the ﬁnancial

institution).

2060.1.4.7 Examples of Unsafe and

Unsound Limitation-of-Liability

Provisions

The following information was contained in

appendix A of the February 9, 2006, inter-

agency advisory.

Presented below are some of the types of

limitation-of-liability provisions (with an illus-

trative example of each type) that the agencies

observed in ﬁnancial institutions’ external audit

engagement letters. The inclusion in external

audit engagement letters or agreements related

to audits of any of the illustrative provisions

(which do not represent an all-inclusive list) or

any other language that would produce similar

effects is considered an unsafe and unsound

practice.

1. “Release from Liability for Auditor

Negligence” Provision

In this type of provision, the ﬁnancial institu-

tion agrees not to hold the audit ﬁrm liable for

any damages, except to the extent determined to

have resulted from willful misconduct or

fraudulent behavior by the audit ﬁrm.

Example: In no event shall [the audit ﬁrm] be

liable to the ﬁnancial institution, whether a

claim be in tort, contract or otherwise, for any

consequential, indirect, lost proﬁt, or similar

damages relating to [the audit ﬁrm’s] services

provided under this engagement letter, except to

the extent ﬁnally determined to have resulted

from the willful misconduct or fraudulent behav-

ior of [the audit ﬁrm] relating to such services.

2. “No Damages” Provision

In this type of provision, the ﬁnancial institu-

tion agrees that in no event will the external

audit ﬁrm’s liability include responsibility for

any compensatory (incidental or consequential)

damages claimed by the ﬁnancial institution.

Example: In no event will [the audit ﬁrm’s]

liability under the terms of this agreement

include responsibility for any claimed incidental

or consequential damages.

3. “Limitation of Period to File Claim”

Provision

In this type of provision, the ﬁnancial institu-

tion agrees that no claim will be asserted after a

ﬁxed period of time that is shorter than the

applicable statute of limitations, effectively

agreeing to limit the ﬁnancial institution’s rights

in ﬁling a claim.

Example: It is agreed by the ﬁnancial institution

and [the audit ﬁrm] or any successors in inter-

est that no claim arising out of services ren-

dered pursuant to this agreement by, or on

behalf of, the ﬁnancial institution shall be

asserted more than two years after the date of

the last audit report issued by [the audit ﬁrm].

4. “Losses Occurring During Periods

Audited” Provision

In this type of provision, the ﬁnancial institu-

tion agrees that the external audit ﬁrm’s liability

Audit 2060.1

BHC Supervision Manual January 2016

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will be limited to any losses occurring during

periods covered by the external audit, and will

not include any losses occurring in later periods

for which the external audit ﬁrm is not engaged.

This provision may not only preclude the collec-

tion of consequential damages for harm in later

years, but could preclude any recovery at all. It

appears that no claim of liability could be

brought against the external audit ﬁrm until the

external audit report is actually delivered. Under

such a clause, any claim for liability thereafter

might be precluded because the losses did not

occur during the period covered by the external

audit. In other words, it might limit the external

audit ﬁrm’s liability to a period before there

could be any liability. Read more broadly, the

external audit ﬁrm might be liable for losses that

arise in subsequent years only if the ﬁrm contin-

ues to be engaged to audit the client’s ﬁnancial

statements in those years.

Example: In the event the ﬁnancial institution is

dissatisﬁed with [the audit ﬁrm’s] services, it is

understood that [the audit ﬁrm’s] liability, if

any, arising from this engagement will be lim-

ited to any losses occurring during the periods

covered by [the audit ﬁrm’s] audit, and shall

not include any losses occurring in later periods

for which is not engaged as auditors.

5. “No Assignment or Transfer”

Provision

In this type of provision, the ﬁnancial institu-

tion agrees that it will not assign or transfer any

claim against the external audit ﬁrm to another

party. This provision could limit the ability of

another party to pursue a claim against the exter-

nal auditor in a sale or merger of the ﬁnancial

institution, in a sale of certain assets or a line of

business of the ﬁnancial institution, or in a

supervisory merger or receivership of the ﬁnan-

cial institution. This provision may also prevent

the ﬁnancial institution from subrogating a

claim against its external auditor to the ﬁnancial

institution’s insurer under its directors’ and ofﬁ-

cers’ liability or other insurance coverage.

Example: The ﬁnancial institution agrees that it

will not, directly or indirectly, agree to assign or

transfer any claim against [the audit ﬁrm] aris-

ing out of this engagement to anyone.

6. “Knowing Misrepresentations by

Management” Provision

In this type of provision, the ﬁnancial institu-

tion releases and indemniﬁes the external audit

ﬁrm from any claims, liabilities, and costs attrib-

utable to any knowing misrepresentation by

management.

Example: Because of the importance of oral and

written management representations to an effec-

tive audit, the ﬁnancial institution releases and

indemniﬁes [the audit ﬁrm] and its personnel

from any and all claims, liabilities, costs, and

expenses attributable to any knowing misrepre-

sentation by management.

7. “Indemniﬁcation for Management

Negligence” Provision

In this type of provision, the ﬁnancial institu-

tion agrees to protect the external auditor from

third-party claims arising from the external audit

ﬁrm’s failure to discover negligent conduct by

management. It would also reinforce the defense

of contributory negligence in cases in which the

ﬁnancial institution brings an action against its

external auditor. In either case, the contractual

defense would insulate the external audit ﬁrm

from claims for damages even if the reason the

external auditor failed to discover the negligent

conduct was a failure to conduct the external

audit in accordance with generally accepted

auditing standards or other applicable profes-

sional standards.

Example: The ﬁnancial institution shall indem-

nify, hold harmless, and defend and its autho-

rized agents, partners, and employees from and

against any and all claims, damages, demands,

actions, costs, and charges arising out of, or by

reason of, the ﬁnancial institution’s negligent

acts or failure to act hereunder.

8. “Damages Not to Exceed Fees Paid”

Provision

In this type of provision, the ﬁnancial institu-

tion agrees to limit the external auditor’s liabil-

ity to the amount of audit fees the ﬁnancial

institution paid the external auditor, regardless

of the extent of damages. This may result in a

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substantial unrecoverable loss or cost to the

ﬁnancial institution.

Example: [The audit ﬁrm] shall not be liable for

any claim for damages arising out of or in

connection with any services provided herein to

the ﬁnancial institution in an amount greater

than the amount of fees actually paid to [the

audit ﬁrm] with respect to the services directly

relating to and forming the basis of such

claim.

2060.1.4.8 Frequently Asked Questions

on the Application of the SEC’s

Auditor-Independence Rules

The following information is contained in

appendix B of the February 9, 2006, inter-

agency advisory. The information is derived

from the SEC’s Ofﬁce of Chief Accountant’s

Codiﬁcation of Financial Reporting Policies.

Question

Inquiry was made as to whether an accoun-

tant who certiﬁes ﬁnancial statements included

in a registration statement or annual report ﬁled

with the commission under the Securities Act or

the Exchange Act would be considered indepen-

dent if he had entered into an indemnity agree-

ment with the registrant. In the particular illus-

tration cited, the board of directors of the

registrant formally approved the ﬁling of a reg-

istration statement with the commission and

agreed to indemnify and save harmless each and

every accountant who certiﬁed any part of such

statement ‘‘from any and all losses, claims, dam-

ages or liabilities arising out of such act or acts

to which they or any of them may become

subject under the Securities Act, as amended, or

at ′common law,’ other than for their willful

misstatements or omissions.’’

Answer

When an accountant and his client, directly or

through an afﬁliate, have entered into an agree-

ment of indemnity which seeks to assure to the

accountant immunity from liability for his own

negligent acts, whether of omission or commis-

sion, one of the major stimuli to objective and

unbiased consideration of the problems encoun-

tered in a particular engagement is removed or

greatly weakened. Such condition must fre-

quently induce a departure from the standards of

objectivity and impartiality which the concept

of independence implies. In such difﬁcult mat-

ters, for example, as the determination of the

scope of audit necessary, existence of such an

agreement may easily lead to the use of less

extensive or thorough procedures than would

otherwise be followed. In other cases it may

result in a failure to appraise with professional

acumen the information disclosed by the exami-

nation. Consequently, the accountant cannot be

recognized as independent for the purpose of

certifying the ﬁnancial statements of the corpo-

ration.

Question

Has there been any change in the commis-

sion’s long-standing view (Financial Reporting

Policies—Section 600—602.02.f.i., ‘‘Indemniﬁ-

cation by Client’’) that when an accountant

enters into an indemnity agreement with the

registrant, his or her independence would come

into question?

Answer

No. When an accountant and his or her client,

directly or through an afﬁliate, enter into an

agreement of indemnity that seeks to provide

the accountant immunity from liability for his or

her own negligent acts, whether of omission or

commission, the accountant is not independent.

Further, including in engagement letters a clause

that a registrant would release, indemnify, or

hold harmless from any liability and costs

resulting from knowing misrepresentations by

management would also impair the ﬁrm’s

independence.

2060.1.3 INSPECTION OBJECTIVES

1. To review the operations of the bank holding

company to determine if an audit program

exits.

2. To determine the independence and compe-

tence of those who administer and provide

the internal and external audit function.

11. The agencies also observed a similar provision that

limited damages to a predetermined amount not related to fees

paid.

12. The subtitles in this section have been revised for this

manual.

Audit 2060.1

BHC Supervision Manual January 2016

Page 8

3. To determine the adequacy of the scope and

frequency of the audit program.

4. To determine with reasonable assurance that

the bank holding company has adequate

internal audit and external audit functions

that ensure efﬁcient and effective operations,

including the safeguarding of assets, reliable

ﬁnancial reporting, and compliance with

applicable laws and regulations.

5. To ascertain if the bank holding company’s

internal audit function monitors, reviews, and

ensures the continued existence and mainte-

nance of sound and adequate internal con-

trols over the bank holding company’s man-

agement process—the control environment,

risk assessment, control activities, informa-

tion and communication, and monitoring

activities.

6. To review and evaluate internal audit out-

sourcing arrangements and the actions of the

outsourcing vendor under the standards

established by the Interagency Policy State-

ment on the Internal Audit Function and Its

Outsourcing.

7. To consider the policies, processes, and per-

sonnel surrounding the bank holding com-

pany’s external auditing program and to

determine the existence of any unsafe and

unsound practices or conditions, including

whether—

a. any engagement letter or other agreement

related to external audit activities (1) pro-

vides any assurances of indemniﬁcation to

the bank’s external auditors that relieves

them of liability for their own negligent

acts (including any losses, claims, dam-

ages, or other liabilities) or (2) raises any

other safety-and-soundness concerns; and

b. the external auditors have not maintained

appropriate independence in their relation-

ships with the bank holding company, in

accordance with relevant professional

standards.

8. To determine, based on the criteria above, if

the work performed by internal and external

auditors is reliable.

2060.1.6 INSPECTION PROCEDURES

The primary thrust of the inspection should be

directed toward the audit activities that relate to

the parent company and all subsidiaries. An

assessment of the audit function as it pertains to

the bank (or banks) is primarily the responsibil-

ity of the regulatory agency that examines that

particular bank. The examiner should review the

latest bank examination reports to note com-

ments and deﬁciencies cited concerning internal

controls and the audit function. In addition to

providing an input into the overall assessment

of the audit function, review of the bank exami-

nation reports may provide a basis for determin-

ing areas of investigation during the inspection.

Further, if matters cited in the latest bank exami-

nation report are deemed to be signiﬁcant and

indications are that corrective action has not

been taken, the examiner should mention the

facts to senior management of the bank holding

company and note the details in the inspection

report.

To judge the adequacy of the audit program,

including its scope and frequency, the following

procedures, with equal emphasis being placed

on the parent, bank, and nonbank subsidiaries,

are recommended as minimum guidelines for

the inspection.

1. Review the parent company and nonbank

operations and the audit comments in

the bank examination reports to ascertain

the adequacy of the existing audit program

or the need for developing such a program,

if the organization currently lacks one.

2. Review the scope of the audit function to

ensure that procedures are in place to cover

adequately those areas that may be suscep-

tible to exposure. When reviewing the audit

scope, determine whether the auditor was

able to perform all the procedures necessary

to complete the audit. If not—

a. establish whether the scope limita-

tions were imposed by the directorship

or management and

b. determine whether the auditor estab-

lished and documented the reasons why

the scope limitations were imposed.

(1) Was the auditor able to quantify the

effects of the scope limitation on the

ﬁnancial statements and the audit

results, and, if not pervasive, was a

qualiﬁed opinion or disclaimer of

opinion issued?

(2) Did the auditor evaluate all possible

effects on his ability to express an

opinion on the ﬁnancial statements?

(3) Were there any external circum-

stances that imposed limitations on

the audit’s scope?

(4) Were alternative procedures used to

accomplish the same audit objec-

tives? If so, did the use of the alterna-

tive procedures justify issuance of an

unqualiﬁed opinion?

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BHC Supervision Manual January 2016

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3. Review the audit schedule to determine that

the audits are satisfactorily spaced and that

all functions are audited with adequate

frequency.

4. Review audit workpapers and reports on a

test-check basis for adequacy of content,

satisfactory maintenance, and conformance

to audit guidelines outlined by the board of

directors.

5. Determine the qualiﬁcations and back-

ground of the auditor and others participat-

ing in the audit function.

6. To establish that the auditor has a direct

communication line to the board of direc-

tors and freedom of access to all records for

audit purposes, review audit reports and

minutes of meetings held by directors or a

committee thereof.

7. Determine the entity responsible for main-

taining the audit function. If a bank pro-

vides audit services to afﬁliates, indicate the

manner in which the bank is reimbursed for

the cost of such services.

8. Determine whether audit reports are submit-

ted on a timely basis to—

a. the directors and senior management and

b. management in the area being audited.

9. Review responses to exceptions and recom-

mendations noted in audit reports.

10. Check on the relationship between the inter-

nal and any external auditors to determine

whether their activities are coordinated in a

manner that effects comprehensive cover-

age of the organization and at the same time

avoids duplication of effort.

11. Review the letter addressed to management

by the external auditor and determine that

steps have been taken to correct any deﬁ-

ciencies noted. If no deﬁciencies were noted

in the letter, inquire as to whether such

comments were communicated to manage-

ment by any other means.

12. Ascertain that the audit program is annually

reviewed and approved by the directors.

13. If the BHC has engaged any external audit

ﬁrms to conduct audits of its ﬁnancial state-

ments (including their certiﬁcation), audits

of internal control over ﬁnancial reporting,

attestations on management’s assessment of

internal control, appraisals of the BHC’s

audit function, or any internal audit or audit

function or operational review, the exam-

iner should:

a. Review the engagement letters (includ-

ing past or pending engagement letters)

and any agreements between the board

of directors (and the audit committee)

and the external auditor, noting any

qualiﬁcations that are contained therein.

b. Review any correspondence exchanged

between the BHC and the external audi-

tor, including any letters requesting opin-

ions from external auditors. Determine if

BHC management inﬂuenced any of the

opinions.

c. Ascertain if any of the engagement let-

ters restricted the scope of the audit in

any way, including whether the letters

limited the degree of reliance to be

placed on the work of the internal audit

staff.

14. Determine if the audit engagement letters or

other agreements include possible unsafe

and unsound provisions or practices that—

a. indemnify the external auditor against

all claims made by third parties;

b. hold harmless, release, or indemnify the

external auditor from liability for claims

or potential claims that the BHC may

assert, thus providing relief from liabil-

ity for the auditors’ own negligent acts,

including any losses, claims, damages,

or other liabilities, (other than claims for

punitive damages); or

c. limit the remedies available to the BHC

(other than punitive damages).

15. Find out whether the BHC’s board of direc-

tors, audit committee, and senior manage-

ment closely review all of the provisions of

audit engagement letters or other agree-

ments for providing external auditing ser-

vices for the bank before agreeing to sign,

thus indicating the BHC’s approval and

ﬁnancial commitment.

16. Verify that the BHC has documented its

business rationale for any engagement letter

or other agreement provisions with external

audit ﬁrms that limit or impair the BHC’s

legal rights.

17. If new external auditors have been engaged,

ascertain the reasons for such change.

18. Determine if the parent company or non-

bank subsidiaries have reported any defal-

cations. If so, determine if adequate con-

trols have been initiated to lessen any

further risk and exposure.

19. Determine if the BHC’s external auditors

received copies of the subsidiary FDIC-

insured institution’s examination and other

designated supervisory reports and corre-

spondence required by section 36(h)(1) of

the FDI Act.

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BHC Supervision Manual January 2016

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20. Determine the degree of independence of

the external audit ﬁrm by reviewing any

ﬁnancial ties between the BHC, audit ﬁrm,

and any of its partners or employees. Also

review any other relationships or potential

conﬂicts of interest that may exist.

The independence of the internal auditor

should be evaluated by ascertaining whether the

following conditions exist: (1) reports are dis-

tributed directly to the board or a committee

thereof or, less desirably, to an ofﬁcer not con-

nected with the area being reviewed; (2) there

are no relationships within the organization that

are incompatible with the internal audit func-

tion; and (3) severe restrictions are not placed

on the program or its scheduling by manage-

ment. In order to maintain the degree of objec-

tivity essential to the audit function, the exam-

iner should establish that the internal auditor

does not install procedures, originate and

approve entries, or otherwise engage in any

activity that would be subject to audit review

and appraisal.

The examiner should consider meeting with

the audit committee and the auditor and, subse-

quently, with senior bank holding company

management to communicate conclusions con-

cerning the adequacy of the scope and fre-

quency of the audit program. During the discus-

sions, the examiner should concentrate on

detailing criticisms or deﬁciencies noted. The

auditor and senior bank holding com-pany man-

agement should be made fully cognizant of the

examiner’s analyses and the comments concern-

ing the audit function that will appear on the

relevant pages in the inspection report.

2060.1.7 (reserved for future use)

2060.1.8 OVERVIEW:

INTERAGENCY ADVISORY ON

EXTERNAL AUDITS OF

INTERNATIONALLY ACTIVE U.S.

FINANCIAL INSTITUTIONS

The federal banking agencies (the agencies)

issued this interagency advisory to communi-

cate the agencies’ support for the principles and

expectations set forth in parts 1 and 2, respec-

tively, of the Basel Committee on Banking

Supervision’s (the BCBS or the Committee)

March 2014 guidance on “External audits of

banks” (hereafter, referred to as “the BCBS

external audit guidance”).

In supporting these principles and expecta-

tions, the agencies acknowledge that the exist-

ing standards and practices in the United States

are broadly consistent with the BCBS external

audit guidance. However, because of the legal

and regulatory framework in the United States,

certain differences exist between the standards

and practices followed in the United States and

the principles and expectations in the BCBS

external audit guidance. These differences are

addressed in this advisory, which also describes

the agencies’ supervisory expectations for U.S.

ﬁnancial institutions within the scope of this

advisory for incorporating the principles and

expectations in the BCBS external audit guid-

ance into their practices. This advisory also

outlines examiner responsibilities related to

these supervisory expectations.

The BCBS external audit guidance is

intended for “internationally active banks” and

is relevant for the management, audit commit-

tees, external auditors, and prudential supervi-

sors of such ﬁnancial institutions. The agencies

deﬁne “internationally active banks” in the advi-

sory. (Refer to SR-16-2 and its attachment.)

13. The Securities and Exchange Commission (SEC) has

also released guidance relating to the independence of audi-

tors for public institutions. According to SEC Rule 101, the

independence of an auditor would be impaired if there are

ﬁnancial, employment, or business relationships between

auditors and audit clients, or if there are relationships between

auditors and audit clients in which the auditors provide certain

nonaudit services to their audit clients. Much of the language

found in the SEC’s independence rules is incorporated in the

Interagency Policy Statement on the Internal Audit Function

and Its Outsourcing. (See section 2060.05.)

14. The Board of Governors of the Federal Reserve Sys-

tem, the Federal Deposit Insurance Corporation, and the

Ofﬁce of the Comptroller of the Currency.

15. See

www.bis.org/publ/bcbs280.pdf.

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Page 11

2060.1.8.1 Appendix A—Interagency

Advisory on External Audits of

Internationally Active U.S. Financial

Institutions

Scope

The BCBS external audit guidance is intended

for “internationally active banks” and is rel-

evant for the management, audit committees,

external auditors, and prudential supervisors of

such ﬁnancial institutions. For purposes of this

advisory, the agencies are deﬁning “internation-

ally active banks” as:

• Insured depository institutions that meet

either of the following two criteria: (1) con-

solidated total assets of $250 billion or more;

or (2) consolidated total on-balance sheet for-

eign exposure of $10 billion or more (referred

to as “core banks”); and

• U.S. depository institution holding companies

that meet any of the following three criteria:

(1) consolidated total assets (excluding assets

held by an insurance underwriting subsidiary)

of $250 billion or more; (2) consolidated total

on-balance sheet foreign exposure of $10 bil-

lion or more; or (3) have a subsidiary deposi-

tory institution that is a core bank.

In the United States, core banks are subject to

12 CFR 363, the Federal Deposit Insurance

Corporation’s (FDIC) regulation on Annual

Independent Audits and Reporting Require-

ments.

Core banks typically comply with 12

CFR 363 requirements at a holding company

level. In addition, these holding companies gen-

erally are public companies that are required to

ﬁle annual, quarterly, and other periodic reports

with the U.S. Securities and Exchange Commis-

sion (SEC). The Public Company Accounting

Oversight Board (PCAOB) regulates the exter-

nal auditors of these public companies.

Background

In March 2014, the Committee published the

BCBS external audit guidance to improve the

external audit quality of banks and enhance the

effectiveness of prudential supervision, which

contributes to ﬁnancial stability. The BCBS

external audit guidance elaborates on Core Prin-

ciple 27, Financial Reporting and External

Audit, of the Committee’s Core Principles for

Effective Banking Supervision

by providing

guidance related to bank audit committees’

responsibilities in overseeing the external audit

function. This guidance also discusses pruden-

tial supervisors’ relationships with external

auditors of banks and audit oversight bodies.

Additionally, the BCBS external audit guidance

includes information relevant to external audits

of ﬁnancial statements that the Committee

believes will enhance the quality of these exter-

nal audits.

The BCBS external audit guidance has two

parts:

• Part 1 provides guidance (principles) on the

roles and responsibilities of audit committees

relevant to external audits and the engage-

ment of bank supervisors with external audi-

tors and external auditors’ regulators.

• Part 2 of the document (expectations) empha-

sizes the proper application of existing inter-

nationally accepted auditing standards. The

BCBS external audit guidance also provides

recommendations for procedures that external

auditors could perform in the execution of

bank audits to enhance audit quality.

Supervisory Expectations Regarding the

Differences Between U.S. Standards and

Practices and the BCBS External Audit

Guidance

The BCBS external audit guidance builds upon

internationally accepted auditing standards and

sets expectations for institutions and their exter-

nal auditors. In the United States, ﬁnancial insti-

tutions within the scope of this advisory are

directly or indirectly subject to the audit require-

ments of 12 CFR 363

and supervisory guid-

16. 12 CFR 363 applies to any insured depository institu-

tion with respect to any ﬁscal year in which its consolidated

total assets as of the beginning of such ﬁscal year are $500

million or more.

17. The Committee’s Core Principles are available at

www.bis.org/publ/bcbs230.pdf. In particular, Core Principle

27 states, “The supervisor determines that banks and banking

groups maintain adequate and reliable records, prepare ﬁnan-

cial statements in accordance with accounting policies and

practices that are widely accepted internationally and annu-

ally publish information that fairly reﬂects their ﬁnancial

condition and performance and bears an independent external

auditor’s opinion. The supervisor also determines that banks

and parent companies of banking groups have adequate gover-

nance and oversight of the external audit function.”

18. The BCBS external audit guidance acknowledges that

the Committee does not have the authority to set professional

standards for external auditors.

19. 12 CFR 363.3(f) requires external auditors to comply

Audit 2060.1

BHC Supervision Manual January 2016

Page 12

ance related to audits of ﬁnancial institutions.

In order for a core bank to comply with the

audited ﬁnancial statements requirement of 12

CFR 363 at a public holding company level, the

audit must be performed in accordance with

PCAOB standards. The 12 CFR 363 audit

requirements, supervisory guidance, and

PCAOB standards, collectively, are generally

consistent with the BCBS external audit guid-

ance, except for the differences noted below.

This advisory discusses the agencies’ supervi-

sory expectations regarding these differences

with reference to the corresponding principles

from part 1 and expectations from part 2 of the

BCBS external audit guidance.

Part 1, Principle 2: The audit committee should

monitor and assess the independence of the

external auditor.

Paragraph 49 of the BCBS external audit guid-

ance indicates that an institution’s audit commit-

tee should have a policy in place that stipulates

the criteria for “tendering,” i.e., putting its exter-

nal audit contract out for bid. This paragraph

further states that the policy also should call for

the audit committee to periodically consider

whether to put the external audit contract out for

bid. Consistent with 12 CFR 363, the banking

agencies encourage audit committees to estab-

lish policies and procedures addressing the

retention and remuneration of the external audi-

tor (independent public accountant).

In addi-

tion, the external auditors of insured depository

institutions subject to 12 CFR 363 must comply

with the SEC’s rules regarding audit partner

rotation. Audit committees are encouraged to

consider whether their policies should explicitly

address the criteria for tendering the audit con-

tract and whether the contract should periodi-

cally be put out for bid.

Part 1, Principle 6: The supervisor and the

external auditor should have an effective rela-

tionship that includes appropriate communica-

tion channels for the exchange of information

relevant to carrying out their respective statu-

tory responsibilities.

and

Part 1, Principle 7: The supervisor should

require the external auditor to report to it

directly on matters arising from an audit that

are likely to be of material signiﬁcance to the

functions of the supervisor.

Paragraphs 95 and 96 of the BCBS external

audit guidance indicate that the auditor may

share information about the external audit of an

institution that may be of interest to the deposi-

tory institution’s supervisor (e.g., signiﬁcant

risks of material misstatements, signiﬁcant or

unusual transactions, evidence of management

bias, signiﬁcant deﬁciencies or material weak-

nesses in internal control over ﬁnancial report-

ing, and actual or suspected breaches of regula-

tions or laws

), either (1) directly with the

supervisor when a safe harbor exists or (2)

indirectly through the institution to the supervi-

sor when a legal safe harbor does not exist.

Paragraph 99 of the BCBS external audit guid-

ance provides that the external auditor should

communicate matters arising from the audit that

may be of material signiﬁcance to the supervi-

sor when required by the legal or regulatory

framework or by a formal agreement or proto-

col. According to the BCBS external audit guid-

ance, “[a] matter or group of matters is normally

of material signiﬁcance ... when, due either to

its nature or its potential ﬁnancial impact, it is

likely of itself to require investigation by the

regulator.”

There is no generally applicable legal or regu-

latory requirement in the United States for exter-

nal auditors of banks and holding companies to

report directly to the institution’s primary fed-

eral (and, if applicable, state) supervisor matters

arising from the audit that may be of material

signiﬁcance, nor is there a legal safe harbor to

do so. Insured depository institutions subject to

12 CFR 363 are required to ﬁle with appropriate

federal and state supervisors copies of reports

and other written communications issued by the

external auditor to the institution in connection

with the external audit services provided to the

institution. Consistent with interagency policy

with the independence standards and interpretations of the

American Institute of Certiﬁed Public Accountants, the SEC,

and the PCAOB.

20. For example, Interagency Policy Statement on Coordi-

nation and Communication Between External Auditors and

Examiners (July 23, 1992).

21. 12 CFR 363.5(a) states, “The duties of the audit com-

mittee shall include the appointment, compensation, and over-

sight of the independent public accountant who performs

services required under this part, and reviewing with manage-

ment and the independent public accountant the basis for the

reports issued under this part.”

22. See also paragraphs 90-94 of the BCBS external audit

guidance.

23. See footnote 9 in the BCBS external audit guidance.

Audit 2060.1

BHC Supervision Manual January 2016

Page 13

statements

and practices, the agencies con-

tinue to encourage open and candid communica-

tion between an institution’s external auditor

and the institution’s supervisors.

Part 2, Expectation 5: The external auditor of a

bank should identify and assess the risks of

material misstatement in the bank’s ﬁnancial

statements, taking into consideration the com-

plexities of the bank’s activities and the effec-

tiveness of its internal control environment.

and

Part 2, Expectation 6: The external auditor of a

bank should respond appropriately to the sig-

niﬁcant risks of material misstatement in the

bank’s ﬁnancial statements.

Paragraphs 157 and 168 of the BCBS external

audit guidance set forth the Committee’s expec-

tations for external auditors to (1) consider regu-

latory ratios in the determination of materiality

for the audit, and (2) evaluate any identiﬁed

audit differences, errors, and adjustments and

their effect on regulatory capital or regulatory

capital ratios. PCAOB standards

and SEC

Staff Accounting Bulletin Topic 1.M, Material-

ity, indicate external auditors should consider

qualitative factors (which include regulatory

capital, ratios, and disclosures) in determining

materiality and when evaluating the effect of

audit differences, errors, and adjustments.

Therefore, the agencies expect institutions’ audit

committees will ensure that their external audi-

tors consider regulatory capital ratios in plan-

ning and performing the audit. In this regard,

audit committees are encouraged to inquire as to

how the external auditors factored these ratios

into their materiality assessments.

Additionally, paragraph 166 of the BCBS

external audit guidance recommends that the

external auditor provide written feedback about

the audit engagement team’s relations with the

institution’s internal audit function, including its

observations on the adequacy of the work of

internal audit, to those charged with governance

of the bank. PCAOB Auditing Standard No. 16,

Communications with Audit Committees,

requires the external auditor, as part of commu-

nicating the overall audit strategy, to explain the

extent to which the auditor plans to use the work

of internal audit in an audit of the ﬁnancial

statements or an audit of internal control over

ﬁnancial reporting. However, PCAOB standards

do not require the external auditor to provide

written feedback about the audit engagement

team’s relations with the institution’s internal

audit function, including its observations on the

adequacy of the work of internal audit. The

agencies encourage audit committees to con-

sider requesting their external auditor to provide

written feedback about the audit engagement

team’s relations with internal audit, including its

observations on the adequacy of the work of

internal audit, as it relates to the audit of the

ﬁnancial statements or the audit of internal con-

trol over ﬁnancial reporting.

Furthermore, consistent with the March 2003

Interagency Policy Statement on the Internal

Audit Function and Its Outsourcing, an institu-

tion’s audit committee should consider whether

the institution’s internal audit activities are con-

ducted in accordance with professional stan-

dards, such as the Institute of Internal Auditors’

(IIA) International Professional Practices

Framework (previously known as the Standards

for the Professional Practice of Internal Audit-

ing). Audit committees may look to the IIA’s

Framework for guidance for both internal and

external assessments of the internal audit func-

tion.

Examiner Responsibilities

Examiners should evaluate any actions taken by

institutions within the scope of this advisory and

their audit committees to ensure such actions

are consistent with the objectives of this advi-

sory and the BCBS external audit guidance.

Where there are differences between the BCBS

external audit guidance and U.S. standards,

examiners should encourage institutions’ audit

committees to follow the practices identiﬁed in

this advisory.

Conclusion

External auditors play an important role in con-

tributing to ﬁnancial stability when they deliver

quality audits, which foster market conﬁdence

in institutions’ ﬁnancial statements. Quality

audits are also a valuable complement to the

supervisory process. The agencies support the

principles and expectations set forth in the

BCBS external audit guidance because

24. See footnote 6 of this advisory.

25. See PCAOB Auditing Standard No. 11, Consideration

of Materiality in Planning and Performing an Audit, para-

graph 6, and PCAOB Auditing Standard No. 14, Evaluating

Audit Results, appendix B, paragraph B2.

Audit 2060.1

BHC Supervision Manual January 2016

Page 14

enhanced audit quality is an important factor in

ensuring the safety and soundness of U.S. insti-

tutions. Institutions and their external auditors

are expected to comply with existing laws, regu-

lations, and professional standards, as applica-

ble, including those referenced in this advisory.

Audit 2060.1

BHC Supervision Manual January 2016

Page 15

Management Information Systems

(Budget) Section 2060.2

An assessment of management’s strategic plans

and its success in meeting previously estab-

lished budgetary goals is one of the factors

considered in evaluating a BHC’s management,

operations, ﬁnancial condition, and prospects.

Through review of the budget ﬁgures, insight

can be gained concerning an organization’s

future plans and other matters such as capital

adequacy, liquidity, sources and applications of

funds, level and quality of earnings, and perfor-

mance of management.

The budget is a coordinated ﬁnancial plan

used to estimate and control all or a few of the

activities of the various divisions or subsidiaries

in a bank holding company. Based on an assess-

ment of future economic developments and con-

ditions, management formulates a plan of action

and indicates anticipated changes in the balance-

sheet accounts and proﬁtability (predicated on

implementation of the plan). The budget is a

signiﬁcant management tool in that it projects

expected results and also serves as an important

check on management decisions and perfor-

mance by providing a basis for comparison and

corrective action on a timely basis. The com-

parison of actual performance to budget allows

management to give careful attention to various

possible courses of action and to choose the

course which should result in the greatest bene-

ﬁt. Budgeting is also useful in measuring the

performance of individuals and the departments

they manage. Further, the comparison of budget

totals to actual changes in activities such as

loans, investments, and deposits assists in deci-

sion making and can promote coordination and

cooperation among afﬁliates. The variance indi-

cated by the comparison process may be con-

strued as a measure of management’s perfor-

mance and planning record and its relationship

to the organization’s goals and objectives. It

should be noted that some signiﬁcant variances

may be caused by factors beyond management’s

control or factors that could not reasonably be

anticipated.

While various individuals may be responsible

for input to the budget process, the chief execu-

tive ofﬁcer typically has the ultimate responsi-

bility for preparation and implementation of the

formal budget. The time period covered by a

budget typically encompasses one year,

although it often covers longer periods in the

larger, more sophisticated bank holding compa-

nies. The longer the budget period, the greater

are the prospects for increased variances from

original budget ﬁgures. In some cases in which

four- or ﬁve-year projections are made, bank

holding companies may formulate several fore-

casts based on different sets of assumptions. In

such instances, the examiner should work with

the ‘‘most likely’’ situation that may evolve

based on economic trends, history, and

experience of the organization, but should also

give serious consideration to the ‘‘worst-case’’

projections.

Many bank holding companies, particularly

the smaller organizations, may not have formal

written budgets or plans. In small shell compa-

nies, while it is not essential to have a formal

budget, budgeting procedures should be encour-

aged where appropriate. Budgeting at the parent

level could be appropriately limited to debt-

servicing and dividend considerations.

2060.2.1 INSPECTION OBJECTIVES

1. To determine the extent of an organiza-

tion’s ﬁnancial planning and budget program.

2. To indicate to management of organiza-

tions that are without formal planning proce-

dures the advantages of adopting a budget.

3. To understand the institution’s decision-

making process as it relates to the budget.

4. To determine the causes of signiﬁcant

variances between the budget and actual

performance.

5. To assess the reasonableness of projected

ﬁgures, including controls over the data

throughout the budgeting process.

6. To assess the impact of the budget on the

present condition and future prospects of the

bank holding company.

7. To determine whether the plan outlined in

the budget is supported by the ﬁnan-

cial and managerial resources of the holding

company.

1. The stragetic planning process focuses on intermediate

and long-term strategic goals and is the vehicle used to

determine the overall direction and focus of the organization.

The budgeting process refers to the tactical decisions required

to meet goals and objectives. The budget is a subset of the

strategic plan. While smaller bank holding company organiza-

tions may not always have formal written budgets, all organi-

zations should have a strategic planning process, which deter-

mines overall corporate direction, general resource allocation,

and balance-sheet relationships with respect to capital needs,

growth, asset mix, and risk.

BHC Supervision Manual December 1997

Page 1

2060.2.2 INSPECTION PROCEDURES

1. Familiarity with a bank holding com-

pany’s ﬁnancial condition and results of opera-

tions should begin before the start of the inspec-

tion with a review of the annual report to

shareholders, ﬁnancial reports submitted to the

Federal Reserve System, and other ﬁnancial

documentation contained in the ﬁles. The more

signiﬁcant accounts, statistical data, and perti-

nent ratios should be compared on a period-to-

period basis to highlight signiﬁcant changes and

discern trends.

2. The examiner also should become familiar

with current and projected economic conditions,

both nationally and locally, including general

industry conditions.

3. Based on a review of the aforementioned

data, the examiner should be in a position to

substantiate the reasonableness of budgeted ﬁg-

ures without a systematic examination of all of

the transactions affecting the ﬁgures presented.

Further, such an analysis provides a better

understanding of the operation and highlights

matters of interest and potential problem areas

to be investigated during the inspection.

4. Throughout the review process, the exam-

iner must maintain a sense of perspective to

avoid spending excessive time on relatively

immaterial amounts.

5. The examiner should meet with the ofﬁcer

responsible for the preparation of the budget to

determine the scope of the organization’s ﬁnan-

cial plans. The extent of senior management’s

and the board of directors’ involvement in the

strategic planning and budgeting process should

also be ascertained in this preliminary meeting.

6. Workpapers which document or illustrate

the rationale for the budget data should be

reviewed and discussed with budget personnel,

including the existence and extent of internal

controls over the data.

7. The examiner should evaluate plans, pro-

jections, and forecasts in light of market-area

characteristics and the present condition and

history of the organization.

8. The examiner should determine whether

the accounting principles of major importance

have been applied consistently and, if not, the

impact of the alternative accounting treatment

on the budget totals.

9. The sources of input for the budget should

be reviewed and the frequency and procedures

for effecting revision should be ascertained.

10. When there are signiﬁcant budget vari-

ances, the examiner should seek documented

explanations. Review any such documentation

to determine if management policy or factors

beyond management control were responsible

for the variances.

11. A ﬁnal summary discussion should be

held with management to discuss goals which

the examiner believes may be unattainable and

to communicate conclusions concerning the

budget. Due consideration should be given to

management’s views, whether or not in concur-

rence with the examiner’s conclusions. If man-

agement indicates future changes which could

have a signiﬁcant impact on the organization,

the matter should be noted in the inspection

report. Further, management’s assessment of the

effect of contemplated action on the operations

and ﬁnancial condition of the bank holding com-

pany should be noted.

12. For those bank holding companies that

do not have formal written plans, the examiner

should obtain from senior management informa-

tion on their plans for matters such as growth

and expansion, capital injections, debt retire-

ment, and changes in sources of funding. Except

for small, shell companies, the examiner should

recommend adoption of a budget program and

emphasize the need for strategic planning by

indicating how management methods may be

improved as a result of a logically conceived

and properly operated budget. Budgets and plan-

ning are especially important in cases in which a

bank holding company is losing its share of the

market or in which inefﬁciencies are depressing

proﬁtability.

Management Information Systems (Budget) 2060.2

BHC Supervision Manual December 1997

Page 2

Management Information Systems

(Records and Statements) Section 2060.3

Adequate and accurate records and ﬁnancial

statements are an integral part of a sound bank

holding company operation. Records should be

maintained to allow preparation of ﬁnancial

statements in accordance with generally

accepted accounting principles and to ensure

proper accountability for all assets, liabilities,

income, and expenses. Generally, an indepen-

dently certiﬁed statement inspires greater conﬁ-

dence than a statement prepared internally.

Moreover, an unqualiﬁed, independently certi-

ﬁed statement may act as a check on manage-

ment recordkeeping policies and procedures,

and provide more assurance that transactions are

being properly recorded and that books accu-

rately reﬂect overall ﬁnancial condition.

Management may exercise reasonable discre-

tion in selecting and adopting the type of books

and records it uses and in formulating account-

ing systems and bookkeeping procedures. From

the examiner’s viewpoint, the test of a bank

holding company’s records is one of adequacy,

consistency, and accuracy. The ﬁnancial state-

ments of every bank holding company must

accurately reﬂect ﬁnancial condition and operat-

ing results. This principle is applicable whether

a bank holding company is small and has a

relatively simple bookkeeping system or

whether it is a larger institution with a fully

automated system. A recordkeeping system that

is capable of generating a wide variety of perti-

nent internal data and other information facili-

tates problem solving and decision making and,

thus, contributes to the efﬁciency of a bank

holding company’s operations. Further, such a

system serves as a convenient tool to provide

directors, stockholders, and other interested par-

ties with information on conditions in a bank

holding company.

2060.3.1 INSPECTION OBJECTIVES

1. To determine whether ﬁnancial statements

are prepared in accordance with generally

accepted accounting principles and are sufﬁ-

ciently detailed to accurately portray the com-

pany’s ﬁnancial condition.

2. To determine that sufﬁcient records are

maintained to provide detail on material

balance-sheet items, income-statement items,

and various contingent liabilities and off-

balance-sheet risks that permit the preparation

of appropriate ﬁnancial information.

3. To recommend corrective action when

policies and procedures employed have resulted

in inadequate or inaccurate records and ﬁnancial

statements.

2060.3.2 INSPECTION PROCEDURES

1. The examiner should review the sections

relating to audit and records in the prior inspec-

tion report and the latest examination reports of

the subsidiary banks to note any comments or

deﬁciencies cited concerning records, including

any MIS deﬁciencies. In addition to providing

an input into the overall assessment of the qual-

ity of records, the review may provide a basis

for determining areas of emphasis and follow-up

during the inspection.

2. The examiner should discuss recommen-

dations and criticisms contained in such reports

with an appropriate ofﬁcer to ascertain what

changes, if any, have taken place.

3. The examiner should review the external

auditing ﬁrm’s management letter, giving par-

ticular attention to comments concerning rec-

ordkeeping. Determine if any corrective actions

were recommended by the external auditors and

the extent to which the cited items have been

corrected.

4. In those situations when it appears that

records are deﬁcient or ﬁnancial statements are

inaccurate, a thorough investigation of applica-

ble transactions may be required. The purpose

of the investigation is to obtain information

needed in outlining improved controls over

MIS, accounting methods, and records so that

the ﬁnancial data presented are in accordance

with generally accepted accounting principles.

Thus, information is provided which will better

serve bank holding company management. The

investigation should not necessarily involve a

review of every transaction, but should involve

a check of a sufﬁcient number of transactions to

ensure the examiner that the records, as

checked, reﬂect an accurate ﬁnancial condition.

The extent of the review will depend largely on

the procedures and controls over MIS and the

condition and adequacy of the books and under-

lying records. During the investigative process,

the examiner should be careful to distinguish

between documented facts and statements of

intent or interpretations set forth by company

representatives.

BHC Supervision Manual December 1997

Page 1

Management of Information Systems

(Structure and Reporting) Section 2060.4

The directorate and management of bank hold-

ing companies have a responsibility to contrib-

ute to the health and growth of the organization

they serve. To carry out this responsibility effec-

tively, they must be kept fully informed of con-

ditions throughout the organization and trends

within the banking industry. Reporting is the

process of developing and communicating infor-

mation internally to directors and management

and externally to shareholders and regulatory

authorities. Management and the board of direc-

tors must recognize that as a company develops

and grows, its environment, strategic goals, and

information needs change. The guidelines and

requirements for reports ﬂowing to management

and the board of directors should be established

and allow for change, recognizing the fact that

informational needs can vary, including those at

different levels of the organization.

Informational needs will also be dictated by

the particular type of management structure in

place—centralized, decentralized, legal entity,

or business line. The ultimate decision-making

responsibility rests with the corporation’s board

of directors, and the responsibility for imple-

menting their decisions rests with designated

board committees, executive management, or

other designated management committees or

individuals. As such, examiners should make an

assessment of the qualiﬁcations of the persons

on the board of directors, executive manage-

ment staff, and the board and executive manage-

ment committees to ensure that they have the

necessary knowledge, experience, and expertise

to understand the information presented and to

act on it constructively. The assessment should

include a review of reporting lines to identify

information ﬂows and the various decision-

making levels involved or needed.

All reports ﬂowing to executive management,

board committees, and the board of directors

should be analyzed for clarity, consistency,

timeliness, quality, and coverage of crucial areas

of the organization. A review of board and

committee minutes should reveal if participants

had any questions or whether there were any

uncertainties as to the meaning of the data

presented.

Each bank holding company prepares various

reports for submission to its management and

directors; an effective internal reporting system

facilitates their ability to analyze a situation and

to make informed decisions. Although such

reports may vary in content from company to

company, emphasis is generally placed on the

ﬁnancial data generated. The important consid-

eration is whether each company is providing

sufﬁcient data to keep the interested parties

informed of the ﬁnancial condition and perfor-

mance of all the divisions or entities. The fre-

quency of the reporting and the detail of infor-

mation provided can be categorized as being on

a need-to-know basis. The form of reports

ranges from consultations and meetings to sub-

mission of printed material for study and review.

The scope and size of the operations will have

an effect on the frequency and detail of the

information submitted. In the larger, more

sophisticated companies, frequent meetings and

consultations are held to discuss the perfor-

mance of various entities, the impact of perfor-

mance on the organization’s goals and objec-

tives, and policies and strategies to be followed.

Written reports outlining important matters and

summarizing various ﬁnancial data are typically

reviewed and discussed regularly.

The number and variety of reports depends

on the size and sophistication of the bank hold-

ing company operation. For smaller bank hold-

ing companies, the extent of their reports may

be limited to annual statements, as more fre-

quent periodic reports may not be necessary

under normal conditions. The larger holding

companies normally prepare monthly compara-

tive balance sheets and income statements cov-

ering similar periods for two consecutive years.

Thus, any signiﬁcant deviation from the prior

year’s data can be readily detected. Generally,

reports detailing the extent of delinquent and

nonaccrual loans are prepared monthly. Facts

and ﬁgures pertaining to the adequacy of the

loan-loss provision are presented periodically.

Additional reports containing information on

budgets, cash ﬂow, liquidity, and capital

adequacy are prepared to assist management in

assessing the organization’s overall ﬁnancial

condition and performance. Summaries of inter-

nal audit reports and reports of examinations of

subsidiary banks are brought to management’s

attention. Data relative to other bank holding

companies or banks in the same peer groups are

assembled, when available, so that comparisons

with similarly sized organizations are possible.

All of the aforementioned information may be

prepared for directors, although not necessarily

in as much detail as that submitted to manage-

ment. On occasion, key management personnel

of the holding company attend directors’ meet-

ings to expand on the topics being discussed.

BHC Supervision Manual December 1997

Page 1

Reports to shareholders usually consist of

quarterly and annual reports which detail the

company’s ﬁnancial condition and results of

operations. Additional information may include

the chief executive ofﬁcer’s overall assessment

of the company, future plans, and other ﬁnancial

and analytical data. The ﬁnancial information is

used for public disclosure and enables investors,

depositors, and creditors to make informed judg-

ments concerning the ﬁnancial condition of the

bank holding company. Bank holding compa-

nies whose securities have been registered pur-

suant to the Securities and Exchange Act of

1934 are required to prepare various reports

containing speciﬁc ﬁnancial information.

2060.4.1 INSPECTION OBJECTIVES

1. To review the organizational structure to

determine the various levels of decision-

making and reporting lines, including board

and executive management committees.

2. To determine whether the bank holding com-

pany has written policies and procedures,

and internal controls covering the types of

reports required to be submitted to manage-

ment and the directors.

3. To determine that the required reports are

adequate to accurately reﬂect the ﬁnancial

condition and performance within the organi-

zation’s divisions and units and whether the

reporting systems and reports are adequate to

monitor the risks therein.

4. To evaluate whether the reports and report-

ing systems are adequate to measure and

reﬂect the company’s ﬁnancial position and

performance in all areas, to measure the com-

pany’s progress in meeting its ﬁnancial and

business goals, and to monitor inherent risks.

5. To determine that the contents of the reports

are complete and submitted on a timely basis.

6. To recommend corrective action when

reporting practices, policies, or procedures

are deﬁcient.

7. To evaluate management’s procedures for

reacting to elevated risk, weaknesses, or deﬁ-

ciencies disclosed by reporting systems, and

to evaluate the system’s ability to adapt to

change caused by regulatory and accounting

issues or other market conditions.

2060.4.2 INSPECTION PROCEDURES

1. Review the organizational structure to deter-

mine reporting lines and the various levels of

decision making, risk assessment, and

controls.

2. Ascertain whether any corporate policies

address risk managment or internal reporting

requirements and determine:

a. the types of reports required to be

submitted and

b. the adequacy of such reporting require-

ments in light of a company’s particular

circumstances.

Comment: In a holding company with a

decentralized system of control over subsid-

iaries, the existence of written policies and

procedures is important since each subsidi-

ary operates as a relatively autonomous unit.

3. Obtain a listing of internal reports that are

submitted to corporate executive manage-

ment and the board of directors (including

packages for the board of directors and

executive committees).

4. Randomly sample, based on a material risk

focus, the individual as well as the various

types of management reports and determine

whether they are adequately prepared in

accordance with established policies and pro-

cedures and submitted to the appropriate

individuals on a timely basis. Determine

whether the management reports are sufﬁ-

cient to measure the company’s progress in

achieving its ﬁnancial and business goals and

forecasts.

5. Identify and document management proce-

dures for reacting to elevated risk, weak-

nesses, or deﬁciencies disclosed by MIS.

Also evaluate the ability of the information

system to handle regulatory and accounting

issues and to adapt to change.

6. At the conclusion of the review process, the

examiner should discuss with management,

as appropriate, topics such as—

a. the lack of established policies and proce-

dures and internal controls,

b. inadequate reporting requirements, and

c. noncompliance with reporting require-

ments and/or the untimely submission of

reports.

Management of Information Systems (Structure and Reporting) 2060.4

BHC Supervision Manual December 1997

Page 2

2060.4.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Registration, reports, and

examinations or inspections

225.5

Reporting requirements

emanating from the

Securities Exchange Act of

1934

15 USC 78a

et seq.

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Management of Information Systems (Structure and Reporting) 2060.4

BHC Supervision Manual December 1997

Page 3

Management Information Systems

(Insurance) Section 2060.5

2060.5.1 INTRODUCTION

In establishing an insurance program, a bank

holding company should be aware of where it is

exposed to loss, the extent to which insurance is

available to cover potential losses and the cost

of such insurance. These various factors should

be weighed to determine how much risk the

bank holding company will assume directly. In

assessing the extent of risk an organization is

willing to assume, it is important to analyze the

impact of an uninsured loss not only on the

entity where the loss occurs, but also on the

afﬁliates and the parent. Once appropriate cover-

age has been acquired, procedures should be

established for the periodic review of the pro-

gram to assure the continuing adequacy of the

coverage. Particularly for larger BHCs, these

procedures should include at least an annual

review of the program by the board of directors

of the parent organization.

Insurance is a highly specialized ﬁeld and no

attempt is made here to discuss all the various

types and forms of insurance coverage that are

available to ﬁnancial institutions. Examiners are

not expected to be insurance experts; however,

examiners should recognize that a ﬁnancial

organization’s primary defenses against loss

include adequate internal controls and proce-

dures and that insurance is intended to comple-

ment, not replace, an effective system of inter-

nal controls. Thus, an overall appraisal of the

control environment becomes a signiﬁcant con-

sideration in assessing the adequacy of the

insurance program. To the extent controls are

lacking, the need for additional coverage

increases.

2060.5.2 BANKER’S BLANKET BOND

The most important and comprehensive insur-

ance coverage available is the bankers’ blanket

bond which is usually extended to encompass

all the entities in a bank holding company struc-

ture. Generally, the scope of the blanket bond

contract is intended to cover risks of loss due to

criminal acts, such as embezzlement, burglary,

robbery, theft, larceny, forgery, etc., but in addi-

tion it provides indemnity for loss of property

through damage, destruction, misplacement and

mysterious, unexplainable disappearance. The

most important item of protection under the

bond, however, is the blanket ﬁdelity coverage

for ofﬁcers and employees.

2060.5.3 TYPES OF BLANKET BONDS

While there are several similar forms of blanket

bonds in use, those commonly found are the

Financial Institutions Bond Standard Form No.

24, the Bankers Blanket Bond Standard Form

No. 2, and Lloyd’s Banks’ and Trust Compa-

nies’ Policy HAN Form (C). Under these blan-

ket forms, every employee is usually covered

for the total amount of the bond. Typically, new

employees and new ofﬁces are automatically

covered and no notice is required for an increase

in the number of employees or in the number of

ofﬁces established, unless such increases result

from a merger or consolidation with another

institution. The word ‘‘blanket,’’ however, refers

to the over-all amount that applies to the several

speciﬁed risks covered under the bond and is

not intended to mean ‘‘all risks’’ coverage. A

most important feature of the bankers’ blanket

bond is the ‘‘discovery rider.’’ The rider, which

converts the blanket bond from a ‘‘loss sus-

tained basis’’ to a ‘‘discovery basis,’’ provides

indemnity against any loss sustained by the

insured entity at any time but discovered after

the effective date of the bond and prior to the

termination or cancellation of the bond, even

though lower amounts of insurance and more

restrictive coverage may have been carried

when the loss was actually sustained.

2060.5.4 DETERMINING THE

COVERAGE NEEDED

One of the most difﬁcult insurance problems

management faces is the determination of the

amount of blanket bond coverage that should be

maintained. An estimate of the maximum

amount of money and securities that may be lost

through burglary or robbery can be calculated

with reasonable accuracy, but the potential loss

resulting from dishonest acts of ofﬁcers and

employees is not easily measured. The Insur-

ance and Protective Committee of the American

Bankers Association has conducted several stud-

ies of the problems of determining adequate

coverage and has concluded that total deposits

represent the most appropriate item in bank

ﬁnancial statements upon which to base an esti-

mate of a reasonable or suitable amount of

blanket bond coverage.

BHC Supervision Manual December 1992

Page 1

In a bank holding company structure, the

amount of blanket bond coverage is generally

determined by the deposits of the largest bank

and the amount of suggested coverage in the

ABA’s schedule. Such an amount is considered

to be a minimum and other factors such as a

rapidly expanding operation, excessive cash on

hand, or inferior audit and control practices may

suggest the need for larger coverage. Since cov-

erages are generally extended to include the

nonbank subsidiaries and such subsidiaries usu-

ally operate on a smaller scale than their afﬁli-

ated banks, the question concerning the

adequacy of the amount of the blanket bond

coverage for a nonbank subsidiary is more eas-

ily addressed and is typically a function of the

parent’s and the bank’s coverage.

2060.5.5 NOTIFICATION OF LOSS

When submitting a claim, most blanket bonds

have provisions which require a report to be

submitted within a speciﬁed period after a

reportable item comes to the attention of man-

agement. Occasionally, items are not reported to

the bonding company because of uncertainty as

to whether the incident constitutes a reportable

item. Failure to report in a timely manner could

invalidate the claim and jeopardize existing cov-

erages. Thus, it should be emphasized to man-

agement that any questionable items should be

reported.

2060.5.6 DIRECTORS’ AND

OFFICERS’ LIABILITY INSURANCE

Directors’ and Ofﬁcers’ Liability Insurance

(‘‘DOL Insurance’’) insures the Directors and

Ofﬁcers against personal liability resulting from

claims of alleged negligence, wrongful acts,

errors and omissions, etc. This insurance is not

included in the blanket bond or other standard

ﬁdelity coverage.

2060.5.7 INSPECTION OBJECTIVES

1. To determine the scope and extent of

insurance coverages for the various entities in

the organization.

2. To determine the adequacy of insurance

coverage after giving due consideration to the

overall control environment and factors such as

the organization’s claim experience and costs

associated with various coverages.

3. To ascertain that a comprehensive review

of the insurance program is conducted periodi-

cally by management and at least annually by

the board of directors and entered into the min-

utes.

4. To determine the entity(ies) responsible

for paying the premiums and the manner in

which such payments are allocated among the

afﬁliates that receive the coverage beneﬁts.

5. To determine if procedures are in place to

assure that claims are ﬁled promptly.

2060.5.8 INSPECTION PROCEDURES

1. The prior year’s inspection report should

be reviewed for comments relative to controls

and insurance. The examiner should note the

types and extent of coverages, comments con-

cerning the control environment and any deﬁ-

ciencies related to the administration of the

insurance program and the coverages in force.

2. A similar review encompassing the latest

examination reports of all major afﬁliated banks

should be conducted. The review process is

intended to provide a basis for determining areas

of emphasis and follow-up during the inspec-

tion. The examiner need not re-examine the

insurance program or the controls in force in the

individual banks.

3. The examiner should meet with the ofﬁcer

responsible for maintaining the insurance poli-

cies and related documentation and ascertain the

location of such policies and documentation.

Review any independent review of coverages

and any deﬁciencies that may have been cited

by the internal or external auditors.

4. Review the manner and frequency of pre-

sentations to the board of directors of the insur-

ance coverage.

Management Information Systems (Insurance) 2060.5

BHC Supervision Manual December 1992

Page 2

Nonaccrual Loans and Restructured Debt

(Accounting, Reporting, and Disclosure Issues) Section 2065.1

Working with borrowers who are experiencing

ﬁnancial difﬁculties may involve formally

restructuring their loans and taking other mea-

sures to conform the repayment terms to the

borrowers’ ability to repay. Such actions, if

done in a way that is consistent with prudent

lending principles and supervisory practices, can

improve the prospects for collection. Generally

accepted accounting principles (GAAP) and

regulatory reporting requirements provide a

framework for reporting that may alleviate cer-

tain concerns that lenders may have about work-

ing constructively with borrowers who are hav-

ing ﬁnancial difﬁculties.

Interagency policy statements and guidance,

issued on March 1, 1991; March 10, 1993; and

June 10, 1993, clariﬁed supervisory policies

regarding nonaccrual assets, restructured loans,

and collateral valuation (additional clariﬁcation

guidance may be found in SR-95-38 and in the

glossary of the reporting instructions for the

bank call report and the FR-Y-9C, the consoli-

dated bank holding company report). When cer-

tain criteria

are met, (1) interest payments on

nonaccrual assets can be recognized as income

on a cash basis without ﬁrst recovering any

prior partial charge-offs; (2) nonaccrual assets

can be restored to accrual status when subject to

formal restructurings, according to Financial

Accounting Standards Board (FASB) Statement

Nos. 15 and 114, ‘‘Accounting by Debtors and

Creditors for Troubled Debt Restructurings’’

(FAS 15) and ‘‘Accounting by Creditors for

Impairment of a Loan’’ (FAS 114); and

(3) restructurings that specify a market rate of

interest would not have to be included in

restructured loan amounts reported in the years

after the year of the restructuring. These super-

visory policies apply to federally supervised

ﬁnancial institutions. The board of directors and

management of bank holding companies should

therefore incorporate these policies into the

supervision of their federally supervised ﬁnan-

cial institution subsidiaries.

2065.1.1 CASH-BASIS INCOME

RECOGNITION ON NONACCRUAL

ASSETS

Current regulatory reporting requirements do

not preclude the cash-basis recognition of

income on nonaccrual assets (including loans

that have been partially charged off), if the

remaining book balance of the loan is deemed

fully collectible. Interest income recognized on

a cash basis should be limited to that which

would have been accrued on the recorded bal-

ance at the contractual rate. Any cash interest

received over this limit should be recorded as

recoveries of prior charge-offs until these

charge-offs have been fully recovered.

2065.1.2 NONACCRUAL ASSETS

SUBJECT TO FAS 15 AND FAS 114

RESTRUCTURINGS

A loan or other debt instrument that has been

formally restructured to ensure repayment and

performance need not be maintained in non-

accrual status. When the asset is returned to

accrual status, payment performance that had

been sustained for a reasonable time before the

restructuring may be considered. For example, a

loan may have been restructured, in part, to

reduce the amount of the borrower’s contractual

payments. It may be that the amount and fre-

quency of payments under the restructured

terms do not exceed those of the payments that

the borrower had made over a sustained period,

within a reasonable time before the restruc-

turing. In this situation, if the lender is reason-

ably assured of repayment and performance

according to the modiﬁed terms, the loan can be

immediately restored to accrual status.

Clearly, a period of sustained performance,

whether before or after the date of the restructur-

ing, is very important in determining whether

there is reasonable assurance of repayment

and performance. In certain circumstances, other

information may be sufﬁcient to demonstrate an

improvement in the borrower’s condition or in

economic conditions that may affect the bor-

rower’s ability to repay. Such information may

reduce the need to rely on the borrower’s perfor-

mance to date in assessing repayment prospects.

For example, if the borrower has obtained sub-

stantial and reliable sales, lease, or rental con-

tracts or if other important developments are

expected to signiﬁcantly increase the borrow-

er’s cash ﬂow and debt-service capacity and

strength, then the borrower’s commitment to

repay may be sufﬁcient. A preponderance of

such evidence may be sufﬁcient to warrant

1. A discussion of the criteria is found within the corre-

sponding subsections that follow.

BHC Supervision Manual December 2002

Page 1

returning a restructured loan to accrual status.

The restructured terms must reasonably ensure

performance and full repayment.

It is imperative that the reasons for restoring

restructured debt to accrual status be docu-

mented. A restoration should be supported by

a current, well-documented evaluation of the

borrower’s ﬁnancial condition and prospects

for repayment. This documentation will be

reviewed by examiners.

The formal restructuring of a loan or other

debt instrument should be undertaken in ways

that will improve the likelihood that the credit

will be repaid in full in accordance with reason-

ably restructured repayment terms.

Regulatory

reporting requirements and GAAP do not

require a banking organization that restructures

a loan to grant excessive concessions, forgive

principal, or take other steps not commensurate

with the borrower’s ability to repay in order to

use the reporting treatment speciﬁed in FAS 15.

Furthermore, the restructured terms may include

prudent contingent payment provisions that per-

mit an institution to obtain appropriate recovery

of concessions granted in the restructuring, if

the borrower’s condition substantially improves.

2065.1.3 RESTRUCTURINGS

RESULTING IN A MARKET

INTEREST RATE

A FAS 114 restructuring that speciﬁes an effec-

tive interest rate that is equal to or greater than

the rate the lending banking organization is will-

ing to accept at the time of the restructuring, for

a new loan with comparable risk (assuming the

loan is not impaired by the restructuring agree-

ment), does not have to be reported as

a troubled-debt restructuring after the year of

restructuring.

2065.l.4 NONACCRUAL TREATMENT

OF MULTIPLE LOANS TO ONE

BORROWER

As a general principle, whether to place an asset

in nonaccrual status should be determined by an

assessment of the individual asset’s collect-

ibility. One loan to a borrower being placed

in nonaccrual status does not automatically have

to result in all other extensions of credit to that

borrower being placed in nonaccrual status.

When a single borrower has multiple extensions

of credit outstanding and one meets the criteria

for nonaccrual status, the lender should evalu-

ate the others to determine whether one or more

of them should also be placed in nonaccrual

status.

2065.1.4.1 Troubled-Debt

Restructuring—Returning a Multiple-Note

Structure to Accrual Status

On June 10, 1993, interagency guidance was

issued to clarify a March 10, 1993, interagency

policy statement on credit availability. The guid-

ance addresses a troubled-debt restructuring

(TDR) that involves multiple notes (some-

times referred to as A/B note structures). An

example of a multiple-note structure is when

the ﬁrst, or A, note would represent the portion

of the original-loan principal amount that would

be expected to be fully collected along with

contractual interest. The second part of the

restructured loan, or B note, represents the por-

tion of the original loan that has been charged

off.

Such TDRs generally may take any of three

forms: (1) In certain TDRs, the B note may be a

contingent receivable that is payable only if

certain conditions are met (for example, if there

is sufﬁcient cash ﬂow from the property).

(2) For other TDRs, the B note may be

contingency-forgiven (note B is forgiven if note

A is paid in full). (3) In other instances, an

institution would have granted a concession (for

example, a rate reduction) to the troubled bor-

rower but the B note would remain a contractual

obligation of the borrower. Because the B note

is not reﬂected as an asset on the institution’s

books and is unlikely to be collected, the B note

is viewed as a contingent receivable for report-

ing purposes.

Financial institutions may return the A note

to accrual status provided the following condi-

tions are met:

1. The restructuring qualiﬁes as a TDR as

deﬁned by FAS 15, and there is economic

substance to the restructuring. (Under FAS

15, a restructuring of debt is considered a

TDR if ‘‘the creditor for economic or legal

reasons related to the debtor’s ﬁnancial difﬁ-

culties grants a concession to the debtor that

it would not otherwise consider.’’)

2. A restructured loan may not be restored to accrual status

unless there is reasonable assurance of repayment and perfor-

mance under its modiﬁed terms in accordance with a reason-

able repayment schedule.

Nonaccrual Loans and Restructured Debt 2065.1

BHC Supervision Manual December 2002

Page 2

2. 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 evaluation of the bor-

rower’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.

3. The institution is reasonably assured of

repayment of the A note and of performance

in accordance with the modiﬁed terms.

4. In general, the borrower must have demon-

strated sustained repayment performance

(either immediately before or after the

restructuring) in accordance with the modi-

ﬁed terms for a reasonable period before the

date on which the A note is returned to

accrual status. Sustained payment perfor-

mance generally would be for a minimum of

six months and involve payments in the form

of cash or cash equivalents.

The A note would be initially disclosed as a

TDR. However, if the A note yields a market

rate of interest and performs in accordance with

the restructured terms, the note would not have

to be disclosed as a TDR in the year after the

restructuring. To be considered a market rate of

interest, the interest rate on the A note at the

time of the restructuring must be equal to or

greater than the rate that the institution is will-

ing to accept for a new receivable with compa-

rable risk. (See SR-93-30.)

2065.1.4.2 Nonaccrual Loans That Have

Demonstrated Sustained Contractual

Performance

Certain borrowers have resumed paying the full

amount of scheduled contractual interest and

principal payments on loans that are past due

and in nonaccrual status. Although prior arrear-

ages may not have been eliminated by payments

from the borrowers, some borrowers have dem-

onstrated sustained performance over a time in

accordance with contractual terms. The inter-

agency guidance of June 10, 1993, announced

that such loans may henceforth be returned to

accrual status, even though the loans have not

been brought fully current. They may be

returned to accrual status if (1) there is reason-

able assurance of repayment of all principal and

interest amounts contractually due (including

arrearages) within a reasonable period and

(2) the borrower has made payments of cash or

cash equivalents over a sustained period (gener-

ally a minimum of six months) in accordance

with the contractual terms. When the federal

ﬁnancial institution regulatory reporting criteria

for restoration to accrual status are met, previ-

ous charge-offs taken would not have to be fully

recovered before such loans are returned to

accrual status. Loans that meet this criteria

should continue to be disclosed as past due as

appropriate (for example, 90 days past due and

still accruing) until they have been brought fully

current. (See SR-93-30.)

2065.1.5 ACQUISITION OF

NONACCRUAL ASSETS

Banking organizations (or the receiver of a

failed institution) may sell loans or debt securi-

ties maintained in nonaccrual status. Such loans

or debt securities that have been acquired from

an unafﬁliated third party should be reported by

the purchaser in accordance with AICPA Prac-

tice Bulletin No. 6. When the criteria speciﬁed

in this bulletin are met, these assets may be

placed in nonaccrual status.

2065.1.6 TREATMENT OF

NONACCRUAL LOANS WITH

PARTIAL CHARGE-OFFS

Whether partial charge-offs associated with a

nonaccrual loan that has not been formally

restructured must ﬁrst be fully recovered before

the loan can be restored to accrual status is an

issue that has not been explicitly addressed by

GAAP and bank regulatory reporting require-

ments. In accordance with the instructions for

the bank call report and the bank holding com-

pany reports (FR-Y series), restoration to

accrual status is permitted when (1) the loan has

been brought fully current with respect to princi-

pal and interest and (2) it is expected that the

full contractual balance of the loan (including

any amounts charged off) plus interest will be

fully collectible under the terms of the loan.

3. AICPA Practice Bulletin No. 6, ‘‘Amortization of Dis-

counts on Certain Acquired Loans,’’ American Institute of

Certiﬁed Public Accountants, August 1989.

4. The instructions for the call reports and FR-Y reports

discuss the criteria for restoration to accrual status in the

glossary entries for ‘‘nonaccrual status.’’ This guidance also

permits restoration to accrual status for nonaccrual assets that

are both well secured and in the process of collection. In

addition, this guidance permits restoration to accrual status,

when certain criteria are met, of formally restructured debt

and acquired nonaccrual assets.

Nonaccrual Loans and Restructured Debt 2065.1

BHC Supervision Manual December 2002

Page 3

Thus, in determining whether a partially

charged-off loan that has been brought fully

current can be returned to accrual status, it is

important to determine whether the banking

organization expects to receive the full amount

of principal and interest called for by the terms

of the loan.

When a loan has been brought fully current

with respect to contractual principal and inter-

est, and when the borrower’s ﬁnancial condition

and economic conditions that could affect the

borrower’s ability to repay have improved to the

point that repayment of the full amount of con-

tractual principal (including any amounts

charged off) and interest is expected, the loan

may be restored to accrual status even if the

charge-off has not been recovered. However,

this treatment would not be appropriate if the

charge-off reﬂects continuing doubt about the

collectibility of principal or interest. Because

loans or other assets are required to be placed in

nonaccrual status when full repayment of princi-

pal or interest is not expected, such loans could

not be restored to accrual status.

It is imperative that the reasons for the resto-

ration of a partially charged-off loan to accrual

status be supported by a current, well-

documented evaluation of the borrower’s ﬁnan-

cial condition and prospects for full repayment

of contractual principal (including any amounts

charged off) and interest. This documentation

will be subject to review by examiners.

A nonaccrual loan or debt instrument may

have been formally restructured in accordance

with FAS 15 so that it meets the criteria for

restoration to accrual status presented in section

2065.1.2 addressing restructured loans. Under

GAAP, when a charge-off was taken before the

date of the restructuring, it does not have to

be recovered before the restructured loan can

be restored to accrual status. When a charge-off

occurs after the date of the restructuring, the

considerations and treatments discussed earlier

in this section are applicable.

2065.1.7 IN-SUBSTANCE

FORECLOSURES

FAS 114 addresses the accounting for impaired

loans and clariﬁes existing accounting guidance

for in-substance foreclosures. Under the impair-

ment standard and related amendments to FAS

15, a collateral-dependent real estate loan

would be reported as ‘‘other real estate owned’’

(OREO) only if the lender had taken possession

of the collateral. For other collateral-dependent

real estate loans, loss recognition would be

based on the fair value of the collateral if fore-

closure is probable.

Such loans would remain

in the loan category and would not be reported

as OREO. For depository institution examina-

tions, any portion of the loan balance on a

collateral-dependent loan that exceeds the fair

value of the collateral and that can be identiﬁed

as uncollectible would generally be classiﬁed as

a loss and be promptly charged off against the

ALLL.

A collateralized loan that becomes impaired

is not considered ‘‘collateral dependent’’ if

repayment is available from reliable sources

other than the collateral. Any impairment on

such a loan may, at the depository institution’s

option, be determined based on the present value

of the expected future cash ﬂows discounted at

the loan’s effective interest rate or, as a practical

expedient, based on the loan’s observable mar-

ket price. (See SR-95-38.)

Losses must be recognized on real estate

loans that meet the in-substance foreclosure

criteria with the collateral being valued accord-

ing to its fair value. Such loans do not have to

be reported as OREO unless possession of the

underlying collateral has been obtained. (See

SR-93-30.)

2065.1.8 LIQUIDATION VALUES OF

REAL ESTATE LOANS

In accordance with the March 10, 1993, inter-

agency policy statement Credit Availability,

loans secured by real estate should be based on

the borrower’s ability to pay over time, rather

than on a presumption of immediate liquidation.

Interagency guidance issued on June 10, 1993,

emphasizes that it is not regulatory policy to

value collateral that underlies real estate loans

on a liquidation basis. (See SR-93-30.)

5. A collateral-dependent real estate loan is a loan for

which repayment is expected to be provided solely by the

underlying collateral and there are no other available and

reliable sources of repayment.

6. The fair value of the assets transferred is the amount that

the debtor could reasonably expect to receive for them in a

current sale between a willing buyer and a willing seller, other

than in a forced or liquidation sale.

Nonaccrual Loans and Restructured Debt 2065.1

BHC Supervision Manual December 2002

Page 4

Maintaining and Documenting the Allowance for Loan

and Lease Losses Section 2065.2

2065.2.1 PURPOSE OF THE

ALLOWANCE FOR LOAN LEASE

LOSSES

The allowance for loan and lease losses (ALLL)

reﬂects estimated credit losses within a holding

company’s portfolio of loans and leases. Esti-

mated credit losses are estimates of the current

amount of loans that are probable that the hold-

ing company will be unable to collect given the

facts and circumstances since the evaluation

date (generally the date of the holding com-

pany’s balance sheet). That is, estimated credit

losses represent net charge-offs that are likely to

be realized for a loan or group of loans as of the

evaluation date.

In accordance with U.S. Generally Accepted

Accounting Principles (GAAP), a holding com-

pany maintains an ALLL at a level that is appro-

priate to cover estimated credit losses associated

with its loan and lease portfolio, that is, loans

and leases that the holding company has intent

and ability to hold for the foreseeable future or

until maturity or payoff. The ALLL is presented

on an institution’s balance sheet as a contra-

asset account that reduces the amount of the

loan portfolio reported on the balance sheet.

Each holding company should also maintain, as

a separate liability account, an ALLL at a level

that is appropriate to cover estimated credit

losses associated with off-balance sheet credit

instruments such as off-balance sheet loan com-

mitments, standby letters of credit, and guaran-

tees. The

FR-Y9C report instructions provide

more ALLL reporting information for holding

companies.

The ALLL also is a component for calculat-

ing tier 2 capital, as set forth in Regulation Q

(12 CFR 217.20(d)). Tier 2 capital includes

surplus related to the issuance of tier 2 capital

instruments; limited amounts of total capital

minority interest not included in an institution’s

tier 1 capital; and limited amounts of the ALLL,

or adjusted allowances for credit losses (AACL),

as applicable, less applicable regulatory adjust-

ments and deductions.

An institution calculat-

ing its total capital ratio using the standardized

approach may include in tier 2 capital the

amount of ALLL or AACL that does not exceed

1.25 percent of its standardized total risk-

weighted assets.

2065.2.2 DETERMINING AN

ADEQUATE LEVEL FOR THE ALLL

In determining the adequacy of an institution’s

ALLL (including amounts based on an analysis

of the commercial real estate portfolio), examin-

ers will consider an institution’s process for

conducting the analysis and whether manage-

ment consistently applies this process to the

loan and lease portfolio.

The determination of

the adequacy of the ALLL should be based on

management’s consideration of all current sig-

niﬁcant conditions that might affect the ability

of borrowers (or guarantors, if any) to fulﬁll

their obligations to the institution. While histori-

cal loss experience provides a reasonable start-

ing point, historical losses or even recent trends

in losses are not sufﬁcient, without further

analysis, to produce a reliable estimate of antici-

pated loss.

In determining the adequacy of the ALLL,

management should consider factors such as

• changes in the nature and volume of the port-

folio;

• the experience, ability, and depth of relevant

staff;

• changes in credit standards;

• collection policies and historical collection

experience;

• concentrations of credit risk;

• trends in the volume and severity of past-due

and classiﬁed loans; and

• trends in the volume of nonaccrual loans,

speciﬁc problem loans, and commitments.

1. ALLL means valuation allowances that have been estab-

lished through a charge against earnings to cover estimated

credit losses on loans, lease ﬁnancing receivables, or other

extensions of credit as determined in accordance with GAAP.

ALLL excludes “allocated transfer risk reserves.” For pur-

poses of Regulation Q, ALLL includes allowances that have

been established through a charge against earnings to cover

estimated credit losses associated with off-balance-sheet credit

exposures as determined in accordance with GAAP.

2. The estimation process described in this section permits

a more accurate estimate of anticipated losses than could be

achieved by assessing the loan portfolio solely on an aggre-

gate basis. However, it is only an estimation process and does

not imply that any part of the ALLL is segregated for, or

allocated to, any particular asset or group of assets. The

ALLL is available to absorb overall credit losses originating

from the loan and lease portfolio. The balance of the ALLL is

management’s estimation of potential credit losses, synony-

mous with its determination as to the adequacy of the overall

ALLL.

BHC Supervision Manual November 2021

Page 1

In addition, this analysis should consider the

quality of the institution’s systems and manage-

ment in identifying, monitoring, and addressing

asset-quality problems. Further, management

should consider external factors such as local

and national economic conditions and develop-

ments, competition, and legal and regulatory

requirements, as well as reasonably foreseeable

events that are likely to affect the performance

of the loan portfolio.

Management should adequately document the

factors that were considered, the methodology

and process that were used in determining the

adequacy of the ALLL, and the range of pos-

sible credit losses estimated by this process. The

complexity and scope of this analysis must be

appropriate to the size and nature of the institu-

tion and provide for sufﬁcient ﬂexibility to

accommodate changing circumstances.

Management should maintain reasonable

records to support evaluating the adequacy the

ALLL. Further, each institution is responsible

for ensuring that controls are in place to consis-

tently determine the allowance for loan and

lease losses in accordance with GAAP (includ-

ing ASC Subtopic 450-20, Contingencies – Loss

Contingencies, and ASC Topic 310, Receiv-

ables), the institution’s policies and procedures,

management’s best judgment, and relevant

supervisory guidance.

2065.2.3 OVERVIEW OF THE 2006

ALLL POLICY STATEMENT

In 2006, the Federal Reserve and the other bank-

ing agencies issued a policy statement

(2006 policy statement) regarding the ALLL

that discusses

• its nature and purpose;

• the responsibilities of boards of directors, the

institution’s management, and the examiners

of institutions; and

• factors to be considered in the estimation of

the ALLL.

The 2006 policy statement applies to all

depository institutions supervised by the bank-

ing agencies, except for U.S. branches and agen-

cies of foreign banks.

In addition, the Federal

Reserve believes the guidance is broadly appli-

cable to bank holding companies as well as

savings and loan holding companies.

Accord-

ingly, examiners should apply the policy, as

appropriate, during inspections of holding com-

panies and their nonbank subsidiaries, in addi-

tion to the examination of state member banks.

The 2006 policy statement indicates that it is

the responsibility of an institution’s board of

directors and management to maintain the

ALLL at an appropriate level. Each institution is

responsible for developing, maintaining, and

documenting a comprehensive, systematic, and

consistently applied process for determining the

amounts of the ALLL and the provision for loan

and lease losses. To fulﬁll this responsibility, an

institution should have controls to consistently

determine the ALLL in accordance with GAAP,

the institution’s policies and procedures, man-

agement’s best judgment, and relevant supervi-

sory guidance. The 2006 policy statement also

discusses the analysis of the loan and lease

portfolio, factors to consider in estimating credit

losses, and the characteristics of an effective

loan-review system.

The 2006 policy statement reiterates the pol-

icy that Federal Reserve examiners will gener-

ally accept management’s estimates in their

assessment of the appropriateness of the ALLL

when management has (1) maintained effective

loan review systems and controls for identify-

ing, monitoring, and addressing asset-quality

problems in a timely manner; (2) analyzed all

signiﬁcant environmental factors that affect the

collectibility of the portfolio as of the evaluation

date in a reasonable manner; (3) established an

acceptable ALLL-evaluation process for both

individual loans and groups of loans that meets

the objectives for an appropriate ALLL; and

(4) incorporated reasonable and properly sup-

ported assumptions, valuations, and judgments

into the evaluation process.

The 2006 policy statement emphasizes that an

institution should provide reasonable support

3. For the entire text of the 2006 policy statement, see

SR-06-17, “Interagency Policy Statement on the Allowance

for Loan and Lease Losses.”

4. See SR-95-42, “Allowance for Loan and Lease Losses

for U.S. Branches and Agencies of Foreign Banking Organiza-

tions,” and

SR-95-4, “Allowance for Loan and Lease Losses

for U.S. Branches and Agencies of Foreign Banking Organiza-

tions.”

5. See

SR-14-9, “Incorporation of Federal Reserve Policies

into the Savings and Loan Holding Company Supervision

Program.”

6. Attachment 1, “Loan Review Systems,” of the 2006 pol-

icy statement has been superseded. For more guidance on

effective credit risk review systems. See 85 Fed. Reg. 33,278

(June 1, 2020);

SR-20-13, “Interagency Guidance on Credit

Risk Review Systems;” and the Commercial Bank Examina-

tion Manual’s section entitled, “Credit Risk Review Sys-

tems.”

Maintaining and Documenting the Allowance for Loan and Lease Losses 2065.2

BHC Supervision Manual November 2021

Page 2

and documentation of its ALLL estimates,

including adjustments to the allowance for

qualitative or environmental factors and unallo-

cated portions of the allowance. This emphasis

on support and documentation supplements, but

does not replace, the guidance in the 2001 Inter-

agency Policy Statement on the Allowance for

Loan and Lease Losses Methodologies and

Documentation for Banks and Savings Institu-

tions (see

SR-01-17).

Additionally, an institution-speciﬁc loss esti-

mate generally should not be based solely on a

“standard percentage” of loans. While peer

group or other benchmark averages are an

appropriate tool to evaluate the reasonableness

of the allowance, an institution should analyze

the collectibility of the loan portfolio to estimate

the allowance and not assume a set percentage

for loss estimates (that is, 15 percent for loans

classiﬁed as substandard and 50 percent for

loans classiﬁed as doubtful).

The 2006 policy statement also includes

accounting guidance covering the acceptable

methods to measure impairment. Lastly, the

2006 policy statement reminds institutions that

allowances related to off-balance-sheet ﬁnancial

instruments such as loan commitments or letters

of credit should not be reported as part of the

ALLL. Any allowance for these types of instru-

ments is recorded as an “other liability.”

2065.2.4 ALLL METHODOLOGIES

AND DOCUMENTATION

In 2001, the Federal Financial Institutions

Examination Council issued the “Interagency

Policy Statement on Allowance for Loan and

Lease Losses Methodologies and Documenta-

tion for Banks and Savings Institutions”

(2001 policy statement).

The 2001 policy state-

ment clariﬁes the agencies’ expectations for

documentation that supports the ALLL method-

ology. Additionally, this statement emphasizes

the need for an institution to have appropriate

ALLL policies and procedures, including an

effective loan-review system. The guidance also

provides examples of appropriate supporting

documentation. While the 2001 policy state-

ment was intended for insured depository insti-

tutions, the Federal Reserve believes this guid-

ance is broadly applicable to bank holding

companies and to savings and loan holding com-

panies.

Accordingly, examiners should con-

sider this policy statement in their inspection of

holding companies and their nonbank subsidi-

aries.

As discussed in the 2001 policy statement, an

institution needs to establish its ALLL method-

ology in accordance with GAAP. An ALLL

methodology should be systematic, consistently

applied, and auditable. The methodology should

be validated periodically and modiﬁed to incor-

porate new events or ﬁndings, as needed. Under

the direction of the board of directors, an institu-

tion’s management should implement appropri-

ate procedures and controls to promote compli-

ance with the institution’s ALLL policies and

procedures. Institution management should

(1) segment the portfolio to evaluate credit risks;

(2) select loss rates that best reﬂect the probable

loss; and (3) be responsive to changes in the

institution, the economy, or the lending environ-

ment by changing the methodology, when

appropriate.

An institution’s determination of an appropri-

ate allowance involves a high degree of manage-

ment judgment and is inevitably imprecise.

Accordingly, an institution may determine that

the amount of loss falls within a range. In accor-

dance with GAAP, an institution should record

its best estimate within the range of credit

losses.

2065.2.5 ALLL ESTIMATION

PRACTICES FOR LOANS SECURED

BY JUNIOR LIENS

In January 2012, the Federal Reserve and the

other federal banking agencies issued, “Inter-

agency Supervisory Guidance on Allowance for

Loan and Lease Losses Estimation Practices for

Loans and Lines of Credit Secured by Junior

Liens on 1–4 Family Residential Properties.”

(See

SR-12-3.)

An institution should consider all credit qual-

ity indicators relevant to their junior liens. Gen-

erally, this information should include the delin-

quency status of senior liens associated with the

institution’s junior liens and whether the senior

lien has been modiﬁed. Further, institutions

should ensure that during the ALLL estimation

process, sufﬁcient information is gathered to

adequately assess the probable loss incurred

within junior-lien portfolios. As discussed in the

7. For the entire text of the 2001 policy statement, see

SR-01-17, “Final Interagency Policy Statement on Allowance

for Loan and Lease Losses (ALLL) Methodologies and Docu-

mentation for Banks and Savings Institutions.” See also

66 Fed. Reg. 35,629 (July 6, 2001).

8. See SR-14-9.

Maintaining and Documenting the Allowance for Loan and Lease Losses 2065.2

BHC Supervision Manual November 2021

Page 3

guidance, an institution should refer to GAAP

for recognizing ALLL.

The guidance states that an institution should

use reasonably available tools to determine the

payment status of senior liens associated with

its junior liens, such as credit reports, third-

party services, or, in certain cases, a proxy.

Typically, large, complex institutions with sig-

niﬁcant home equity lending activity would ﬁnd

most tools reasonably available and would use

proxies in limited circumstances.

More information on risk-management prin-

ciples for junior-lien loans and home equity

lines of credit is available in the May 2005

“Interagency Credit Risk Management Guid-

ance for Home Equity Lending.” (See

SR-05-11

and section 2010.2.4 of this manual.)

2065.2.6 SUPERVISORY

CONSIDERATIONS FOR ASSESSING

ALLL

Examiners should assess the credit quality of an

institution’s loan portfolio, the appropriateness

of its ALLL methodology and documentation,

and the appropriateness of its ALLL. The Fed-

eral Reserve Board, the Federal Deposit Insur-

ance Corporation, the National Credit Union

Administration, and the Ofﬁce of the Comptrol-

ler of the Currency issued interagency guidance

on credit risk review systems for supervised

institutions in 2020.

The credit risk review

guidance discusses sound management of an

institution’s credit risk; a system of indepen-

dent, ongoing credit review; and appropriate

communication regarding the performance of

the institution’s loan portfolio to its manage-

ment and board of directors. In addition, the

Commercial Bank Examination Manual pro-

vides speciﬁc examination objectives and proce-

dures to assist examiners in reviewing the

appropriateness of an institution’s ALLL.

In their review and classiﬁcation or grading

of the loan portfolio, examiners consider signiﬁ-

cant factors that affect the collectibility of the

loan portfolio, including the value of any collat-

eral. In reviewing the appropriateness of the

ALLL, examiners should:

• Consider the effectiveness of board oversight

as well as the quality of the institution’s loan

review system and its management in identi-

fying, monitoring, and addressing asset qual-

ity problems. This will include a review of the

institution’s loan review function and credit

grading system. Typically, examiners will test

a sample of the institution’s loans.

• Evaluate the institution’s ALLL policies and

procedures and assess the methodology that

management uses to arrive at an overall esti-

mate of the ALLL, including whether man-

agement’s assumptions, valuations, and judg-

ments appear reasonable and are properly

supported. If a range of credit losses has been

estimated by management, evaluate the rea-

sonableness of the range and management’s

best estimate within the range. In making

these evaluations, examiners should ensure

that the institution’s historical loss experience

and all signiﬁcant qualitative or environmen-

tal factors that affect the collectibility of the

portfolio (including changes in the quality of

the institution’s loan review function and the

other factors previously discussed) have been

appropriately considered and that manage-

ment has appropriately applied GAAP.

• Review management’s use of loss estimation

models or other loss estimation tools to ensure

that the resulting estimated credit losses are in

conformity with GAAP.

• Review the appropriateness and reasonable-

ness of the overall level of the ALLL. In some

instances, this may include a quantitative

analysis (for example, using the types of ratio

analysis previously discussed) as a prelimi-

nary check on the reasonableness of the

ALLL. This quantitative analysis should dem-

onstrate whether changes in the key ratios

from prior periods are reasonable based on the

examiner’s knowledge of the collectibility of

loans at the institution and its current environ-

ment.

• Review the ALLL amount reported in the

institution’s regulatory reports and ﬁnancial

statements and ensure these amounts recon-

cile to its ALLL analyses. There should be no

material differences between the consolidated

loss estimate, as determined by the ALLL

methodology, and the ﬁnal ALLL balance

9. See SR-20-13.

10. An institution may have a credit risk rating framework

that differs from the framework for loan classiﬁcations used

by the federal banking agencies. Such institutions should

maintain documentation that translates their risk ratings into

the regulatory classiﬁcation framework used by the federal

banking agencies. This documentation will enable examiners

to reconcile the totals for the various loan classiﬁcations or

risk ratings under the institution’s system to the federal bank-

ing agencies’ categories contained in the Uniform Agreement

on the Classiﬁcation and Appraisal of Securities Held by

Depository Institutions Attachment 1 — Classiﬁcation Deﬁni-

tions (

SR-13-18). See also SR-20-13 for more information.

Maintaining and Documenting the Allowance for Loan and Lease Losses 2065.2

BHC Supervision Manual November 2021

Page 4

reported in the ﬁnancial statements. Inquire

about reasons for any material differences

between the results of the institution’s ALLL

analyses and the institution’s reported ALLL

to determine whether the differences can be

satisfactorily explained.

• Review the adequacy of the documentation

and controls maintained by management to

support the appropriateness of the ALLL.

• Review the interest and fee income accounts

associated with the lending process to ensure

that the institution’s net income is not materi-

ally misstated.

When assessing the appropriateness of the

ALLL, examiners should evaluate an institu-

tion’s related process, methodology, and under-

lying assumptions that require a substantial

degree of management judgment. Even when an

institution maintains sound loan administration

and collection procedures and an effective loan

review system and controls, examiners should

not use an institution’s estimate of credit losses

as a single precise amount due to the wide range

of qualitative or environmental factors that

should be considered.

An institution’s ability to estimate credit

losses on speciﬁc loans and groups of loans

should improve over time as substantive infor-

mation accumulates regarding the factors affect-

ing repayment prospects. Therefore, examiners

should generally accept management’s estimates

when they assess the appropriateness of the

institution’s ALLL, and not seek adjustments to

the ALLL, when management has

• maintained effective loan review systems and

controls for identifying, monitoring and

addressing asset quality problems in a timely

manner.

• analyzed all signiﬁcant qualitative or environ-

mental factors that affect the collectibility of

the portfolio as of the evaluation date in a

reasonable manner.

• established an acceptable ALLL evaluation

process for both individual loans and groups

of loans that meets the GAAP requirements

for an appropriate ALLL.

• incorporated reasonable and properly sup-

ported assumptions, valuations, and judg-

ments into the evaluation process.

If the examiner concludes that the level of

ALLL is not appropriate or determines that the

ALLL evaluation process is based on the results

of an unreliable loan review system or is other-

wise deﬁcient, the examiner should include rec-

ommendations for correcting these deﬁciencies

in their communications to the institution and its

board of directors. Additional supervisory action

may be necessary to address the weaknesses in

the ALLL process, including the materiality of

errors in the institution’s reported ALLL.

2065.2.6.1 ALLL Level Reﬂected in

Regulatory Reports

When the reported amount of an institution’s

ALLL is not appropriate, examiners will require

an institution to adjust its ALLL by an amount

sufﬁcient to bring the ALLL reported on its

regulatory reports to an appropriate level as of

the balance sheet’s evaluation date. This adjust-

ment should be reﬂected in the current period

provision or through the restatement of prior

period provisions, as appropriate in the circum-

stances.

Maintaining and Documenting the Allowance for Loan and Lease Losses 2065.2

BHC Supervision Manual November 2021

Page 5

Allowance for Credit Losses

Section 2065.3

2065.3.1 BACKGROUND ON

CURRENT EXPECTED CREDIT

LOSSES METHODOLOGY

The Financial Accounting Standards Board

(FASB) issued Accounting Standards Update

(ASU) No. 2016–13, Financial Instruments—

Credit Losses (Topic 326): Measurement of

Credit Losses on Financial Instruments, as well

as amendments since June 2016. These updates

are codiﬁed in Accounting Standards Codiﬁca-

tion (ASC) Topic 326, Financial Instruments—

Credit Losses (FASB ASC Topic 326). FASB

ASC Topic 326 introduces the current expected

credit losses methodology (CECL), which

replaces the incurred loss methodology for

ﬁnancial assets measured at amortized cost;

introduces the term “purchased credit-

deteriorated (PCD) assets,” which replaces the

term “purchased credit-impaired (PCI) assets”;

and modiﬁes the treatment of credit losses on

available-for-sale (AFS) debt securities.

The allowance for credit losses or ACL is a

valuation account that is deducted from, or

added to, the amortized cost basis of ﬁnancial

assets to present the net amount expected to be

collected over the contractual term of the assets,

considering expected prepayments. Renewals,

extensions, and modiﬁcations are excluded from

the contractual term of a ﬁnancial asset for

purposes of estimating the ACL, unless there is

a reasonable expectation of executing a troubled

debt restructuring or the renewal and extension

options are part of the original or modiﬁed

contract and are cancellable by the institution

based on the contractual terms in the loan agree-

ment.

In estimating the net amount expected to be

collected, management should consider the

effects of past events, current conditions, and

reasonable and supportable forecasts on the col-

lectibility of the institution’s ﬁnancial assets.

FASB ASC Topic 326 requires management to

use relevant forward-looking information and

expectations drawn from reasonable and sup-

portable forecasts when estimating expected

credit losses.

As of the end of each quarter, or more fre-

quently if warranted, each holding company

should evaluate the collectibility of its ﬁnancial

assets measured at amortized cost, including, if

applicable, any recorded accrued interest receiv-

able (that is, not already reversed or charged off,

as applicable), and make adjusting entries to

maintain the appropriate balance of each of the

separate ACLs reported on the balance sheet. A

holding company should measure expected

credit losses on a collective or pool basis when

ﬁnancial assets share similar risk characteristics.

If a ﬁnancial asset does not share similar risk

characteristics with other assets, expected credit

losses for that asset should be evaluated indi-

vidually. Individually evaluated assets should

not be included in a collective assessment of

expected credit losses. If a ﬁnancial asset ceases

to share similar risk characteristics with other

assets in its pool, the asset should be moved to a

different pool with assets sharing similar risk

characteristics, if such a pool exists. For more

information on ACLs, see the glossary to the

Consolidated Financial Statements for Holding

Companies (FR Y-9C).

The ACL also is a component for calculating

tier 2 capital, as set forth in Regulation Q

(12 CFR 217.20(d)). Tier 2 capital includes

surplus related to the issuance of tier 2 capital

instruments; limited amounts of total capital

minority interest not included in a banking orga-

nization’s tier 1 capital; and limited amounts of

the allowance for loan and lease losses (ALLL),

or adjusted allowances for credit losses (AACL),

as applicable, less applicable regulatory adjust-

ments and deductions. A banking organization

calculating its total capital ratio using the stan-

dardized approach may include in tier 2 capital

the amount of ALLL or AACL that does not

exceed 1.25 percent of its standardized total

risk-weighted assets.

2065.3.2 APPLICABILITY

FASB ASC Topic 326 applies to all banks,

savings associations, credit unions, and ﬁnancial

institution holding companies, regardless of

size, that ﬁle regulatory reports for which the

reporting requirements conform to U.S. gener-

ally accepted accounting principles (GAAP).

Further, FASB ASC Topic 326 applies to all

ﬁnancial assets carried at amortized cost (includ-

ing loans held for investment (HFI) and held-to-

maturity (HTM) debt securities, as well as trade

1. See section 37(a) of the Federal Deposit Insurance Act.

Under these statutory provisions, the accounting principles

are applicable to reports or statements required to be ﬁled by

all insured depository institutions with the federal banking

agencies (the Ofﬁce of the Comptroller of the Currency, the

Board of Governors of the Federal Reserve System, and the

Federal Deposit Insurance Corporation).

BHC Supervision Manual November 2021

Page 1

receivables, reinsurance recoverables, and

receivables that relate to repurchase agreements

and securities lending agreements), a lessor’s

net investments in leases, and off-balance-sheet

credit exposures not accounted for as insurance

or as derivatives, including loan commitments,

standby letters of credit, and ﬁnancial guar-

antees.

FASB ASC Topic 326 does not apply to

trading assets, loans held for sale, ﬁnancial

assets for which the fair value option has been

elected, or loans and receivables between enti-

ties under common control. Table 1 provides a

high-level overview of the scope of key ﬁnan-

cial assets covered and excluded from CECL.

2065.3.3 KEY ELEMENTS OF THE

ACCOUNTING STANDARD

ASU 2016–13 and subsequent amendments

revise U.S. GAAP and, consequently, affect

regulatory reports based on U.S. GAAP. CECL

differs from the incurred loss methodology in

several key respects. First, for ﬁnancial assets

measured at amortized cost, CECL requires

institutions to recognize lifetime expected credit

losses, not just credit losses incurred as of the

reporting date. CECL requires the incorporation

of reasonable and supportable forecasts in

developing an estimate of lifetime expected

credit losses, while also maintaining the current

requirement that institutions consider past

events and current conditions. Furthermore, the

probable threshold for recognition of allow-

ances in accordance with the incurred loss meth-

odology is removed under CECL. Taken

together, estimating expected credit losses over

the life of an asset under CECL, including con-

sideration of reasonable and supportable fore-

casts but without applying the probable thresh-

old that exists under the incurred loss

methodology, results in earlier recognition of

credit losses.

CECL replaces multiple impairment

approaches in existing U.S. GAAP. CECL

allowances generally cover a broader range of

ﬁnancial assets than the ALLL under the

incurred loss methodology. Under the incurred

loss methodology, ALLL generally covers credit

losses on loans held for investment and lease

ﬁnancing receivables, with additional allow-

ances for certain other extensions of credit and

allowances for credit losses on certain off-

Table 1. Summary Scope of CECL

Financial assets within the scope of CECL

The CECL methodology does not apply to

the following ﬁnancial assets

• Financing receivables such as loans held-for-investment

• Overdrawn deposit accounts (i.e., overdrafts) that are

reclassiﬁed as held-for-investment loans

• Held-to-maturity debt securities

• Receivables that result from revenue transactions within

the scope of Topic 606 on revenue from contracts with

customers and Topic 610 on other income, which

applies, for example, to the sale of foreclosed real estate

• Reinsurance recoverables that result from insurance

transactions within the scope of Topic 944 on insurance

• Receivables related to repurchase agreements and

securities lending agreements within the scope of

Topic 860 on transfers and servicing

• Net investments in leases recognized by a lessor in

accordance with Topic 842 on leases

• Off-balance-sheet credit exposures including

off-balance-sheet loan commitments, standby letters

of credit, ﬁnancial guarantees not accounted for as

insurance, and other similar instruments except for

those within the scope of Topic 815 on derivatives and

hedging

• Financial assets measured at fair value

through net income, including those assets

for which the fair value option has been

elected

• Available-for-sale debt securities

• Loans held-for-sale

• Policy loan receivables of an insurance

entity

• Loans and receivables between entities

under common control

• Receivables arising from operating leases.

Allowance for Credit Losses 2065.3

BHC Supervision Manual November 2021

Page 2

balance-sheet credit exposures (with the latter

allowances presented as liabilities).

These

exposures will be within the scope of CECL.

As previously mentioned, FASB ASC

Topic 326 introduces the term PCD assets,

which replaces the term PCI assets. The PCD

asset deﬁnition covers a broader range of assets

than the PCI asset deﬁnition. CECL requires

institutions to estimate and record a credit loss

allowance for a PCD asset at the time of pur-

chase. This credit loss allowance is then added

to the purchase price to determine the purchase

date amortized cost basis of the asset for ﬁnan-

cial reporting purposes. Post-acquisition

changes in credit loss allowances on PCD assets

will be established through earnings. This is

different from the treatment of PCI assets, for

which institutions are not permitted to estimate

and recognize credit loss allowances at the time

of purchase. Rather, institutions generally esti-

mate credit loss allowances for PCI assets sub-

sequent to the purchase only if there is deteriora-

tion in the expected cash ﬂows from such assets.

FASB ASC Topic 326 also introduces new

requirements for AFS debt securities. The

accounting standard requires that an institution

recognize credit losses on individual AFS debt

securities through credit loss allowances, rather

than through direct write-downs, as was

required under U.S. GAAP prior to the adoption

of FASB ASC Topic 326. AFS debt securities

continue to be measured at fair value, with

changes in fair value not related to credit losses

recognized in other comprehensive income.

Credit loss allowances on an AFS debt security

are limited to the amount by which the securi-

ty’s fair value is less than its amortized cost.

2065.3.4 INTERAGENCY POLICY

STATEMENT ON ALLOWANCES FOR

CREDIT LOSSES

In June 2020, the Ofﬁce of the Comptroller of

the Currency, the Board of Governors of the

Federal Reserve System, the Federal Deposit

Insurance Corporation, and the National Credit

Union Administration (collectively, the agen-

cies) issued an interagency policy statement on

allowances for credit losses (ACLs).

The agen-

cies issued the policy statement in response to

changes to U.S. GAAP as promulgated by the

FASB in FASB ASC Topic 326.

The interagency policy statement on ACLs

describes

• the measurement of expected credit losses

under the CECL methodology and the

accounting for impairment on available-for-

sale debt securities in accordance with FASB

ASC Topic 326;

• the design, documentation, and validation of

expected credit loss estimation processes,

including the internal controls over these pro-

cesses;

• the maintenance of appropriate ACLs;

• the responsibilities of boards of directors and

management; and

• examiner reviews of ACLs.

The interagency policy statement becomes

applicable to an institution upon that institu-

tion’s adoption of FASB ASC Topic 326. The

following policy statements are no longer effec-

tive for an institution upon its adoption of FASB

ASC Topic 326: the December 2006 Inter-

agency Policy Statement on the Allowance for

Loan and Lease Losses;

and the July 2001

Policy Statement on Allowance for Loan and

Lease Losses Methodologies and Documenta-

tion for Banks and Savings Institutions.

The

agencies will rescind the ALLL Policy State-

ments once FASB ASC Topic 326 is effective

for all institutions.

2065.3.5 TRANSITION FROM

ALLOWANCE FOR LOAN LEASE

LOSSES

For all holding companies, early application of

the credit losses standard is permitted for ﬁscal

years beginning after December 15, 2018,

2. ‘‘Other extensions of credit’’ includes trade and reinsur-

ance receivables, and receivables that relate to repurchase

agreements and securities lending agreements. ‘‘Off-balance-

sheet credit exposures’’ includes off-balance-sheet credit

exposures not accounted for as insurance, such as loan com-

mitments, standby letters of credit, and ﬁnancial guarantees.

Credit losses for off-balance-sheet credit exposures that are

unconditionally cancellable by the issuer are not recognized

under CECL.

3. The policy statement in its entirety is available at 85

Fed. Reg. 32,991 (June 1, 2020) and

SR-20-12, “Interagency

Policy Statement on Allowances for Credit Losses.”

4. See

SR-06-17, “Interagency Policy Statement on the

Allowance for Loan and Lease Losses (ALLL).” The ﬁnal

policy statement attached to SR-20-12 does not affect Attach-

ment 1 to SR-06-17. Attachment 1 has been revised through a

separate interagency notice published at 85 Fed. Reg. 33,278

(June 1, 2020). See also

SR-20-13, “Interagency Guidance on

Credit Risk Review Systems.”

5. See

SR-01-17, “Final Interagency Policy Statement on

Allowance for Loan and Lease Losses (ALLL) Methodolo-

gies and Documentation for Banks and Savings Institutions.”

Allowance for Credit Losses 2065.3

BHC Supervision Manual November 2021

Page 3

including interim ﬁnancial reporting periods

within that ﬁscal year. On November 15, 2019,

the FASB issued ASU No. 2019-10 to defer the

effective dates of ASU 2016-13 for certain hold-

ing companies. Under this ASU, for holding

companies that are Securities and Exchange

Commission (SEC) ﬁlers, excluding those that

are eligible to be “smaller reporting companies”

as deﬁned in the SEC’s rules, FASB ASC

Topic 326 continues to be effective for ﬁscal

years beginning after December 15, 2019,

including interim ﬁnancial reporting periods

within those ﬁscal years (that is, January 1,

2020, for such entities with calendar year ﬁscal

years). For all other holding companies, includ-

ing those SEC ﬁlers that are eligible to be

smaller reporting holding companies, FASB

Topic 326 will take effect for ﬁscal years begin-

ning after December 15, 2022, including interim

ﬁnancial reporting periods within those ﬁscal

years (that is, January 1, 2023, for such entities

with calendar year ﬁscal years).

Holding companies must apply FASB ASC

Topic 326 for completing the FR Y-9C in accor-

dance with the U.S. GAAP effective dates. A

holding company that early adopts FASB ASC

Topic 326 for U.S. GAAP ﬁnancial reporting

purposes should also early adopt the standard in

the same period for FR Y-9 purposes. Sec-

tion 4014 of the CARES Act, as amended by

section 540 of the Consolidated Appropriations

Act, 2021, allows a holding company to delay

the adoption of ASC Topic 326 until the earlier

of (1) January 1, 2022, or (2) the ﬁrst day of the

institution’s ﬁscal year that begins after the date

of the termination of the national emergency

concerning the coronavirus outbreak declared

by the President on March 13, 2020, under the

National Emergencies Act.

The agencies have adopted rules providing

institutions the option to phase in the day-one

adverse effects on regulatory capital that may

result from the adoption of the CECL account-

ing standard.

For institutions that are phasing

in the capital impact of implementing the CECL

accounting standard, the denominator for con-

centration calculations is tier 1 capital plus

allowance for loan and lease losses or allowance

for credit losses adjusted for the amount of

CECL phase-in capital included in both allow-

ance and tier 1 capital.

For purposes of determining whether an insti-

tution phasing in the capital impact of imple-

menting the CECL methodology is in compli-

ance with its regulatory capital requirements

(including capital buffer and prompt corrective

action requirements, which apply to state mem-

ber banks), the agencies will use the institu-

tion’s regulatory capital ratios as adjusted by the

CECL transition provision.

Through the super-

visory process, the agencies will continue to

examine institutions’ credit loss estimates and

allowance balances regardless of whether the

institution has elected to use the CECL transi-

tion provision. In addition, the agencies may

examine whether the electing institution will

have adequate amounts of capital at the expira-

tion of their CECL transition provision period.

After all institutions have adopted the CECL

methodology and have exited their CECL transi-

tion provision periods, it will no longer be nec-

essary to adjust for the amount of CECL

phase-in capital included in both the allowance

and tier 1 capital.

For the purposes of measuring concentrations

at institutions that are phasing in the adoption of

the CECL accounting standard, examiners

should evaluate the appropriateness of the

amounts included in the denominator for the

tier 1 capital calculation and conﬁrm that the

CECL transitioned amounts, if elected, plus the

allowance for credit losses related to loans and

leases have been excluded. To calculate the

amount to be excluded from tier 1 capital, exam-

iners should use the difference between

“retained earnings” as reported on item 26.a of

Schedule HC to the Y-9C Report and “retained

earnings” as reported on item 2 Schedule HC-R,

Part I, to the Y-9C. This resulting difference is

the amount of retained earnings that should

have been used to calculate tier 1 capital for

purposes of measuring concentrations and

should equal the retained earnings on the institu-

tion’s balance sheet.

2065.3.6 SUPERVISORY

CONSIDERATIONS FOR ASSESSING

ACL

Examiners are expected to assess the appropri-

ateness of management’s loss estimation pro-

6. See 84 Fed. Reg. 4222 (February 14, 2019); 85 Fed.

Reg. 17,723 (March 31, 2020); and 85 Fed. Reg. 61,577

(September 30, 2020).

7. For more information, see SR-20-8, “Joint Statement on

Adjustment to the Calculation for Credit Concentration Ratios

Used in the Supervisory Approach.”

8. See 84 Fed. Reg. 4222 (February 14, 2019).

Allowance for Credit Losses 2065.3

BHC Supervision Manual November 2021

Page 4

cesses and the appropriateness of the institu-

tion’s ACL balances as part of their supervisory

activities. The review of ACLs, including the

depth of the examiner’s assessment, should be

commensurate with the institution’s size, com-

plexity, and risk proﬁle. As part of their supervi-

sory activities, examiners generally assess the

credit quality and credit risk of an institution’s

ﬁnancial asset portfolios, the adequacy of the

institution’s credit loss estimation processes, the

adequacy of supporting documentation, and the

appropriateness of the reported ACLs and provi-

sions for credit losses in the institution’s regula-

tory reports and ﬁnancial statements, if applica-

ble. Examiners may consider the signiﬁcant fac-

tors that affect collectibility, including the value

of collateral securing ﬁnancial assets and any

other repayment sources. Supervisory activities

may include evaluating management’s effective-

ness in assessing credit risk for debt securities

(both prior to purchase and on an on-going

basis). The

Commercial Bank Examination

Manual

provides speciﬁc examination objec-

tives and procedures to assist examiners in

reviewing the appropriateness of an institu-

tion’s ACL.

Allowance for Credit Losses 2065.3

BHC Supervision Manual November 2021

Page 5

Sound Incentive Compensation Policies

Section 2068.0

Incentive compensation practices in the ﬁnan-

cial industry were one of many factors that

contributed to the ﬁnancial crisis that began in

mid-2007. Banking organizations too often

rewarded employees for increasing the organiza-

tion’s revenue or short-term proﬁt without

adequate recognition of the risks the employees’

activities posed to the organization.

These prac-

tices exacerbated the risks and losses at a num-

ber of banking organizations and resulted in the

misalignment of the interests of employees with

the long-term well-being and safety and sound-

ness of their organizations. This section pro-

vides guidance on sound incentive compensa-

tion practices to banking organizations

supervised by the Federal Reserve (also the

Ofﬁce of the Comptroller of the Currency, the

Federal Deposit Insurance Corporation, and the

Ofﬁce of Thrift Supervision (collectively, the

‘‘Agencies’’)).

This guidance is intended to

assist banking organizations in designing and

implementing incentive compensation arrange-

ments and related policies and procedures that

effectively consider potential risks and risk

outcomes.

Alignment of incentives provided to employ-

ees with the interests of shareholders of the

organization often also beneﬁts safety and

soundness. However, aligning employee incen-

tives with the interests of shareholders is not

always sufﬁcient to address safety-and-

soundness concerns. Because of the presence of

the federal safety net, (including the ability of

insured depository institutions to raise insured

deposits and access the discount window and

payment services of the Federal Reserve), share-

holders of a banking organization in some cases

may be willing to tolerate a degree of risk that is

inconsistent with the organization’s safety and

soundness. Accordingly, the Federal Reserve

expects banking organizations to maintain

incentive compensation practices that are con-

sistent with safety and soundness, even when

these practices go beyond those needed to align

shareholder and employee interests.

To be consistent with safety and soundness,

incentive compensation arrangements

at a

banking organization should:

1. Provide employees incentives that appropri-

ately balance risk and reward;

2. Be compatible with effective controls and

risk-management; and

3. Be supported by strong corporate gover-

nance, including active and effective over-

sight by the organization’s board of directors.

These principles, and the types of policies, pro-

cedures, and systems that banking organiza-

tions should have to help ensure compliance

with them, are discussed later in this guidance.

The Federal Reserve expects banking organi-

zations to regularly review their incentive com-

pensation arrangements for all executive and

non-executive employees who, either individu-

ally or as part of a group, have the ability to

expose the organization to material amounts of

risk, as well as to regularly review the risk-

management, control, and corporate governance

processes related to these arrangements. Bank-

ing organizations should immediately address

any identiﬁed deﬁciencies in these arrangements

or processes that are inconsistent with safety

and soundness. Banking organizations are

responsible for ensuring that their incentive

compensation arrangements are consistent with

the principles described in this guidance and

that they do not encourage employees to expose

the organization to imprudent risks that may

pose a threat to the safety and soundness of the

organization.

1. Examples of risks that may present a threat to the

organization’s safety and soundness include credit, market,

liquidity, operational, legal, compliance, and reputational

risks.

2. As used in this guidance, the term ‘‘banking organiza-

tion’’ includes national banks, state member banks, state

nonmember banks, savings associations, U.S. bank holding

companies, savings and loan holding companies, Edge and

agreement corporations, and the U.S. operations of foreign

banking organizations (FBOs) with a branch, agency, or com-

mercial lending company in the United States. If the Federal

Reserve is referenced, the reference is intended to also include

the other supervisory Agencies.

3. This guidance (see 75 Fed. Reg. 36395, June 25, 2010,

for the entire text) and the principles reﬂected herein are

consistent with the Principles for Sound Compensation Prac-

tices issued by the Financial Stability Board (FSB) in April

2009, and with the FSB’s Implementation Standards for those

principles, issued in September 2009.

4. In this guidance, the term ‘‘incentive compensation’’

refers to that portion of an employee’s current or potential

compensation that is tied to achievement of one or more

speciﬁc metrics (e.g., a level of sales, revenue, or income).

Incentive compensation does not include compensation that is

awarded solely for, and the payment of which is solely tied to,

continued employment (e.g., salary). In addition, the term

does not include compensation arrangements that are deter-

mined based solely on the employee’s level of compensation

and does not vary based on one or more performance metrics

(e.g., a 401(k) plan under which the organization contributes a

set percentage of an employee’s salary).

BHC Supervision Manual July 2010

Page 1

The Federal Reserve recognizes that incen-

tive compensation arrangements often seek to

serve several important and worthy objectives.

For example, incentive compensation arrange-

ments may be used to help attract skilled staff,

induce better organization-wide and employee

performance, promote employee retention, pro-

vide retirement security to employees, or allow

compensation expenses to vary with revenue on

an organization-wide basis. Moreover, the

analysis and methods for ensuring that incentive

compensation arrangements take appropriate

account of risk should be tailored to the size,

complexity, business strategy, and risk tolerance

of each organization. The resources required

will depend upon the complexity of the ﬁrm and

its use of incentive compensation arrangements.

For some, the task of designing and implement-

ing compensation arrangements that properly

offer incentives for executive and non-executive

employees to pursue the organization’s long-

term well-being and that do not encourage

imprudent risk-taking is a complex task that will

require the commitment of adequate resources.

While issues related to designing and imple-

menting incentive compensation arrangements

are complex, the Federal Reserve is committed

to ensuring that banking organizations move

forward in incorporating the principles

described in this guidance into their incentive

compensation practices.

As discussed further below, because of the

size and complexity of their operations, Large

complex banking organizations (LCBOs)

should have and adhere to systematic and for-

malized policies, procedures, and processes.

These are considered important in ensuring that

incentive compensation arrangements for all

covered employees are identiﬁed and reviewed

by appropriate levels of management (including

the board of directors where appropriate and

control units), and that they appropriately bal-

ance risks and rewards. In several places, this

guidance speciﬁcally highlights the types of

policies, procedures, and systems that LCBOs

should have and maintain, but that generally are

not expected of smaller, less complex organiza-

tions. LCBOs warrant the most intensive super-

visory attention because they are signiﬁcant

users of incentive compensation arrangements

and because ﬂawed approaches at these organi-

zations are more likely to have adverse effects

on the broader ﬁnancial system. The Federal

Reserve will work with LCBOs as necessary

through the supervisory process to ensure that

they promptly correct any deﬁciencies that may

be inconsistent with the safety and soundness of

the organization.

The policies, procedures, and systems of

smaller banking organizations that use incentive

compensation arrangements

are expected to be

less extensive, formalized, and detailed than

those of LCBOs. Supervisory reviews of incen-

tive compensation arrangements at smaller, less-

complex banking organizations will be con-

ducted by the Federal Reserve as part of the

evaluation of those organizations’ risk-

management, internal controls, and corporate

governance during the regular, risk-focused

examination process. These reviews will be tai-

lored to reﬂect the scope and complexity of an

organization’s activities, as well as the preva-

lence and scope of its incentive compensation

arrangements. Little, if any, additional examina-

tion work is expected for smaller banking orga-

nizations that do not use, to a signiﬁcant extent,

incentive compensation arrangements.

For all banking organizations, supervisory

ﬁndings related to incentive compensation will

be communicated to the organization and

included in the relevant report of examination or

inspection. In addition, these ﬁndings will be

incorporated, as appropriate, into the organiza-

5. In December 2009 the Federal Reserve, working with

the other Agencies, initiated a special horizontal review of

incentive compensation arrangements and related risk-

management, control, and corporate governance practices of

large banking organizations (LBOs). This initiative was

designed to spur and monitor the industry’s progress towards

the implementation of safe and sound incentive compensation

arrangements, identify emerging best practices, and advance

the state of practice more generally in the industry.

6. For supervisory purposes, the Federal Reserve (as well

as the other federal bank regulatory agencies) segments the

organizations it supervises into different supervisory port-

folios based on, among other things, size, complexity, and risk

proﬁle. For purposes of this guidance, the LBOs referred to in

the guidance are identiﬁed in this section as large complex

banking organizations to be consistent with the Federal

Reserve’s other supervisory policies. LBOs are designated by

(1) the OCC as the largest and most complex national banks

as deﬁned in the Large Bank Supervision booklet of the

Comptroller’s Handbook; (2) the FDIC, large, complex

insured depository institutions (IDIs); and (3) the OTS, the

largest and most complex savings associations and savings

and loan holding companies.

7. This guidance does not apply to banking organizations

that do not use incentive compensation.

8. To facilitate these reviews, where appropriate, a smaller

banking organization should review its compensation arrange-

ments to determine whether it uses incentive compensation

arrangements to a signiﬁcant extent in its business operations.

A smaller banking organization will not be considered a

signiﬁcant user of incentive compensation arrangements sim-

ply because the organization has a ﬁrm-wide proﬁt-sharing or

bonus plan that is based on the bank’s proﬁtability, even if the

plan covers all or most of the organization’s employees.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 2

tion’s rating component(s) and subcomponent(s)

relating to risk-management, internal controls,

and corporate governance under the relevant

supervisory rating system, as well as the organi-

zation’s overall supervisory rating.

The Federal Reserve (or the organization’s

appropriate federal supervisor) may take

enforcement action against a banking organiza-

tion if its incentive compensation arrangements

or related risk-management, control, or gover-

nance processes pose a risk to the safety and

soundness of the organization, particularly when

the organization is not taking prompt and effec-

tive measures to correct the deﬁciencies. For

example, the appropriate federal supervisor may

take an enforcement action if material deﬁcien-

cies are found to exist in the organization’s

incentive compensation arrangements or related

risk-management, control, or governance pro-

cesses, or the organization fails to promptly

develop, submit, or adhere to an effective plan

designed to ensure that its incentive compensa-

tion arrangements do not encourage imprudent

risk-taking and are consistent with principles of

safety and soundness. As provided under sec-

tion 8 of the Federal Deposit Insurance Act (12

U.S.C. 1818), an enforcement action may,

among other things, require an organization to

take afﬁrmative action, such as developing a

corrective action plan that is acceptable to the

appropriate federal supervisor to rectify safety-

and-soundness deﬁciencies in its incentive com-

pensation arrangements or related processes.

Where warranted, the appropriate federal super-

visor may require the organization to take addi-

tional afﬁrmative action to correct or remedy

deﬁciencies related to the organization’s incen-

tive compensation practices.

Effective and balanced incentive compensa-

tion practices are likely to evolve signiﬁcantly

in the coming years, spurred by the efforts of

banking organizations, supervisors, and other

stakeholders. The Federal Reserve will review

and update this guidance as appropriate to incor-

porate best practices that emerge from these

efforts.

2068.0.1 SCOPE OF APPLICATION

The incentive compensation arrangements and

related policies and procedures of banking orga-

nizations should be consistent with principles of

safety and soundness.

Incentive compensation

arrangements for executive ofﬁcers as well as

for non-executive personnel who have the abil-

ity to expose a banking organization to material

amounts of risk may, if not properly structured,

pose a threat to the organization’s safety and

soundness. Accordingly, this guidance applies

to incentive compensation arrangements for:

1. Senior executives and others who are respon-

sible for oversight of the organization’s ﬁrm-

wide activities or material business lines;

2. Individual employees, including non-

executive employees, whose activities may

expose the organization to material amounts

of risk (e.g., traders with large position limits

relative to the organization’s overall risk tol-

erance); and

3. Groups of employees who are subject to the

same or similar incentive compensation

arrangements and who, in the aggregate, may

expose the organization to material amounts

of risk, even if no individual employee is

likely to expose the organization to material

risk (e.g., loan ofﬁcers who, as a group,

originate loans that account for a material

amount of the organization’s credit risk).

For ease of reference, these executive and

non-executive employees are collectively

referred to hereafter as ‘‘covered employees’’ or

‘‘employees.’’ Depending on the facts and cir-

cumstances of the individual organization, the

types of employees or categories of employees

that are outside the scope of this guidance

because they do not have the ability to expose

the organization to material risks would likely

include, for example, tellers, bookkeepers, cou-

riers, or data processing personnel.

In determining whether an employee, or

group of employees, may expose a banking

organization to material risk, the organization

9. In the case of the U.S. operations of FBOs, the organiza-

tion’s policies, including management, review, and approval

requirements for its U.S. operations, should be coordinated

with the FBO’s group-wide policies developed in accordance

with the rules of the FBO’s home country supervisor. The

policies of the FBO’s U.S. operations should also be consis-

tent with the FBO’s overall corporate and management struc-

ture, as well as its framework for risk-management and inter-

nal controls. In addition, the policies for the U.S. operations of

FBOs should be consistent with this guidance.

10. Senior executives include, at a minimum, ‘‘executive

ofﬁcers’’ within the meaning of the Federal Reserve’s Regula-

tion O (see 12 CFR 215.2(e)(1)) and, for publicly traded

companies, ‘‘named ofﬁcers’’ within the meaning of the Secu-

rities and Exchange Commission’s rules on disclosure of

executive compensation (see 17 CFR 229.402(a)(3)). Savings

associations should also refer to OTS’s rule on loans by

saving associations to their executive ofﬁcers, directors, and

principal shareholders. (12 CFR 563.43).

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 3

should consider the full range of inherent risks

arising from, or generated by, the employee’s

activities, even if the organization uses risk-

management processes or controls to limit the

risks such activities ultimately may pose to the

organization. Moreover, risks should be consid-

ered to be material for purposes of this guidance

if they are material to the organization, or are

material to a business line or operating unit that

is itself material to the organization.

For purposes of illustration, assume that a

banking organization has a structured-ﬁnance

unit that is material to the organization. A group

of employees within that unit who originate

structured-ﬁnance transactions that may expose

the unit to material risks should be considered

‘‘covered employees’’ for purposes of this guid-

ance even if those transactions must be

approved by an independent risk function prior

to consummation, or the organization uses other

processes or methods to limit the risk that such

transactions may present to the organization.

Strong and effective risk-management and

internal control functions are critical to the

safety and soundness of banking organizations.

However, irrespective of the quality of these

functions, poorly designed or managed incen-

tive compensation arrangements can themselves

be a source of risk to a banking organization.

For example, incentive compensation arrange-

ments that provide employees strong incentives

to increase the organization’s short-term rev-

enues or proﬁts, without regard to the short- or

long-term risk associated with such business,

can place substantial strain on the risk-

management and internal control functions of

even well-managed organizations.

Moreover, poorly balanced incentive compen-

sation arrangements can encourage employees

to take afﬁrmative actions to weaken or circum-

vent the organization’s risk-management or

internal control functions, such as by providing

inaccurate or incomplete information to these

functions, to boost the employee’s personal

compensation. Accordingly, sound compensa-

tion practices are an integral part of strong risk-

management and internal control functions. A

key goal of this guidance is to encourage bank-

ing organizations to incorporate the risks related

to incentive compensation into their broader

risk-management framework. Risk-management

procedures and risk controls that ordinarily limit

risk-taking do not obviate the need for incentive

compensation arrangements to properly balance

risk-taking incentives.

2068.0.2 PRINCIPLES OF A SOUND

INCENTIVE COMPENSATION

SYSTEM

2068.0.2.1 Principle 1: Balanced

Risk-Taking Incentives

Incentive compensation arrangements should

balance risk and ﬁnancial results in a manner

that does not encourage employees to expose

their organizations to imprudent risks.

Incentive compensation arrangements typically

attempt to encourage actions that result in

greater revenue or proﬁt for the organization.

However, short-run revenue or proﬁt can often

diverge sharply from actual long-run proﬁt

because risk outcomes may become clear only

over time. Activities that carry higher risk typi-

cally yield higher short-term revenue, and an

employee who is given incentives to increase

short-term revenue or proﬁt, without regard to

risk, will naturally be attracted to opportunities

to expose the organization to more risk.

An incentive compensation arrangement is

balanced when the amounts paid to an employee

appropriately take into account the risks (includ-

ing compliance risks), as well as the ﬁnancial

beneﬁts, from the employee’s activities and the

impact of those activities on the organization’s

safety and soundness. As an example, under a

balanced incentive compensation arrangement,

two employees who generate the same amount

of short-term revenue or proﬁt for an organiza-

tion should not receive the same amount of

incentive compensation if the risks taken by the

employees in generating that revenue or proﬁt

differ materially. The employee whose activities

create materially larger risks for the organiza-

tion should receive less than the other employee,

all else being equal.

The performance measures used in an incen-

tive compensation arrangement have an impor-

tant effect on the incentives provided employees

and, thus, the potential for the arrangement to

encourage imprudent risk-taking. For example,

if an employee’s incentive compensation pay-

ments are closely tied to short-term revenue or

proﬁt of business generated by the employee,

without any adjustments for the risks associated

with the business generated, the potential for the

arrangement to encourage imprudent risk-taking

11. Thus, risks may be material to an organization even if

they are not large enough themselves to threaten the solvency

of the organization.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 4

may be quite strong. Similarly, traders who

work with positions that close at year-end could

have an incentive to take large risks toward the

end of a year if there is no mechanism for

factoring how such positions perform over a

longer period of time. The same result could

ensue if the performance measures themselves

lack integrity or can be manipulated inappropri-

ately by the employees receiving incentive

compensation.

On the other hand, if an employee’s incentive

compensation payments are determined based

on performance measures that are only distantly

linked to the employee’s activities (e.g., for

most employees, organization-wide proﬁt), the

potential for the arrangement to encourage the

employee to take imprudent risks on behalf of

the organization may be weak. For this reason,

plans that provide for awards based solely on

overall organization-wide performance are

unlikely to provide employees, other than senior

executives and individuals who have the ability

to materially affect the organization’s overall

risk proﬁle, with unbalanced risk-taking

incentives.

Incentive compensation arrangements should

not only be balanced in design, they also should

be implemented so that actual payments vary

based on risks or risk outcomes. If, for example,

employees are paid substantially all of their

potential incentive compensation even when risk

or risk outcomes are materially worse than

expected, employees have less incentive to

avoid activities with substantial risk.

• Banking organizations should consider the

full range of risks associated with an employ-

ee’s activities, as well as the time horizon

over which those risks may be realized, in

assessing whether incentive compensation

arrangements are balanced.

The activities of employees may create a wide

range of risks for a banking organization, such

as credit, market, liquidity, operational, legal,

compliance, and reputational risks, as well as

other risks to the viability or operation of the

organization. Some of these risks may be real-

ized in the short term, while others may become

apparent only over the long term. For example,

future revenues that are booked as current

income may not materialize, and short-term

proﬁt-and-loss measures may not appropriately

reﬂect differences in the risks associated with

the revenue derived from different activities

(e.g., the higher credit or compliance risk associ-

ated with subprime loans versus prime loans).

In addition, some risks (or combinations of risky

strategies and positions) may have a low prob-

ability of being realized, but would have highly

adverse effects on the organization if they were

to be realized (‘‘bad tail risks’’). While share-

holders may have less incentive to guard against

bad tail risks because of the infrequency of their

realization and the existence of the federal

safety net, these risks warrant special attention

for safety-and-soundness reasons given the

threat they pose to the organization’s solvency

and the federal safety net.

Banking organizations should consider the

full range of current and potential risks associ-

ated with the activities of covered employees,

including the cost and amount of capital and

liquidity needed to support those risks, in devel-

oping balanced incentive compensation arrange-

ments. Reliable quantitative measures of risk

and risk outcomes (‘‘quantitative measures’’),

where available, may be particularly useful in

developing balanced compensation arrange-

ments and in assessing the extent to which

arrangements are properly balanced. However,

reliable quantitative measures may not be avail-

able for all types of risk or for all activities, and

their utility for use in compensation arrange-

ments varies across business lines and employ-

ees. The absence of reliable quantitative mea-

sures for certain types of risks or outcomes does

not mean that banking organizations should

ignore such risks or outcomes for purposes of

assessing whether an incentive compensation

arrangement achieves balance. For example,

while reliable quantitative measures may not

exist for many bad-tail risks, it is important that

such risks be considered given their potential

effect on safety and soundness. As in other

risk-management areas, banking organizations

should rely on informed judgments, supported

by available data, to estimate risks and risk

outcomes in the absence of reliable quantitative

risk measures.

Large complex banking organizations. In

designing and modifying incentive compensa-

tion arrangements, LCBOs should assess in

advance of implementation whether such

12. Importantly, the time horizon over which a risk out-

come may be realized is not necessarily the same as the stated

maturity of an exposure. For example, the ongoing reinvest-

ment of funds by a cash management unit in commercial

paper with a one-day maturity not only exposes the organiza-

tion to one-day credit risk, but also exposes the organization

to liquidity risk that may be realized only infrequently.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 5

arrangements are likely to provide balanced

risk-taking incentives. Simulation analysis of

incentive compensation arrangements is one

way of doing so. Such analysis uses forward-

looking projections of incentive compensation

awards and payments based on a range of per-

formance levels, risk outcomes, and levels of

risks taken. This type of analysis, or other analy-

sis that results in assessments of likely effective-

ness, can help an LCBO assess whether incen-

tive compensation awards and payments to an

employee are likely to be reduced appropriately

as the risks to the organization from the employ-

ee’s activities increase.

• An unbalanced arrangement can be moved

toward balance by adding or modifying fea-

tures that cause the amounts ultimately

received by employees to appropriately reﬂect

risk and risk outcomes.

If an incentive compensation arrangement

may encourage employees to expose their bank-

ing organization to imprudent risks, the organi-

zation should modify the arrangement as needed

to ensure that it is consistent with safety and

soundness. Four methods are often used to make

compensation more sensitive to risk. These

methods are:

1. Risk Adjustment of Awards: The amount of

an incentive compensation award for an

employee is adjusted based on measures that

take into account the risk the employee’s

activities may pose to the organization. Such

measures may be quantitative, or the size of

a risk adjustment may be set judgmentally,

subject to appropriate oversight.

2. Deferral of Payment: The actual payout of

an award to an employee is delayed signiﬁ-

cantly beyond the end of the performance

period, and the amounts paid are adjusted for

actual losses or other aspects of performance

that are realized or become better known

only during the deferral period.

Deferred

payouts may be altered according to risk

outcomes either formulaically or judgmen-

tally, subject to appropriate oversight. To be

most effective, the deferral period should be

sufﬁciently long to allow for the realization

of a substantial portion of the risks from

employee activities, and the measures of loss

should be clearly explained to employees

and closely tied to their activities during the

relevant performance period.

3. Longer Performance Periods: The time

period covered by the performance measures

used in determining an employee’s award is

extended (for example, from one year to two

or more years). Longer performance periods

and deferral of payment are related in that

both methods allow awards or payments to

be made after some or all risk outcomes are

realized or better known.

4. Reduced Sensitivity to Short-Term Perfor-

mance: The banking organization reduces

the rate at which awards increase as an

employee achieves higher levels of the rel-

evant performance measure(s). Rather than

offsetting risk-taking incentives associated

with the use of short-term performance mea-

sures, this method reduces the magnitude of

such incentives. This method also can

include improving the quality and reliability

of performance measures in taking into

account both short-term and long-term risks,

for example improving the reliability and

accuracy of estimates of revenues and long-

term proﬁts upon which performance mea-

sures depend.

These methods for achieving balance are not

exclusive, and additional methods or variations

may exist or be developed. Moreover, each

method has its own advantages and disadvan-

tages. For example, where reliable risk mea-

sures exist, risk adjustment of awards may be

more effective than deferral of payment in

reducing incentives for imprudent risk-taking.

This is because risk adjustment potentially can

take account of the full range and time horizon

of risks, rather than just those risk outcomes that

occur or become more evident during the defer-

ral period. On the other hand, deferral of pay-

ment may be more effective than risk adjust-

ment in mitigating incentives to take hard-to-

measure risks (such as the risks of new activities

13. The deferral-of-payment method is sometimes referred

to in the industry as a ‘‘clawback.’’ The term ‘‘clawback’’ also

may refer speciﬁcally to an arrangement under which an

employee must return incentive compensation payments pre-

viously received by the employee (and not just deferred) if

certain risk outcomes occur. Section 304 of the Sarbanes-

Oxley Act of 2002 (15 U.S.C. 7243), which applies to chief

executive ofﬁcers and chief ﬁnancial ofﬁcers of public bank-

ing organizations, is an example of this more speciﬁc type of

‘‘clawback’’ requirement.

14. Performance targets may have a material effect on

risk-taking incentives. Such targets may offer employees

greater rewards for increments of performance that are above

the target or may provide that awards will be granted only if a

target is met or exceeded. Employees may be particularly

motivated to take imprudent risk in order to reach perfor-

mance targets that are aggressive, but potentially achievable.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 6

or products, or certain risks such as reputational

or operational risk that may be difﬁcult to mea-

sure with respect to particular activities), espe-

cially if such risks are likely to be realized

during the deferral period. Accordingly, in some

cases two or more methods may be needed in

combination for an incentive compensation

arrangement to be balanced.

The greater the potential incentives an

arrangement creates for an employee to increase

the risks associated with the employee’s activi-

ties, the stronger the effect should be of the

methods applied to achieve balance. Thus, for

example, risk adjustments used to counteract a

materially unbalanced compensation arrange-

ment should have a similarly material impact on

the incentive compensation paid under the

arrangement. Further, improvements in the qual-

ity and reliability of performance measures

themselves, for example improving the relia-

bility and accuracy of estimates of revenues and

proﬁts upon which performance measures

depend, can signiﬁcantly improve the degree of

balance in risk-taking incentives.

Where judgment plays a signiﬁcant role in

the design or operation of an incentive compen-

sation arrangement, strong policies and proce-

dures, internal controls, and ex post monitoring

of incentive compensation payments relative to

actual risk outcomes are particularly important

to help ensure that the arrangements as imple-

mented are balanced and do not encourage

imprudent risk-taking. For example, if a bank-

ing organization relies to a signiﬁcant degree on

the judgment of one or more managers to ensure

that the incentive compensation awards to

employees are appropriately risk-adjusted, the

organization should have policies and proce-

dures that describe how managers are expected

to exercise that judgment to achieve balance and

that provide for the manager(s) to receive appro-

priate available information about the employ-

ee’s risk-taking activities to make informed

judgments.

Large complex banking organizations. Meth-

ods and practices for making compensation sen-

sitive to risk are likely to evolve rapidly during

the next few years, driven in part by the efforts

of supervisors and other stakeholders. LCBOs

should actively monitor developments in the

ﬁeld and should incorporate into their incentive

compensation systems new or emerging meth-

ods or practices that are likely to improve the

organization’s long-term ﬁnancial well-being

and safety and soundness.

• The manner in which a banking organization

seeks to achieve balanced incentive compen-

sation arrangements should be tailored to

account for the differences between

employees—including the substantial differ-

ences between senior executives and other

employees—as well as between banking

organizations.

Activities and risks may vary signiﬁcantly

both across banking organizations and across

employees within a particular banking organiza-

tion. For example, activities, risks, and incentive

compensation practices may differ materially

among banking organizations based on, among

other things, the scope or complexity of activi-

ties conducted and the business strategies pur-

sued by the organizations. These differences

mean that methods for achieving balanced com-

pensation arrangements at one organization may

not be effective in restraining incentives to

engage in imprudent risk-taking at another orga-

nization. Each organization is responsible for

ensuring that its incentive compensation

arrangements are consistent with the safety and

soundness of the organization.

Moreover, the risks associated with the activi-

ties of one group of non-executive employees

(e.g., loan originators) within a banking organi-

zation may differ signiﬁcantly from those of

another group of non-executive employees (e.g.,

spot foreign exchange traders) within the orga-

nization. In addition, reliable quantitative mea-

sures of risk and risk outcomes are unlikely to

be available for a banking organization as a

whole, particularly a large, complex organiza-

tion. This factor can make it difﬁcult for bank-

ing organizations to achieve balanced compen-

sation arrangements for senior executives who

have responsibility for managing risks on an

organization-wide basis solely through use of

the risk-adjustment-of-award method.

Furthermore, the payment of deferred incen-

tive compensation in equity (such as restricted

stock of the organization) or equity-based instru-

ments (such as options to acquire the organiza-

tion’s stock) may be helpful in restraining the

risk-taking incentives of senior executives and

other covered employees whose activities may

have a material effect on the overall ﬁnancial

performance of the organization. However,

equity-related deferred compensation may not

be as effective in restraining the incentives of

lower-level covered employees (particularly at

large organizations) to take risks because such

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 7

employees are unlikely to believe that their

actions will materially affect the organization’s

stock price.

Banking organizations should take account of

these differences when constructing balanced

compensation arrangements. For most banking

organizations, the use of a single, formulaic

approach to making employee incentive com-

pensation arrangements appropriately risk-

sensitive is likely to result in arrangements that

are unbalanced at least with respect to some

employees.

Large complex banking organizations. Incen-

tive compensation arrangements for senior

executives at LCBOs are likely to be better

balanced if they involve deferral of a substantial

portion of the executives’ incentive compensa-

tion over a multi-year period in a way that

reduces the amount received in the event of

poor performance, substantial use of multi-year

performance periods, or both. Similarly, the

compensation arrangements for senior execu-

tives at LCBOs are likely to be better balanced

if a signiﬁcant portion of the incentive compen-

sation of these executives is paid in the form of

equity-based instruments that vest over multiple

years, with the number of instruments ulti-

mately received dependent on the performance

of the organization during the deferral period.

The portion of the incentive compensation of

other covered employees that is deferred or paid

in the form of equity-based instruments should

appropriately take into account the level, nature,

and duration of the risks that the employees’

activities create for the organization and the

extent to which those activities may materially

affect the overall performance of the organiza-

tion and its stock price. Deferral of a substantial

portion of an employee’s incentive compensa-

tion may not be workable for employees at

lower pay scales because of their more limited

ﬁnancial resources. This may require increased

reliance on other measures in the incentive com-

pensation arrangements for these employees to

achieve balance.

• Banking organizations should carefully con-

sider the potential for ‘‘golden parachutes’’

and the vesting arrangements for deferred

compensation to affect the risk-taking behav-

ior of employees while at the organizations.

Arrangements that provide for an employee

(typically a senior executive), upon departure

from the organization or a change in control of

the organization, to receive large additional pay-

ments or the accelerated payment of deferred

amounts without regard to risk or risk outcomes

can provide the employee signiﬁcant incentives

to expose the organization to undue risk. For

example, an arrangement that provides an

employee with a guaranteed payout upon depar-

ture from an organization, regardless of perfor-

mance, may neutralize the effect of any balanc-

ing features included in the arrangement to help

prevent imprudent risk-taking.

Banking organizations should carefully

review any such existing or proposed arrange-

ments (sometimes called ‘‘golden parachutes’’)

and the potential impact of such arrangements

on the organization’s safety and soundness. In

appropriate circumstances an organization

should consider including balancing features—

such as risk adjustment or deferral requirements

that extend past the employee’s departure—in

the arrangements to mitigate the potential for

the arrangements to encourage imprudent risk-

taking. In all cases, a banking organization

should ensure that the structure and terms of any

golden parachute arrangement entered into by

the organization do not encourage imprudent

risk-taking in light of the other features of the

employee’s incentive compensation arrange-

ments.

Large complex banking organizations. Provi-

sions that require a departing employee to for-

feit deferred incentive compensation payments

may weaken the effectiveness of the deferral

arrangement if the departing employee is able to

negotiate a ‘‘golden handshake’’ arrangement

with the new employer.

This weakening effect

can be particularly signiﬁcant for senior execu-

tives or other skilled employees at LCBOs

whose services are in high demand within the

market.

Golden handshake arrangements present spe-

cial issues for LCBOs and supervisors. For

example, while a banking organization could

adjust its deferral arrangements so that depart-

ing employees will continue to receive any

accrued deferred compensation after departure

15. For example, spreading payouts of incentive compen-

sation awards over a standard three-year period may not

appropriately reﬂect the differences in the type and time

horizon of risk associated with the activities of different

groups of employees, and may not be sufﬁcient by itself to

balance the compensation arrangements of employees who

may expose the organization to substantial longer-term risks.

16. Golden handshakes are arrangements that compensate

an employee for some or all of the estimated, non-adjusted

value of deferred incentive compensation that would have

been forfeited upon departure from the employee’s previous

employment.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 8

(subject to any clawback or malus

), these

changes could reduce the employee’s incentive

to remain at the organization and, thus, weaken

an organization’s ability to retain qualiﬁed tal-

ent, which is an important goal of compensa-

tion, and create conﬂicts of interest. Moreover,

actions of the hiring organization (which may or

may not be a supervised banking organization)

ultimately may defeat these or other risk-

balancing aspects of a banking organization’s

deferral arrangements. LCBOs should monitor

whether golden handshake arrangements are

materially weakening the organization’s efforts

to constrain the risk-taking incentives of

employees. The Federal Reserve will continue

to work with banking organizations and others

to develop appropriate methods for addressing

any effect that such arrangements may have on

the safety and soundness of banking organiza-

tions.

• Banking organizations should effectively com-

municate to employees the ways in which

incentive compensation awards and payments

will be reduced as risks increase.

In order for the risk-sensitive provisions of

incentive compensation arrangements to affect

employee risk-taking behavior, the organiza-

tion’s employees need to understand that the

amount of incentive compensation that they may

receive will vary based on the risk associated

with their activities. Accordingly, banking orga-

nizations should ensure that employees covered

by an incentive compensation arrangement are

informed about the key ways in which risks are

taken into account in determining the amount of

incentive compensation paid. Where feasible, an

organization’s communications with employees

should include examples of how incentive com-

pensation payments may be adjusted to reﬂect

projected or actual risk outcomes. An organiza-

tion’s communications should be tailored appro-

priately to reﬂect the sophistication of the rel-

evant audience(s).

2068.0.2.2 Principle 2: Compatibility

with Effective Controls and

Risk-Management

A banking organization’s risk-management pro-

cesses and internal controls should reinforce

and support the development and maintenance

of balanced incentive compensation arrange-

ments.

In order to increase their own compensation,

employees may seek to evade the processes

established by a banking organization to achieve

balanced compensation arrangements. Similarly,

an employee covered by an incentive compensa-

tion arrangement may seek to inﬂuence, in ways

designed to increase the employee’s pay, the

risk measures or other information or judgments

that are used to make the employee’s pay sensi-

tive to risk.

Such actions may signiﬁcantly weaken the

effectiveness of an organization’s incentive

compensation arrangements in restricting impru-

dent risk-taking. These actions can have a par-

ticularly damaging effect on the safety and

soundness of the organization if they result in

the weakening of risk measures, information, or

judgments that the organization uses for other

risk-management, internal control, or ﬁnancial

purposes. In such cases, the employee’s actions

may weaken not only the balance of the organi-

zation’s incentive compensation arrangements,

but also the risk-management, internal controls,

and other functions that are supposed to act as a

separate check on risk-taking. For this reason,

traditional risk-management controls alone do

not eliminate the need to identify employees

who may expose the organization to material

risk, nor do they obviate the need for the incen-

tive compensation arrangements for these

employees to be balanced. Rather, a banking

organization’s risk-management processes and

internal controls should reinforce and support

the development and maintenance of balanced

incentive compensation arrangements.

• Banking organizations should have appropri-

ate controls to ensure that their processes for

achieving balanced compensation arrange-

ments are followed and to maintain the integ-

rity of their risk-management and other func-

tions.

To help prevent damage from occurring, a

banking organization should have strong con-

17. A malus arrangement permits the employer to prevent

vesting of all or part of the amount of a deferred remuneration

award. Malus provisions are invoked when risk outcomes are

worse than expected or when the information upon which the

award was based turns out to have been incorrect. Loss of

unvested compensation due to the employee voluntarily leav-

ing the ﬁrm is not an example of malus as the term is used in

this guidance.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 9

trols governing its process for designing, imple-

menting, and monitoring incentive compensa-

tion arrangements. Banking organizations

should create and maintain sufﬁcient documen-

tation to permit an audit of the effectiveness of

the organization’s processes for establishing,

modifying, and monitoring incentive compensa-

tion arrangements. Smaller banking organiza-

tions should incorporate reviews of these pro-

cesses into their overall framework for

compliance monitoring (including internal

audit).

Large complex banking organizations.

LCBOs should have and maintain policies and

procedures that (1) identify and describe the

role(s) of the personnel, business units, and con-

trol units authorized to be involved in the

design, implementation, and monitoring of

incentive compensation arrangements; (2) iden-

tify the source of signiﬁcant risk-related inputs

into these processes and establish appropriate

controls governing the development and

approval of these inputs to help ensure their

integrity; and (3) identify the individual(s) and

control unit(s) whose approval is necessary for

the establishment of new incentive compensa-

tion arrangements or modiﬁcation of existing

arrangements.

An LCBO also should conduct regular inter-

nal reviews to ensure that its processes for

achieving and maintaining balanced incentive

compensation arrangements are consistently fol-

lowed. Such reviews should be conducted by

audit, compliance, or other personnel in a man-

ner consistent with the organization’s overall

framework for compliance monitoring. An

LCBO’s internal audit department also should

separately conduct regular audits of the organi-

zation’s compliance with its established policies

and controls relating to incentive compensation

arrangements. The results should be reported to

appropriate levels of management and, where

appropriate, the organization’s board of

directors.

• Appropriate personnel, including risk-

management personnel, should have input

into the organization’s processes for design-

ing incentive compensation arrangements and

assessing their effectiveness in restraining

imprudent risk-taking.

Developing incentive compensation arrange-

ments that provide balanced risk-taking incen-

tives and monitoring arrangements to ensure

they achieve balance over time requires an

understanding of the risks (including compli-

ance risks) and potential risk outcomes associ-

ated with the activities of the relevant employ-

ees. Accordingly, banking organizations should

have policies and procedures that ensure that

risk-management personnel have an appropriate

role in the organization’s processes for design-

ing incentive compensation arrangements and

for assessing their effectiveness in restraining

imprudent risk-taking.

Ways that risk manag-

ers might assist in achieving balanced compen-

sation arrangements include, but are not limited

1. reviewing the types of risks associated with

the activities of covered employees;

2. approving the risk measures used in risk

adjustments and performance measures, as

well as measures of risk outcomes used in

deferred-payout arrangements; and

3. analyzing risk-taking and risk outcomes rela-

tive to incentive compensation payments.

Other functions within an organization, such

as its control, human resources, or ﬁnance func-

tions, also play an important role in helping

ensure that incentive compensation arrange-

ments are balanced. For example, these func-

tions may contribute to the design and review of

performance measures used in compensation

arrangements or may supply data used as part of

these measures.

• Compensation for employees in risk-

management and control functions should be

sufﬁcient to attract and retain qualiﬁed per-

sonnel and should avoid conﬂicts of interest.

The risk-management and control personnel

involved in the design, oversight, and operation

of incentive compensation arrangements should

have appropriate skills and experience needed to

effectively fulﬁll their roles. These skills and

experiences should be sufﬁcient to equip the

personnel to remain effective in the face of

challenges by covered employees seeking to

increase their incentive compensation in ways

that are inconsistent with sound risk-

management or internal controls. The compen-

sation arrangements for employees in risk-

management and control functions thus should

be sufﬁcient to attract and retain qualiﬁed per-

18. Involvement of risk-management personnel in the

design and monitoring of these arrangements also should help

ensure that the organization’s risk-management functions can

properly understand and address the full range of risks facing

the organization.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 10

sonnel with experience and expertise in these

ﬁelds that is appropriate in light of the size,

activities, and complexity of the organization.

In addition, to help preserve the indepen-

dence of their perspectives, the incentive com-

pensation received by risk-management and

control personnel staff should not be based sub-

stantially on the ﬁnancial performance of the

business units that they review. Rather, the per-

formance measures used in the incentive com-

pensation arrangements for these personnel

should be based primarily on the achievement

of the objectives of their functions (e.g., adher-

ence to internal controls).

• Banking organizations should monitor the

performance of their incentive compensation

arrangements and should revise the arrange-

ments as needed if payments do not appropri-

ately reﬂect risk.

Banking organizations should monitor incen-

tive compensation awards and payments, risks

taken, and actual risk outcomes to determine

whether incentive compensation payments to

employees are reduced to reﬂect adverse risk

outcomes or high levels of risk taken. Results

should be reported to appropriate levels of man-

agement, including the board of directors where

warranted and consistent with Principle 3 below.

The monitoring methods and processes used by

a banking organization should be commensurate

with the size and complexity of the organiza-

tion, as well as its use of incentive compensa-

tion. Thus, for example, a small, noncomplex

organization that uses incentive compensation

only to a limited extent may ﬁnd that it can

appropriately monitor its arrangements through

normal management processes.

A banking organization should take the

results of such monitoring into account in estab-

lishing or modifying incentive compensation

arrangements and in overseeing associated con-

trols. If, over time, incentive compensation paid

by a banking organization does not appropri-

ately reﬂect risk outcomes, the organization

should review and revise its incentive compen-

sation arrangements and related controls to

ensure that the arrangements, as designed and

implemented, are balanced and do not provide

employees incentives to take imprudent risks.

2068.0.2.3 Principle 3: Strong Corporate

Governance

Banking organizations should have strong and

effective corporate governance to help ensure

sound compensation practices, including active

and effective oversight by the board of directors.

Given the key role of senior executives in man-

aging the overall risk-taking activities of an

organization, the board of directors of a banking

organization should directly approve the incen-

tive compensation arrangements for senior

executives.

The board also should approve

and document any material exceptions or adjust-

ments to the incentive compensation arrange-

ments established for senior executives and

should carefully consider and monitor the

effects of any approved exceptions or adjust-

ments on the balance of the arrangement, the

risk-taking incentives of the senior executive,

and the safety and soundness of the

organization.

The board of directors of an organization

also is ultimately responsible for ensuring that

the organization’s incentive compensation

arrangements for all covered employees are

appropriately balanced and do not jeopardize

the safety and soundness of the organization.

The involvement of the board of directors in

oversight of the organization’s overall incen-

tive compensation program should be scaled

appropriately to the scope and prevalence of

the organization’s incentive compensation

arrangements.

Large complex banking organizations and

organizations that are signiﬁcant users of incen-

tive compensation. The board of directors of an

LCBO or other banking organization that uses

incentive compensation to a signiﬁcant extent

should actively oversee the development and

operation of the organization’s incentive com-

pensation policies, systems, and related control

processes. The board of directors of such an

organization should review and approve the

overall goals and purposes of the organization’s

incentive compensation system. In addition, the

board should provide clear direction to manage-

ment to ensure that the goals and policies it

establishes are carried out in a manner that

19. As used in this guidance, the term ‘‘board of directors’’

is used to refer to the members of the board of directors who

have primary responsibility for overseeing the incentive com-

pensation system. Depending on the manner in which the

board is organized, the term may refer to the entire board of

directors, a compensation committee of the board, or another

committee of the board that has primary responsibility for

overseeing the incentive compensation system. In the case of

FBOs, the term refers to the relevant oversight body for the

ﬁrm’s U.S. operations, consistent with the FBO’s overall

corporate and management structure.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 11

achieves balance and is consistent with safety

and soundness.

The board of directors of such an organiza-

tion also should ensure that steps are taken so

that the incentive compensation system—

including performance measures and targets—is

designed and operated in a manner that will

achieve balance.

• The board of directors should monitor the

performance, and regularly review the design

and function, of incentive compensation

arrangements.

To allow for informed reviews, the board

should receive data and analysis from manage-

ment or other sources that are sufﬁcient to allow

the board to assess whether the overall design

and performance of the organization’s incentive

compensation arrangements are consistent with

the organization’s safety and soundness. These

reviews and reports should be appropriately

scoped to reﬂect the size and complexity of the

banking organization’s activities and the preva-

lence and scope of its incentive compensation

arrangements.

The board of directors of a banking organiza-

tion should closely monitor incentive compensa-

tion payments to senior executives and the sen-

sitivity of those payments to risk outcomes. In

addition, if the compensation arrangement for a

senior executive includes a clawback provision,

then the review should include sufﬁcient infor-

mation to determine if the provision has been

triggered and executed as planned.

The board of directors of a banking organiza-

tion should seek to stay abreast of signiﬁcant

emerging changes in compensation plan mecha-

nisms and incentives in the marketplace as well

as developments in academic research and regu-

latory advice regarding incentive compensation

policies. However, the board should recognize

that organizations, activities, and practices

within the industry are not identical. Incentive

compensation arrangements at one organization

may not be suitable for use at another organiza-

tion because of differences in the risks, controls,

structure, and management among organiza-

tions. The board of directors of each organiza-

tion is responsible for ensuring that the incen-

tive compensation arrangements for its

organization do not encourage employees to

take risks that are beyond the organization’s

ability to manage effectively, regardless of the

practices employed by other organizations.

Large complex banking organizations and

organizations that are signiﬁcant users of incen-

tive compensation. The board of an LCBO or

other organization that uses incentive compensa-

tion to a signiﬁcant extent should receive and

review, on an annual or more frequent basis, an

assessment by management, with appropriate

input from risk-management personnel, of the

effectiveness of the design and operation of the

organization’s incentive compensation system

in providing risk-taking incentives that are con-

sistent with the organization’s safety and sound-

ness. These reports should include an evaluation

of whether or how incentive compensation prac-

tices may increase the potential for imprudent

risk-taking.

The board of such an organization also should

receive periodic reports that review incentive

compensation awards and payments relative to

risk outcomes on a backward-looking basis to

determine whether the organization’s incentive

compensation arrangements may be promoting

imprudent risk-taking. Boards of directors of

these organizations also should consider periodi-

cally obtaining and reviewing simulation analy-

sis of compensation on a forward-looking basis

based on a range of performance levels, risk

outcomes, and the amount of risks taken.

• The organization, composition, and resources

of the board of directors should permit effec-

tive oversight of incentive compensation.

The board of directors of a banking organiza-

tion should have, or have access to, a level of

expertise and experience in risk-management

and compensation practices in the ﬁnancial ser-

vices industry that is appropriate for the nature,

scope, and complexity of the organization’s

activities. This level of expertise may be present

collectively among the members of the board,

may come from formal training or from experi-

ence in addressing these issues, including as a

director, or may be obtained through advice

received from outside counsel, consultants, or

other experts with expertise in incentive com-

pensation and risk-management. The board of

directors of an organization with less complex

and extensive incentive compensation arrange-

ments may not ﬁnd it necessary or appropriate

to require special board expertise or to retain

and use outside experts in this area.

In selecting and using outside parties, the

board of directors should give due attention to

potential conﬂicts of interest arising from other

dealings of the parties with the organization or

for other reasons. The board also should exer-

cise caution to avoid allowing outside parties to

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 12

obtain undue levels of inﬂuence. While the

retention and use of outside parties may be

helpful, the board retains ultimate responsibility

for ensuring that the organization’s incentive

compensation arrangements are consistent with

safety and soundness.

Large complex banking organizations and

organizations that are signiﬁcant users of incen-

tive compensation. If a separate compensation

committee is not already in place or required by

other authorities,

the board of directors of an

LCBO or other banking organization that uses

incentive compensation to a signiﬁcant extent

should consider establishing such a

committee—reporting to the full board—that

has primary responsibility for overseeing the

organization’s incentive compensation systems.

A compensation committee should be composed

solely or predominantly of non-executive direc-

tors. If the board does not have such a compen-

sation committee, the board should take other

steps to ensure that non-executive directors of

the board are actively involved in the oversight

of incentive compensation systems. The com-

pensation committee should work closely with

any board-level risk and audit committees where

the substance of their actions overlap.

• A banking organization’s disclosure prac-

tices should support safe and sound incentive

compensation arrangements.

If a banking organization’s incentive compen-

sation arrangements provide employees incen-

tives to take risks that are beyond the tolerance

of the organization’s shareholders, these risks

are likely to also present a risk to the safety and

soundness of the organization.

To help pro-

mote safety and soundness, a banking organiza-

tion should provide an appropriate amount of

information concerning its incentive compensa-

tion arrangements for executive and non-

executive employees and related risk-

management, control, and governance processes

to shareholders to allow them to monitor and,

where appropriate, take actions to restrain the

potential for such arrangements and processes

that encourage employees to take imprudent

risks. Such disclosures should include informa-

tion relevant to employees other than senior

executives. The scope and level of the informa-

tion disclosed by the organization should be

tailored to the nature and complexity of the

organization and its incentive compensation

arrangements.

• Large complex banking organizations should

follow a systematic approach to developing a

compensation system that has balanced incen-

tive compensation arrangements.

At banking organizations with large numbers

of risk-taking employees engaged in diverse

activities, an ad hoc approach to developing

balanced arrangements is unlikely to be reliable.

Thus, an LCBO should use a systematic

approach—supported by robust and formalized

policies, procedures, and systems—to ensure

that those arrangements are appropriately bal-

anced and consistent with safety and soundness.

Such an approach should provide for the organi-

zation effectively to:

1. Identify employees who are eligible to

receive incentive compensation and whose

activities may expose the organization to

material risks. These employees should

include

a. senior executives and others who are

responsible for oversight of the organiza-

tion’s ﬁrm-wide activities or material

business lines;

b. individual employees, including non-

executive employees, whose activities

may expose the organization to material

amounts of risk; and

c. groups of employees who are subject to

the same or similar incentive compensa-

tion arrangements and who, in the aggre-

gate, may expose the organization to

material amounts of risk;

2. Identify the types and time horizons of risks

to the organization from the activities of

these employees;

3. Assess the potential for the performance

measures included in the incentive compen-

sation arrangements for these employees to

encourage the employees to take imprudent

risks;

20. See New York Stock Exchange Listed Company

Manual Section 303A.05(a); Nasdaq Listing Rule 5605(d);

Internal Revenue Code section 162(m) (26 U.S.C. 162(m)).

21. On the other hand, as noted previously, compensation

arrangements that are in the interests of the shareholders of a

banking organization are not necessarily consistent with safety

and soundness.

22. A banking organization also should comply with the

incentive compensation disclosure requirements of the federal

securities law and other laws as applicable. See, for example,

Proxy Disclosure Enhancements, SEC Release Nos. 33-9089,

34-61175, 74 F.R. 68334 (Dec. 23, 2009) (to be codiﬁed at 17

C.F.R. 229 and 249).

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 13

4. Include balancing elements, such as risk

adjustments or deferral periods, within the

incentive compensation arrangements for

these employees that are reasonably designed

to ensure that the arrangement will be bal-

anced in light of the size, type, and time

horizon of the inherent risks of the employ-

ees’ activities;

5. Communicate to the employees the ways in

which their incentive compensation awards

or payments will be adjusted to reﬂect the

risks of their activities to the organization;

and

6. Monitor incentive compensation awards,

payments, risks taken, and risk outcomes for

these employees and modify the relevant

arrangements if payments made are not

appropriately sensitive to risk and risk

outcomes.

2068.0.3 CONCLUSION ON SOUND

INCENTIVE COMPENSATION

Banking organizations are responsible for ensur-

ing that their incentive compensation arrange-

ments do not encourage imprudent risk-taking

behavior and are consistent with the safety and

soundness of the organization. The Federal

Reserve expects banking organizations to take

prompt action to address deﬁciencies in their

incentive compensation arrangements or related

risk-management, control, and governance

processes.

The Federal Reserve intends to actively moni-

tor the actions taken by banking organizations

in this area and will promote further advances in

designing and implementing balanced incentive

compensation arrangements. Where appropri-

ate, the Federal Reserve will take supervisory or

enforcement action to ensure that material deﬁ-

ciencies that pose a threat to the safety and

soundness of the organization are promptly

addressed. The Federal Reserve also will update

this guidance as appropriate to incorporate best

practices as they develop over time.

Sound Incentive Compensation Policies 2068.0

BHC Supervision Manual July 2010

Page 14

Taxes (Consolidated Tax Filing)

Section 2070.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2014, this section is revised to

include a June 13, 2014, interagency Addendum

to the 1998 “Interagency Policy Statement on

Income Tax Allocation in a Holding Company

Structure” (Addendum). The Board of Gover-

nors of the Federal Reserve System, Federal

Deposit Insurance Corporation, and the Ofﬁce

of the Comptroller of the Currency (Agencies)

announced the issuance of the Addendum to

ensure that insured depository institutions (IDIs)

in a consolidated group maintain an appropri-

ate relationship regarding the payment of taxes

and treatment of tax refunds. The purpose of the

Addendum is to ensure that tax allocation agree-

ments expressly acknowledge an agency rela-

tionship between a holding company

and its

subsidiary IDI to protect the IDI’s ownership

rights in tax refunds. State member banks and

holding companies should implement the guid-

ance as soon as reasonably possible, which the

Agency expect would not be later than October

31, 2014. This Addendum clariﬁes and supple-

ments but does not replace the 1998 Interagency

Policy Statement. (Refer to SR-14-6.)

A holding company and its depository institu-

tion subsidiaries may generally ﬁle a consoli-

dated group income tax return. For bank regula-

tory purposes, however, each depository

institution is viewed as, and reports as, a sepa-

rate legal and accounting entity. Each holding

company subsidiary that participates in ﬁling a

consolidated tax return should record its tax

expenses or tax beneﬁts as though it had ﬁled a

tax return as a separate entity. The amount and

timing of any intercompany payments or

refunds to the subsidiary that result from its

being a part of the consolidated return group

should be no more favorable than if the subsidi-

ary was a separate taxpayer. A consolidated

return permits the parent’s and other subsidi-

aries’ taxable losses to be offset against other

subsidiaries’ taxable income, with the parent

most often providing the principal loss. This can

be illustrated with the following example:

Parent

Only Bank

Non-

bank A

Non-

bank B

Consoli-

dated

Contribution to

consolidated net

taxable income

(loss): $(100) $2,000 $500 $(50) $2,350

Assumed tax

rate 40% 40% 40% 40% 40%

Tax payment/

(beneﬁt) $(40) $ 800 $200 $(20) $ 940

In this example, the parent, as the representa-

tive of the consolidated group to the Internal

Revenue Service, would collect $800 from the

bank subsidiary and $200 from Nonbank Sub-

sidiary A, and pay $20 to Nonbank Subsidiary

B. In return, the parent would remit to the tax

authorities $940, resulting in a net cash reten-

tion of $40 by the parent.

Bank holding companies employ numerous

methods to determine the amount of estimated

payments to be received from their subsidiaries.

Although the tax-accounting methods to be used

by bank holding companies are not prescribed

by the Federal Reserve System, the method

employed must afford subsidiaries equitable

treatment compared with ﬁling separate returns.

In general terms, tax transactions between any

subsidiary and its parent should be conducted as

though the subsidiary was dealing directly with

state or federal taxing authorities.

The tax structure of holding companies

becomes more complicated when deferred taxes

are considered in the intercorporate tax settle-

ments.

Deferred taxes occur when taxable

income, for ﬁnancial reporting purposes, differs

from taxable income as reported to the taxing

authorities. This difference is due to timing dif-

ferences between ﬁnancial-statement income

and tax income for loan-loss provisions and

other items, such as foreign tax credits. In addi-

tion, differences result from the use of the cash

basis of accounting for tax purposes, as opposed

to the accrual basis of accounting used in ﬁnan-

1. For the purpose of this guidance, the term, “holding

company” refers to a bank holding company or a savings and

loan holding company.

2. The issue becomes more complex because of GAAP-

based tax expenses versus actual taxes paid under relevant tax

laws (the difference between the two expenses is either a

deferred tax liability or asset on the balance sheet). If the

sharing agreement is based on the tax expense on the state-

ment of income, more funds may be transferred to the paying

agent than are required to settle the actual taxes owed.

BHC Supervision Manual July 2014

Page 1

cial reporting. The different bases are chosen by

management.

An example of deferred income taxes fol-

lows, using an estimated tax rate of 40 percent.

Financial

Reporting

Tax

Return

Pre-tax income $200 $150

Currently payable 60 60

Deferred portion 20

—

TOTAL 80 60

Net income $120 $90

The deferred portion represents the tax effect of

delaying the recognition of income or taking

more of a deduction for tax-return purposes

(40% x $50). This is a temporary difference

since over the “life” of the holding company,

income and deductions should theoretically

equalize for both book and tax purposes.

Financial Accounting Standards Board

Accounting Standards Codiﬁcation 740-10

Statement No. 109 (FAS 109), “Accounting for

Income Taxes,” provides guidance on many

aspects of accounting for income taxes, includ-

ing the accounting for deferred tax liabilities

and assets. FAS 109 describes how a bank hold-

ing company should record (1) taxes payable or

refundable for the current year and (2) deferred

tax liabilities and assets for the future tax conse-

quences of events that have been recognized in

the banking organization’s ﬁnancial statements

or tax returns.

Generally, all bank and other holding compa-

nies ﬁle annual income tax returns. The holding

company pays the entire amount of tax (that is,

the amount still due after estimated tax pay-

ments) on or before the due date for ﬁling, or it

can elect to pay by the extension deadline if one

is granted. Bank holding companies may receive

extensions from taxing authorities to ﬁle their

returns later. For the federal tax return, a six-

month extension may be granted.

Bank holding companies generally pay esti-

mated taxes throughout the year. The most com-

mon payment dates will be as follows (assum-

ing calendar period):

April 15 —ﬁrst estimate (25%)

June 15 —second estimate (25%)

September 15 —third estimate (25%)

December 15 —fourth estimate (25%)

March 15 —Due date for income tax

return for U.S. corporations

or foreign corporations with

ofﬁces in the United States.

Last day for ﬁling for the auto-

matic six-month extension.

September 15 —Due date of return if six-month

extensions were granted.

Bank holding companies have engaged in

intercorporate income tax settlements that have

the effect of transferring assets and income from

a bank subsidiary to the parent company. The

Board will apply appropriate supervisory rem-

edies to situations that are considered inequi-

table or improper. These remedies may include,

under certain circumstances, the Board’s cease-

and-desist powers.

On occasion, bank holding companies have

used deferred tax assets as a vehicle to transfer

cash or other earning assets of subsidiaries, prin-

cipally from the bank, into the parent company.

The Board’s opinion is that each deferred tax

asset or liability must remain on the books of

the subsidiary. If deferred tax assets have been

transferred to the parent, regardless of when the

transfer may have occurred, immediate arrange-

ments must be made to return the asset to the

appropriate subsidiary. Instances of transferring

deferred tax assets to the parent are worthy of

inclusion in the Examiner’s Comments and Mat-

ters Requiring Special Board Attention section

or page of the inspection report.

2070.0.1 INTERAGENCY POLICY

STATEMENT ON INCOME TAX

ALLOCATION IN A HOLDING

COMPANY STRUCTURE

In 1998, the federal bank and savings associa-

tion’s regulatory agencies (the agencies) issued

the following policy statement to provide guid-

ance to banking organizations and savings asso-

ciations regarding the allocation and payment of

taxes among a holding company and its subsidi-

aries. A holding company and its subsidiaries

will often ﬁle a consolidated group income tax

return. However, for bank regulatory purposes,

each depository institution of the consolidated

group is viewed as, and reports as, a separate

legal and accounting entity. Accordingly, each

depository institution’s applicable income taxes,

reﬂecting either an expense or beneﬁt, should be

recorded as if the institution had ﬁled as a

Taxes (Consolidated Tax Filing) 2070.0

BHC Supervision Manual July 2014

Page 2

separate tax-paying entity.

The amount and tim-

ing of payments or refunds should be no less

favorable to a subsidiary than if it was a sepa-

rate taxpayer. Any practice that is not consistent

with this policy statement may be viewed as an

unsafe and unsound practice prompting either

informal or formal corrective action. See SR-98-

38.

2070.0.1.1 Tax-Sharing Agreements

A holding company and its subsidiary institu-

tions are encouraged to enter into a written

comprehensive tax-allocation agreement tai-

lored to their speciﬁc circumstances. The agree-

ment should be approved by the respective

boards of directors. Although each agreement

will be different, tax-allocation agreements usu-

ally address certain issues common to consoli-

dated groups.

Therefore, such an agreement should—

1. require a subsidiary depository institution to

compute its income taxes (both current and

deferred) on a separate-entity basis;

2. discuss the amount and timing of the institu-

tion’s payments for current tax expense,

including estimated tax payments;

3. discuss reimbursements to an institution

when it has a loss for tax purposes; and

4. prohibit the payment or other transfer of

deferred taxes by the institution to another

member of the consolidated group.

2070.0.1.2 Measurement of Current and

Deferred Income Taxes

Generally accepted accounting principles,

instructions for the preparation of the federally

supervised bank Consolidated Reports of Condi-

tion and Income, and other guidance issued by

the agencies require depository institutions to

account for their current and deferred tax liabil-

ity or beneﬁt.

When the depository-institution members of a

consolidated group prepare separate bank regu-

latory reports, each subsidiary institution should

record current and deferred taxes as if it ﬁles its

tax returns on a separate-entity basis, regardless

of the consolidated group’s tax-paying or

-refund status. Certain adjustments for statutory

tax considerations that arise in a consolidated

return, e.g., application of graduated tax rates,

may be made to the separate-entity calculation

as long as they are made on a consistent and

equitable basis among the holding company

afﬁliates.

In addition, when an organization’s consoli-

dated income tax obligation arising from the

alternative minimum tax (AMT) exceeds its

regular tax on a consolidated basis, the excess

should be consistently and equitably allocated

among the members of the consolidated group.

The allocation method should be based upon the

portion of tax preferences, adjustments, and

other items generated by each group member

which causes the AMT to be applicable at the

consolidated level.

2070.0.1.3 Tax Payments to the Parent

Company

Tax payments from a subsidiary institution to

the parent company should not exceed the

amount the institution has properly recorded as

its current tax expense on a separate-entity basis.

Furthermore, such payments, including esti-

mated tax payments, generally should not be

made before the institution would have been

obligated to pay the taxing authority had it ﬁled

as a separate entity. Payments made in advance

may be considered extensions of credit from the

subsidiary to the parent and may be subject to

afﬁliate transaction rules, i.e., sections 23A and

23B of the Federal Reserve Act.

A subsidiary institution should not pay its

deferred tax liabilities or the deferred portion of

its applicable income taxes to the parent. The

deferred tax account is not a tax liability

required to be paid in the current reporting

period. As a result, the payment of deferred

income taxes by an institution to its holding

company is considered a dividend subject to

dividend restrictions,

not the extinguishment of

a liability. Furthermore, such payments may

constitute an unsafe and unsound banking prac-

tice.

3. Throughout the policy statement, the terms “separate

entity” and “separate taxpayer” are used synonymously. When

a depository institution has subsidiaries of its own, the institu-

tion’s applicable income taxes on a separate-entity basis

include the taxes of the subsidiaries of the institution that are

included with the institution in the consolidated group return.

4. These restrictions include the prompt-corrective-action

provisions of section 38(d)(1) of the Federal Deposit Insur-

ance Act (12 U.S.C. 1831o(d)(1)) and its implementing regu-

lations: for insured state nonmember banks, 12 CFR 325,

subpart B; for national banks, 12 CFR section 6.6; for savings

associations, 12 CFR 565; and for state member banks, 12

CFR 208.45.

Taxes (Consolidated Tax Filing) 2070.0

BHC Supervision Manual July 2014

Page 3

2070.0.1.4 Tax Refunds from the Parent

Company

An institution incurring a loss for tax purposes

should record a current income tax beneﬁt and

receive a refund from its parent in an amount no

less than the amount the institution would have

been entitled to receive as a separate entity. The

refund should be made to the institution within a

reasonable period following the date the institu-

tion would have ﬁled its own return, regardless

of whether the consolidated group is receiving a

refund. If a refund is not made to the institution

within this period, the institution’s primary fed-

eral regulator may consider the receivable as

either an extension of credit or a dividend from

the subsidiary to the parent. A parent company

may reimburse an institution more than the

refund amount it is due on a separate-entity

basis. Provided the institution will not later be

required to repay this excess amount to the

parent, the additional funds received should be

reported as a capital contribution.

If the institution, as a separate entity, would

not be entitled to a current refund because it has

no carry-back beneﬁts available on a separate-

entity basis, its holding company may still be

able to utilize the institution’s tax loss to reduce

the consolidated group’s current tax liability. In

this situation, the holding company may reim-

burse the institution for the use of the tax loss. If

the reimbursement will be made on a timely

basis, the institution should reﬂect the tax bene-

ﬁt of the loss in the current portion of its appli-

cable income taxes in the period the loss is

incurred. Otherwise, the institution should not

recognize the tax beneﬁt in the current portion

of its applicable income taxes in the loss year.

Rather, the tax loss represents a loss carry-

forward, the beneﬁt of which is recognized as a

deferred tax asset, net of any valuation allow-

ance.

Regardless of the treatment of an institution’s

tax loss for regulatory reporting and supervisory

purposes, a parent company that receives a tax

refund from a taxing authority obtains these

funds as agent for the consolidated group on

behalf of the group members.

Accordingly, an

organization’s tax-allocation agreement or other

corporate policies should not purport to charac-

terize refunds attributable to a subsidiary deposi-

tory institution that the parent receives from a

taxing authority as the property of the parent.

2070.0.1.5 Income-Tax-Forgiveness

Transactions

A parent company may require a subsidiary

institution to pay it less than the full amount of

the current income tax liability that the institu-

tion calculated on a separate-entity basis. Pro-

vided the parent will not later require the institu-

tion to pay the remainder of the current tax

liability, the amount of this unremitted liability

should be accounted for as having been paid

with a simultaneous capital contribution by the

parent to the subsidiary.

In contrast, a parent cannot make a capital

contribution to a subsidiary institution by “for-

giving” some or all of the subsidiary’s deferred

tax liability. Transactions in which a parent “for-

gives” any portion of a subsidiary institution’s

deferred tax liability should not be reﬂected in

the institution’s regulatory reports. These trans-

actions lack economic substance because each

member of the consolidated group is jointly and

severally liable for the group’s potential future

obligation to the taxing authorities. Although

the subsidiaries have no direct obligation to

remit tax payments to the taxing authorities,

these authorities can collect some or all of a

group liability from any of the group members

if tax payments are not made when due.

2070.0.1.6 Appendix — 2014 Addendum

to 1998 Interagency Policy Statement on

Income Tax Allocation in a Holding

Company Structure

Since the issuance of the 1998 Interagency Pol-

icy Statement, courts have reached varying con-

clusions regarding whether tax allocation agree-

ments create a debtor-creditor relationship

between a holding company and its IDI.

Some

courts have found that the tax refunds in ques-

tion were the property of the holding company

in bankruptcy (rather than property of the sub-

5. See 26 CFR 1.1502-77(a).

6. Case law on this issue is mixed. Compare Zucker v.

FDIC, as Receiver for BankUnited, 727 F.3d 1100, 1108-09

(11th Cir. Aug. 15, 2013) (“The relationship between the

Holding Company and the Bank is not a debtor-creditor

relationship. When the Holding Company received the tax

refunds it held the funds intact—as if in escrow—for the

beneﬁt of the Bank and thus the remaining members of the

Consolidated Group.”) with F.D.I.C. v. Siegel (In re IndyMac

Bancorp, Inc.), F. App’x , 2014 WL 1568759, *2

(9th Cir. Apr. 21, 2014) (per curiam) (“The TSA does not

create a trust relationship. The absence of language creating a

trust relationship is explicitly an indication of a debtor-

creditor relationship in California”).

Taxes (Consolidated Tax Filing) 2070.0

BHC Supervision Manual July 2014

Page 4

sidiary IDI) and held by the holding company as

the IDI’s debtor.

On June 13, 2014, an Addendum to the 1998

Interagency Policy Statement (Addendum) was

issued by the Board of Governors of the Federal

Reserve System, Federal Deposit Insurance Cor-

poration, and the Ofﬁce of the Comptroller of

the Currency (Agencies). It explains that Con-

solidated Groups should review their tax alloca-

tion agreements to ensure the agreements

achieve the objectives of the Interagency Policy

Statement. This Addendum also clariﬁes how

certain of the requirements of sections 23A and

23B of the Federal Reserve Act (FRA) apply to

tax allocation agreements between IDIs and

their afﬁliates.

In reviewing their tax allocation agreements,

Consolidated Groups should ensure the agree-

ments: (1) clearly acknowledge that an agency

relationship exists between the holding com-

pany and its subsidiary IDIs with respect to tax

refunds, and (2) do not contain other language

to suggest a contrary intent.

In addition, all

Consolidated Groups should amend their tax

allocation agreements to include the following

paragraph or substantially similar language:

The [holding company] is an agent for the

[IDI and its subsidiaries] (the “Institution”) with

respect to all matters related to consolidated tax

returns and refund claims, and nothing in this

agreement shall be construed to alter or modify

this agency relationship. If the [holding com-

pany] receives a tax refund from a taxing

authority, these funds are obtained as agent for

the Institution. Any tax refund attributable to

income earned, taxes paid, and losses incurred

by the Institution is the property of and owned

by the Institution, and shall be held in trust by

the [holding company] for the beneﬁt of the

Institution. The [holding company] shall for-

ward promptly the amounts held in trust to the

Institution. Nothing in this agreement is

intended to be or should be construed to provide

the [holding company] with an ownership inter-

est in a tax refund that is attributable to income

earned, taxes paid, and losses incurred by the

Institution. The [holding company] hereby

agrees that this tax sharing agreement does not

give it an ownership interest in a tax refund

generated by the tax attributes of the Institution.

Going forward, the Agencies generally will

deem tax allocation agreements that contain this

or similar language to acknowledge that an

agency relationship exists for purposes of the

Interagency Policy Statement, this Addendum,

and sections 23A and 23B of the FRA.

All tax allocation agreements are subject to

the requirements of section 23B of the FRA, and

tax allocation agreements that do not clearly

acknowledge that an agency relationship exists

may be subject to additional requirements under

section 23A of the FRA.

In general, section

23B requires afﬁliate transactions to be made on

terms and under circumstances that are substan-

tially the same, or at least as favorable to the

IDI, as comparable transactions involving non-

afﬁliated companies or, in the absence of compa-

rable transactions, on terms and circumstances

that would in good faith be offered to non-

afﬁliated companies.

Tax allocation agree-

ments should require the holding company to

forward promptly any payment due the IDI

under the tax allocation agreement and specify

the timing of such payment. Agreements that

allow a holding company to hold and not

promptly transmit tax refunds received from the

taxing authority and owed to an IDI are incon-

sistent with the requirements of section 23B and

subject to supervisory action. However, an

Agency’s determination of whether such provi-

sion, or the tax allocation agreement in total, is

consistent with section 23B will be based on the

facts and circumstances of the particular tax

allocation agreement and any associated refund.

State member banks and holding companies

should implement this 2014 Addendum guid-

ance as soon as reasonably possible, which the

Agencies expect would not be later than Octo-

ber 31, 2014. See 79 Fed. Reg. 35230, June 19,

2014, and SR-14-6, July 15, 2014, “Addendum

to the Interagency Policy Statement on Income

Tax Allocation in a Holding Company Struc-

ture.”

7. See e.g., F.D.I.C. v. Siegel (In re IndyMac Bancorp, Inc.),

F. App’x , 2014 WL 1568759 (9th Cir. Apr. 21,

2014) (per curiam).

8. This Addendum clariﬁes and supplements but does not

replace the Interagency Policy Statement.

9. Section 23A requires, among other things, that loans and

extensions of credit from a bank to its afﬁliates be properly

collateralized. 12 U.S.C. 371c(c).

10. 12 U.S.C. 371c-1(a). Transactions subject to section 23B

include the payment of money by a bank to an afﬁliate under

contract, lease, or otherwise and transactions in which the

afﬁliate acts as agent of the bank. Id. at § 371c-1(a)(2) &

(a)(4).

Taxes (Consolidated Tax Filing) 2070.0

BHC Supervision Manual July 2014

Page 5

2070.0.2 Qualifying Subchapter S

Corporations

The Small Business Job Protection Act of 1996

made changes to the Internal Revenue Code (the

code). On October 29, 1996, the FFIEC issued a

bulletin notifying all federally insured banks

and thrifts of the impact of these changes. Thrift

organizations may qualify for Subchapter S cor-

poration

status under the code’s revisions and

could generally receive pass-through tax treat-

ment for federal income tax purposes if certain

criteria are met.

The bulletin states that no formal application

is required to be ﬁled with the federal bank and

thrift regulatory agencies merely as a result of

an election by a bank, thrift, or parent holding

company to become a Subchapter S corporation.

However, if an institution takes certain steps to

meet the criteria to qualify for this tax status,

particularly the code’s limitations on the num-

ber and types of shareholders, applications or

notices to the agencies may be required.

The FFIEC bulletin also states that any distri-

butions made by the Subchapter S banking orga-

nization to its shareholders, including distribu-

tions intended to cover shareholders’ personal

tax liabilities for their shares of the income of

the institution, will continue to be regarded as

dividends and subject to any limitations under

relevant banking law. See SR-96-28.

2070.0.3 Inspection Objectives

1. To determine whether the supervisory and

accounting guidance set forth in ASC 740-10

(FASB 109), other tax-accounting standards,

and the 1998 interagency policy statement on

income tax allocation has been appropriately,

equitably, and consistently applied.

2. To verify that the parent’s intercorporate tax

policy contains a provision requiring the sub-

sidiaries to receive an appropriate refund

from the parent when they incur a loss, and

that such a refund would have been receiv-

able from the tax authorities if the subsidiary

was ﬁling a separate return.

3. To ascertain that tax payments and tax

refunds between ﬁnancial institution subsidi-

aries and the parent company have been lim-

ited to no more than what the institution

might have paid to or received from the tax

authorities, if it had ﬁled its tax returns on a

timely, separate-entity basis.

4. To determine that no deferred tax liability,

corresponding asset, or the deferred portion

of its applicable income taxes has been trans-

ferred from a bank subsidiary to the parent

company.

5. To verify that there has been proper account-

ability for tax-forgiveness transactions

between the parent company and its ﬁnancial

institution subsidiaries.

6. To substantiate that corporate practices are

consistent with corporate policies.

2070.0.4 Inspection Procedures

1. Obtain and discuss with the holding com-

pany’s management its intercorporate

income tax policies and tax-sharing agree-

ments. Obtain and retain a copy of the inter-

corporate tax policies and agreements in the

workpaper ﬁles. Review the written intercor-

porate tax-settlement policy and ascertain

that it includes the following:

a. a description of the method(s) used in

determining the amount of estimated taxes

paid by each subsidiary to the parent

b. an indication of when payments are to be

made

c. a statement that deferred taxes are main-

tained on the afﬁliate’s general ledger

d. procedures for handling tax claims and

refunds

Holding companies of depository institutions

should also have written tax-sharing agreements

with their subsidiaries that specify intercorpo-

rate tax-settlement policies. The Board encour-

ages these holding companies to develop such

agreements. For tax-sharing agreements, the fol-

lowing inspection procedures should be fol-

lowed:

a. Determine whether each subsidiary is

required to compute its income taxes (cur-

rent and deferred) on a separate-entity

basis.

b. Ascertain if the amount and timing of

payments for current tax expense, includ-

ing estimated tax payments, are discussed.

c. Determine if reimbursements are dis-

cussed when an institution has a loss for

11. Subchapter S corporations are corporations that elect to

pass corporate income tax losses, deductions, and credit

through to their shareholders for federal income tax purposes.

12. The term “separate-entity basis” recognizes that certain

adjustments, in particular tax elections in a consolidated

return, may, in certain periods, result in higher payments by

the depository institution than would have been made if the

depository institution was unafﬁliated.

Taxes (Consolidated Tax Filing) 2070.0

BHC Supervision Manual July 2014

Page 6

tax purposes.

d. Determine if there is a prohibition on the

payment or other transfer of deferred

taxes by an institution to another member

of the consolidated group.

2. Review brieﬂy the parent’s intercompany

transaction report; general ledger income tax

accounts; cash receipts and disbursements;

and, if necessary, tax-return workpapers and

sponsored ABCP program under the risk-

based capital guidelines.

b. Verify that the assets of the banking orga-

nization’s eligible ABCP program and

any associated minority interest were

included in the banking organization’s

calculation of its risk-based capital ratios.

c. Ascertain whether the liquidity facilities

the banking organization extends to the

ABCP program satisfy the risk-based

capital requirements, including the appro-

priate asset-quality test, of an eligible

ABCP program liquidity facility. (See

12 C.F.R. 225, appendix A, section

III.B.3.a.iv.)

d. Determine whether the banking organiza-

tion applied the correct credit-conversion

Credit-Supported and Asset-Backed Commercial Paper 2128.03

BHC Supervision Manual July 2015

Page 7

factor to the eligible ABCP liquidity

facilities when it determined the amount

of risk-weighted assets for its risk-based

capital ratios. (See 12 C.F.R. 225, appen-

dix A, section III.D.)

e. Determine if all ineligible ABCP liquidity

facilities were treated as either direct-

credit substitutes or as recourse obliga-

tions, as required by the risk-based capital

guidelines.

f. If the banking organization had multiple

overlapping exposures, determine if the

banking organization applied the risk-

based capital treatment that resulted in the

highest capital charge. (See 12 CFR 225,

appendix A, section III.B.6.c.)

6. Include in the inspection report a discussion

of the size, effectiveness, and risks associ-

ated with ABCP programs (include the dis-

cussion in the conﬁdential section of the

inspection report if not appropriate for the

open section).

Credit-Supported and Asset-Backed Commercial Paper 2128.03

BHC Supervision Manual July 2015

Page 8

Implicit Recourse Provided to Asset Securitizations

(Risk Management and Internal Controls) Section 2128.04

Implicit recourse arises when a bank holding

company

provides credit support to one of

more of its securitizations beyond its contractual

obligation. Implicit recourse, like contractual

recourse, exposes a bank holding company to

the risk of loss arising from deterioration in the

credit quality of the underlying assets of the

securitization. Implicit recourse is of supervi-

sory concern because it demonstrates that the

securitizing bank holding company is reassum-

ing risk associated with the securitized assets—

risk that the bank holding company initially

transferred to the marketplace. For risk-based

capital purposes, bank holding companies

deemed to be providing implicit recourse are

generally required to hold capital against the

entire outstanding amount of assets sold, as

though the assets remained on the bank holding

company’s books.

Banking organizations have typically pro-

vided implicit recourse in situations where the

originating banking organization perceived that

the failure to provide this support, even though

not contractually required, would damage its

future access to the asset-backed securities mar-

ket. An originating bank holding company can

provide implicit recourse in a variety of ways.

The ultimate determination as to whether

implicit recourse exists depends on the facts.

The following actions point to a ﬁnding of

implicit recourse:

1. selling assets to a securitization trust or other

special-purpose entity (SPE) at a discount

from the price speciﬁed in the securitization

documents, which is typically par value

2. purchasing assets from a trust or other SPE at

an amount greater than fair value

3. exchanging performing assets for nonper-

forming assets in a trust or other SPE

4. funding credit enhancements

beyond con-

tractual requirements

By providing implicit recourse, a bank hold-

ing company signals to the market that it still

holds the risks inherent in the securitized assets,

and, in effect, the risks have not been trans-

ferred. Accordingly, examiners must be atten-

tive to bank holding companies that provide

implicit support, given the risk these actions

pose to a bank holding company’s ﬁnancial

condition. Increased attention should be given

to situations where a bank holding company is

more likely to provide implicit support.

Particular attention should be paid to revolv-

ing securitizations, such as those used for credit

card lines and home equity lines of credit, in

which receivables generated by the lines are

sold into the securitizations. These securitiza-

tions typically provide that, when certain perfor-

mance criteria hit speciﬁed thresholds, no new

receivables can be sold into the securitization,

and the principal on the bonds issued will begin

to pay out. These early-amortization events are

intended to protect investors from further dete-

rioration in the underlying asset pool. Once an

early-amortization event has occurred, the bank

holding company could have difﬁculties using

securitization as a continuing source of funding

and, at the same time, have to fund the new

receivables generated by the lines of credit on

its balance sheet. Thus, bank holding companies

have an incentive to avoid early amortization by

providing implicit support to the securitization.

Examiners should be alert for securitizations

that are approaching early-amortization triggers,

such as a decrease in the excess spread

below a

certain threshold or an increase in delinquencies

beyond a certain rate. Providing implicit

recourse can pose a degree of risk to a bank

holding company’s ﬁnancial condition and to

the integrity of its regulatory and public ﬁnan-

cial statements and reports. Examiners should

review securitization documents (for example,

pooling and servicing agreements) to ensure that

the selling institution limits any post-sale sup-

port to that speciﬁed in the terms and conditions

in the securitization documents. Examiners

should also review a sample of receivables

transferred between the seller and the trust to

ensure that these transfers were conducted in

accordance with the contractual terms of the

securitization, particularly in cases where the

overall credit quality of the securitized loans or

receivables has deteriorated. While bank hold-

1. The reference to implicit-recourse activities of bank

holding companies is intended to include all of a bank holding

company’s domestic and foreign subsidiaries supervised by

the Federal Reserve, as well as its federally insured depository

institutions and other entities that are subject to this interpreta-

tion and guidance of the Federal Financial Institutions Exami-

nation Council (FFIEC).

2. Credit enhancements include retained subordinated

interests, asset-purchase obligations, overcollateralization,

cash-collateral accounts, spread accounts, and interest-only

strips.

3. Excess spread generally is deﬁned as ﬁnance-charge

collections minus certiﬁcate interest, servicing fees, and

charge-offs allocated to the series.

BHC Supervision Manual December 2002

Page 1

ing companies are not prohibited from provid-

ing implicit recourse, such support will gener-

ally result in higher capital requirements.

Examiners should recommend that prompt

supervisory action be taken when implicit

recourse is identiﬁed. To determine the appro-

priate action, examiners need to understand the

bank holding company’s reasons for providing

support and the extent of the impact of this

support on the bank holding company’s earn-

ings and capital. As with contractual recourse,

actions involving noncontractual post-sale credit

enhancement generally result in the requirement

that the bank holding company hold risk-based

capital against the entire outstanding amount of

the securitized assets. The Federal Reserve may

require the bank holding company to bring all

assets in existing securitizations back on the

balance sheet for risk-based capital purposes, as

well as require the bank holding company to

increase its minimum capital ratios. The Federal

Reserve may prevent a bank holding company

from removing assets from its risk-weighted

asset base on future transactions until the bank

holding company demonstrates its intent and

ability to transfer risk to the marketplace. The

Federal Reserve may consider other actions to

ensure that the risks associated with implicit

recourse are adequately reﬂected in the capital

ratios. For example, supervisors may require the

bank holding company to deduct residual inter-

ests from tier 1 capital as well as hold risk-based

capital on the underlying assets. (See SR-02-

15.)

The following examples illustrate post-sale

actions that banking organizations may take

with respect to assets they have securitized.

These examples are intended to provide guid-

ance on whether these actions would be consid-

ered implicit recourse for risk-based capital and

other supervisory purposes. A key factor in each

scenario and analysis is the potential risk of loss

a bank holding company’s earnings and capital

may be exposed to as a result of its actions.

Account Removal: Example 1a

Facts. A bank holding company originates and

services credit card receivables throughout the

country. The bank holding company decides to

divest those credit card accounts of customers

who reside in speciﬁc geographic areas where

the bank holding company lacks a signiﬁcant

market presence. To achieve the maximum sales

price, the sale must include both the credit card

relationships and the receivables. Because many

of the credit card receivables are securitized

through a master-trust structure, the bank hold-

ing company needs to remove the receivables

from the trust. The affected receivables are not

experiencing any unusual performance prob-

lems. In that respect, the charge-off and delin-

quency ratios for the receivables to be removed

from the trust are substantially similar to those

for the trust as a whole.

The bank holding company enters into a con-

tract to sell the speciﬁed credit card accounts

before the receivables are removed from the

trust. The terms of the transaction are arm’s

length, wherein the bank holding company will

sell the receivables at market value. The bank

holding company separately agrees to purchase

the receivables from the trust at this same price.

Therefore, no loss is incurred as a result of

removing the receivables from the trust. The

bank holding company will remove from the

trust only those receivables that are due from

customers located in the geographic areas where

the bank holding company lacks a signiﬁcant

market presence, and it will remove all such

receivables from the trust.

Analysis. The removal of the above-described

receivables from the trust does not constitute

implicit recourse for regulatory capital purposes.

Supporting factors for this conclusion include

the following:

1. The bank holding company’s earnings and

capital are not exposed to actual or potential

risk of loss as a result of removing the receiv-

ables from the trust.

2. There is no indication that the receivables are

removed from the trust because of perfor-

mance concerns.

3. The bank holding company is removing the

receivables from the trust for a legitimate

business purpose other than to systematically

improve the quality of the trust’s assets. The

legitimate business purpose is evidenced by

the bank holding company’s prearranged,

arm’s-length sale agreement that facilitates

exiting the business in identiﬁed geographic

locations.

Examiners should review the terms and condi-

tions of the transaction to ensure that the market

value of the receivables is documented and well

supported before concluding that this transac-

tion does not represent implicit recourse. Exam-

iners should also ensure that the selling bank

holding company has not provided the pur-

Implicit Recourse Provided to Asset Securitizations 2128.04

BHC Supervision Manual December 2002

Page 2

chaser with any guarantees or credit enhance-

ments on the sold receivables.

Account Removal: Example 1b

Facts. After the establishment of a master trust

for a pool of credit card receivables, the receiv-

ables in the trust begin to experience adverse

performance. A combination of lower-than-

expected yields and higher-than-anticipated

charge-offs on the pool causes spreads to com-

press signiﬁcantly (although not to zero). The

bank holding company’s internally generated

forecasts indicate that spreads will likely

become negative in the near future. Manage-

ment takes action to support the trust by pur-

chasing the low-quality (delinquent) receivables

from the trust at par, although their market value

is less than par. The receivables purchased from

the trust represent approximately one-third of

the trust’s total receivables. This action

improves the overall performance of the trust

and avoids a potential early-amortization event.

Analysis. The purchase of low-quality receiv-

ables from a trust at par constitutes implicit

recourse for regulatory capital purposes. The

purchase of low-quality receivables at an above-

market price exposes the bank holding com-

pany’s earnings and capital to potential future

losses from assets that had previously been sold.

Accordingly, the bank holding company is

required to hold risk-based capital for the

remaining assets in the trust as if they were

retained on the balance sheet, as well as hold

capital for the assets that were repurchased.

Additions of Future Assets or

Receivables: Example 2a

Facts. Months after the issuance of credit card

asset-backed securities, charge-offs and delin-

quencies on the underlying pool of receivables

rise dramatically. A rating agency places the

securities on watch for a potential rating down-

grade. The securitization documents require the

bank holding company to transfer new receiv-

ables to the securitization trust at par value.

However, to maintain the rating on the securi-

ties, the bank holding company begins to sell

replacement receivables into the trust at a dis-

count from par value.

Analysis. The sale of receivables to the trust at a

discount constitutes implicit recourse for regula-

tory capital purposes. The sale of assets at a

discount from the price speciﬁed in the securiti-

zation documents, par value in this example,

exposes the bank holding company’s earnings

and capital to future losses. The bank holding

company must hold regulatory capital against

the outstanding assets in the trust.

Additions of Future Assets or

Receivables: Example 2b

Facts. A bank holding company established a

credit card master trust. The receivables from

the accounts placed in the trust were, on aver-

age, of lesser quality than the receivables from

certain afﬁnity accounts retained on the bank

holding company’s balance sheet. Under the

criteria for selecting the receivables to be trans-

ferred to the master trust, the bank holding

company was prevented from including the

better-performing afﬁnity accounts in the initial

pool of accounts because the afﬁnity-

relationship contract was expiring. The bank

holding company and the afﬁnity client subse-

quently revised the terms of their contract,

enabling the afﬁnity accounts to meet the selec-

tion criteria and be included in future securitiza-

tion transactions. Later, rising charge-offs within

the pool of receivables held by the trust caused

spread compression in the trust. To improve the

performance of the assets in the trust, the bank

holding company begins to include the better-

performing and now-eligible receivables from

the afﬁnity accounts among the receivables sold

to the trust. This action improves the trust’s

performance, including its spread levels and

charge-off ratios. However, the replacement

assets were sold at par in accordance with the

terms of the trust agreement, so no current or

future charge to the bank holding company’s

earnings or capital will result from these asset

sales. As another result of this action, the perfor-

mance of the trust’s assets closely tracks the

credit card receivables that remain on the bank

holding company’s balance sheet.

Analysis. The actions described above do not

constitute implicit recourse for regulatory capi-

tal purposes. The bank holding company did not

incur any additional risk to earnings or capital

after the afﬁnity accounts met the selection crite-

ria for replacement assets and after the associ-

ated receivables were among the receivables

sold to the trust. The replacement assets were

sold at par in accordance with the terms of the

Implicit Recourse Provided to Asset Securitizations 2128.04

BHC Supervision Manual December 2002

Page 3

trust agreement, so no future charge to earnings

or capital will result from these asset sales. The

sale of replacement assets into a master-trust

structure is part of normal trust management.

In this example, the credit card receivables

that remain on the bank holding company’s

balance sheet closely track the performance of

the trust’s assets. Nevertheless, examiners

should ascertain whether a securitizing bank

holding company sells disproportionately

higher-quality assets into securitizations while

retaining comparatively lower-quality assets on

its books. If a bank holding company engages in

this practice, examiners should consider its

effect on the bank holding company’s capital

adequacy.

Additions of Future Assets or

Receivables: Example 2c

Facts. A bank holding company establishes a

credit card master trust composed of receivables

from accounts that were generally of lower qual-

ity than the receivables retained on the bank

holding company’s balance sheet. The differ-

ence in the two portfolios is primarily due to

logistical and operational problems that prevent

the bank holding company from including cer-

tain better-quality afﬁnity accounts in the initial

pool from which accounts were selected for

securitization. Rising charge-offs and other fac-

tors later result in margin compression on the

assets in the master trust, which causes some

concern in the market regarding the stability of

the outstanding asset-backed securities. A rating

agency places several tranches of the securities

on its watch list for a potential rating down-

grade. In response to the margin compression,

as part of the bank holding company’s contrac-

tual obligations, spread accounts are increased

for all classes by trapping excess spread in

conformance with the terms and conditions of

the securitization documents. To stabilize the

quality of the receivables in the master trust, as

well as to preclude a downgrade, the bank hold-

ing company takes several actions beyond its

contractual obligations:

1. Afﬁnity accounts are added to the pool of

receivables eligible for inclusion in the trust.

This change results in improved overall trust

performance. However, these receivables are

sold to the trust at par value, consistent with

the terms of the securitization documents, so

no current or future charge to the bank hold-

ing company’s earnings or capital will result

from these asset sales.

2. The charge-off policy for cardholders that

have ﬁled for bankruptcy is changed from

criteria that were more conservative than

industry standards, the applicable Federal

Reserve classiﬁcation policy for bank hold-

ing companies, and the FFIEC Uniform

Retail Credit Classiﬁcation and Account

Management Policy to criteria that conform

to industry standards, the Federal Reserve’s

standards, and the FFIEC’s policy.

3. Charged-off receivables held by the trust are

sold to a third party. The funds generated by

this sale, effectively accelerating the recov-

ery on these receivables, improve the trust’s

spread performance.

Analysis. The actions described above do not

constitute implicit recourse for regulatory capi-

tal purposes. None of the noncontractual actions

result in a loss or expose the bank holding

company’s earnings or capital to the risk of loss.

Because of the margin compression, the bank

holding company is obligated to increase the

spread accounts in conformance with the terms

and conditions of the securitization documents.

To the extent this results in an increase in the

value of the subordinated spread accounts

(residual interests) on the bank holding com-

pany’s balance sheet, the bank holding company

will need to hold additional capital on a dollar-

for-dollar basis for the additional credit risk it

retains. In contrast, if the bank holding company

increased the spread accounts beyond its con-

tractual obligation under the securitization docu-

ments, this action would be considered a form

of implicit recourse. None of the other actions

the bank holding company took would affect its

earnings or capital:

1. Like other additions to credit card trusts, the

additions of receivables from the new afﬁnity

accounts were made at par value, in accor-

dance with the securitization documents.

Therefore, the additions of receivables from

the new afﬁnity accounts would not affect the

bank holding company’s earnings or capital.

2. The trust’s policy on the timing of charge-

offs on accounts of cardholders who have

ﬁled for bankruptcy was changed to meet the

less stringent standards of the industry and

those required under the Federal Reserve’s

policy in order to improve trust performance,

at least temporarily. Nonetheless, this would

not affect the bank holding company’s earn-

ings or capital.

Implicit Recourse Provided to Asset Securitizations 2128.04

BHC Supervision Manual December 2002

Page 4

3. In accordance with the securitization docu-

ments, proceeds from recoveries on charged-

off accounts are the property of the trust.

These and other proceeds would continue to

be paid out in accordance with the pooling

and servicing agreement. No impact on the

bank holding company’s earnings or capital

would result.

Modiﬁcation of Loan-Repayment Terms:

Example 3

Facts. In performing the role of servicer for its

securitization, a bank holding company is autho-

rized under its pooling and servicing agreement

to modify loan-repayment terms when it appears

that this action will improve the likelihood of

repayment on the loan. These actions are part of

the bank holding company’s process of working

with customers who are delinquent or otherwise

experiencing temporary ﬁnancial difﬁculties. All

of the modiﬁcations are consistent with the bank

holding company’s internal loan policy. How-

ever, in modifying the loan terms, the contrac-

tual maturity of some loans may be extended

beyond the ﬁnal maturity date of the most junior

class of securities sold to investors. When this

occurs, the bank holding company repurchases

these loans from the securitization trust at par.

Analysis. The combination of the loan-term

modiﬁcation for securitized assets and the sub-

sequent repurchase constitutes implicit recourse

for regulatory capital purposes. While the modi-

ﬁcation of loan terms is permitted under the

pooling and servicing agreement, the repurchase

of modiﬁed loans with extended maturities at

par exposes the bank holding company’s earn-

ings and capital to potential risk of loss.

Servicer’s Payment of Deﬁciency

Balances: Example 4

Facts. A wholly owned subsidiary of a bank

holding company originates and services a port-

folio of home equity loans. After liquidation of

the collateral for a defaulted loan, the subsidiary

makes the trust whole in terms of principal and

interest if the proceeds from the collateral are

not sufﬁcient. However, there is no contractual

commitment that requires the subsidiary to sup-

port the pool in this manner. The payments

made to the trust to cover deﬁcient balances on

the defaulted loans are not recoverable under

the terms of the pooling and servicing

agreement.

Analysis. The subsidiary’s action constitutes

implicit recourse to the bank holding company

for regulatory capital purposes. This action is

considered implicit recourse because it

adversely affects the bank holding company’s

earnings and capital since the bank holding

company absorbs losses on the loans resulting

from the actions taken by its subsidiary. Further,

no mechanism exists to provide for and ensure

that the subsidiary will be reimbursed for the

payments made to the trust. In addition, examin-

ers will consider any servicer advance a credit

enhancement if the servicer is not entitled to full

reimbursement

or if the reimbursement is sub-

ordinate to other claims.

Reimbursement of Credit Enhancer’s

Actual Losses: Example 5

Facts. A bank holding company sponsoring a

securitization arranges for an unrelated third

party to provide a ﬁrst-loss credit enhancement,

such as a ﬁnancial standby letter of credit, that

will cover losses up to the ﬁrst 10 percent of the

securitized assets. The bank holding company

agrees to pay a ﬁxed amount as an annual pre-

mium for this credit enhancement. The third

party initially covers actual losses that occur in

the underlying asset pool in accordance with its

contractual commitment under the letter of

credit. Later, the bank holding company agrees

not only to pay the credit enhancer the annual

premium on the credit enhancement, but also to

reimburse the credit enhancer for the losses it

absorbed during the preceding year. This reim-

bursement for actual losses was not originally

provided for in the contractual arrangement

between the bank holding company and the

credit-enhancement provider.

Analysis. The bank holding company’s subse-

quent reimbursement of the credit-enhancement

provider’s losses constitutes implicit recourse

because the bank holding company’s reimburse-

ment of losses went beyond its contractual obli-

gations. Furthermore, the Federal Reserve

would consider any requirement contained in

the original credit-enhancement contract that

obligates the bank holding company to reim-

4. A servicer advance will also be considered a form of

credit enhancement if, for any one loan, nonreimbursable

advances are not contractually limited to an insigniﬁcant

amount of that loan’s outstanding principal.

Implicit Recourse Provided to Asset Securitizations 2128.04

BHC Supervision Manual December 2002

Page 5

burse the credit-enhancement provider for its

losses to be a recourse arrangement.

2128.04.1 INSPECTION OBJECTIVES

1. To identify asset-securitization transactions

in which the bank holding company has pro-

vided implicit recourse.

2. To ascertain whether implicit recourse pro-

vided to asset-securitization transactions may

be detrimental to the bank holding com-

pany’s earnings performance, capital

adequacy, and ﬁnancial condition.

3. To initiate quick supervisory action, which

may include increased minimum-capital

requirements, when implicit recourse is

identiﬁed.

2128.04.2 INSPECTION PROCEDURES

1. Be attentive to situations in which the bank

holding company may have provided implicit

support to an asset-securitization transaction.

2. Be alert for securitizations that are approach-

ing early-amortization triggers, such as a

decrease in the excess spread below a certain

threshold or an increase in delinquencies

beyond a certain rate.

3. Review securitization documents to ensure

that the selling institution limits any post-

sale support to that speciﬁed in the terms and

conditions in the securitization documents.

4. Review a sample of receivables transferred

between the seller and the trust to ensure that

the transfers were conducted in accordance

with the contractual terms of the securitiza-

tion, particularly in cases where the overall

credit quality of the securitized loans or

receivables has deteriorated.

5. Review the terms and conditions of the secu-

ritization transactions reviewed to ensure that

the market value of the receivables is docu-

mented and well supported.

6. Ascertain that the selling bank holding com-

pany has not provided a purchaser with any

guarantees or credit enhancements on the

sold receivables.

7. Ascertain whether a securitizing bank hold-

ing company sells disproportionately higher-

quality assets into securitizations while

retaining comparatively lower-quality assets

on its books. Evaluate the effect of this prac-

tice on the bank holding company’s earnings

and capital adequacy.

8. Provide appropriate written documentation

and recommend that prompt supervisory

action be taken when implicit recourse is

identiﬁed.

Implicit Recourse Provided to Asset Securitizations 2128.04

BHC Supervision Manual December 2002

Page 6

Securitization Covenants Linked to Supervisory Actions or Thresholds

(Risk Management and Internal Controls) Section 2128.05

A bank holding company’s board of directors

and senior management are responsible for initi-

ating policies and procedures, and for monitor-

ing processes and internal controls, that will

provide reasonable assurance that the bank hold-

ing company’s contracts and commitments do

not include detrimental covenants that affect its

safety and soundness. When examiners review a

bank holding company’s securitization contracts

and related documentation, they should be alert

to any covenants that use adverse supervisory

actions or the breach of supervisory thresholds

as triggers for early-amortization events or the

transfer of servicing. Examples of such supervi-

sory actions can include a downgrade in the

banking organization’s RFI/C(D) or CAMELS

rating, an enforcement action, or a downgrade

in a depository institution’s prompt-corrective-

action capital category. The inclusion of

supervisory-linked covenants in securitization

documents is considered to be an ‘‘unsafe and

unsound banking practice’’ that undermines the

objective of supervisory actions and thresholds.

An early amortization or transfer of servicing

triggered by such events can create or exacer-

bate liquidity and earnings problems for a bank

holding company that may lead to further dete-

rioration in its ﬁnancial condition.

Covenants that contain triggers tied, directly

or indirectly, to supervisory actions or thresh-

olds can also result in the early amortization of a

securitization at a time when the sponsoring

organization’s ability to access other funding

sources is limited. If an early-amortization event

occurs, investors may lose conﬁdence in the

stability of the sponsoring organization’s asset-

backed securities, thus limiting its ability to

raise new funds through securitization. At the

same time, the organization must fund new

receivables on the balance sheet, potentially

resulting in liquidity problems. Moreover, the

existence of a supervisory-linked trigger poten-

tially could inhibit supervisors from taking

action intended to address problems at a

troubled organization because the action could

trigger an event that worsens its condition or

causes its failure.

The Federal Reserve is concerned that cov-

enants related to supervisory actions may obli-

gate a bank holding company’s management to

disclose conﬁdential information, such as

RFI/C(D) or CAMELS ratings. Disclosure of

such information by a banking organization’s

directors, ofﬁcers, employees, attorneys, or

independent auditors, without explicit authoriza-

tion by its primary regulator, violates supervi-

sory information disclosure rules and policies

and may result in follow-up supervisory action.

Because of the supervisory concerns about

covenants that are linked to supervisory actions,

a federal bank interagency advisory was issued

on May 23, 2002. (See SR-02-14.) The advisory

emphasizes that a banking organization’s man-

agement and board of directors should ensure

that covenants related to supervisory actions or

thresholds are not included in securitization

documents. Covenants that provide for the early

termination of the transaction or compel the

transfer of servicing due, directly or indirectly,

to the occurrence of a supervisory action or

event will be criticized, under appropriate cir-

cumstances, as an unsafe and unsound banking

practice. The Federal Reserve (and other super-

visors) may also take other supervisory actions,

such as requiring additional capital or denying

capital relief for risk-based capital calculations,

regardless of the treatment under generally

accepted accounting principles (GAAP).

Examiners should consider the potential

impact of such covenants in existing transac-

tions when evaluating both the overall condition

of the bank holding company and the speciﬁc

component ratings of capital, liquidity, and man-

agement. Early-amortization triggers will spe-

ciﬁcally be considered in the context of the bank

holding company’s overall liquidity position and

contingency funding plan. For organizations

with limited access to other funding sources or a

signiﬁcant reliance on securitization, the

existence of these triggers presents a greater

degree of supervisory concern. Any bank hold-

ing company that uses securitization as a fund-

ing source should have a viable contingency

funding plan in the event it can no longer access

the securitization market. Examiners should

encourage bank holding company management

to amend, modify, or remove covenants linked

to supervisory actions from existing transac-

tions. Any impediments a bank holding com-

pany may have to taking such actions should be

documented and discussed with the appropriate

supervisory staff of its responsible Reserve

Bank.

2128.05.1 INSPECTION OBJECTIVES

1. During the review of securitization activities

and contracts, to be alert to securitization

BHC Supervision Manual July 2005

Page 1

documents containing covenants that have

triggers tied, directly or indirectly, to supervi-

sory actions or thresholds.

2. Under appropriate circumstances, to criticize

as an unsafe and unsound banking practice

the inclusion of covenants in a securitization-

transaction document when the covenants

provide for the early termination of the trans-

action or compel the transfer of servicing

due, directly or indirectly, to the occurrence

of a supervisory action or event.

3. To determine if the bank holding company

has a viable contingency funding plan that it

can use if it can no longer access the securiti-

zation market.

2128.05.2 INSPECTION PROCEDURES

1. Review a sample of the bank holding com-

pany’s securitization contracts and related

documentation.

2. Evaluate the overall condition of the bank

holding company, as well as the speciﬁc

component ratings of capital, liquidity, and

management.

3. If the bank holding company uses securitiza-

tion as a funding source, determine its over-

all liquidity position and whether it has an

adequate and viable contingency funding

plan that can be used if the bank holding

company can no longer access the securitiza-

tion market.

4. Determine the potential impact of any early-

amortization triggers or transfer of servicing

within the asset-securitization contracts (any

covenants that use adverse supervisory

actions or the crossing of supervisory thresh-

olds as triggers for early-amortization events

or the transfer of servicing).

5. Encourage bank holding company manage-

ment to amend, modify, or remove from

existing transactions any securitization cov-

enants linked to supervisory actions.

6. Report to and consult with Reserve Bank

supervisory staff on any impediments the

directors and senior management of the bank

holding company have to amending, modify-

ing, or removing any such detrimental securi-

tization convenants.

Securitization Covenants Linked to Supervisory Actions or Thresholds 2128.05

BHC Supervision Manual July 2005

Page 2

Valuation of Retained Interests and Risk Management of Securitization

Activities (Risk Management and Internal Controls) Section 2128.06

WHAT’S NEW IN THIS REVISED

SECTION

This section has been revised to replace, as

appropriate, the references to FAS 125 with

either FAS 140 or FAS 157. The Financial

Accounting Standards Board (FASB), issued in

September 2000, FAS 140, “Accounting for

Transfers and Servicing of Financial Assets and

Extinguishments of Liabilities (a replacement of

FAS No. 125).” FAS 157, “Fair Value Measure-

ments,” was issued in September 2006 and was

made effective on November 15, 2007.

2128.06.05 RETAINED INTERESTS

FROM SECURITIZATION ACTIVITIES

Securitization activities present unique and

sometimes complex risks that require the atten-

tion of senior management and the board of

directors. Retained interests from securitization

activities, including interest-only strips receiv-

able, arise when a banking organization (BO)

keeps an interest in the assets sold to a securiti-

zation vehicle that, in turn, issues bonds to

investors.

The methods and models BOs use to value

retained interests and the difﬁculties in manag-

ing exposure to these volatile assets can raise

supervisory concerns. Under generally accepted

accounting principles (GAAP), a BO recognizes

an immediate gain (or loss) on the sale of assets,

in part, by recording its retained interest at fair

value. The valuation of the retained interest is

based on the present value of future cash ﬂows

in excess of the amounts needed to service the

bonds and cover credit losses and other fees of

the securitization vehicle.

Determinations of fair value should be based

on reasonable assumptions about factors such as

discount rates, projected credit losses, and pre-

payment rates. Bank supervisors expect retained

interests to be supported by veriﬁable documen-

tation of fair value in accordance with GAAP. In

the absence of such support, the retained inter-

ests, for regulatory reporting purposes, should

not be carried as assets on a BO’s books, but

should be charged off. Other supervisory con-

cerns include failure to recognize and hold sufﬁ-

cient capital against recourse obligations gener-

ated by securitizations, and the absence of an

adequate independent audit function.

The supervisory guidance focuses on and

incorporates important fundamental concepts of

risk-management and risk-focused supervision:

active oversight by senior management and the

board of directors, the use of effective policies

and limits, accurate and independent procedures

to measure and assess risk, and the maintenance

of strong internal controls.

The guidance

stresses sound risk-management, modeling,

valuation, and disclosure practices for asset

securitization; complements previous supervi-

sory guidance issued on this subject; and supple-

ments existing policy statements and

examination-inspection procedures.

Emphasis

is placed on the expectation that a BO’s

securitization-related retained interest must be

supported by documentation of the interest’s

fair value, using reasonable valuation

assumptions that can be objectively veriﬁed.

Retained interests that lack such objectively

veriﬁable support or that fail to meet these

supervisory standards will be classiﬁed as loss

and disallowed for inclusion as assets of the BO

for regulatory capital purposes. See SR-99-37

and the more complete text of its referenced

interagency guidance on the risk mangement

and valuation of retained interests arising from

asset securitization activities. See also SR-03-4

and its attachment and section 3071.0.

Examiners will review a BO’s valuation of

retained interests and the concentration of these

assets relative to capital. Consistent with exist-

ing supervisory authority, BOs may be required,

on a case-by-case basis, to hold additional capi-

tal commensurate with their risk exposures.

1. The term ‘‘banking organization’’ (BO) refers to any

federally supervised banking organization. This includes fed-

erally insured, federally chartered ﬁnancial institutions that

are supervised by a federal bank or savings association super-

visory authority, as well as bank holding companies and their

nonbank subsidiaries.

2. See Financial Accounting Standards Board (FASB)

Statement of Financial Accounting Standard No. 140 (FAS

140), ‘‘Accounting for Transfers and Servicing of Financial

Assets and Extinguishments of Liabilities (a replacement of

FASB Statement No. 125).’’

3. See SR-96-14, ‘‘Risk-Focused Safety-and-Soundness

Examinations and Inspections’’ (section 2124.0 of this

manual), and SR-95-51, ‘‘Rating the Adequacy of Risk-

Management Processes and Internal Controls at State Mem-

ber Banks and Bank Holding Companies’’ (section 4070.1 of

this manual).

4. See SR-97-21, ‘‘Risk Management and Capital

Adequacy of Exposures Arising from Secondary-Market

Credit Activities,’’ and SR-96-30, ‘‘Risk-Based Capital Treat-

ment for Spread Accounts That Provide Credit Enhancement

for Securitized Receivables.’’

5. For instance, a BO has high concentrations of retained

BHC Supervision Manual July 2008

Page 1

excessive dependence on securitizations for day-

to-day core funding can present signiﬁcant

liquidity problems during times of market turbu-

lence or if there are difﬁculties speciﬁc to the

BO.

2128.06.1 ASSET SECURITIZATION

Asset securitization typically involves the trans-

fer of on-balance-sheet assets to a third party or

trust. In turn, the third party or trust issues

certiﬁcates or notes to investors. The cash ﬂow

from the transferred assets supports repayment

of the certiﬁcates or notes. BOs use asset securi-

tization to access alternative funding sources,

manage concentrations, improve ﬁnancial-

performance ratios, and more efﬁciently meet

customer needs. Assets typically securitized

include credit card receivables, automobile

receivable paper, commercial and residential

ﬁrst mortgages, commercial loans, home equity

loans, and student loans.

Senior management and directors must have

the requisite knowledge of the effect of securiti-

zation on the BO’s risk proﬁle and must be fully

aware of the accounting, legal, and risk-based

capital nuances of this activity. BOs must fully

and accurately distinguish and measure the risks

that are transferred versus those retained, and

must adequately manage the retained portion. It

is essential that BOs engaging in securitization

activities have appropriate front- and back-ofﬁce

stafﬁng, internal and external accounting and

legal support, audit or independent review cov-

erage, information systems capacity, and over-

sight mechanisms to execute, record, and

administer these transactions correctly.

Appropriate valuation and modeling method-

ologies must be used. They must be able to

determine the initial and ongoing value of

retained interests. Accounting rules provide a

method to recognize an immediate gain (or loss)

on the sale, in part, through booking a ‘‘retained

interest.’’ The carrying value, however, of that

interest must be fully documented, based on

reasonable assumptions, and regularly analyzed

for any subsequent impairment in value. The

best evidence of fair value is a quoted market

price in an active market. When quoted market

prices are not available, accounting rules allow

fair value to be estimated. This estimate must be

based on the ‘‘best information available in the

circumstances.’’

An estimate of fair value must

be supported by reasonable and current assump-

tions. If a best estimate of fair value is not

practicable, the asset is to be recorded at zero in

ﬁnancial and regulatory reports. (See FAS 140,

para. 71.)

Unforeseen market events that affect the dis-

count rate or performance of receivables sup-

porting a retained interest can swiftly and dra-

matically alter its value. Without appropriate

internal controls and independent oversight, a

BO that securitizes assets may inappropriately

generate ‘‘paper proﬁts’’ or mask actual losses

through ﬂawed loss assumptions, inaccurate pre-

payment rates, and inappropriate discount rates.

Liberal and unsubstantiated assumptions can

result in material inaccuracies in ﬁnancial state-

ments; substantial write-downs of retained inter-

ests; and, if retained interests represent an exces-

sive concentration of the sponsoring BO’s

capital, the BO’s demise. BO managers and

directors need to ensure the following:

1. Independent risk-management processes are

in place to monitor securitization-pool per-

formance on an aggregate and individual

transaction level. An effective risk-

management function includes appropriate

information systems to monitor securitiza-

tion activities.

2. Appropriate valuation assumptions and mod-

eling methodologies are used to establish,

evaluate, and adjust the carrying value of

retained interests on a regular and timely

basis.

3. Audit or internal review staffs periodically

review data integrity, model algorithms, key

underlying assumptions, and the appropriate-

ness of the valuation and modeling process

for the securitized assets the BO retains. The

ﬁndings of such reviews should be reported

directly to the board or an appropriate board

committee.

4. Accurate and timely risk-based capital calcu-

lations are maintained, including recognition

and reporting of any recourse obligation

resulting from securitization activity.

5. Internal limits are in place to govern the

maximum amount of retained interests as a

percentage of total equity capital.

6. A realistic liquidity plan is in place for the

BO in case of market disruptions.

interests relative to its capital or is otherwise at risk from

impairment of these assets.

6. See FAS 157, ‘‘Fair Value Measurements.’’

Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06

BHC Supervision Manual July 2008

Page 2

2128.06.2 INDEPENDENT

RISK-MANAGEMENT FUNCTION

BOs engaged in securitizations should have an

independent risk-management function com-

mensurate with the complexity and volume of

their securitizations and their overall risk expo-

sures. The risk-management function should

ensure that securitization policies and operating

procedures, including clearly articulated risk

limits, are in place and appropriate for the BO’s

circumstances. A sound asset securitization pol-

icy should include or address, at a minimum—

1. a written and consistently applied accounting

methodology;

2. regulatory reporting requirements;

3. valuation methods, including FAS 157 valua-

tion assumptions, and procedures to formally

approve changes to those assumptions;

4. a management reporting process; and

5. exposure limits and requirements for

both aggregate and individual transaction

monitoring.

It is essential that the risk-management func-

tion monitor origination, collection, and default-

management practices. This includes regular

evaluations of the quality of underwriting,

soundness of the appraisal process, effective-

ness of collections activities, ability of the

default-management staff to resolve severely

delinquent loans in a timely and efﬁcient man-

ner, and the appropriateness of loss-recognition

practices. Because the securitization of assets

can result in the current recognition of antici-

pated income, the risk-management function

should pay particular attention to the types, vol-

umes, and risks of assets being originated, trans-

ferred, and serviced. Senior management and

the risk-management staff must be alert to any

pressures on line managers to originate abnor-

mally large volumes or higher-risk assets to

sustain ongoing income needs. Such pressures

can lead to a compromise of credit-underwriting

standards. This may accelerate credit losses in

future periods, impair the value of retained inter-

ests, and potentially lead to funding problems.

The risk-management function should also

ensure that appropriate management informa-

tion systems (MIS) exist to monitor securitiza-

tion activities. Reporting and documentation

methods must support the initial valuation of

retained interests and ongoing impairment

analyses of these assets. Pool-performance

information will help well-managed BOs

ensure, on a qualitative basis, that a sufﬁcient

amount of economic capital is being held to

cover the various risks inherent in securitization

transactions. The absence of quality MIS will

hinder management’s ability to monitor speciﬁc

pool performance and securitization activities.

At a minimum, MIS reports should address

the following:

1. Securitization summaries for each transac-

tion. The summary should include relevant

transaction terms such as collateral type,

facility amount, maturity, credit-

enhancement and subordination features,

ﬁnancial covenants (termination events and

spread-account capture ‘‘triggers’’), right of

repurchase, and counterparty exposures.

Management should ensure that the summa-

ries for each transaction are distributed to all

personnel associated with securitization

activities.

2. Performance reports by portfolio and spe-

ciﬁc product type. Performance factors

include gross portfolio yield, default rates

and loss severity, delinquencies, prepayments

or payments, and excess spread amounts.

The reports should reﬂect the performance of

assets, both on an individual-pool basis and

total managed assets. These reports should

segregate speciﬁc products and different mar-

keting campaigns.

3. Vintage analysis for each pool using monthly

data. Vintage analysis will help management

understand historical performance trends and

their implications for future default rates,

prepayments, and delinquencies, and there-

fore retained interest values. Management

can use these reports to compare historical

performance trends with underwriting stan-

dards, including the use of a validated credit-

scoring model, to ensure loan pricing is con-

sistent with risk levels. Vintage analysis also

helps in the comparison of deal performance

at periodic intervals and validates retained-

interest valuation assumptions.

4. Static-pool cash-collection analysis. A static-

pool cash-collection analysis involves

reviewing monthly cash receipts relative to

the principal balance of the pool to determine

the cash yield on the portfolio, comparing

the cash yield to the accrual yield, and track-

ing monthly changes. Management should

compare monthly the timing and amount of

cash ﬂows received from the trust with those

projected as part of the FAS 157 retained-

interest valuation analysis. Some master-trust

structures allow excess cash ﬂow to be

Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06

BHC Supervision Manual January 2016

Page 3

shared between series or pools. For

revolving-asset trusts with this master-trust

structure, management should perform a

cash-collection analysis for each master-trust

structure. These analyses are essential in

assessing the actual performance of the port-

folio in terms of default and prepayment

rates. If cash receipts are less than those

assumed in the original valuation of the

retained interest, this analysis will provide

management and the board with an early

warning of possible problems with collec-

tions or extension practices, and impairment

of the retained interest.

5. Sensitivity analysis. A sensitivity analysis

measures the effect of changes in default

rates, prepayment or payment rates, and dis-

count rates to assist management in establish-

ing and validating the carrying value of the

retained interest. Stress tests should be per-

formed at least quarterly. Analyses should

consider potential adverse trends and deter-

mine ‘‘best,’’ ‘‘probable,’’ and ‘‘worst case’’

scenarios for each event. Other factors that

need to be considered are the impact of

increased defaults on collections stafﬁng, the

timing of cash ﬂows, spread-account capture

triggers, overcollateralization triggers, and

early-amortization triggers. An increase in

defaults can result in higher-than-expected

costs and a delay in cash ﬂows, thus decreas-

ing the value of the retained interests. Man-

agement should periodically quantify and

document the potential impact to both earn-

ings and capital, and report the results to the

board of directors. Management should

incorporate this analysis into their overall

interest-rate risk measurement system.

Examiners will review the BO-conducted

analysis and the volatility associated with

retained interests when assessing the Sensi-

tivity to Market Risk component rating (the

‘‘S’’ in the CAMELS rating system for banks

or the ‘‘M’’ for the BHC rating system

6. Statement of covenant compliance. Ongoing

compliance with deal-performance triggers

as deﬁned by the pooling and servicing

agreements should be afﬁrmed at least

monthly. Performance triggers include early

amortization, spread capture, changes to

overcollateralization requirements, and

events that would result in servicer removal.

2128.06.3 VALUATION AND

MODELING PROCESSES

The method and key assumptions used to value

the retained interests and servicing assets or

liabilities must be reasonable and fully

documented. The key assumptions in all valua-

tion analyses include prepayment or payment

rates, default rates, loss-severity factors, and

discount rates. BOs are expected to take a logi-

cal appropriate approach when developing

securitization assumptions and capitalizing

future income ﬂows. It is important that

management quantiﬁes the assumptions at least

quarterly on a pool-by-pool basis and maintains

supporting documentation for all changes to the

assumptions as part of the valuation. Policies

should deﬁne the acceptable reasons for chang-

ing assumptions and require appropriate

management approval.

An exception to this pool-by-pool valuation

analysis may be applied to revolving-asset trusts

if the master-trust structure allows excess cash

ﬂows to be shared between series. In a master

trust, each certiﬁcate of each series represents

an undivided interest in all of the receivables in

the trust. Therefore, valuations are appropriate

at the master-trust level.

To determine the value of the retained interest

at inception, and make appropriate adjustments

going forward, the BO must implement a rea-

sonable modeling process to comply with FAS

157. Management is expected to employ appro-

priate valuation assumptions and projections,

and to maintain veriﬁable objective documenta-

tion of the fair value of the retained interest.

Senior management is responsible for ensuring

that the valuation model accurately reﬂects the

cash ﬂows according to the terms of the securiti-

zation’s structure. For example, the model

should account for any cash collateral or over-

collateralization triggers, trust fees, and

insurance payments if appropriate. The board

and management are accountable for the model

builders’ possessing the necessary expertise and

technical proﬁciency to perform the modeling

process. Senior management should ensure that

internal controls are in place to provide for the

ongoing integrity of MIS associated with securi-

tization activities.

As part of the modeling process, the risk-

management function should ensure that peri-

odic validations are performed to reduce vulner-

7. The Joint Agency Policy Statement on Interest-Rate

Risk (see SR-96-13 and section 2127.0) advises institutions

with a high level of exposure to interest-rate risk relative to

capital that they will be directed to take corrective action.

8. See sections 4070.0 and 4070.1.

Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06

BHC Supervision Manual January 2016

Page 4

ability to model risk. Validation of the model

includes testing the internal logic, ensuring

empirical support for the model assumptions,

and back-testing the models using actual cash

ﬂows on a pool-by-pool basis. The validation

process should be documented to support con-

clusions. Senior management should ensure the

validation process is independent from line

management and from the modeling process.

The audit scope should include procedures to

ensure that the modeling process and validation

mechanisms are both appropriate for the BO’s

circumstances and executed consistent with its

asset securitization policy.

2128.06.4 USE OF OUTSIDE PARTIES

Third parties are often engaged to provide pro-

fessional guidance and support regarding a BO’s

securitization activities, transactions, and valu-

ing of retained interests. The use of outside

resources does not relieve directors of their

oversight responsibility, or relieve senior man-

agement of its responsibilities to provide super-

vision, monitoring, and oversight of securitiza-

tion activities, particularly the management of

the risks associated with retained interests. Man-

agement is expected to have the experience,

knowledge, and abilities to discharge its duties

and understand the nature and extent of the risks

retained interests present, and to have the poli-

cies and procedures necessary to implement an

effective risk-management system to control

such risks. Management must have a full under-

standing of the valuation techniques employed,

including the basis and reasonableness of under-

lying assumptions and projections.

2128.06.5 INTERNAL CONTROLS

Effective internal controls are essential to a

BO’s management of the risks associated with

securitization. When properly designed and con-

sistently enforced, a sound system of internal

controls will help management safeguard the

BO’s resources; ensure that ﬁnancial informa-

tion and reports are reliable; and comply with

contractual obligations, including securitization

covenants. It will also reduce the possibility of

signiﬁcant errors and irregularities, and assist in

their timely detection. Internal controls typically

(1) limit authorities; (2) safeguard access to and

use of records; (3) separate and rotate duties;

and (4) ensure both regular and unscheduled

reviews, including testing.

Operational and managerial standards have

been established for internal control and infor-

mation systems.

A system of internal controls

should be maintained that is appropriate to the

BO’s size and the nature, scope, and risk of its

activities.

2128.06.6 AUDIT FUNCTION OR

INTERNAL REVIEW

A BO’s board of directors is responsible for

ensuring that its audit staff or independent

review function is competent regarding securiti-

zation activities. The audit function should per-

form periodic reviews of securitization activi-

ties, including transaction testing and

veriﬁcation, and report all ﬁndings to the board

or appropriate board committee. The audit func-

tion also may be useful to senior management in

identifying and measuring risk related to securi-

tization activities. Principal audit targets should

include compliance with securitization policies,

operating and accounting procedures (FAS 140),

deal covenants, and the accuracy of MIS and

regulatory reports. The audit function also

should conﬁrm that the BO’s regulatory report-

ing process is designed and managed to facili-

tate timely and accurate report ﬁling. Further-

more, when a third party services loans, the

auditors should perform an independent veriﬁ-

cation of the existence of the loans to ensure

that balances reconcile to internal records.

2128.06.7 REGULATORY REPORTING

OF RETAINED INTERESTS

The securitization and subsequent removal of

assets from a BO’s balance sheet requires addi-

tional reporting as part of the regulatory report-

ing process. Common regulatory reporting

errors stemming from securitization activities

may include—

9. See the safety-and-soundness standards for national

banks at 12 CFR 30 (OCC), and for savings associations at 12

CFR 570 (OTS).

10. BOs that are subject to the requirements of FDIC

regulation 12 CFR 363 should include an assessment of the

effectiveness of internal controls over their asset securitiza-

tion activities as part of management’s report on the overall

effectiveness of the system of internal controls over ﬁnancial

reporting. This assessment implicitly includes the internal

controls over ﬁnancial information that is included in regula-

tory reports.

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BHC Supervision Manual January 2016

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1. failure to include off-balance-sheet assets

subject to recourse treatment when calculat-

ing risk-based capital ratios;

2. failure to recognize retained interests and

retained subordinate security interests as a

form of credit enhancement;

3. failure to report loans sold with recourse in

the appropriate section of the regulatory

report; and

4. overvaluing retained interests.

A BO’s directors and senior management are

responsible for the accuracy of its regulatory

reports. Because of the complexities associated

with securitization accounting and risk-based

capital treatment, attention should be directed to

ensuring that personnel who prepare these

reports maintain current knowledge of reporting

rules and associated interpretations. This often

will require ongoing support by qualiﬁed

accounting and legal personnel.

2128.06.8 MARKET DISCIPLINE AND

DISCLOSURES

Transparency through public disclosure is cru-

cial to effective market discipline and can rein-

force supervisory efforts to promote high stan-

dards in risk management. Timely and adequate

information on the BO’s asset securitization

activities should be disclosed. The information

in the disclosures should be comprehensive;

however, the amount of disclosure that is appro-

priate will depend on the volume of securitiza-

tions and complexity of the BO. Well-informed

investors, depositors, creditors, and other coun-

terparties can provide a BO with strong incen-

tives for maintaining sound risk-management

systems and internal controls. Adequate disclo-

sure allows market participants to better under-

stand the BO’s ﬁnancial condition and apply

market discipline, creating incentives to reduce

inappropriate risk taking or inadequate risk-

management practices. Examples of sound dis-

closures include—

1. accounting policies for measuring retained

interests, including a discussion of the

impact of key assumptions on the recorded

value;

2. the process and methodology used to adjust

the value of retained interests for changes in

key assumptions;

3. risk characteristics, both quantitative and

qualitative, of the underlying securitized

assets;

4. the role of retained interests as credit

enhancements to special-purpose entities and

other securitization vehicles, including a dis-

cussion of techniques used for measuring

credit risk; and

5. sensitivity analyses or stress-testing con-

ducted by the BO, showing the effect of

changes in key assumptions on the fair value

of retained interests.

2128.06.9 RISK-BASED CAPITAL FOR

RECOURSE AND LOW-LEVEL-

RECOURSE TRANSACTIONS

For regulatory purposes, recourse is generally

deﬁned as an arrangement in which an institu-

tion retains the risk of credit loss in connection

with an asset transfer, if the risk of credit loss

exceeds a pro rata share of its claim on the

assets.

In addition to broad contractual lan-

guage that may require the seller to support a

securitization, recourse can arise from retained

interests, retained subordinated security inter-

ests, the funding of cash-collateral accounts, or

other forms of credit enhancements that place a

BO’s earnings and capital at risk. These

enhancements should generally be aggregated

to determine the extent of a BO’s support of

securitized assets. Although an asset securitiza-

tion qualiﬁes for sales treatment under GAAP,

the underlying assets may still be subject to

regulatory risk-based capital requirements.

Assets sold with recourse should generally be

risk-weighted as if they had not been sold.

Securitization transactions involving recourse

may be eligible for ‘‘low-level-recourse’’ treat-

ment.

Risk-based capital standards provide

that the dollar amount of risk-based capital

required for assets transferred with recourse

should not exceed the maximum dollar amount

for which a BO is contractually liable. The

low-level-recourse treatment applies to transac-

tions accounted for as sales under GAAP in

which a BO contractually limits its recourse

exposure to less than the full risk-based capital

requirements for the assets transferred. Under

the low-level-recourse principle, the BO holds

11. See the risk-based capital treatment for sales with

recourse at 12 CFR 3, appendix A, section (3)(b)(1)(iii)

(OCC), and 12 CFR 567.6(a)(2)(i)(c) (OTS). For a further

explanation of recourse, see the glossary of the Call Report

instructions, ‘‘Sales of Assets for Risk-Based Capital

Purposes.’’

12. See 60 Fed. Reg. 8177, February 13, 1995 (FRB).

Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06

BHC Supervision Manual January 2016

Page 6

capital on approximately a dollar-for-dollar

basis up to the amount of the aggregate credit

enhancements.

If a BO does not contractually limit the maxi-

mum amount of its recourse obligation, or if the

amount of credit enhancement is greater than

the risk-based capital requirement that would

exist if the assets were not sold, the low-level-

recourse treatment does not apply. Instead, the

BO must hold risk-based capital against the

securitized assets as if those assets had not been

sold. Retained interests that lack objectively

veriﬁable support or that fail to meet the super-

visory standards set forth in this section will be

classiﬁed as loss and disallowed as assets of the

BO for regulatory capital purposes.

2128.06.10 CONCENTRATION LIMITS

IMPOSED ON RETAINED INTERESTS

The creation of a retained interest asset (the

debit) typically also results in an offsetting

‘‘gain on sale’’ (the credit). BOs that securitize

high-yielding assets with long durations may

create a retained-interest asset value that

exceeds the risk-based capital charge that would

be in place if it had not sold the assets (under the

existing risk-based capital guidelines, capital is

not required for the amount over 8 percent of

the securitized assets). Serious problems can

arise for those BOs that distribute contrived

earnings only later to be faced with a downward

valuation and charge-off of part or all of the

retained interests.

As an example, a BO could sell $100 in

subprime home-equity loans and book a retained

interest of $20 using innapropriate valuation

assumptions. Under the current capital rules, the

BO is required to hold approximately $8 in

capital. This $8 is the current capital require-

ment if the loans were never removed from the

balance sheet (8 percent of $100 = $8). How-

ever, the institution is still exposed to substan-

tially all the credit risk, plus the additional risk

to earnings and capital from the volatility of the

retained interest. If the value of the retained

interest decreases to $10 due to the inappropri-

ate assumptions or changes in market condi-

tions, the $8 in capital is insufﬁcient to cover the

entire loss.

Normally, the sponsor will eventually receive

any excess cash ﬂow remaining from securitiza-

tions after investor interests have been met.

However, recent experience has shown that

retained interests are vulnerable to sudden and

sizeable write-downs that can hinder a BO’s

access to the capital markets; damage its reputa-

tion in the marketplace; and, in some cases,

threaten its solvency. A BO’s board of directors

and management is expected to develop and

implement policies that limit the amount of

retained interests that may be carried as a per-

centage of total equity capital, based on the

results of their valuation and modeling pro-

cesses. Well-constructed internal limits also

lessen the incentives for a BO’s personnel to

engage in activities designed to generate near-

term ‘‘paper proﬁts’’ that may be at the expense

of its long-term ﬁnancial position and

reputation.

2128.06.11 INSPECTION OBJECTIVES

1. To determine whether the BO’s retained

interests from asset securitization are prop-

erly documented, valued, and accounted for.

2. To verify that the amount of those retained

interests not supported by adequate docu-

mentation has been charged off for regula-

tory reporting purposes and that the involved

assets are not used for risk-based calculation

purposes.

3. To ascertain the existence of sound risk mod-

eling, management information systems

(MIS), and disclosure practices for asset

securitization.

4. To obtain assurances that the board of direc-

tors and management oversee sound policies

and internal controls concerning the record-

ing and valuation of retained interests

derived from asset securitization activities.

5. To determine if liquidity problems may arise

as the result of an overdependence on asset

securitization activities for day-to-day core

funding.

6. To determine that sufﬁcient capital is held

commensurate with the risk exposures aris-

ing from recourse obligations generated by

asset securitizations.

7. To determine whether there is an indepen-

dent audit function that is capable of evaluat-

ing retained interests involving asset securiti-

zation activities.

2128.06.12 INSPECTION

PROCEDURES

1. Determine the existence of independent risk-

management processes and MIS, and

whether they are being used to monitor

Valuation of Retained Interests and Risk Management of Securitization Activities 2128.06

BHC Supervision Manual January 2016

Page 7

securitization-pool performance on an aggre-

gate and individual transaction level.

2. Review the MIS reports and determine

whether the reports provide—

a. securitization summaries for each transac-

tion;

b. performance reports by portfolio and spe-

ciﬁc product type;

c. vintage analysis for each pool using

monthly data;

d. static-pool cash-collection analysis;

e. sensitivity analysis; and

f. a statement of covenant compliance.

3. Review the BO’s valuation assumptions and

modeling methodologies, and determine if

they are appropriate and are being used to

establish, evaluate, and adjust the carrying

value of retained interests on a regular and

timely basis.

4. Determine if audit or internal review staffs

periodically review data integrity, model

algorithms, key underlying assumptions, and

the appropriateness of the valuation and

modeling process for the securitized assets

that the BO retains.

5. Review the risk-based capital calculations,

and determine if they include recognition

and reporting of any recourse obligation

resulting from securitization activities.

6. Ascertain that internal limits govern the

amount of retained interests held as a per-

centage of total equity capital.

7. Establish that an adequate liquidity contin-

gency plan is in place and that it will be used

in the event of market disruptions. Determine

further whether liquidity problems may arise

as the result of an overdependence on asset

securitization activities for day-to-day core

funding.

8. Determine whether consistent, conservative

accounting practices are in place that satisfy

the reporting requirements of regulatory

supervisors, GAAP reporting requirements,

and valuation assumptions and methods.

Ascertain that adequate disclosures of asset

securitization activities are made commensu-

rate with the volume of securitizations and

the complexities of the BO.

9. Establish that risk-exposure limits and

requirements exist and are adhered to on an

aggregate and individual transaction basis.

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BHC Supervision Manual January 2016

Page 8

Subprime Lending (Risk Management and

Internal Controls) Section 2128.08

Subprime lending presents unique and signiﬁ-

cantly greater risk to banking organizations

(BOs) associated with the activity,

raising

issues about how well they are prepared to

manage and control those risks. Subprime-

lending institutions need strong risk-

management practices and internal controls, as

well as board-approved policies and procedures

that appropriately identify, measure, monitor,

and control all associated risks. BOs consider-

ing or engaging in this type of lending should

recognize the additional risks inherent in this

activity and determine if these risks are accept-

able and controllable, given their organization’s

ﬁnancial condition, asset size, level of capital

support, and staff size.

In response to concerns about subprime lend-

ing, the statement Interagency Guidance on Sub-

prime Lending was issued on March 1, 1999.

The statement’s objective is to increase aware-

ness among examiners and ﬁnancial institutions

of some of the pitfalls and hazards of this type

of lending. (See SR-99-06.) Additional inter-

agency examination guidance was issued on

January 31, 2001, to further strengthen the

supervision of certain institutions, primarily

those institutions having subprime-lending pro-

grams with an aggregate credit exposure equal-

ing or exceeding 25 percent of their tier 1 capi-

tal.

(See SR-01-04.) The aggregate credit

exposure includes principal outstanding and

committed, accrued and unpaid interest, and any

retained residual interests

relating to securi-

tized subprime loans. The Federal Reserve may

also apply the additional guidelines to certain

smaller subprime portfolios, such as those expe-

riencing rapid growth or adverse performance

trends, those administered by inexperienced

management, and those with inadequate or weak

controls. The subprime-lending policy state-

ments are directed primarily to insured deposi-

tory institutions and their subsidiaries. As such,

the guidance applies to bank holding companies

with regard to their oversight and supervision of

insured depository institutions. Bank holding

companies should also consider the statements’

guidance as they supervise the lending activities

of their nonbanking subsidiaries. Bank holding

company examiners should consider this guid-

ance in conjunction with the loan-administration

and lending-standards inspection guidance in

section 2010.2 and with the guidance for asset

securitization in section 2128.02. The inter-

agency subprime-lending policy statements are

described below.

2128.08.1 INTERAGENCY GUIDANCE

ON SUBPRIME LENDING

Insured depository institutions traditionally

avoided lending to customers with poor credit

histories because of the higher risk of default

and resulting loan losses. However, some lend-

ers

extend their risk-selection standards to

attract lower-credit-quality accounts. Moreover,

previous turmoil in the equity and asset-backed

securities markets has caused some nonbank

subprime specialists to exit the market, which

created increased opportunities for ﬁnancial

institutions to enter, or expand their participa-

tion in, the subprime-lending business

The term ‘‘subprime lending’’ is deﬁned for

this statement as extending credit to borrowers

who exhibit characteristics indicating a signiﬁ-

cantly higher risk of default than traditional

bank lending customers.

Subprime borrowers

represent a broad spectrum of debtors, ranging

from those who have repayment problems

because of an adverse event, such as job loss or

medical emergency, to those who persistently

mismanage their ﬁnances and debt obligations.

Subprime borrowers typically have weakened

credit histories that include payment delinquen-

cies and possibly more severe problems, such as

charge-offs, judgments, and bankruptcies. They

1. The term ‘‘banking organizations’’ refers to bank hold-

ing companies and their banking and nonbanking subsidiaries.

2. The statement was adopted and issued by the Board of

Governors of the Federal Reserve System, the Federal

Deposit Insurance Corporation, the Ofﬁce of the Comptroller

of the Currency, and the Ofﬁce of Thrift Supervision.

3. The March 1999 and January 2001 subprime-lending

interagency guidance is consolidated within this section. To

focus on the supervisory guidance that applies primarily to

institutions having subprime-lending programs equaling or

exceeding 25 percent of tier 1 capital, see the January 2001

release speciﬁcally. The March 1999 interagency supervisory

guidance applies to all institutions that engage in subprime

lending.

4. Residual interests are on-balance-sheet assets that repre-

sent interests (including beneﬁcial interests) in transferred

ﬁnancial assets retained by a seller (or transferor) after a

securitization or other transfer of ﬁnancial assets. They are

structured to absorb more than a pro rata share of credit loss

related to the transferred assets through subordination provi-

sions or other credit-enhancement techniques.

5. The terms ‘‘lenders,’’ ‘‘ﬁnancial institutions,’’ and ‘‘insti-

tutions’’ refer to insured depository institutions and their

subsidiaries.

6. For purposes of this statement, loans to customers who

are not subprime borrowers are referred to as ‘‘prime.’’

BHC Supervision Manual December 2002

Page 1

may also display reduced repayment capacity as

measured by credit scores, debt-to-income

ratios, or other criteria that may encompass bor-

rowers with incomplete credit histories. Gener-

ally, subprime borrowers will display a range of

one or more credit-risk characteristics, such

as—

1. two or more 30-day delinquencies in the last

12 months, or one or more 60-day delinquen-

cies in the last 24 months;

2. judgment, foreclosure, repossession, or

charge-off in the prior 24 months;

3. bankruptcy in the last ﬁve years;

4. relatively high default probability as evi-

denced by, for example, a credit bureau risk

score (FICO) of 660 or below (depending on

the product or collateral), or by other bureau

or proprietary scores with an equivalent

default-probability likelihood; or

5. debt-service-to-income ratio of 50 percent or

greater, or an otherwise limited ability to

cover family living expenses after deducting

total monthly debt-service requirements from

monthly income.

Subprime loans are loans to borrowers display-

ing one or more of these characteristics at the

time of origination or purchase.

This guidance applies to direct extensions of

credit; the purchase of subprime loans from

other lenders, including delinquent or credit-

impaired loans purchased at a discount; the pur-

chase of subprime automobile or other ﬁnancing

‘‘paper’’ from lenders or dealers; and the pur-

chase of loan companies that originate subprime

loans. Subprime lending does not include loans

to borrowers who have had minor, temporary

credit difﬁculties but are now current. Also, the

subprime-lending guidance does not generally

apply to prime loans that develop credit prob-

lems after acquisition; loans initially extended

in subprime programs that are later upgraded, as

a result of their performance, to programs tar-

geted to prime borrowers; and community

development loans as deﬁned in the Community

Reinvestment Act (CRA) regulations that may

have some higher risk characteristics, but are

otherwise mitigated by guarantees from govern-

ment programs, private credit enhancements, or

other appropriate risk-mitigation techniques.

Subprime loans command higher interest

rates and loan fees than those offered to

standard-risk borrowers. Subprime loans can be

proﬁtable, provided the price charged by the

lender is sufﬁcient to cover higher loan-loss

rates and overhead costs related to underwriting,

servicing, and collecting the loans. The ability

to securitize and sell subprime portfolios at a

proﬁt while retaining the servicing rights has

made subprime lending attractive to a larger

number of institutions, further increasing the

number of subprime lenders and loans. Some

ﬁnancial institutions have experienced losses

attributable to ill-advised or poorly structured

subprime-lending programs. The losses have

attracted greater supervisory attention to sub-

prime lending and the ability of an insured

depository institution to manage the unique risks

associated with this activity.

Institutions should recognize the additional

risks inherent in subprime lending and deter-

mine if these risks are acceptable and con-

trollable given the institution’s staff, ﬁnancial

condition, size, and level of capital support.

Institutions that engage in a small volume of

subprime lending should have systems in place

commensurate with their level of risk.

2128.08.1.1 Risk Management

The following items are essential components of

a well-structured risk-management program for

subprime lenders:

1. Planning and strategy. Before engaging in

subprime lending, the board and manage-

ment should ensure that proposed activities

are consistent with the institution’s over-

all business strategy and risk tolerances,

and that all involved parties have properly

acknowledged and addressed critical busi-

ness risk issues. These issues include the

costs associated with attracting and retaining

qualiﬁed personnel, investments in the tech-

nology necessary to manage a more complex

portfolio, a clear solicitation and origination

strategy that allows for after-the-fact assess-

ment of underwriting performance, and the

establishment of appropriate feedback and

control systems. The risk-assessment process

should extend beyond credit risk and appro-

priately incorporate operating, compliance,

and legal risks. Finally, the planning process

should set clear objectives for performance,

including the identiﬁcation and segmentation

of target markets or customers, as well as set

performance expectations and benchmarks

for each segment and the portfolio as a

whole. Institutions establishing a subprime-

lending program should proceed slowly and

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 2

cautiously into this activity to minimize the

impact of unforeseen personnel, technology,

or internal-control problems and to deter-

mine if favorable initial proﬁtability esti-

mates are realistic and sustainable.

2. Staff expertise. Subprime lending requires

specialized knowledge and skills that many

ﬁnancial institutions may not possess. Mar-

keting, account-origination, and collections

strategies and techniques often differ from

those employed for prime credit; thus, it may

not be sufﬁcient to have the same lending

staff responsible for both subprime loans and

other loans. Additionally, servicing and col-

lecting subprime loans can be very labor

intensive. If necessary, the institution should

implement programs to train staff. The board

should ensure that staff possess sufﬁcient

expertise to appropriately manage the risks

in subprime lending and that stafﬁng levels

are adequate for the planned volume of sub-

prime activity. The experience, or seasoning,

of staff and loans should be taken into

account as performance is assessed over

time.

3. Lending policy. A subprime-lending policy

should be appropriate to the size and

complexity of the institution’s operations

and should clearly state the goals of the

subprime-lending program. While not

exhaustive, the following lending standards

should be addressed in any subprime-lending

policy:

a. types of products offered as well as those

that are not authorized

b. portfolio targets and limits for each credit

grade or class

c. lending and investment authority clearly

stated for individual ofﬁcers, supervisors,

and loan committees

d. a framework for pricing decisions and

proﬁtability analysis that considers all

costs associated with the loan, including

origination costs, administrative or servic-

ing costs, expected charge-offs, and

capital

e. evaluation of collateral and appraisal

standards

f. well-deﬁned and speciﬁc underwriting

parameters (that is, acceptable loan term,

debt-to-income ratios, and loan-to-

collateral-value ratios for each credit

grade and a minimum acceptable credit

score) that are consistent with any appli-

cable supervisory guidelines

g. procedures for separate tracking and

monitoring of loans approved as excep-

tions to stated policy guidelines

h. credit-ﬁle documentation requirements,

such as applications, offering sheets, loan

and collateral documents, ﬁnancial state-

ments, credit reports, and credit memo-

randa to support the loan decision

i. a correspondent/broker/dealer approval

process, including measures to ensure that

loans originated through this process meet

the institution’s lending standards

If the institution elects to use credit scoring

(including applications scoring) for approv-

als or pricing, the scoring model should be

based on a development population that cap-

tures the behavioral and credit characteristics

of the subprime population targeted for the

products offered. Because of the signiﬁcant

variance in characteristics between the sub-

prime and prime populations, institutions

should not rely on models developed solely

for products offered to prime borrowers. Fur-

ther, the model should be reviewed fre-

quently and updated as necessary to ensure

that assumptions remain valid.

4. Purchase evaluation. As they evaluate

expected proﬁts, institutions that purchase

subprime loans from other lenders or dealers

must give due consideration to the cost of

servicing these assets and to the loan losses

that may be experienced. For instance, some

lenders who sell subprime loans charge bor-

rowers high up-front fees, which are usually

ﬁnanced into the loan. This provides an

incentive for originators to produce a high

volume of loans with little emphasis on qual-

ity, to the detriment of a potential purchaser.

Further, subprime loans, especially those pur-

chased from outside the institution’s lending

area, are at special risk for fraud or misrepre-

sentation (that is, the quality of the loan may

be less than the loan documents indicate).

Institutions should perform a thorough

due-diligence review before committing to

purchase subprime loans. Institutions should

not accept loans from originators that do not

meet their underwriting criteria, and they

should regularly review loans offered to

ensure that loans purchased continue to meet

7. Extensions of credit secured by real estate, whether the

credit is subprime or otherwise, are subject to the Interagency

Guidelines for Real Estate Lending Policies, which establish

supervisory loan-to-value (LTV) limits on various types of

real estate loans and impose limits on an institution’s aggre-

gate investment in loans that exceed the supervisory LTV

limits. (See 12 C.F.R. 208, appendix C.)

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 3

those criteria. Deterioration in the quality of

purchased loans or in the portfolio’s actual

performance versus expectations requires a

thorough reevaluation of the lenders or deal-

ers who originated or sold the loans, as well

as a reevaluation of the institution’s criteria

for underwriting loans and selecting dealers

and lenders. Any such deterioration may also

highlight the need to modify or terminate the

correspondent relationship or to adjust under-

writing and dealer or lender selection criteria.

5. Loan-administration procedures. After

the loan is made or purchased, loan-

administration procedures should provide for

the diligent monitoring of loan performance

and establish sound collection efforts. To

minimize loan losses, successful subprime

lenders have historically employed stronger

collection efforts, such as calling delinquent

borrowers frequently, investing in tech-

nology (for example, using automatic dialing

for follow-up telephone calls on delinquent

accounts), assigning more experienced col-

lection personnel to seriously delinquent

accounts, moving quickly to foreclose or

repossess collateral, and allowing few loan

extensions. This aspect of subprime lending

is very labor intensive but critical to the

program’s success. To a large extent, the cost

of such efforts can be a tradeoff with future

loss expectations, when an institution ana-

lyzes the proﬁtability of subprime lending

and assesses its appetite to expand or con-

tinue this line of business. Subprime-loan-

administration procedures should be in writ-

ing and at a minimum should detail—

a. billing and statement procedures;

b. collection procedures;

c. content, format, and frequency of manage-

ment reports;

d. asset-classiﬁcation criteria;

e. methodology to evaluate the adequacy of

the allowance for loan and lease losses

(ALLL);

f. criteria for allowing loan extensions,

deferrals, and re-agings;

g. foreclosure and repossession policies and

procedures; and

h. loss-recognition policies and procedures.

6. Loan review and monitoring. Once an institu-

tion books the loans, designated staff must

perform an ongoing analysis of subprime

loans, not only on an aggregate basis but also

for subportfolios. Information systems

should be in place to segment and stratify the

institution’s portfolio (for example, by origi-

nator, loan-to-value, debt-to-income ratios,

or credit scores), and assigned staff should

produce reports that management can use to

evaluate the performance of subprime loans.

The review process should focus on whether

performance meets expectations. Institutions

then need to consider the source and charac-

teristics of loans that do not meet expecta-

tions and make changes in their underwriting

policies and loan-administration procedures

to restore performance to acceptable levels.

When evaluating actual performance

against expectations, it is particularly impor-

tant that management review credit scoring,

pricing, and ALLL-adequacy models. Mod-

els driven by the volume and severity of

historical losses experienced during an eco-

nomic expansion may have little relevance in

an economic slowdown, particularly in the

subprime market. Management should ensure

that models used to estimate credit losses or

to set pricing allow for ﬂuctuations in the

economic cycle and are adjusted to account

for other unexpected events.

7. Consumer protection. Institutions that origi-

nate or purchase subprime loans must take

special care to avoid violating fair lending

and consumer protection laws and regula-

tions. Higher fees and interest rates com-

bined with compensation incentives can fos-

ter predatory pricing or discriminatory

‘‘steering’’ of borrowers to subprime prod-

ucts for reasons other than the borrower’s

underlying creditworthiness. An adequate

compliance-management program must iden-

tify, monitor, and control the consumer pro-

tection hazards associated with subprime

lending.

Subprime mortgage lending may trigger

the special protections of the Home Owner-

ship and Equity Protection Act of 1994, sub-

title B of title I of the Riegle Community

Development and Regulatory Improvement

Act of 1994. This act amended the Truth in

Lending Act to provide certain consumer

protections in transactions involving a class

of nonpurchase, closed-end home mortgage

loans. Institutions engaging in this type of

lending must also be thoroughly familiar

with the obligations set forth in Regulation Z

(12 C.F.R. 226.32), Regulation X, and the

Real Estate Settlement Procedures Act

(RESPA) (12 U.S.C. 2601) and should adopt

policies and implement practices that ensure

compliance.

The Equal Credit Opportunity Act makes

it unlawful for a creditor to discriminate

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 4

against an applicant on a prohibited basis

regarding any aspect of a credit transaction.

Similarly, the Fair Housing Act prohibits dis-

crimination in connection with residential

real estate–related transactions. Loan ofﬁcers

and brokers must treat all similarly situated

applicants equally and without regard to any

prohibited-basis characteristic (for example,

race, sex, or age). This is especially impor-

tant with respect to how loan ofﬁcers or

brokers assist customers in preparing their

applications or otherwise help them to

qualify for loan approval.

8. Securitization and sale. To increase their

loan-production and -servicing income, some

subprime lenders originate loans and then

securitize and sell them in the asset-backed

securities market. Strong demand from

investors and favorable accounting rules

often allow securitization pools to be sold

at a gain, providing further incentive for

lenders to expand their subprime-lending

program. However, the securitization of sub-

prime loans carries inherent risks, including

interim credit risk and liquidity risk,

that are potentially greater than those

for securitizing prime loans. Accounting for

the sale of subprime pools requires assump-

tions that can be difﬁcult to quantify, and

erroneous assumptions could lead to the sig-

niﬁcant overstatement of an institution’s

assets. Moreover, the practice of providing

support and substituting performing loans for

nonperforming loans to maintain the desired

level of performance on securitized pools has

the effect of masking credit-quality

problems.

Institutions should recognize the volatility

of the secondary market for subprime loans

and the signiﬁcant liquidity risk incurred

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 mar-

kets become volatile. As a result, institutions

that have originated, but have not yet sold,

pools of subprime loans may be forced to sell

the pools at deep discounts. If an institution

lacks adequate personnel, risk-management

procedures, or capital support to hold sub-

prime loans originally intended for sale,

these loans may strain an institution’s liquid-

ity, asset quality, earnings, and capital. Con-

sequently, institutions actively involved in

the securitization and sale of subprime loans

should develop a contingency plan that

addresses back-up purchasers of the securi-

ties or the attendant servicing functions,

alternate funding sources, and measures for

raising additional capital.

Institutions should refer to the Statement

of Financial Accounting Standards No. 140

(FAS 140), ‘‘Accounting for Transfers and

Servicing of Financial Assets and Extin-

guishments of Liabilities,’’ for guidance on

accounting for these transactions. If a securi-

tization transaction meets FAS 140 sale or

servicing criteria, the seller must recognize

any gain or loss on the sale of the pool

immediately and carry any retained interests

in the assets sold (including servicing rights/

obligations and interest-only strips) at fair

value. Management should ensure that the

key assumptions used to value these retained

interests are reasonable and well supported,

both for the initial valuation and for subse-

quent quarterly revaluations. In particular,

management should consider the appropriate

discount rates, credit-loss rates, and prepay-

ment rates associated with subprime pools

when valuing these assets. Since the relative

importance of each assumption varies with

the underlying characteristics of the product

types, management should segment securi-

tized assets by speciﬁc pool, as well as by

predominant risk and cash-ﬂow characteris-

tics, when making the underlying valuation

assumptions. In all cases, however, institu-

tions should take a conservative approach

when developing securitization assumptions

and capitalizing expected future income from

subprime lending pools. Institutions should

also consult with their auditors as necessary

to ensure their accounting for securitizations

is accurate.

9. Reevaluation. Institutions should periodically

evaluate whether the subprime-lending pro-

gram has met proﬁtability, risk, and perfor-

mance goals. Whenever the program falls

short of original objectives, an analysis

should be performed to determine the cause,

and the program should be modiﬁed appro-

priately. If the program falls far short of

the institution’s expectations, management

should consider terminating it. Questions that

management and the board need to ask may

include the following:

a. Have cost and proﬁt projections been

met?

b. Have projected loss estimates been

accurate?

c. Has the institution been called upon to

provide support to enhance the quality

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 5

and performance of loan pools it has

securitized?

d. Were the risks inherent in subprime lend-

ing properly identiﬁed, measured, moni-

tored, and controlled?

e. Has the program met the credit needs of

the community that it was designed to

address?

2128.08.1.2 Examination Review and

Analysis

The following supervisory guidance (up to the

inspection objectives) applies only to the exami-

nation of a bank holding company’s federally

insured subsidiary banks that have subprime-

lending programs equaling or exceeding 25 per-

cent of tier 1 capital and to those insured banks

that have other designated subprime programs

referenced in SR-01-4.

The heightened risk levels and potential vola-

tility in delinquency and loss rates posed by

subprime-lending programs warrant examiners’

increased ongoing attention. The risks inherent

in subprime-lending programs call for frequent

reviews. There are generally two levels of

review appropriate for subprime activities:

1. Portfolio-level reviews include assessments

of underwriting standards, marketing prac-

tices, pricing, management information and

control systems (quality control, audit and

loan review, vendor management, compli-

ance), portfolio performance, and the appro-

priate application of regulatory and internal

allowance and capital policies.

2. Transaction-level testing includes the testing

of individual loans for compliance with

underwriting and loan-administration guide-

lines; the appropriate treatment of loans

under delinquency, re-aging, and cure pro-

grams; and the appropriate application of

regulatory and internal allowance and capital

policies.

Examiners should perform a portfolio-level

review and some transaction testing at each

institution engaged in subprime lending, during

each regularly scheduled examination cycle.

The Federal Reserve will perform regular off-

site supervisory monitoring and may require

subprime lenders to supply supplementary infor-

mation about their subprime portfolios between

examinations. The examiner’s ﬁndings from

transaction-level testing and portfolio-level

reviews should be incorporated into the conclu-

sions about overall asset quality, the adequacy

of the ALLL and capital, and the adequacy of

portfolio risk-management practices.

2128.08.1.2.1 Transaction-Level Testing

Subprime-loan portfolios contain elevated risks,

and actual subprime-lending practices often can

deviate from stated policy and procedural guid-

ance. Therefore, examiners should supplement

the portfolio-level examination procedures with

transaction-level testing to determine whether—

1. individual loans adhere to existing policy,

underwriting, risk-selection, and pricing

standards;

2. individual loans and portfolios are classiﬁed

in accordance with the subprime-lending

guidelines described in this section, or in

other Federal Reserve credit-extending

supervisory guidance;

3. management, board, and regulatory reporting

is accurate and timely;

4. existing loans conform to speciﬁed account-

management standards (such as over-limits,

line increases, reductions, cancellations,

re-scoring, or collections);

5. key risk controls and control processes are

adequate and functioning as intended;

6. roll rates and other loss-forecasting methods

used to determine ALLL levels are accurate

and reliable; and

7. lending practices exist that may appear

unsafe, unsound, or abusive and unfair.

2128.08.1.3 Adequacy of the ALLL

Examiners should assess the adequacy of the

ALLL to ensure that the portion allocated to the

subprime portfolio is sufﬁcient to absorb esti-

mated credit losses for this portfolio. Consistent

with interagency policy,

the term ‘‘estimated

credit losses’’ means an estimate of the amount

that is not likely to be collected; that is, net

charge-offs that are likely to be realized given

the facts and circumstances as of the evaluation

date.

These estimated losses should meet the

8. The Interagency Policy Statement on the Allowance for

Loan and Lease Losses was issued December 21, 1993, and

the ALLL methodologies and documentation standards were

issued July 2, 2001.

9. Estimates of credit losses should include accrued inter-

est and other accrued fees (for example, uncollected credit

card fees or uncollected late fees) that have been added to the

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 6

criteria for accrual of loss contingency, as set

forth under generally accepted accounting prin-

ciples (GAAP), consistent with supervisory

ALLL policy.

2128.08.1.3.1 New Entrants to the

Business

In some instances, an institution (for example, a

newly chartered institution or an existing institu-

tion entering the subprime-lending business)

may not have sufﬁcient previous loss experience

to estimate an allowance for subprime-lending

activities. In such cases, industry statistics or

another institution’s loss data for similar loans

may be a better starting point to determine the

ALLL than the institution’s own data for devel-

oping loss rates. When an institution uses loss

rates developed from industry statistics or from

other institutions to determine its ALLL, it

should demonstrate and document that the

attributes of the loans in its portfolio or portfolio

segment are similar to those in the other institu-

tion’s (or industry’s) portfolio.

2128.08.1.3.2 Pools of Subprime

Loans—Not Classiﬁed

The ALLL required for subprime loans should

be sufﬁcient to absorb at least all estimated

credit losses on outstanding balances over the

current operating cycle, typically 12 months.

The board of directors and management are

expected to ensure that the institution’s process

for determining an adequate level for the ALLL

is based on a comprehensive and adequately

documented analysis of all signiﬁcant factors.

The consideration factors should include histori-

cal loss experience, ratio analysis, peer-group

analysis, and other quantitative analysis as a

basis for the reasonableness of the ALLL. To

the extent that the historical net charge-off rate

is used to estimate expected credit losses, it

should be adjusted for changes in trends, condi-

tions, and other relevant factors, including busi-

ness volume, underwriting, risk selection,

account-management practices, and current eco-

nomic or business conditions that may alter

such experience. The allowance should repre-

sent a prudent, conservative estimate of losses

that allows a reasonable margin for imprecision.

Institutions should clearly document loss esti-

mates and the allowance methodology in writ-

ing. This documentation should describe the

analytical process used, including—

1. portfolio-segmentation methods applied;

2. loss-forecasting techniques and assumptions

employed;

3. deﬁnitions of terms used in ratios and model

computations;

4. relevance of the baseline loss information

used;

5. rationale for adjustments to historical experi-

ence; and

6. a reconciliation of forecasted loss rates to

actual loss rates, with signiﬁcant variances

explained.

2128.08.1.4 Classiﬁcation Guidelines for

Subprime Lending

Well-managed subprime lenders should recog-

nize the heightened loss characteristics in their

portfolios and internally classify their delin-

quent accounts well before the time frames out-

lined in the retail classiﬁcation policy issued by

the Federal Financial Institutions Examination

Council (FFIEC) on June 12, 2000. Examiners

should classify subprime loans and portfolios in

accordance with the guidelines in this section

and other applicable Federal Reserve supervi-

sory guidelines. Classiﬁed loans are loans that

are not protected adequately by the current

sound worth and paying capacity of the bor-

rower or the collateral pledged. As such, full

liquidation of the debt may be in jeopardy. Pools

of 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 con-

sistent with existing interagency policy.

2128.08.1.4.1 Individual Loans

Examiners should not automatically classify or

place loans in special mention merely because

they are subprime. Rather, classiﬁcations should

loan balances and, as a result, that are reported as part of the

institution’s loans on the balance sheet. An institution may

include these types of estimated losses in either the ALLL or a

separate valuation allowance, which would be netted against

the aggregated loan balance for regulatory reporting purposes.

When accrued interest and other accrued fees are not added to

the loan balances and are not reported as part of loans on the

balance sheet, the collectibility of these accrued amounts

should nevertheless be evaluated to ensure that the institu-

tion’s income is not overstated.

Subprime Lending 2128.08

BHC Supervision Manual December 2002

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reﬂect the borrower’s capacity and willingness

to repay and the adequacy of collateral pledged.

Loans to borrowers that do not have the capac-

ity to service their loans generally will be classi-

ﬁed substandard. When repayment capacity is

insufﬁcient to support the orderly liquidation of

the debt, and the collateral pledged is insufﬁ-

cient to mitigate risk of loss, then a more severe

classiﬁcation and nonaccrual is warranted. Sub-

prime loans that are past due 90 days or more

should be classiﬁed at least substandard based

on a reasonable presumption that their past-due

status indicates an inadequate capacity or

unwillingness to repay. A more stringent classi-

ﬁcation approach may be appropriate based on

the historical loss experience of a particular

institution. Classiﬁcation of other subprime

loans as doubtful or loss will be based on exam-

iners’ analysis of the borrower’s capacity to

repay, and on the quality of institution under-

writing and account-management practices as

evidenced in the loan ﬁle or by other

documentation.

In some cases, the repayment of principal,

interest, and fees on some subprime loans may

be overly dependent on collateral pledged. This

occurs when the risk of default is so high that an

abundance of collateral is taken to mitigate risk

of loss in the event of default. From a safety-

and-soundness perspective, institutions should

be discouraged from lending solely on the basis

of collateral pledged. Such loans will generally

be classiﬁed substandard. Further, when the bor-

rower does not demonstrate the capacity to ser-

vice the loan from sources other than collateral

pledged, the loan may be placed on nonaccrual.

2128.08.1.4.2 Portfolios

When the portfolio review or loan sample indi-

cates serious concerns with credit-risk selection

practices, underwriting standards, or loan qual-

ity, examiners should consider classifying or

criticizing the entire portfolio or segments of the

portfolio. Such a decision may be appropriate in

cases where risk is inordinately high or delin-

quency reports reﬂect performance problems.

Some subprime-lending portfolios may pose

very high risk. These may include portfolios of

unsecured loans or secured, high loan-to-value

loans to borrowers who clearly exhibit inad-

equate capacity to repay the debt in a reasonable

time frame. Most such portfolios should be clas-

siﬁed at least substandard.

2128.08.1.5 Required Documentation for

Cure Programs

Cure programs, including such practices as

re-aging, extensions, renewals, rewrites, or other

types of account restructuring, are subject to the

standards outlined in the retail classiﬁcation pol-

icy. In accordance with that policy, cure pro-

grams should be used only when the institution

has substantiated the customer’s renewed will-

ingness and ability to repay. Examiners will

expect institutions to maintain documentation

supporting their analysis of the customer’s

renewed ability and willingness to repay the

loan at the time it is extended, renewed, or

deferred. When the institution cannot demon-

strate both the willingness and ability of the

customer to repay, the loan should not be

renewed, extended, deferred, or rewritten, and

the loan should be moved back to its pre-cure

delinquency status. Documentation should

include one or more of the following:

1. a new veriﬁcation of employment

2. a recomputed debt-to-income ratio indicating

sufﬁcient improvement in the borrower’s

ﬁnancial condition to support orderly

repayment

3. a refreshed credit score or updated bureau

report

4. a ﬁle memo evidencing discussion with the

customer

When documentation of the customer’s renewed

willingness and ability to repay the loan is

absent or deﬁcient, management practices

should be criticized.

2128.08.1.6 Predatory or Abusive

Lending Practices

The term ’’subprime’’ is often misused to refer

to certain predatory or abusive lending prac-

tices. Lending practices can be designed to

responsibly provide service to customers and

enhance credit access for borrowers with special

credit needs. Subprime lending that is appropri-

ately underwritten, priced, and administered can

serve these goals.

Some forms of subprime lending may be abu-

sive or predatory, however. Lending practices

may be designed to transfer wealth from the

borrower to the lender or loan originator with-

out a commensurate exchange of value. This is

sometimes accomplished when the lender struc-

tures a loan to a borrower who has little or no

ability to repay the loan from sources other than

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 8

the collateral pledged. When default occurs, the

lender forecloses or otherwise takes possession

of the borrower’s property (generally the bor-

rower’s home or automobile). In other cases, the

lender may use the threat of foreclosure or

repossession to induce duress on the borrower

for payment. Typically, predatory lending

involves at least one, and perhaps all three, of

the following elements:

1. making unaffordable loans based on the

assets of the borrower rather than on the

borrower’s ability to repay an obligation

2. inducing a borrower to reﬁnance a loan

repeatedly in order to charge high points and

fees each time the loan is reﬁnanced (that is,

‘‘loan ﬂipping’’)

3. engaging in fraud or deception to conceal the

true nature of the loan obligation or ancillary

products from an unsuspecting or unsophisti-

cated borrower

Loans to borrowers who do not demonstrate

the capacity to repay the loan, as structured,

from sources other than the collateral pledged

are generally considered unsafe and unsound.

Such lending practices should be criticized in

the examination report as imprudent. Further,

examiners should refer any loans with the afore-

mentioned characteristics to Federal Reserve

consumer compliance/fair lending specialists for

additional review.

2128.08.1.7 Capitalization

The Federal Reserve’s minimum capital require-

ments generally apply to portfolios that exhibit

substantially lower risk proﬁles than those that

exist in subprime-loan programs. Therefore,

these requirements may not be sufﬁcient to

reﬂect the risks associated with subprime port-

folios.

Subprime-lending activities can present a

greater-than-normal risk for ﬁnancial institu-

tions and the deposit insurance funds; therefore,

the level of capital institutions need to support

this activity should be commensurate with the

additional risks incurred. Each subprime lender

is responsible for quantifying the amount of

capital needed to offset the additional risk in

subprime-lending activities and for fully docu-

menting the methodology and analysis support-

ing the amount speciﬁed.

The amount of additional capital necessary

will vary according to the volume and type of

subprime activities conducted and the adequacy

of the institution’s risk-management program.

An institution’s overall capital adequacy will be

evaluated on a case-by-case basis through

on-site examinations and off-site monitoring

procedures, considering, among other factors,

the institution’s own documented analysis of the

capital needed to support subprime lending.

Institutions that are determined to have insufﬁ-

cient capital must correct the deﬁciency within a

reasonable time frame or be subject to supervi-

sory action. In light of the higher risks associ-

ated with this type of lending, higher minimum-

capital requirements may be imposed on

institutions engaging in subprime lending.

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 fol-

lowing elements:

1. portfolio-growth rates

2. trends in the level and volatility of expected

losses

3. the level of subprime-loan losses incurred

over one or more economic downturns, if

such data or analyses are available

4. the impact of planned underwriting or mar-

keting 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

5. any deterioration in the average credit qual-

ity over time due to adverse selection or

retention

6. the amount, quality, and liquidity of collat-

eral securing the individual loans

7. any asset, income, or funding-source

concentrations

8. the degree of concentration of subprime

credits

9. the extent to which current capitalization

consists of residual assets or other poten-

tially volatile components

10. the degree of legal or reputation risk associ-

ated with the subprime business lines

pursued

11. the amount of capital necessary to support

the institution’s other risks and activities

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 nonsub-

prime assets of a similar type. Reﬁnements

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 9

should depend on the factors analyzed above,

with particular emphasis on the trends in the

level and volatility of loss rates, and on the

amount, quality, and liquidity of collateral

securing the loans. Institutions should have capi-

tal ratios that are well above the averages for

their traditional peer groups or other similarly

situated institutions that are not engaged in sub-

prime lending.

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 with

prime loans, and they 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 percent of the loans outstanding, depending

on the level and volatility of risk.

2128.08.1.7.1 Stress Testing

An institution’s capital adequacy analysis

should include stress testing as a tool for esti-

mating 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 recov-

ery rates on collateral. Stress tests should also

consider other potentially adverse scenarios,

such as changing attrition or prepayment rates;

changing utilization rates for revolving prod-

ucts; changes in credit score distribution; and

changes in the capital-market 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 tech-

niques, it is expected that—

1. the process is clearly documented, rational,

and easily understood by the institution’s

board and senior management;

2. the inputs are reliable and relate directly to

the subject portfolios (for example, baseline

loss history or default probabilities should

reﬂect each segment of the institution’s port-

folio and not just a blend of prime and sub-

prime borrowers);

3. assumptions are well documented and con-

servative; and

4. any models are subject to a comprehensive

validation process.

The results of the stress-test exercises should be

a documented factor in the analysis and determi-

nation of capital adequacy for the subprime

portfolios.

Institutions that engage in subprime-lending

programs without adequate procedures to esti-

mate and document the level of capital neces-

sary to support their activities should be criti-

cized. Where capital is deemed inadequate to

support the risk in subprime-lending activities,

examiners should consult with their Reserve

Bank supervisory ofﬁcial to determine the

appropriate course of action. Such actions may

include requiring additional capital in accor-

dance with the Federal Reserve’s capital

adequacy rules or requiring the institution to

submit an acceptable capital plan in accordance

with safety-and-soundness guidelines.

2128.08.1.8 Subprime-Lending Examiner

Responsibilities

Using the interagency guidance and any supple-

mental Federal Reserve guidelines, examiners

should assess carefully management’s ability to

administer the higher risk in subprime port-

folios. The examiner should judge manage-

ment’s ability to manage the risk involved in the

subprime-lending program, in particular, the

quality of the risk-management and control pro-

cesses in place, and more importantly, the extent

to which management is adhering to those pro-

cesses. When examiners determine that risk-

management practices are deﬁcient, they should

criticize management and initiate corrective

action. Such actions may include formal or

informal enforcement actions or a plan to

achieve adequate capitalization. When a pri-

mary supervisor determines that an institution’s

risk-management practices are materially deﬁ-

cient, the primary supervisor may instruct the

institution to discontinue its subprime-lending

programs.

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 10

2128.08.1.9 Appendix—Questions and

Answers for Examiners Regarding the

Expanded Guidance for

Subprime-Lending Programs

To assist examiners who review subprime-

lending activities, the following questions and

answers were developed to provide additional

guidance on the expanded interagency guidance

that was issued on January 31, 2001.

2128.08.1.9.1 Applicability of the

Guidance

Question 1: Does the guidance apply to all

institutions?

No. The guidance will not affect the vast major-

ity of insured institutions engaged in traditional

consumer lending. The guidance applies to insti-

tutions that systematically target the subprime

market through programs that employ tailored

marketing, underwriting standards, and risk

selection.

The guidance does not address traditional

consumer lending that has historically been the

mainstay of community banking. It does not

apply to institutions extending credit to sub-

prime borrowers as part of their standard

community-lending process, or making loans to

subprime borrowers as an occasional exception

to a prime-lending program, even if the aggre-

gate of these loans totals more than 25 percent

of tier 1 capital. Such institutions continue to be

subject to the normal supervisory process.

Institutions engaging in subprime-lending

programs generally have knowingly and pur-

posefully focused on the subprime-lending mar-

kets through planned business strategies, tai-

lored products, and explicit borrower targeting.

In instances where signiﬁcant exposures to sub-

prime borrowers are identiﬁed, examiners

should consider the institution’s marketing pro-

gram, loan products, pricing, underwriting stan-

dards and practices, and portfolio performance

to determine if the institution has a program that

warrants the supervision and safeguards out-

lined in the guidance.

Question 2: Does the guidance apply when an

institution offers a product that attracts a dis-

proportionate number of subprime borrowers,

but which the institution does not explicitly iden-

tify as subprime?

A subprime program commonly features prod-

ucts speciﬁcally tailored to borrowers with

weakened credit histories. Such products often

differ substantially in pricing and terms from

products offered to prime borrowers, and they

usually have separate and distinctly different

underwriting standards. An institution offering a

product that attracts a disproportionate number

of borrowers with weakened credit histories

likely has a subprime program whether or not

the activity is called a subprime program. The

guidance will apply to these programs when the

resultant aggregate credit exposure is at least

25 percent of the institution’s tier 1 capital.

Institutions with signiﬁcant programs are

expected to have the necessary risk-management

and internal-control systems in place to properly

identify, measure, monitor, and control the

inherent risks in their subprime portfolios. Risk

management and controls for these programs

typically involve enhanced performance moni-

toring, intensive collection activities, and other

loss-mitigation strategies. If an institution sys-

tematically targets the subprime market but does

not segregate these loans from its prime port-

folio, it is doubtful that the institution has the

necessary risk-management and control systems

in place to safely engage in the activity.

2128.08.1.9.2 Subprime Characteristics

Question 3: Why does the Expanded Guidance

for Subprime Lending Programs use a credit

bureau risk score (FICO) of 660 as a cutoff

point for subprime lending?

The guidance does not use credit scores, or any

other single risk factor, as a deﬁnitive cutoff

point for subprime lending. The characteristics

listed are not explicit, bright-line deﬁnitions.

The range of credit characteristics used to

describe subprime borrowers is intended to help

examiners identify lenders that are engaged in

subprime-lending programs. These characteris-

tics describe borrowers with varying, but signiﬁ-

cantly higher, probabilities of default than prime

borrowers. The guidance states that ‘‘this list is

illustrative rather than exhaustive and is not

meant to deﬁne speciﬁc parameters for all

borrowers.’’

A credit bureau score of 660 (FICO) is used

only as an example to illustrate a credit score

that generally indicates a higher default prob-

ability. The guidance indicates the probability of

default, as evidenced by the credit score, will

vary by product and collateral. The subprime

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 11

guidance lists several characteristics that denote

a higher probability of default. Examiners are

directed to use these characteristics as a starting

point to expand their review of lending pro-

grams targeting subprime borrowers in accor-

dance with risk-focused examination proce-

dures. The severity of risk may vary

signiﬁcantly for the different characteristics

listed, as well as for the type and quality of

collateral. Examiners should take this into con-

sideration when reviewing the portfolio and

determining the adequacy of loan-loss reserves

and capital.

The characteristics used in the guidance are

well recognized in the investment and lending

industries. A number of public debt rating agen-

cies and ﬁnancial institutions, including the

government-sponsored enterprises (GSEs), use

similar credit characteristics to differentiate risk

among borrowers. Speciﬁc examples include the

following:

1. Fitch deﬁnes a subprime borrower as ‘‘...one

with a credit proﬁle worse than that of a

prime A quality borrower, whose credit

report would typically reveal no recent mort-

gage delinquencies and whose credit proﬁle

would yield a credit score in the range above

680.’’ Fitch’s mortgage credit grade matrix

lists the following credit-history elements for

A- the highest subprime grade: one 30-day

delinquency in the last 12 months on a mort-

gage debt; one 30-day delinquency in the last

24 months on installment debt, or two 30-day

delinquencies in the last 24 months on

revolving debt; bankruptcy in past ﬁve years;

chargeoff or judgments exceeding $500 in

the past 24 months; and/or a debt-to-income

ratio of 45 percent.

2. Standard & Poor’s subprime-mortgage

underwriting guidelines deﬁne subprime A-

characteristics as two or more 30-day

delinquencies on mortgage and consumer

credit, one 60-day delinquency on consumer

credit, debt-to-income ratio of 45 percent,

and no bankruptcy in the past ﬁve years.

Standard & Poor’s also ‘‘...considers sub-

prime borrowers to have a FICO credit score

of 659 or below.’’

3. Standard & Poor’s has classiﬁed nonprime B

auto securitization pools as having occa-

sional delinquencies and minor charge-offs

on revolving debt, static pool net losses of

3.1 percent to 7.5 percent, and FICO credit

scores ranging from 620–679.

4. Freddie Mac has used the FICO score of 660

or below to designate higher-risk borrowers

requiring more comprehensive review. Fred-

die Mac views a score in the 620–660 range

as an indication that the ‘‘borrower’s willing-

ness to repay debt as agreed is uncertain.’’

FICO scores below 620 are placed in the

‘‘cautious-review category,’’ and Freddie

Mac considers scores below 620 ‘‘as a strong

indication that the borrower’s credit reputa-

tion is not acceptable...’’

2128.08.1.9.3 Capital Guidance

Question 4: If an institution is engaged in sub-

prime lending as described by the guidance,

does the 1.5-to-3-times capital described in the

guidance automatically apply?

No. The expanded interagency guidance on sub-

prime lending is ﬂexible examination guidance;

the capital range does not automatically apply

because the guidance is not a capital rule or

regulation. Rather, the guidance describes an

expectation that subprime lenders hold sufﬁcient

loan-loss reserves and capital to offset the addi-

tional risks that may exist in subprime activities.

The agencies expect institutions to have meth-

odologies and analyses in place to support and

document the level of reserves and capital

needed for the additional risks assumed. The

higher the risk, the more reserves and capital

needed to support the activity. Institutions with

lower-risk subprime portfolios may not need

additional reserves and capital. In addition,

examiners are reminded that subprime lending

is only one element in the evaluation of the

institution’s overall capital adequacy. If the

analysis shows that the institution has adequate

capital for all its assets and activities, including

subprime lending, there is no additional capital

requirement arising from the guidance.

Examiners are instructed not to unilaterally

require additional reserves and capital based on

the guidance. Any determination made by an

examiner that an institution’s reserves or capital

are deﬁcient will be discussed with the institu-

10. Fitch IBCA, Duff & Phelps, ‘‘Rating U.S. Residential

Subprime Mortgage Securities,’’ March 16, 2001: 2.

11. Standard & Poor’s, ‘‘U.S. Residential Subprime Mort-

gage Criteria,’’ Structured Finance, 1999: 12, 169.

12. Standard & Poor’s, ‘‘Auto Loan Criteria and Market

Overview 1998,’’ Structured Finance Ratings Asset-Backed

Securities, 6.

13. Freddie Mac, Single-Family Seller/Servicer Guide,

chapter 37, section 37.6, ‘‘Using FICO Scores in Underwrit-

ing,’’ March 7, 2001.

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 12

tion’s management and with each agency’s

appropriate supervisory ofﬁce before a ﬁnal

decision is made.

Question 5: Are the regulatory expectations for

higher capital levels consistent with capital lev-

els supporting subprime assets outside the

insured banking industry?

Yes. The regulatory expectations of higher capi-

tal maintenance are consistent with expectations

in the capital markets. The 1.5-to-3-times-

capital multiple is risk based, for example, the

level of additional capital varies by relative loan

quality and is applied only to the subprime

portfolio, not the institution’s entire asset struc-

ture. This is consistent with the ﬁnancial market-

place’s assessment of relative risk in subprime

assets outside the banking industry. For exam-

ple, the amount of credit enhancement required

for subprime securitization structures varies

according to the level and volatility of perceived

credit risk in the underlying assets. In addition,

publicly traded subprime-ﬁnance companies

(that are not currently suffering from adverse

ratings) maintain equity-capital-to-managed-

asset ratios that are 1.5 to as much as 6 times

(depending on loan type and relative quality)

those of ﬁnance companies that do not special-

ize in subprime loans.

2128.08.2 INSPECTION OBJECTIVES

1. To assess and evaluate the extent of

subprime-lending activities; whether man-

agement has adequately planned for these

activities; and whether management has

developed and maintains board-approved

policies and procedures, systems, and inter-

nal controls that identify, measure, monitor,

and control the additional risks in a manner

that is commensurate with the risks associ-

ated with the subprime-lending program.

2. To conduct portfolio-level reviews and

transaction-level testing of the subprime-

lending activities, assessing the quality and

performance of the subprime-loan portfolios

and subprime-lending program, including its

proﬁtability, delinquency, and potential and

actual loss experience.

3. To assess the adequacy of the ALLL for the

subprime-loan portfolio.

2128.08.3 INSPECTION PROCEDURES

1. Determine whether the subprime-lending

activities are consistent with the bank hold

ing company’s overall business strategy and

risk tolerances, and that critical business

risks have been identiﬁed and considered.

2. Assess whether the bank holding company

has the ﬁnancial capacity, including capital

adequacy, to conduct the high-risk activity

of subprime lending safely, without any

undue concentrations of credit.

3. Ascertain if management has committed the

necessary resources, including, in particu-

lar, technology and skilled personnel, to

manage and control the risks associated

with the volume and complexity of the bank

holding company’s subprime-lending

programs.

4. Determine whether the bank holding com-

pany’s contingency plans (including those

of its banking and nonbanking subsidiaries)

are adequate to address alternative funding

sources, including back-up purchasers of

any subprime loan–backed securities issued

by the bank holding company or of the

attendant servicing functions, and methods

of raising additional capital during an eco-

nomic downturn or when ﬁnancial markets

become volatile.

5. Determine if management has established

adequate lending standards that are appro-

priate for the size and complexity of the

bank holding company’s operations, includ-

ing those of its subsidiaries, and if manage-

ment is maintaining proper controls over

the program. (See in section 2128.08.1.1 for

the lending standards that should be

included in the subprime-loan program.)

6. Incorporate the results of the loan-

administration portfolio-level and

transaction-level testing reviews into the

conclusions about overall asset quality, the

adequacy of the ALLL and capital, and the

adequacy of portfolio risk-management

practices.

7. Review securitization transactions for com-

pliance with FAS 140 and this guidance,

including whether the bank holding com-

pany and its subsidiaries have provided any

support to maintain the credit quality of

loan pools they have securitized.

8. Evaluate the ALLL and regulatory capital

allocated to support subprime-lending pro-

grams, including whether the total protec-

tion for subprime-asset programs and the

levels for each component are adequate.

9. Ascertain that a sound risk-management

program exists that includes the ability of

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 13

management to determine and quantify

appropriate levels for each component of

the program.

10. Evaluate the bank holding company’s docu-

mented analysis of the capital needed to

support its subprime-lending activities.

Ascertain whether the capital levels are risk

sensitive, that is, does allocated capital

reﬂect the level and variability of loss esti-

mates within reasonably conservative

parameters? Determine if there is a direct

link between the expected loss rates used to

determine the required ALLL and the unex-

pected loss estimates used to determine

capital. Document and reference the bank

holding company’s overall subprime capital

evaluation in the inspection comments and

conclusions regarding capital adequacy.

11. Analyze the performance of the subprime-

lending program, including its proﬁtability,

delinquency, and loss experience.

12. Consider management’s response to

adverse performance trends, such as higher-

than-expected prepayments, delinquencies,

charge-offs, customer complaints, and

expenses.

13. Determine if the bank holding company’s

subprime-lending program effectively man-

ages the credit, market, liquidity, reputa-

tional, operational, and legal risks associ-

ated with subprime-lending operations.

14. Classify loans of the parent bank holding

company and its nonbank subsidiaries

according to the following criteria:

a. Classify as substandard loans to borrow-

ers that do not have the capacity to ser-

vice their loans.

b. Classify as at least substandard subprime

loans that are 90 days or more past due

based on a reasonable presumption that

their past-due status indicates an inad-

equate capacity or unwillingness to

repay.

c. Consider classifying or criticizing the

entire portfolio or segments of the port-

folio when the portfolio review or loan

sample indicates serious concerns with

credit-risk-selection practices, underwrit-

ing standards, or loan quality.

d. Classify as substandard high-risk unse-

cured loan portfolios or secured high

loan-to-value loans to borrowers who

clearly exhibit inadequate capacity to

repay the debt in a reasonable time

frame.

15. Report as unsafe and unsound imprudent

loans to borrowers who do not demonstrate

the capacity to repay the loan, as structured,

from sources other than the pledged

collateral.

16. Carefully assess the ability of the parent

bank holding company’s board of directors

and management to oversee and administer

the higher risk in subprime portfolios,

including those of its nonbank subsidiaries.

If risk-management practices are deﬁcient,

criticize management and reach speciﬁc

agreements with the board of directors and

senior management to initiate corrective

action.

Subprime Lending 2128.08

BHC Supervision Manual December 2002

Page 14

Elevated-Risk Complex Structured Finance Activities

(Risk Management and Internal Controls) Section 2128.09

When a ﬁnancial institution participates in a

complex structured ﬁnance transaction (CSFT),

it bears the usual market, credit, and operational

risks associated with the transaction.

In some

circumstances, a ﬁnancial institution may also

face heightened legal or reputational risks due

to its involvement in a CSFT. For example, a

ﬁnancial institution may face heightened legal

or reputational risks if a customer’s regulatory,

tax, or accounting treatment for a CSFT, or

disclosures to investors concerning the CSFT in

the customer’s public ﬁlings or ﬁnancial state-

ments, do not comply with applicable laws,

regulations, or accounting principles.

The agencies have long expected ﬁnancial

institutions to develop and maintain robust con-

trol infrastructures that enable them to identify,

evaluate, and address the risks associated with

their business activities.

Financial institutions

must also conduct their activities in accordance

with applicable statutes and regulations. There-

fore, ﬁnancial institutions engaged in CSFTs are

expected to have policies and procedures that

are designed to allow the institution to effec-

tively manage and address the full range of risks

associated with its CSFT activities, including

the elevated legal or reputational risks that may

arise in connection with certain CSFTs. The

agencies continue to believe that this is

important.

This section sets forth the Interagency State-

ment on Sound Practices Concerning Elevated-

Risk Complex Structured Finance Activities,

issued January 11, 2007. The supervisory guid-

ance addresses risk-management principles that

should assist institutions to identify, evaluate,

and manage the heightened legal and reputa-

tional risks that may arise from their involve-

ment in CSFTs. The guidance is focused on

those CSFTs that may present heightened levels

of legal or reputational risk to the institution and

are deﬁned as ‘‘elevated-risk CSFTs.’’ Such

transactions are typically conducted by a limited

number of large ﬁnancial institutions.

(See

SR-07-05 and 72 Fed. Reg. 1,372, January 11,

2007.)

2128.09.1 INTERAGENCY

STATEMENT ON SOUND PRACTICES

CONCERNING ELEVATED-RISK

COMPLEX STRUCTURED FINANCE

ACTIVITIES

Financial markets have grown rapidly over the

past decade, and innovations in ﬁnancial instru-

ments have facilitated the structuring of cash

ﬂows and allocation of risk among creditors,

borrowers, and investors in more efﬁcient ways.

Financial derivatives for market and credit

risk, asset-backed securities with customized

cash-ﬂow features, specialized ﬁnancial con-

duits that manage pools of assets, and other

types of structured ﬁnance transactions serve

important business purposes, such as diversify-

ing risks, allocating cash ﬂows, and reducing

cost of capital. As a result, structured ﬁnance

transactions have become an essential part of

U.S. and international capital markets. Financial

institutions have played and continue to play an

active and important role in the development of

structured ﬁnance products and markets, includ-

ing the market for the more complex variations

of structured ﬁnance products.

When a ﬁnancial institution participates in a

complex structured ﬁnance transaction (CSFT),

it bears the usual market, credit, and operational

risks associated with the transaction. In some

circumstances, a ﬁnancial institution may also

face heightened legal or reputational risks due

to its involvement in a CSFT. For example, in

some circumstances, a ﬁnancial institution may

face heightened legal or reputational risk if a

customer’s regulatory, tax, or accounting treat-

ment for a CSFT, or disclosures to investors

concerning the CSFT in the customer’s public

ﬁlings or ﬁnancial statements, do not comply

with applicable laws, regulations, or accounting

principles. Indeed, in some instances, CSFTs

have been used to misrepresent a customer’s

ﬁnancial condition to investors, regulatory

authorities, and others. In these situations, inves-

tors have been harmed and ﬁnancial institutions

1. The term ﬁnancial institutions is not limited to federally

insured depository institutions. It refers broadly to bank hold-

ing companies (other than foreign banks), national banks,

state banks, federal and state savings associations, savings and

loan holding companies, U.S. branches and agencies of for-

eign banks, and SEC-registered broker-dealers and invest-

ment advisors.

2. The agencies are the Board of Governors of the Federal

Reserve System (FRB), the Ofﬁce of the Comptroller of the

Currency (OCC), the Federal Deposit Insurance Corporation

(FDIC), the Ofﬁce of Thrift Supervision (OTS), and the

Securities and Exchange Commission (SEC).

3. The statement will not affect or apply to the vast major-

ity of ﬁnancial institutions, including most small institutions.

BHC Supervision Manual January 2008

Page 1

have incurred signiﬁcant legal and reputational

exposure. In addition to legal risk, reputational

risk poses a signiﬁcant threat to ﬁnancial institu-

tions because the nature of their business

requires them to maintain the conﬁdence of

customers, creditors, and the general market-

place.

The agencies have long expected ﬁnancial

institutions to develop and maintain robust con-

trol infrastructures that enable them to identify,

evaluate, and address the risks associated with

their business activities. Financial institutions

must also conduct their activities in accordance

with applicable statutes and regulations.

2128.09.2 SCOPE AND PURPOSE OF

STATEMENT

This statement was issued to describe the types

of risk-management principles that the agencies

believe may help a ﬁnancial institution to iden-

tify CSFTs that may pose heightened legal or

reputational risks to the institution and to evalu-

ate, manage, and address these risks within the

institution’s internal control framework.

Structured ﬁnance transactions encompass a

broad array of products with varying levels of

complexity. Most structured ﬁnance transac-

tions, such as standard public mortgage-backed

securities transactions, public securitizations of

retail credit cards, asset-backed commercial

paper conduit transactions, and hedging-type

transactions involving ‘‘plain vanilla’’ deriva-

tives and collateralized loan obligations, are

familiar to participants in the ﬁnancial markets,

and these vehicles have a well-established track

record. These transactions typically would not

be considered CSFTs for the purpose of this

statement.

Because this statement focuses on sound

practices related to CSFTs that may create

heightened legal or reputational risks—

transactions that typically are conducted by a

limited number of large ﬁnancial institutions—it

will not affect or apply to the vast majority of

ﬁnancial institutions, including most small insti-

tutions. As in all cases, a ﬁnancial institution

should tailor its internal controls so that they are

appropriate in light of the nature, scope, com-

plexity, and risks of its activities. Thus, for

example, an institution that is actively involved

in structuring and offering CSFTs that may cre-

ate heightened legal or reputational risk for the

institution should have a more formalized and

detailed control framework than an institution

that participates in these types of transactions

less frequently. The internal controls and proce-

dures discussed in this statement are not all

inclusive, and, in appropriate circumstances, an

institution may ﬁnd that other controls, policies,

or procedures are appropriate in light of its

particular CSFT activities.

Because many of the core elements of an

effective control infrastructure are the same

regardless of the business line involved, this

statement draws heavily on controls and proce-

dures that the agencies previously have found to

be effective in assisting a ﬁnancial institution to

manage and control risks and identiﬁes ways in

which these controls and procedures can be

effectively applied to elevated-risk CSFTs.

Although this statement highlights some of the

most signiﬁcant risks associated with elevated-

risk CSFTs, it is not intended to present a full

exposition of all risks associated with these

transactions. Financial institutions are encour-

aged to refer to other supervisory guidance pre-

pared by the agencies for further information

concerning market, credit, operational, legal,

and reputational risks, as well as internal audit

and other appropriate internal controls.

This statement does not create any private

rights of action and does not alter or expand the

legal duties and obligations that a ﬁnancial insti-

tution may have to a customer, its shareholders,

or other third parties under applicable law. At

the same time, adherence to the principles dis-

cussed in this statement would not necessarily

insulate a ﬁnancial institution from regulatory

action or any liability the institution may have

to third parties under applicable law.

2128.09.3 IDENTIFICATION AND

REVIEW OF ELEVATED-RISK

COMPLEX STRUCTURED FINANCE

TRANSACTIONS

A ﬁnancial institution that engages in CSFTs

should maintain a set of formal, written, ﬁrm-

wide policies and procedures that are designed

to allow the institution to identify, evaluate,

4. As used in this statement, the term ﬁnancial institution

or institution refers to state member banks and bank holding

companies (other than foreign banking organizations) in the

case of the FRB, national banks in the case of the OCC,

federal and state savings associations and savings and loan

holding companies in the case of the OTS, state nonmember

banks in the case of the FDIC, and registered broker-dealers

and investment advisors in the case of the SEC. The U.S.

branches and agencies of foreign banks supervised by the

FRB, the OCC, and the FDIC also are considered to be

ﬁnancial institutions for purposes of this statement.

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 2

assess, document, and control the full range of

credit, market, operational, legal, and reputa-

tional risks associated with these transactions.

These policies may be developed speciﬁcally

for CSFTs or included in the set of broader

policies governing the institution generally. A

ﬁnancial institution operating in foreign jurisdic-

tions may tailor its policies and procedures as

appropriate to account for, and comply with, the

applicable laws, regulations, and standards of

those jurisdictions.

Financial institution’s policies and procedures

should establish a clear framework for the

review and approval of individual CSFTs. These

policies and procedures should set forth the

responsibilities of the personnel involved in the

origination, structuring, trading, review,

approval, documentation, veriﬁcation, and

execution of CSFTs. Financial institutions may

ﬁnd it helpful to incorporate the review of new

CSFTs into their existing new product policies.

In this regard, a ﬁnancial institution should

deﬁne what constitutes a ‘‘new’’ complex struc-

tured ﬁnance product and establish a control

process for the approval of such new products.

In determining whether a CSFT is new, a ﬁnan-

cial institution may consider a variety of factors,

including whether it contains structural or pric-

ing variations from existing products; whether

the product is targeted at a new class of custom-

ers; whether it is designed to address a new need

of customers; whether it raises signiﬁcant new

legal, compliance, or regulatory issues; and

whether it or the manner in which it would be

offered would materially deviate from standard

market practices. An institution’s policies

should require new complex structured ﬁnance

products to receive the approval of all relevant

control areas that are independent of the proﬁt

center before the product is offered to

customers.

2128.09.3.1 Identifying Elevated-Risk

CSFTs

As part of its transaction and new product

approval controls, a ﬁnancial institution should

establish and maintain policies, procedures, and

systems to identify elevated-risk CSFTs.

Because of the potential risks they present to the

institution, transactions or new products identi-

ﬁed as elevated-risk CSFTs should be subject to

heightened reviews during the institution’s

transaction or new product approval processes.

Examples of transactions that an institution may

determine warrant this additional scrutiny are

those that (either individually or collectively)

appear to the institution during the ordinary

course of its transaction approval or new prod-

uct approval process to—

1. lack economic substance or business

purpose;

2. be designed or used primarily for question-

able accounting, regulatory, or tax objec-

tives, particularly when the transactions are

executed at year end or at the end of a

reporting period for the customer;

3. raise concerns that the client will report or

disclose the transaction in its public ﬁlings or

ﬁnancial statements in a manner that is mate-

rially misleading or inconsistent with the

substance of the transaction or applicable

regulatory or accounting requirements;

4. involve circular transfers of risk (either

between the ﬁnancial institution and the cus-

tomer or between the customer and other

related parties) that lack economic substance

or business purpose;

5. involve oral or undocumented agreements

that, when taken into account, would have a

material impact on the regulatory, tax, or

accounting treatment of the related transac-

tion, or the client’s disclosure obligations;

6. have material economic terms that are incon-

sistent with market norms (for example, deep

‘‘in the money’’ options or historic rate roll-

overs); or

7. provide the ﬁnancial institution with com-

pensation that appears substantially dispro-

portionate to the services provided or invest-

ment made by the ﬁnancial institution or to

the credit, market, or operational risk

assumed by the institution.

The examples listed previously are provided

for illustrative purposes only, and the policies

and procedures established by ﬁnancial institu-

5. In the case of U.S. branches and agencies of foreign

banks, these policies, including management, review, and

approval requirements, should be coordinated with the foreign

bank’s group-wide policies developed in accordance with the

rules of the foreign bank’s home country supervisor and

should be consistent with the foreign bank’s overall corporate

and management structure as well as its framework for risk

management and internal controls.

6. This item is not intended to include traditional, non-

binding ‘‘comfort’’ letters or assurances provided to ﬁnancial

institutions in the loan process where, for example, the parent

of a loan customer states that the customer (that is, the

parent’s subsidiary) is an integral and important part of the

parent’s operations.

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 3

tions may differ in how they seek to identify

elevated-risk CSFTs. The goal of each institu-

tion’s policies and procedures, however, should

remain the same: to identify those CSFTs that

warrant additional scrutiny in the transaction or

new product approval process due to concerns

regarding legal or reputational risks.

Financial institutions that structure or market,

act as an advisor to a customer regarding, or

otherwise play a substantial role in a transaction

may have more information concerning the cus-

tomer’s business purpose for the transaction and

any special accounting, tax, or ﬁnancial disclo-

sure issues raised by the transaction than institu-

tions that play a more limited role. Thus, the

ability of a ﬁnancial institution to identify the

risks associated with an elevated-risk CSFT may

differ depending on its role.

2128.09.3.2 Due-Diligence, Approval,

and Documentation Process for

Elevated-Risk CSFTs

Having developed a process to identify

elevated-risk CSFTs, a ﬁnancial institution

should implement policies and procedures to

conduct a heightened level of due diligence for

these transactions. The ﬁnancial institution

should design these policies and procedures to

allow personnel at an appropriate level to under-

stand and evaluate the potential legal or reputa-

tional risks presented by the transaction to the

institution and to manage and address any

heightened legal or reputational risks ultimately

found to exist with the transaction.

2128.09.3.2.1 Due Diligence

If a CSFT is identiﬁed as an elevated-risk CSFT,

the institution should carefully evaluate and take

appropriate steps to address the risks presented

by the transaction with a particular focus on

those issues identiﬁed as potentially creating

heightened levels of legal or reputational risk

for the institution. In general, a ﬁnancial institu-

tion should conduct the level and amount of due

diligence for an elevated-risk CSFT that is com-

mensurate with the level of risks identiﬁed. A

ﬁnancial institution that structures or markets an

elevated-risk CSFT to a customer, or that acts as

an advisor to a customer or investors concerning

an elevated-risk CSFT, may have additional

responsibilities under the federal securities laws,

the Internal Revenue Code, state ﬁduciary laws

or other laws or regulations and, thus, may have

greater legal and reputational risk exposure with

respect to an elevated-risk CSFT than a ﬁnan-

cial institution that acts only as a counterparty

for the transaction. Accordingly, a ﬁnancial

institution may need to exercise a higher degree

of care in conducting its due diligence when the

institution structures or markets an elevated-risk

CSFT or acts as an advisor concerning such a

transaction than when the institution plays a

more limited role in the transaction.

To appropriately understand and evaluate the

potential legal and reputational risks associated

with an elevated-risk CSFT that a ﬁnancial insti-

tution has identiﬁed, the institution may ﬁnd it

useful or necessary to obtain additional informa-

tion from the customer or to obtain specialized

advice from qualiﬁed in-house or outside

accounting, tax, legal, or other professionals. As

with any transaction, an institution should obtain

satisfactory responses to its material questions

and concerns prior to consummation of a

transaction.

In conducting its due diligence for an

elevated-risk CSFT, a ﬁnancial institution

should independently analyze the potential risks

to the institution from both the transaction and

the institution’s overall relationship with the

customer. Institutions should not conclude that a

transaction identiﬁed as being an elevated-risk

CSFT involves minimal or manageable risks

solely because another ﬁnancial institution will

participate in the transaction or because of the

size or sophistication of the customer or coun-

terparty. Moreover, a ﬁnancial institution should

carefully consider whether it would be appropri-

ate to rely on opinions or analyses prepared by

or for the customer concerning any signiﬁcant

accounting, tax, or legal issues associated with

an elevated-risk CSFT.

2128.09.3.2.2 Approval Process

A ﬁnancial institution’s policies and procedures

should provide that CSFTs identiﬁed as having

elevated legal or reputational risk are reviewed

and approved by appropriate levels of control

and management personnel. The designated

approval process for such CSFTs should include

representatives from the relevant business

line(s) and/or client management, as well as

from appropriate control areas that are indepen-

7. Of course, ﬁnancial institutions also should ensure that

their own accounting for transactions complies with applica-

ble accounting standards, consistently applied.

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 4

dent of the business line(s) involved in the trans-

action. The personnel responsible for approving

an elevated-risk CSFT on behalf of a ﬁnancial

institution should have sufﬁcient experience,

training, and stature within the organization to

evaluate the legal and reputational risks, as well

as the credit, market, and operational risks to the

institution.

The institution’s control framework should

have procedures to deliver the necessary or

appropriate information to the personnel respon-

sible for reviewing or approving an elevated-

risk CSFT to allow them to properly perform

their duties. Such information may include, for

example, the material terms of the transaction, a

summary of the institution’s relationship with

the customer, and a discussion of the signiﬁcant

legal, reputational, credit, market, and opera-

tional risks presented by the transaction.

Some institutions have established a senior

management committee that is designed to

involve experienced business executives and

senior representatives from all of the relevant

control functions within the ﬁnancial institution

(including such groups as independent risk man-

agement, tax, accounting, policy, legal, compli-

ance, and ﬁnancial control) in the oversight and

approval of those elevated-risk CSFTs that are

identiﬁed by the institution’s personnel as

requiring senior management review and

approval due to the potential risks associated

with the transactions. While this type of man-

agement committee may not be appropriate for

all ﬁnancial institutions, a ﬁnancial institution

should establish processes that assist the institu-

tion in consistently managing the review and

approval of elevated-risk CSFTs on a ﬁrmwide

basis.

If, after evaluating an elevated-risk CSFT, the

ﬁnancial institution determines that its participa-

tion in the CSFT would create signiﬁcant legal

or reputational risks for the institution, the insti-

tution should take appropriate steps to address

those risks. Such actions may include declining

to participate in the transaction or conditioning

its participation upon the receipt of representa-

tions or assurances from the customer that rea-

sonably address the heightened legal or reputa-

tional risks presented by the transaction. Any

representations or assurances provided by a cus-

tomer should be obtained before a transaction is

executed and be received from, or approved by,

an appropriate level of the customer’s manage-

ment. A ﬁnancial institution should decline to

participate in an elevated-risk CSFT if, after

conducting appropriate due diligence and taking

appropriate steps to address the risks from the

transaction, the institution determines that the

transaction presents unacceptable risk to the

institution or would result in a violation of

applicable laws, regulations, or accounting

principles.

2128.09.3.2.3 Documentation

The documentation that ﬁnancial institutions use

to support CSFTs is often highly customized for

individual transactions and negotiated with the

customer. Careful generation, collection, and

retention of documents associated with elevated-

risk CSFTs are important control mechanisms

that may help an institution monitor and manage

the legal, reputational, operational, market, and

credit risks associated with the transactions. In

addition, sound documentation practices may

help reduce unwarranted exposure to the ﬁnan-

cial institution’s reputation.

A ﬁnancial institution should create and col-

lect sufﬁcient documentation to allow the insti-

tution to—

1. Document the material terms of the transac-

tion,

2. Enforce the material obligations of the coun-

terparties,

3. Conﬁrm that the institution has provided the

customer any disclosures concerning the

transaction that the institution is otherwise

required to provide, and

4. Verify that the institution’s policies and pro-

cedures are being followed and allow the

internal audit function to monitor compli-

ance with those policies and procedures.

When an institution’s policies and procedures

require an elevated-risk CSFT to be submitted

for approval to senior management, the institu-

tion should maintain the transaction-related

documentation provided to senior management

as well as other documentation, such as minutes

of the relevant senior management committee,

that reﬂect senior management’s approval (or

disapproval) of the transaction, any conditions

imposed by senior management, and the factors

considered in taking such action. The institution

should retain documents created for elevated-

risk CSFTs in accordance with its record reten-

8. The control processes that a ﬁnancial institution estab-

lishes for CSFTs should take account of, and be consistent

with, any informational barriers established by the institution

to manage potential conﬂicts of interest, insider trading, or

other concerns.

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 5

tion policies and procedures as well as applica-

ble statutes and regulations.

2128.09.3.3 Other Risk-Management

Principles for Elevated-Risk CSFTs

2128.09.3.3.1 General Business Ethics

The board and senior management of a ﬁnancial

institution also should establish a ‘‘tone at the

top’’ through both actions and formalized poli-

cies that sends a strong message throughout the

ﬁnancial institution about the importance of

compliance with the law and overall good busi-

ness ethics. The board and senior management

should strive to create a ﬁrm-wide corporate

culture that is sensitive to ethical or legal issues

as well as the potential risks to the ﬁnancial

institution that may arise from unethical or ille-

gal behavior. This kind of culture coupled with

appropriate procedures should reinforce

business-line ownership of risk identiﬁcation,

and encourage personnel to move ethical or

legal concerns regarding elevated-risk CSFTs to

appropriate levels of management. In appropri-

ate circumstances, ﬁnancial institutions may

also need to consider implementing mechanisms

to protect personnel by permitting the conﬁden-

tial disclosure of concerns.

As in other areas of

ﬁnancial institution management, compensation

and incentive plans should be structured, in the

context of elevated-risk CSFTs, so that they

provide personnel with appropriate incentives to

have due regard for the legal, ethical, and repu-

tational risk interests of the institution.

2128.09.3.3.2 Reporting

A ﬁnancial institution’s policies and procedures

should provide for the appropriate levels of

management and the board of directors to

receive sufﬁcient information and reports con-

cerning the institution’s elevated-risk CSFTs to

perform their oversight functions.

2128.09.3.3.3 Monitoring Compliance

with Internal Policies and Procedures

The events of recent years evidence the need for

an effective oversight and review program for

elevated-risk CSFTs. A ﬁnancial institution’s

program should provide for periodic indepen-

dent reviews of its CSFT activities to verify and

monitor that its policies and controls relating to

elevated-risk CSFTs are being implemented

effectively and that elevated-risk CSFTs are

accurately identiﬁed and received proper

approvals. These independent reviews should be

performed by appropriately qualiﬁed audit,

compliance, or other personnel in a manner

consistent with the institution’s overall frame-

work for compliance monitoring, which should

include consideration of issues such as the inde-

pendence of reviewing personnel from the busi-

ness line. Such monitoring may include more

frequent assessments of the risk arising from

elevated-risk CSFTs, both individually and

within the context of the overall customer rela-

tionship, and the results of this monitoring

should be provided to an appropriate level of

management in the ﬁnancial institution.

2128.09.3.3.4 Audit

The internal audit department of any ﬁnancial

institution is integral to its defense against fraud,

unauthorized risk taking, and damage to the

ﬁnancial institution’s reputation. The internal

audit department of a ﬁnancial institution should

regularly audit the ﬁnancial institution’s adher-

ence to its own control procedures relating to

elevated-risk CSFTs, and further assess the

adequacy of its policies and procedures related

to elevated-risk CSFTs. Internal audit should

periodically validate that business lines and indi-

vidual employees are complying with the ﬁnan-

cial institution’s standards for elevated-risk

CSFTs and appropriately identifying any excep-

tions. This validation should include transaction

testing for elevated-risk CSFTs.

2128.09.3.3.5 Training

An institution should identify relevant personnel

who may need specialized training regarding

CSFTs to be able to effectively perform their

oversight and review responsibilities. Appropri-

ate training on the ﬁnancial institution’s policies

and procedures for handling elevated-risk

CSFTs is critical. Financial institution personnel

involved in CSFTs should be familiar with the

9. The agencies note that the Sarbanes-Oxley Act of 2002

requires companies listed on a national securities exchange or

inter-dealer quotation system of a national securities associa-

tion to establish procedures that enable employees to submit

concerns regarding questionable accounting or auditing mat-

ters on a conﬁdential, anonymous basis. (See 15 U.S.C.

78j-1(m).)

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 6

institution’s policies and procedures concerning

elevated-risk CSFTs, including the processes

established by the institution for identiﬁcation

and approval of elevated-risk CSFTs and new

complex structured ﬁnance products and for the

elevation of concerns regarding transactions or

products to appropriate levels of management.

Financial institution personnel involved in

CSFTs should be trained to identify and prop-

erly handle elevated-risk CSFTs that may result

in a violation of law.

2128.09.4 CONCLUSION

Structured ﬁnance products have become an

essential and important part of the U.S. and

international capital markets, and ﬁnancial insti-

tutions have played an important role in the

development of structured ﬁnance markets. In

some instances, however, CSFTs have been

used to misrepresent a customer’s ﬁnancial con-

dition to investors and others, and ﬁnancial insti-

tutions involved in these transactions have sus-

tained signiﬁcant legal and reputational harm. In

light of the potential legal and reputational risks

associated with CSFTs, a ﬁnancial institution

should have effective risk-management and

internal control systems that are designed to

allow the institution to identify elevated-risk

CSFTs; to evaluate, manage, and address the

risks arising from such transactions; and to con-

duct those activities in compliance with applica-

ble law.

Elevated-Risk Complex Structured Finance Activities 2128.09

BHC Supervision Manual January 2008

Page 7

Credit Derivatives

(Risk Management and Internal Controls) Section 2129.0

Banking organizations must establish and main-

tain sound risk-management policies and proce-

dures and effective internal controls over their

use of credit derivatives. Credit derivatives are

off-balance-sheet ﬁnancial instruments that are

used to assume or lay off credit risk on loans

and other assets, some only to a limited extent.

They allow one party (the beneﬁciary) to trans-

fer the credit risk of a ‘‘reference asset,’’ which

it often actually owns, to another party (the

guarantor).

This arrangement allows the guar-

antor party to assume the credit risk associated

with the reference asset without directly pur-

chasing it. Unlike traditional guarantee arrange-

ments, credit-derivative transactions often are

documented using master agreements developed

by the International Swaps and Derivatives

Association (ISDA) that are similar to those

governing swaps or options. Since credit deriva-

tives are privately negotiated ﬁnancial contracts,

they expose the user to credit risk as well as

liquidity risk (thin secondary market for credit

derivatives), operational risk (instruments used

for speculation rather than hedging), counter-

party risk (default), and legal risk (the contracts

may be deemed illegal).

Banking organizations use credit-derivative

instruments either as end-users, purchasing

credit protection from or providing credit pro-

tection to third parties, or as dealers intermediat-

ing such protection. Credit derivatives are used

to manage overall credit-risk exposure. A bank-

ing organization may use credit derivatives to

mitigate its concentration to a particular bor-

rower or industry without severing the customer

relationship. In addition, organizations that are

approaching established in-house limits on

counterparty credit exposure could continue to

originate loans to a particular industry, using

credit derivatives to transfer the credit risk to a

third party.

Banking organizations may also use credit

derivatives to diversify their portfolios by

assuming the associated credit exposures and

revenue returns to different borrowers or indus-

tries without actually purchasing the underlying

assets. Nonbank companies may serve as coun-

terparties to credit-derivative transactions with

banks to gain access to the commercial bank

loan market. Such entities may not lend or may

not have the facilities or staff to adequately

administer a loan portfolio.

Under some credit-derivative arrangements, a

beneﬁciary may pay a fee to the guarantor in

exchange for a guarantee against any loss that

may occur, usually in excess of a prespeciﬁed

amount, if the reference asset defaults (a

‘‘credit-default swap’’). Alternatively, the bene-

ﬁciary may pay the total return on a reference

asset, including any appreciation in the asset’s

price, to a guarantor in exchange for a spread

over funding costs plus any depreciation in the

value of the reference asset (a ‘‘total-rate-of-

return swap’’).

Credit derivatives and their market are likely

to take on various forms, such as the market for

put options on speciﬁc corporate bonds or loans.

While the payoffs of these puts are expressed in

terms of a strike price, rather than a default

event, if the strike price is sufﬁciently high,

credit risk effectively could be transferred from

the buyer of the put to the writer of the put. See

SR-96-17.

2129.0.1 SUPERVISORY AND

EXAMINER GUIDANCE

In reviewing credit derivatives, examiners

should consider the credit risk associated with

the reference asset as the primary risk, as they

do for loan participations or guarantees. A bank-

ing organization providing credit protection

through a credit derivative may be as exposed to

the credit risk of the reference asset as it would

be if the asset were on its own balance sheet.

Thus, for supervisory purposes, the exposure

generally should be treated as if it were a letter

of credit or other off-balance-sheet guarantee.

This treatment would apply, for example, in

determining a banking organization’s overall

credit exposure to a borrower for purposes of

evaluating concentrations of credit. The overall

exposure should include exposure it assumes

1. For purposes of this supervisory guidance, when the

beneﬁciary owns the reference asset, it will be referred to as

the ‘‘underlying’’ asset. However, in some cases, the reference

asset and the underlying asset are not the same. For example,

the credit-derivative contract may reference the performance

of an ABC Company bond, while the beneﬁciary banking

organization may actually own an ABC Company loan. The

use of the term ‘‘guarantor’’ does not necessarily refer to a

guarantor involving a suretyship contract. The transferred risk

can be in a primary liability of the acquiring party that

assumes the credit risk.

2. Credit derivatives that are based on a broad-based index,

such as the Lehman Brothers Bond Index or the S&P 500

stock index, could be treated for capital and other supervisory

purposes as a derivative contract. This determination should

be made on a case-by-case basis.

BHC Supervision Manual December 1999

Page 1

by acting as a guarantor in a credit-derivative

transaction where the borrower is the obligor of

the reference asset.

Banking organizations providing credit pro-

tection through a credit derivative should hold

capital and reserves against their exposure to

the reference asset.

This broad principle holds

for all credit derivatives, except for credit-

derivative contracts that incorporate periodic

payments for depreciation or appreciation,

including most total-rate-of-return swaps. For

these transactions, the guarantor can deduct the

amount of depreciation paid to the beneﬁciary

from the notional amount of the contract in

determining the amount of reference exposure

subject to a capital charge.

In some cases (for example, total-rate-of-

return swaps), the guarantor also is exposed to

the credit risk of the counterparty, which for

derivative contracts generally is measured as the

replacement cost of the credit-derivative trans-

action plus an add-on for the potential future

exposure of the derivative to market price

changes. For banking organizations acting as

dealers that have matching offsetting positions,

the counterparty risk stemming from credit-

derivative transactions could be the principal

risk to which the dealer banks are exposed.

In reviewing a credit derivative entered into

by a beneﬁciary banking organization, the

examiner should review the organization’s

credit exposure to the guarantor, as well as to

the reference asset—if the asset is actually

owned by the beneﬁciary. The degree to which a

credit derivative, unlike most other credit-

guarantee arrangements, transfers the credit risk

of an underlying asset from the beneﬁciary to

the guarantor may be uncertain or limited. The

degree of risk transference depends on the terms

of the transaction. For example, some credit

derivatives are structured so that a payout only

occurs when a predeﬁned event of default or a

downgrade below a prespeciﬁed credit rating

occurs.

Others may require a payment only

when a deﬁned default event occurs and a pre-

determined materiality (or loss) threshold is

exceeded. Default payments themselves may be

based on an average of dealer prices for the

reference asset during some period of time after

default using a prespeciﬁed sampling procedure

or may be speciﬁed in advance as a set percent-

age of the notional amount of the reference

asset. Finally, the term of many credit-derivative

transactions is shorter than the maturity of the

underlying asset and, thus, provides only tempo-

rary credit protection to the beneﬁciary.

Examiners must ascertain whether the amount

of credit protection a beneﬁciary receives by

entering into a credit derivative is sufﬁcient to

warrant treatment of the derivative as a guaran-

tee for regulatory capital and other supervisory

purposes. Those arrangements that provide vir-

tually complete credit protection to the under-

lying asset will be considered effective guaran-

tees for purposes of asset classiﬁcation and risk-

based capital calculations. On the other hand, if

the amount of credit risk transferred by the

beneﬁciary is severely limited or uncertain, then

the limited credit protection provided by the

derivative should not be taken into account for

these purposes.

In this regard, examiners should carefully

review credit-derivative transactions in which

the reference asset is not identical to the asset

actually owned by the beneﬁciary banking orga-

nization. For the derivative contract to be con-

sidered as providing effective credit protection,

the examiner must review the arrangement and

be satisﬁed that the reference asset is an appro-

priate proxy for the loan or other asset, whose

credit exposure the banking organization intends

to offset. To determine this, examiners should

consider, among other factors, whether the refer-

ence asset and owned asset have the same obli-

gor and seniority in bankruptcy and whether

both contain mutual cross-default provisions.

A banking organization’s management should

not enter into credit-derivative transactions

unless it has the ability to understand and man-

age the credit and other risks associated with

these instruments in a safe and sound manner.

Accordingly, examiners should determine the

appropriateness of these instruments on an

entity-by-entity basis, taking into account man-

agement’s expertise in evaluating the instru-

ments used; the adequacy of relevant policies,

including position limits; and the quality of the

banking organization’s relevant information sys-

tems and internal controls.

3. For guidance on risk-based capital treatment of credit

derivatives, see section 4060.3.5.3.9.

4. It may also be necessary to review the credit documenta-

tion of the primary obligor to determine the degree of trans-

ferred risk.

5. For further guidance on examining the risk-management

practices of banking organizations, including guidance on

derivatives, that examiners may ﬁnd helpful in reviewing an

organization’s management of its credit-derivative activity,

see sections 2125.0, 2126.0, 2128.0, and 4070.1. See also the

Commercial Bank Examination Manual and the Trading and

Capital-Markets Activities Manual.

Credit Derivatives 2129.0

BHC Supervision Manual December 1999

Page 2

2129.0.2 TYPES OF CREDIT

DERIVATIVES

The most widely used types of credit derivatives

are credit-default swaps and total-rate-of-return

(TROR) swaps.

While the timing and structure

of the cash ﬂows associated with credit default

and TROR swaps differ, the economic substance

of both arrangements is that they seek to trans-

fer the credit risk on the asset(s) referenced in

the transaction.

2129.0.2.1 Credit-Default Swaps

The purpose of a credit-default swap is to pro-

vide protection against credit losses associated

with a default on a speciﬁed reference asset. The

swap purchaser (the beneﬁciary) ‘‘swaps’’ the

credit risk with the provider of the swap (the

guarantor). The transaction is very similar to a

guarantee or ﬁnancial standby letter of credit.

In a credit-default swap, illustrated in ﬁg-

ure 1, the beneﬁciary (Bank A) agrees to pay to

the guarantor (Bank B) a quarterly or annual

fee, typically amounting to a certain number of

basis points on the par value of the reference

asset. In return, the guarantor agrees to pay the

beneﬁciary an agreed-upon, market-based, post-

default amount or a predetermined ﬁxed per-

centage of the value of the reference asset if

there is a default. The guarantor makes no pay-

ment until there is a default. A default is strictly

deﬁned in the contract to include, for example,

bankruptcy, insolvency, or payment default, and

the event of default itself must be publicly veri-

ﬁable. The guarantor may not be obliged to

6. Another less common form of credit derivative is the

credit-linked note, which is an obligation that is based on a

reference asset. Credit-linked notes are similar to structured

notes with embedded credit derivatives. If there is a credit

event, the repayment of the bond’s principal is based on the

price of the reference asset. A credit-linked note may be a

combination of a regular bond and a credit option. The note

can promise to make periodic interest payments and a large

lump-sum payment when the bond matures. The credit option

on the note may allow the issuer to reduce the note’s pay-

ments if a primary ﬁnancial indicator or variable deteriorates.

When reviewing these transactions, examiners should con-

sider the purchasing banking organization’s exposure to the

underlying reference asset as well as the exposure to the

issuing entity.

Figure 1

Credit-Default Swap Cash-Flow Diagram

Credit-Default Swap

Fixed payments per quarter

Bank A Bank B

Payment upon default

If default occurs, then B pays A

for the depreciated amount of the

loan or an amount agreed upon at

the outset.

C & I Loan

Principal and interest

Five-year note

Credit Derivatives 2129.0

BHC Supervision Manual December 1996

Page 3

make any payments to the beneﬁciary until a

preestablished amount of loss has been

exceeded in conjunction with a default event

(called a materiality threshold).

The swap is terminated if the reference asset

defaults before the maturity of the swap. The

amount owed by the guarantor is the difference

between the reference asset’s initial principal

(or notional) amount and the actual market value

of the defaulted, reference asset. The method-

ology for establishing the post-default market

value of the reference asset should be set out in

the contract. Often, the market value of the

defaulted reference asset may be determined by

sampling dealer quotes. The guarantor may have

the option to purchase the defaulted, underlying

asset and pursue a workout with the borrower

directly, an action it may take if it believes that

the ‘‘true’’ value of the reference asset is higher

than that determined by the swap-pricing

mechanism. Alternatively, the swap may call for

a ﬁxed payment in the event of default, such as

a percentage of the notional value of the refer-

ence asset.

2129.0.2.2 Total-Rate-of-Return Swaps

In a total-rate-of-return (TROR) swap, illus-

trated in ﬁgure 2, the beneﬁciary (Bank A)

agrees to pay the guarantor (Bank B) the ‘‘total

return’’ on the reference asset, which consists of

all contractual payments, as well as any appreci-

ation in the market value of the reference asset.

To complete the swap arrangement, the guaran-

tor agrees to pay LIBOR plus a spread and any

depreciation to the beneﬁciary.

Since it bears

the risks and rewards of ownership over the

term of the swap, the guarantor in a TROR swap

could be viewed as having synthetic ownership

of the reference asset.

At each payment-exchange date (including

when the swap matures) or on default, at which-

point the swap may terminate, any depreciation

7. The reference asset is often a ﬂoating-rate instrument,

for example, a prime-based loan. Thus, if both sides of a

TROR swap are based on ﬂoating rates, interest-rate risk is

effectively eliminated with the exception of some basis risk.

Figure 2

Total-Rate-of-Return Swap Cash-Flow Diagram

Total-Rate-of-Return Swap

Principal & Interest

plus appreciation

Bank A Bank B

(beneﬁciary) (Total Return) (guarantor)

LIBOR plus spread

plus depreciation

The swap has a maturity of one

year, with the C & I loan as the

‘‘reference asset.’’ At each

payment date, or on default

of the loan, Bank B pays Bank A

for any depreciation of the loan.

Five-year note

C & I Loan

Principal and interest

Credit Derivatives 2129.0

BHC Supervision Manual December 1996

Page 4

or appreciation in the amortized value of the

reference asset is calculated as the difference

between the notional principal balance of the

reference asset and the ‘‘dealer price.’’

The

dealer price is generally determined either by

referring to a market quotation source or by

polling a group of dealers, and the price reﬂects

changes in the credit proﬁle of the reference

obligor and reference asset.

If the dealer price is less than the notional

amount of the contract (the hypothetical original

price of the reference asset), then the guarantor

must pay the difference to the beneﬁciary,

absorbing any loss caused by a decline in the

credit quality of the reference asset.

Thus, a

TROR swap differs from a standard direct credit

substitute in that the guarantor is guaranteeing

not only against default of the reference obligor,

but also against a deterioration in that obligor’s

credit quality, which can occur even if there is

no default.

TROR swaps allow banking organizations to

diversify credit risk and at the same time main-

tain conﬁdentiality of their client’s ﬁnancial

records since the borrowing entity’s ﬁnancial

records are held by the originating lender. When

the loans are sold, the records are transferred to

the new acquiring lender. TROR swaps gener-

ally involve fewer administrative costs than

those involved in a loan-sales transaction. Risk

diversiﬁcation can thus be achieved at a reduced

cost.

2129.0.3 OTHER SUPERVISORY

ISSUES

The decision to treat credit derivatives as guar-

antees could have signiﬁcant supervisory impli-

cations for the way examiners treat concentra-

tion risk, classiﬁed assets, the adequacy of the

allowance for loan and lease losses (ALLL),

and transactions involving afﬁliates. Examples

of how credit derivatives that effectively trans-

fer credit risk could affect supervisory proce-

dures are discussed below.

2129.0.3.1 Credit Exposure

For internal purposes of managing credit risk,

banking organizations are encouraged to

develop policies to determine how credit-

derivative activity will be used to manage credit

exposures. For example, a banking organiza-

tion’s internal credit policies may set forth situ-

ations in which it is appropriate to reduce credit

exposure to an underlying obligor through

credit-derivative transactions. Such policies

need to address when credit exposure is effec-

tively reduced and how all credit exposures will

be monitored, including those resulting from

credit-derivative activities.

2129.0.3.2 Concentrations of Credit

Concentrations of credit may be deﬁned as—

• loans collateralized by a common security;

• loans to one borrower or related group of

borrowers;

• loans that depend on a particular agricultural

commodity;

• aggregate loans to major employers, their

employees, and their major suppliers;

• loans within industry groups;

• out-of-territory loans;

• the aggregate amount of paper purchased from

any one source; or

• those loans that often have been included in

other homogeneous risk groupings.

Credit concentrations, by their nature, depend

on common key factors, and when weaknesses

develop, they have an adverse impact on each

individual loan making up the concentration.

Generally, examiners should not consider a

banking organization’s asset concentration to a

particular borrower reduced because of the exis-

tence of a nongovernment guarantee on one of

the borrower’s loans since the underlying con-

centration to the borrower still exists. However,

examiners should consider how the banking

organization manages the concentration, which

could include the use of nongovernmental guar-

antees. Asset concentrations are to be listed in

the conﬁdential ‘‘Administrative and Other Mat-

ters’’ page D of the inspection report to high-

light that the ultimate risk to the banking organi-

zation stems from these concentrations,

8. Depending on contract terms, a TROR swap may not

terminate on default of the reference asset. Instead, payments

would continue to be made on subsequent payment dates

based on the reference asset’s post-default prices until the

swap’s contractual maturity.

9. As in a credit-default swap, the guarantor may have the

option of purchasing the underlying asset from the beneﬁciary

at the dealer price and trying to collect from the borrower

directly.

10. See sections 2010.7 and 2065.2.

11. See sections 2010.2, 2010.7, and 2065.2.

Credit Derivatives 2129.0

BHC Supervision Manual December 1996

Page 5

although the associated credit risk may be miti-

gated by the existence of nongovernmental

guarantees.

Any nongovernment guarantee will be

included with other exposures to the guarantor

to determine if there is an asset concentration

with respect to the guarantor. Thus, the use of

credit derivatives will increase the beneﬁciary’s

concentration exposure to the guarantor without

reducing the concentration risk of the under-

lying borrower. Similarly, a guarantor banking

organization’s exposure to all reference assets

will be included in its overall credit exposure to

the reference obligor.

2129.0.3.3 Classiﬁcation of Assets

The criteria used to classify assets are primarily

based on their degree of risk and the likelihood

of repayment, as well as on the potential effect

of the assets on the bank’s safety and sound-

ness.

When evaluating the quality of a loan,

examiners should review the overall ﬁnancial

condition of the borrower; the borrower’s credit

history; any secondary sources of repayment,

such as guarantees; and other factors. The pri-

mary focus in the review of a loan’s quality is

the original source of payment. The assessment

of the credit quality of a troubled loan, however,

should take into account support provided by a

‘‘ﬁnancially responsible guarantor.’’

The protection that a credit derivative from a

ﬁnancially responsible guarantor provides on an

underlying asset may be sufﬁcient to preclude

classiﬁcation of the underlying asset or reduce

the severity of classiﬁcation. Sufﬁciency

depends on the extent of credit protection that is

provided. To be considered a guarantee for pur-

poses of determining the classiﬁcation of assets,

a credit derivative must transfer the credit risk

from the beneﬁciary to the ﬁnancially respon-

sible guarantor; the ﬁnancially responsible guar-

antor must have both the ﬁnancial capacity and

willingness to provide support for the credit; the

guarantee (the credit-derivative contract) must

be legally enforceable; and the guarantee must

provide support for repayment of the indebted-

ness, in whole or in part, during the remaining

term of the underlying asset.

However, credit derivatives tend to have a

shorter maturity than the underlying asset being

protected. Furthermore, it is uncertain whether

the credit derivative will be renewed once it

matures. Thus, when determining whether to

classify an underlying asset protected by a credit

derivative, examiners need to consider the term

of the credit derivative in relation to the matu-

rity of the protected underlying asset, the prob-

ability that the protected underlying asset will

default while the guarantee is in force, and

whether the credit risk has actually been trans-

ferred. In general, the beneﬁciary banking orga-

nization continues to be exposed to the credit

risk of the classiﬁed underlying asset when the

maturity of the credit derivative is shorter than

the underlying asset. Thus, in these situations of

maturity mismatch, the examiner’s presumption

may be against a diminution of the severity of

the underlying asset’s classiﬁcation.

For guarantor banking organizations, examin-

ers should review the credit quality of indi-

vidual reference assets in derivative contracts in

the same manner as other credit instruments,

such as standby letters of credit. Thus, examin-

ers should evaluate a credit derivative in which

a banking organization provides credit protec-

tion based on the overall ﬁnancial condition and

resources of the reference obligor; the obligor’s

credit history; and any secondary sources of

repayment, such as collateral. As a rule, expo-

sure from providing credit protection through a

credit derivative should be classiﬁed if the refer-

ence asset is classiﬁed.

2129.0.3.4 Transactions Involving

Afﬁliates

Credit-derivative transactions can involve two

or more legal entities (afﬁliates) within the

same banking organization. Thus, transactions

between or involving afﬁliates raise important

supervisory issues, especially whether such

arrangements are effective guarantees of afﬁliate

obligations or transfers of assets and their

related credit exposure between afﬁliates. Bank-

ing organizations should carefully consider

existing supervisory guidance on interafﬁliate

12. Loans that exhibit potential weaknesses are catego-

rized as ‘‘substandard,’’ while those with well-deﬁned weak-

nesses and a distinct possibility of loss are either ‘‘doubtful’’

or ‘‘loss.’’

13. See section 5010.10 of this manual and section 2060.1

of the Commercial Bank Examination Manual.

14. A guarantor banking organization providing credit pro-

tection through the use of a credit derivative on a classiﬁed

asset of a beneﬁciary bank may preclude classiﬁcation of its

derivative contract by laying off the risk exposure to another

ﬁnancially responsible guarantor. This could be accomplished

through the use of a second offsetting credit-derivative

transaction.

Credit Derivatives 2129.0

BHC Supervision Manual December 1996

Page 6

transactions before entering into credit-

derivative arrangements involving afﬁliates, par-

ticularly when substantially the same objec-

tives could be met using traditional guarantee

instruments.

2129.0.4 INSPECTION OBJECTIVES

1. To determine if the banking organization

is providing credit protection through a credit

derivative.

2. To ascertain whether the banking orga-

nization has and maintains sound risk-

management policies and procedures and effec-

tive internal controls over the use of credit

derivatives.

3. To review and evaluate existing risk

involving credit-derivative arrangements.

4. To ascertain whether adequate capital and

reserves are held against exposures to reference

assets, including whether risk-based capital

computations have accounted for any additional

risk resulting from derivative arrangements.

2129.0.5 INSPECTION PROCEDURES

1. Consider credit risk associated with refer-

ence assets as primary risks. Determine whether

the credit-risk exposure is treated as if it was a

letter of credit or other off-balance-sheet

guarantee.

2. Review the organization’s credit exposure

to the guarantor, as well as to the reference

asset. Determine if the asset is actually owned

by the beneﬁciary.

3. Ascertain whether the amount of credit

protection a beneﬁciary receives when entering

into a credit derivative is sufﬁcient to warrant

treatment of the derivative as a guarantee for

regulatory capital and other supervisory

purposes.

4. Review credit-derivative transactions in

which the reference asset is not identical to the

asset actually owned by the beneﬁciary banking

organization.

a. Ascertain if the reference asset is an

appropriate proxy for loans or other assets

whose credit exposure the banking organization

intends to offset.

b. Consider whether the reference asset

and owned asset have the same obligor and

seniority in bankruptcy and whether both con-

tain mutual cross-default provisions.

5. Determine whether management has the

ability to understand and manage the credit and

other risks associated with credit derivatives in

a safe and sound manner. Consider manage-

ment’s expertise in evaluating the instruments;

the adequacy of relevant policies, including

position limits; and the quality of the banking

organization’s relevant management informa-

tion systems and internal controls.

6. Evaluate the management of a banking

organization’s asset concentration to a particular

borrower, which could include the use of non-

governmental guarantees on one or more of the

borrower’s loans. List the asset concentrations

in the conﬁdential ‘‘Administrative and Other

Matters’’ page D of the inspection report.

7. Review the quality of loans and the overall

ﬁnancial condition of the borrower; the bor-

rower’s credit history; any secondary sources of

repayment, such as ﬁnancially responsible guar-

antors; and other factors.

8. When determining whether to classify an

underlying asset protected by a credit deriva-

tive, compare the term of the credit derivative in

relation to the maturity of the protected under-

lying asset, the probability that the protected

underlying asset will default while the guarantee

is in force, and whether the credit risk has

actually been transferred.

9. For guarantor banking organizations,

review the credit quality of individual reference

assets in derivative contracts in the same man-

ner as other credit instruments, such as standby

letters of credit.

a. Evaluate a credit derivative in which a

banking organization provides credit protection

based on the overall ﬁnancial condition and

resources of the reference obligor; the obligor’s

credit history; and any secondary sources of

repayment, such as collateral.

b. If the reference asset is classiﬁed, clas-

sify the exposure from providing credit protec-

tion through a credit derivative.

Credit Derivatives 2129.0

BHC Supervision Manual December 1996

Page 7

Risk and Capital Management—Secondary-Market Credit Activities

(Risk Management and Internal Controls) Section 2129.05

2129.05.05 RISK IDENTIFICATION

AND RISK MANAGEMENT OF

SECONDARY MARKET CREDIT

ACTIVITIES

A ﬁrm engages secondary-market credit activi-

ties, such as loan syndications, loan sales and

participations, credit derivatives, and asset secu-

ritizations. These activities can enhance both

credit availability and a ﬁrm’s proﬁtability, but

managing the risks of these activities poses

increasing challenges. The risks involved, while

not new to banking, may be less obvious and

more complex than the risks of traditional lend-

ing activities. Concentrations in certain

secondary-market credit activities involve

credit, liquidity, operational, legal, and reputa-

tional risks that may not be fully recognized by

management or adequately incorporated in a

ﬁrm’s risk-management systems. In reviewing

these activities, examiners should assess

whether a ﬁrm fully understands and adequately

manages the full range of the risks involved in

secondary-market credit activities.

Improvements in technology, greater stan-

dardization of lending products, and the use of

credit enhancements have helped to increase

dramatically the volume of loan syndications,

loan sales, loan participations, asset securitiza-

tions, and credit guarantees undertaken by com-

mercial banks, afﬁliates of holding companies,

and some U.S. branches and agencies of foreign

banks. In addition, credit derivatives permit

ﬁrms to trade credit risk, manage it in isolation

from other types of risk, and maintain credit

relationships while transferring the associated

credit risk. If appropriately managed, such rela-

tionships can improve the availability of credit

to businesses and consumers, allow manage-

ment to better tailor the mix of credit risk within

loan and securities portfolios, and improve over-

all bank proﬁtability.

This section identiﬁes some of the important

risks involved in several of the more common

types of secondary-market credit activities.

Guidance is provided on sound risk-

management practices, along with special con-

siderations that examiners should consider in

assessing the risk-management systems for these

activities. A ﬁrm’s failure to adequately under-

stand the risks inherent in secondary market

credit activities and the failure to incorporate

such risk within its risk-management systems

and internal capital allocations may constitute

an unsafe and unsound banking practice.

A ﬁrm should incorporate the full range of

risks of their secondary-market credit activities

into their overall risk-management systems. In

particular, examiners should determine whether

ﬁrms are recognizing the risks of secondary-

market credit activities by

(1) adequately identifying, quantifying, and

monitoring these risks;

(2) providing sufﬁcient information on the

extent and depth of these risks to senior

management and the ﬁrm’s board of direc-

tors;

(3) conducting ongoing stress testing to identify

potential losses and liquidity needs under

adverse circumstances; and

(4) setting adequate minimum internal stan-

dards for allowances or liabilities for losses,

capital, and contingency funding.

Incorporating secondary-market credit activi-

ties into a ﬁrm’s risk-management systems and

internal capital adequacy allocations is particu-

larly important.

Certain credit and liquidity enhancements that

a ﬁrm requires for its secondary-market credit

activities can make the evaluation of risks less

straightforward than evaluating the risks

involved in traditional on-balance-sheet lending

activities. These enhancements, or guarantees,

generally include recourse provisions; securiti-

zation structures that entail credit-linked early

amortization and collateral-replacement events;

and direct-credit substitutes, such as letters of

credit and subordinated interests that, in effect,

provide credit support to secondary-market

instruments and transactions.

The transactions involving credit and liquid-

ity enhancements tend to be complex and may

expose a ﬁrm to additional obligations that may

not become evident until a transaction has dete-

1. For a more general discussion of risk management, see

SR-95-51, “Rating the Adequacy of Risk Management Pro-

cesses and Internal Controls at State Member Banks and Bank

Holding Companies” and

SR-98-12, “Investment Securities

and End-User Derivatives Activities.”

2. Examiners should also refer to the Board’s regulatory

capital rules at 12 CFR part 217 (Regulation Q). In addition,

ﬁrms have retained the risk of loss, that is, recourse, on sales

and securitizations of assets when, in accordance with gener-

ally accepted accounting principles, they record on their bal-

ance sheets interest-only strips receivables or other assets that

serve as credit enhancements. For more information, see the

instructions to the Reports of Condition and Income and the

FR-Y9 series reports.

BHC Supervision Manual November 2021

Page 1

riorated. In substance, such activities move the

credit risk off the balance sheet by shifting risks

associated with traditional on-balance-sheet

assets into off-balance-sheet contingent liabili-

ties. Given the potential complexity and, in

some cases, the indirect nature of these enhance-

ments, the actual credit-risk exposure can be

difﬁcult to assess, especially in the context of

traditional credit-risk limit, measurement, and

reporting systems.

Moreover, many secondary-market credit

activities involve reputational, liquidity, opera-

tional, and legal risks that are not readily identi-

ﬁable and may be difﬁcult to control. For exam-

ple, recourse provisions and certain asset-

backed security structures can give rise to

signiﬁcant reputational- and liquidity-risk expo-

sures, and ongoing management of underlying

collateral in securitization transactions can

expose a ﬁrm to unique operating and legal

risks.

For a ﬁrm providing credit enhancements in

connection with loan sales and securitizations,

and a ﬁrm involved in credit derivatives and

loan syndications, examiners should assess

whether the ﬁrm’s systems and processes

adequately identify, measure, monitor, and con-

trol the risks involved in the secondary-market

credit activities. In particular, the risk-

management systems employed should include

the identiﬁcation, measurement, and monitoring

of these risks, as well as an appropriate method-

ology for the internal allocation of capital and

reserves. The stress testing conducted within the

risk-measurement element of the management

system should fully incorporate the risk expo-

sures of these activities under various scenarios

in order to identify their potential effect on a

ﬁrm’s liquidity, earnings, and capital adequacy.

Moreover, senior management should have suf-

ﬁcient information to assess the risks associated

with these activities, as well as whether contin-

gency plans are adequate to deal with possible

adverse conditions.

2129.05.1 CREDIT RISKS IN

SECONDARY-MARKET CREDIT

ACTIVITIES

A ﬁrm should be aware that the credit risk

involved in many secondary-market credit

activities may not always be obvious. For cer-

tain types of loan sales and securitization trans-

actions, a ﬁrm may actually be exposed to

essentially the same credit risk that arises from

traditional lending activities, even though a par-

ticular transaction may, superﬁcially, appear to

have isolated the ﬁrm from credit risk. For

instance, an off-balance-sheet transaction may

not result in a commensurate reduction in credit

risk. Such transactions include loan sales with

recourse; credit derivatives; direct-credit substi-

tutes, such as letters of credit; liquidity facilities

extended to securitization programs; and certain

asset-securitization structures (for example,

securitized credit card receivables).

2129.05.1.1 Loan Syndications

A ﬁrm should periodically review syndication

underwriting standards and pricing practices to

verify that they remain consistent over time

with (1) the degree of risk associated with the

activity and (2) the potential for unexpected

economic developments to adversely affect bor-

rower creditworthiness.

A ﬁrm may be asked to make a commitment

to participate in a loan syndication within a

shorter period of time that may limit the time for

the ﬁrm to conduct its risk assessment. There-

fore, examiners will periodically review under-

writing standards and consider whether a ﬁrm

performs an independent credit analysis of the

syndicated credit instead of placing undue reli-

ance on the analysis of the lead underwriter or

on commercial-loan credit ratings. A ﬁrm

should avoid making an irrevocable commit-

ment to participate in a syndication until the

ﬁrm completes its own risk assessment.

2129.05.1.2 Credit Derivatives

Credit derivatives are generally off-balance-

sheet ﬁnancial instruments that are used by a

ﬁrm to assume or mitigate the credit risk of

loans and other assets.

A ﬁrm employs these

instruments, either as end-users, purchasing

credit protection from—or providing credit pro-

tection to—third parties, or as dealers intermedi-

ating such protection. In reviewing credit

derivatives, supervisors should consider the

credit risk associated with the referenced asset,

as well as general market risk and the risk of the

counterparty to the contract.

With respect to credit-derivative transactions

in which a ﬁrm is mitigating the credit risk of its

assets, examiners will review those situations in

which the referenced assets are not identical to

3. Credit-linked notes are on-balance-sheet instruments.

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 2

the assets actually owned by the ﬁrm. Examin-

ers should consider whether the referenced asset

is an appropriate proxy for the risks posed by

the underlying loan or other assets of the deriva-

tive transaction.

2129.05.1.3 Recourse Obligations,

Direct-Credit Substitutes, and Liquidity

Facilities

2129.05.1.3.1 Recourse Obligations

Partial, ﬁrst-loss recourse obligations retained

when selling assets, as well as the extension of

partial credit enhancements (for example,

10 percent letters of credit), can be a source of

concentration credit risk by exposing a ﬁrm to

the full amount of expected losses on the pro-

tected assets. For instance, the credit risk associ-

ated with whole loans or a pool of loans that are

sold to secondary-market investors can often be

concentrated within the partial, ﬁrst-loss

recourse obligations retained by the ﬁrm selling

and securitizing the assets. In these situations,

even though a ﬁrm may have reduced its expo-

sure to catastrophic loss on the assets sold, the

ﬁrm generally retains the same credit-risk expo-

sure as if the ﬁrm continued to hold the loans or

assets on its balance sheet.

2129.05.1.3.2 Direct-Credit Substitutes

A ﬁrm should consider the level of credit con-

centration risk that arise from the extension of

partial direct-credit substitutes, such as the pur-

chase of subordinated interests and the exten-

sion of letters of credit. For example, a ﬁrm that

sponsors certain asset-backed commercial paper

programs, or so-called remote-origination con-

duits, can be exposed to a high degree of credit

risk even though its notional exposure is mini-

mal. In these situations, the sponsoring ﬁrm

refers an existing corporate customer to the con-

duit, which becomes the new lender to that

customer. The conduit funds this lending activ-

ity by issuing commercial paper that, in turn, is

guaranteed by the sponsoring ﬁrm. The net

result is that the sponsoring ﬁrm has much the

same credit-risk exposure through its guarantee

as it would have on a direct loan to that corpo-

rate borrower and held on-balance-sheet. How-

ever, this credit extension is an off-balance-

sheet transaction, and the associated risks may

not be fully addressed in the ﬁrm’s risk-

management system.

2129.05.1.3.3 Liquidity Facilities

A ﬁrm that extends liquidity facilities to securi-

tized transactions, particularly asset-backed

commercial paper programs, may be exposed to

a high degree of credit risk that may be embed-

ded within a facility’s provisions. Liquidity

facilities are commitments to extend short-term

credit to cover temporary shortfalls in cash ﬂow

of an asset-backed commercial paper. While all

commitments embody some degree of credit

risk, certain commitments extended to asset-

backed commercial paper programs to provide

liquidity may subject a ﬁrm to the credit risk of

the underlying asset pool, often trade receiv-

ables, or to the credit risk of a speciﬁc company

using the program for funding. Often the stated

purpose of such liquidity facilities is to provide

funds to the program to retire maturing commer-

cial paper when a mismatch occurs in the

maturities of the underlying receivables and the

commercial paper, or when a disruption occurs

in the commercial paper market. However,

depending on the provisions of the facility—

such as whether the facility covers dilution of

the underlying receivable pool—credit risk can

be shifted from the program’s explicit credit

enhancements to the liquidity facility.

Such

provisions may enable certain programs to fund

riskier assets and yet maintain the credit rating

on the program’s commercial paper without

increasing the program’s credit-enhancement

levels.

2129.05.1.4 Asset-Securitization

Structures

The structure of various securitization transac-

tions can result in a ﬁrm retaining the under-

lying credit risk for a pool of assets that the ﬁrm

securitized. An example of this contingent

credit-risk retention is credit card securitizations

in which the securitizing organization explicitly

sells the credit card receivables to a master trust

but, in practice, retains the majority of the eco-

nomic risk of loss associated with the assets—

because of the credit protection provided to

investors by the excess yield, spread accounts,

and structural provisions of the securitization.

4. Dilution essentially occurs when the receivables in the

underlying asset pool—before collection—are no longer

viable ﬁnancial obligations of the customer. For example,

dilution can arise from returns of consumer goods or unsold

merchandise by retailers to manufacturers or distributors.

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 3

Excess yield provides the ﬁrst level of credit

protection that can be drawn upon to cover cash

shortfalls between the principal and coupon

owed to investors and the investors’ pro rata

share of the master trust’s net cash ﬂows. The

excess yield is equal to the difference between

the overall yield on the underlying credit card

portfolio and the master trust’s operating

expenses.

The second level of credit protection

is provided by the spread account, which is

essentially a reserve funded initially from the

excess yield.

The structural provisions of credit card secu-

ritizations generally provide credit protection to

investors through the triggering of early-

amortization events. Such an event usually is

triggered when the underlying pool of credit

card receivables deteriorates beyond a certain

point and requires that the outstanding credit

card securities begin amortizing early to pay off

investors before the prior credit enhancements

are exhausted. As the early amortization acceler-

ates the redemption of principal (paydown) on

the security, the credit card accounts that were

assigned to the master credit card trust return to

the securitizing institution more quickly than

had originally been anticipated, thus exposing

the ﬁrm to liquidity pressures and to further

credit losses on the returned accounts.

2129.05.2 REPUTATIONAL RISKS

A ﬁrm’s secondary-market credit activities give

rise to reputational risks. Loan-syndication

underwriting may present signiﬁcant

reputational-risk exposure to lead underwriters

because syndicate participants may seek to hold

the lead underwriter responsible for actual or

perceived inadequacies in the loan’s underwrit-

ing practices, even though participants are

responsible for conducting an independent due-

diligence in evaluating the credit.

There is the possibility that pressure may be

brought to bear on the lead participant to repur-

chase portions of the syndication if the credit

deteriorates in order to protect its reputation in

the market, even though the syndication was

sold without recourse. In addition, when there is

deterioration in the syndicated credit, a partici-

pant may pursue legal action against the lead

organization. One way to mitigate reputational

risk in a syndication is for a ﬁrm to determine

whether a possible participant in the syndication

is able to conduct its own evaluation of the

credit risks involved in the transaction.

A ﬁrm that sponsors an asset-backed security

may also be acting as the servicer, administrator,

or liquidity provider in the securitization trans-

action. Therefore, a ﬁrm should assess the

potential losses and risk exposure associated

with reputational risk arising from these activi-

ties. An asset securitization with deterioration of

performance may result in a negative market

reaction that could increase the spreads on a

ﬁrm’s future issuances. In order to avoid poten-

tially adverse implications on future issuances, a

ﬁrm may provide support to its securitization

transactions by improving the performance of

the securitized asset pool. For example, a ﬁrm

may sell discounted receivables or add higher-

quality assets to the securitized asset pool. Thus,

a ﬁrm’s voluntary support of its securitization in

order to protect the ﬁrm’s reputation can

adversely affect the sponsoring or issuing orga-

nization’s earnings and capital. A ﬁrm may take

these actions to avoid either a rating downgrade

or an early amortization of the outstanding

asset-backed securities.

2129.05.3 LIQUIDITY RISKS

The existence of recourse provisions in asset

sales, the extension of liquidity facilities to secu-

ritization programs, and the early-amortization

triggers of certain asset-securitization transac-

tions can involve signiﬁcant liquidity risk to

institutions engaged in these secondary-market

credit activities. A ﬁrm should consider whether

its liquidity contingency plans fully incorporate

the potential risk posed by its secondary-market

credit activities. With the issuance of new asset-

backed securities, the issuing ﬁrm should deter-

mine the potential effect on its liquidity at the

inception of each transaction and throughout the

life of the securities to better ascertain its future

funding needs.

A ﬁrm’s contingency plans should consider

the need to obtain replacement funding and

specify the possible alternative funding sources,

addressing the amortization of outstanding

asset-backed securities. This is particularly

important for securitizations with revolving

receivables, such as credit cards, when an early

amortization of the asset-backed securities could

5. The monthly excess yield is the difference between the

overall yield on the underlying credit card portfolio and the

master trust’s operating expenses. It is calculated by subtract-

ing from the gross portfolio yield the (1) coupon paid to

investors; (2) charge-offs for that month; and (3) servicing

fee, usually 200 basis points paid to the ﬁrm sponsoring the

securitization.

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 4

unexpectedly return the outstanding balances of

the securitized accounts to the issuing ﬁrm’s

balance sheet. An early amortization of a ﬁrm’s

asset-backed securities could impede its ability

to fund itself—either through reissuance or other

borrowings—since the ﬁrm’s reputation with

investors and lenders may be adversely affected.

2129.05.4 INCORPORATING THE

RISKS OF SECONDARY-MARKET

CREDIT ACTIVITIES INTO RISK

MANAGEMENT

Supervisors should verify that a ﬁrm incorpo-

rates the risks involved in its secondary-market

credit activities in its overall risk-management

system. The system should entail

(1) information on risk exposures for the ﬁrm’s

senior management;

(2) review, approval, and adoption of appropri-

ate policies, procedures, and guidelines to

manage the risks involved;

(3) appropriate processes to measure and moni-

tor risks; and

(4) appropriate internal controls to verify the

integrity of the management process with

respect to these activities.

The formality and sophistication with which

the risks of these activities are incorporated into

a ﬁrm’s risk-management system should be

commensurate with the nature and volume of its

secondary-market credit activities. A ﬁrm with

signiﬁcant secondary-market activity should

have a more robust risk-management process to

monitor and control the risks of this activity.

2129.05.4.1 Role of the Board of

Directors

The board of directors should consider the

capacity of the ﬁrm’s risk management frame-

work when overseeing aspects of the ﬁrm’s

strategy arising from the ﬁrm’s secondary-

market credit activities. The board should also

review any corresponding risk management or

controls enhancements that are necessary to

align with the risk appetite. The board should

review and approve all signiﬁcant policies relat-

ing to the management of risk arising from

secondary-market credit activities based on the

ﬁrm’s strategy, risk appetite, risk-management

capacity, and structure.

A ﬁrm involved in securitization activities

should have appropriate policies, procedures,

and controls with respect to underwriting asset-

backed securities; funding the possible return of

revolving receivables (for example, credit card

receivables and home equity lines); and estab-

lishing limits on exposures to individual institu-

tions, types of collateral, and geographic and

industrial concentrations. A lead ﬁrm in a loan

syndication should have policies and procedures

in place describing the instances when portions

of syndications may be repurchased. Further-

more, a ﬁrm participating in a loan syndication

should not place undue reliance on the credit

analysis performed by the lead organization.

Rather, the participant should have clearly

deﬁned policies and procedures addressing its

own due diligence in analyzing the risks inher-

ent in the transaction.

2129.05.4.2 Role of Senior Management

Senior management is responsible for under-

standing the credit, market, liquidity, opera-

tional, legal, and reputational risks arising from

the ﬁrm’s secondary-market credit activities.

Senior management is also responsible for

implementing a risk-management structure that

is commensurate with the level of the organiza-

tion’s activities. Senior management should

conﬁrm that the risk exposures are fully incor-

porated into information provided to the ﬁrm’s

board of directors. Senior management is

responsible for ensuring that the risks arising

from secondary-market credit activities are

adequately managed on both a short-term and

long-term basis. Senior management should

establish adequate policies and procedures for

incorporating the risk of these activities into the

overall risk-management process of the institu-

tion. Such policies should clarify that the eco-

nomic substance of the risk exposures generated

by these activities is identiﬁed, monitored, and

controlled. Senior management should provide

the institution’s board of directors with sufﬁ-

cient, timely, and well-organized information

about secondary-market activities so that the

board can understand the risks posed by

secondary-market credit activities.

2129.05.4.3 Management Information and

Risk-Measurement Systems

A ﬁrm’s management information and risk-

measurement systems should fully incorporate

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 5

the risks involved in its secondary-market credit

activities. A ﬁrm should be able to identify

credit exposures from all secondary-market

credit activities and be able to measure, quan-

tify, and control those exposures on a fully

consolidated basis. The economic substance of

the credit exposures of secondary-market credit

activities should be fully incorporated into the

ﬁrm’s efforts to quantify its credit risk, includ-

ing efforts to establish more formal grading of

credits to allow for statistical estimation of loss-

probability distributions. Secondary-market

credit activities should also be included in any

aggregations of credit risk by borrower, indus-

try, or economic sector.

It is particularly important that a ﬁrm’s infor-

mation systems can identify and segregate those

credit exposures arising from the ﬁrm’s loan-

sale and securitization activities. Such expo-

sures include the sold portions of participations

and syndications, exposures arising from the

extension of credit-enhancement and liquidity

facilities, the effects of an early-amortization

event, and the investment in asset-backed secu-

rities. The information that senior management

provides to the board of directors should be

appropriately tailored in order to enable the

board to make sound, well-informed decisions,

and consider potential risk.

2129.05.4.4 System of Internal Controls

The board oversees and holds senior manage-

ment accountable for establishing and maintain-

ing an effective system of internal controls that,

among other things, enforces the ofﬁcial lines of

authority and the appropriate separation of

duties in managing the ﬁrm’s risks. These inter-

nal controls should be commensurate with the

ﬁrm’s activities and associated risks. Moreover,

these internal controls should provide reason-

able assurance of reliable ﬁnancial reporting (in

published ﬁnancial reports and regulatory

reports), including adequate allowances or

liabilities for expected losses.

2129.05.5 STRESS TESTING

The use of stress testing, including consider-

ation of multiple market events that could affect

a ﬁrm’s credit exposures and securitization

activities, is another important element of risk

management. Stress testing involves identifying

possible events or changes in market behavior

that could have unfavorable effects on the ﬁrm

and assessing its ability to withstand them.

Stress testing should consider the probability of

adverse events, as well as likely worst-case sce-

narios. Such an analysis should be done on a

consolidated basis and consider, for instance,

the effect of higher-than-expected levels of

delinquencies and defaults, as well as the conse-

quences of early-amortization events with

respect to credit card securities that could raise

concerns regarding the ﬁrm’s capital adequacy

and its liquidity and funding capabilities. Stress-

test analyses should also include contingency

plans regarding the actions management might

take, given certain situations.

2129.05.6 CAPITAL ADEQUACY

A ﬁrm should fully support the risk exposures

of its secondary-market credit activities with

adequate capital. A ﬁrm should validate that its

capital position is sufﬁciently strong to support

the risks associated with these activities on a

fully consolidated basis and should maintain

adequate capital in afﬁliated entities engaged in

these activities. The Federal Reserve’s Regula-

tion Q (12 CFR part 217) establishes minimum

capital ratios, and a ﬁrm exposed to high or

above-average degrees of risk is therefore

expected to operate above the minimum capital

standards.

Examiners should review the substance of

secondary-market transactions when assessing

underlying risk exposures. For example, partial,

ﬁrst-loss direct-credit substitutes providing

credit protection to a securitization transaction

can, in substance, involve much the same credit

risk as that involved in holding the entire asset

pool on the ﬁrm’s balance sheet. Examiners

should assess whether banking organizations

have appropriately allocated capital against the

economic substance of credit exposures arising

from early-amortization events and liquidity

facilities associated with securitized transac-

tions.

If, in the examiner’s judgment, a ﬁrm’s capi-

tal level is not sufﬁcient to absorb potential

losses from such credit exposures, examiners

should reﬂect this deﬁciency in the ﬁrm’s report

of examination and supervisory ratings, as

appropriate. Furthermore, examiners should dis-

cuss the capital deﬁciency with the ﬁrm’s man-

agement and, if necessary, its board of directors.

6. For further information, refer to the Board’s regulatory

capital rule at 12 CFR part 217 (Regulation Q).

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 6

In these situations, a ﬁrm will be expected to

develop and implement a plan for strengthening

its overall capital adequacy to levels deemed

appropriate given the ﬁrm’s risk exposure.

2129.05.7 INSPECTION OBJECTIVES

1. To determine whether a ﬁrm’s risk-

management systems accurately identify the

risk exposures stemming from secondary-

market activities.

2. To determine whether there has been a lower-

ing of credit standards as a result of the

ﬁrm’s secondary-market credit activities.

3. To determine whether the ﬁrm’s manage-

ment system performs stress testing to evalu-

ate the risk exposures of secondary-market

credit activities under various scenarios and

to evaluate the potential effect of the activi-

ties on the ﬁrm’s liquidity, earnings, and

capital adequacy.

4. To assess the effectiveness of any liquidity

contingency plans as the plans relate to

secondary-market credit activities, including

the need to obtain replacement funding.

5. To determine whether the board of directors

is fully informed of the risks involved in

secondary-market activities and whether it

approves policies, to mitigate credit, liquid-

ity, operational, legal, reputational, and other

risks.

6. To determine whether the ﬁrm’s capital plan-

ning and positions support the risks associ-

ated with secondary-market credit activities.

7. To ascertain whether there is an effective

system of internal controls to monitor and

contain the risks associated with secondary-

market activities.

2129.05.8 INSPECTION PROCEDURES

1. Determine whether the ﬁrm’s senior manage-

ment

a. adequately identiﬁes, quantiﬁes, and

monitors risks involved in secondary-

market credit activities;

b. clearly communicates the extent and depth

of those risks in discussions, presenta-

tions, and inspection reports that are deliv-

ered to the board of directors and senior

ofﬁcials of the institution;

c. presents to the board of directors, for its

approval, all signiﬁcant policies relating

to the risk management of secondary-

market activities;

d. conducts periodic stress testing to identify

potential losses and liquidity needs under

adverse and worst-case scenarios; and

e. has set adequate minimum internal stan-

dards for allowances or liabilities for

losses, capital, and contingency funding.

2. Assess whether the ﬁrm’s risk-management

systems and processes adequately identify,

measure, monitor, and control all of the risks

involved in the ﬁrm’s secondary-market

credit activities.

3. Determine whether the various risks associ-

ated with secondary-market activities are

incorporated into contingency plans, includ-

ing replacement funding plans and identiﬁed

alternative funding sources, to lessen the

impact of those risks.

4. Assess the appropriateness of loan-

syndication contract agreements, underwrit-

ing documentation, and relevant correspon-

dence with loan-syndication contractual

parties to establish whether

a. the ﬁrm’s management has performed

adequate credit investigations and evalua-

tions of the syndicate loans, the syndicate

participants, and the extent of the ﬁrm’s

credit-risk exposures;

b. the syndication customers are in a posi-

tion to evaluate the credit risks involved

in the transaction; and

c. undue reliance is placed on the lead

underwriter, the participants, or on

commercial-loan credit ratings of the par-

ticipants.

5. For credit derivatives—

a. analyze the credit risk associated with the

reference asset, the general market risk,

and the counterparty risk; and

b. determine, for those reference assets that

are not identical assets actually owned,

whether the reference asset is an appropri-

ate proxy for the loan or other assets

whose credit exposure is to be offset.

6. Review the substance of secondary-market

transactions, when evaluating and analyzing

underlying risk exposures.

7. Assess the appropriateness of the ﬁrm’s

methods for internally allocating capital

against the economic substance of credit

exposures that arise from amortization events

and liquidity facilities associated with securi-

tized transactions.

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 7

8. Incorporate the evaluation of potential risks

and losses from credit exposures, including

management deﬁciencies, into the report of

examination and the ﬁrm’s supervisory rat-

ings, as appropriate.

Risk and Capital Management—Secondary-Market Credit Activities 2129.05

BHC Supervision Manual November 2021

Page 8

Futures, Forward, and Option Contracts

Section 2130.0

2130.0.1 INTRODUCTION

Effective March 1, 1983, the Board issued an

amended bank holding company policy state-

ment entitled ‘‘Futures, Forward and Options on

U.S. Government and Agency Securities and

Money Market Instruments.’’ Bank holding

companies are now required to furnish written

notiﬁcation to their District Federal Reserve

Banks within 10 days after ﬁnancial contract

activities are begun by the parent or a nonbank

subsidiary. The policy is consistent with the

joint policy statement previously issued by the

three federal bank regulators with regard to

banks participating in ﬁnancial contracts, and

reﬂects the Board’s judgment that bank holding

companies, as sources of strength for their sub-

sidiary banks, should not take speculative posi-

tions in such activities.

If a bank holding company or nonbank sub-

sidiary is taking or intends to take positions in

ﬁnancial contracts, that company’s board of

directors should approve written policies and

establish appropriate limitations to ensure that

the activity is conducted in a safe and sound

manner. Also, appropriate internal control and

audit procedures should be in place to monitor

the activity. The following discussion and

inspection procedures apply to futures contract

activity generally, but are intended to focus spe-

ciﬁcally on ﬁnancial futures contracts. For a

discussion of currency futures and options and

the examination procedures for those instru-

ments, see sections F and G in the Merchant and

Investment Bank Examination Manual.

Information, instructions, and inspection pro-

cedures have been provided for verifying com-

pliance with the Board’s policy statement. It is

intended that the policy statement will ensure

that contract activities are conducted in accor-

dance with safe and sound banking practices.

The task of evaluating BHC contract activities

is the responsibility of System examiners. The

following information and inspection proce-

dures are intended to serve as a guide for Fed-

eral Reserve Bank staff in that effort.

2130.0.2 DEFINITIONS

Basis—Basis is deﬁned as the difference

between the futures contract price and the cash

market price of the same underlying security,

money market instrument, or commodity.

Call Option—A contract that gives the buyer

(holder) the right, but not the obligation to buy

(call), a speciﬁed quantity of an underlying

security, money market instrument or commod-

ity at or before the stated expiration of the

contract. At expiration, if the value of the option

increases, the holder will exercise the option or

close it at a proﬁt. If the value of the option does

not increase, the holder would probably let the

option expire (or close it out at a proﬁt) and,

consequently, will lose the cost (premium paid)

of (for) the option. Alternatively, the option may

be sold prior to expiration.

Clearing Corporation—A corporation orga-

nized to function as the clearing house for an

exchange. The clearing house registers, moni-

tors, matches and guarantees trades on a futures

market, and carries out ﬁnancial settlement of

futures transactions. The clearing house acts as

the central counterparty to all trades executed

on the exchange. It substitutes as a seller to all

buyers and as a buyer to all sellers. In addition,

the clearing corporation serves to insure that all

contracts will be honored in the event of a

counterparty default.

Clearing Member—A member ﬁrm of the

clearing house or corporation. Membership in

clearing associations or corporations is restricted

to members of the respective commodity

exchanges, but not all exchange members are

clearing house members. All trades of a non-

clearing member must be registered with, and

eventually settled through, a clearing member.

Commodities Futures Trading Commission—

The CFTC is a federal regulatory agency

charged with regulation of futures trading in all

commodities. It has broad regulatory authority

over futures trading. It must approve all future

contracts traded on U.S. commodity exchanges,

ensure that the exchanges enforce their own

rules (which it must review and approve), and

direct an exchange to take any action needed to

maintain orderly markets whenever it believes

that an ‘‘emergency’’ exists.

Contract Activities—This term is used in this

manual to refer to banking organization partici-

pation in the futures, forward, standby contract,

or options markets to purchase and sell U.S.

government and agency securities or money

market instruments, foreign currencies and other

ﬁnancial instruments.

Convergence—The process by which the

futures market price and the cash market price

BHC Supervision Manual December 1992

Page 1

of a ﬁnancial instrument or commodity con-

verge as the futures contract approaches expira-

tion.

Covered Call Options—This term refers to

the issuance or sale of a call option where the

option seller owns the underlying deliverable

security or ﬁnancial instrument.

Cross Hedging—The process of hedging a

‘‘cash’’ or derivative instrument position with

another cash or derivative instrument that has

signiﬁcantly different characteristics. For exam-

ple, an investor who wants to hedge the sales

price of long-term corporate bonds might hedge

by establishing a short position in a treasury

bond or treasury bond futures contract, but since

the corporate bonds cannot be delivered to sat-

isfy the contract, the hedge would be a cross

hedge. To be successful, the price movements of

the hedged instrument must be highly correlated

to that of the position being hedged.

Difference Check—A difference check is sent

by the party which recognizes a loss when a

forward contract is closed out by the execution

of an offsetting forward contract pursuant to a

pair-off clause. In essence, the difference check

represents a net cash settlement on offsetting

transactions between the same two parties and

replaces a physical delivery and redelivery of

the underlying securities pursuant to offsetting

contracts.

Financial Contract—This term is used in the

manual to refer to ﬁnancial futures, forward,

standby contracts, and options to purchase and

sell U.S. government and agency securities,

money market instruments, foreign currency

futures and other ﬁnancial instruments.

Firm Forward Contract—This term is used

to describe a forward contract under which

delivery of a security is mandatory. See

‘‘Standby Contract’’ for a discussion of optional

delivery forward contracts.

Forward Contracts—Over-the-counter con-

tracts for forward placement or delayed delivery

of securities in which one party agrees to pur-

chase and another to sell a speciﬁed security at a

speciﬁed price for future delivery. Contracts

specifying settlement in excess of 30 days fol-

lowing trade date shall be deemed to be forward

contracts. Forward contracts are usually non-

standardized and are not traded on organized

exchanges, generally have no required margin

payments, and can only be terminated by agree-

ment of both parties to the transaction. The term

also applies to derivative contracts such as

swaps, caps, and collars.

Futures Contracts—Standardized contracts

traded on organized commodity exchanges to

purchase or sell a speciﬁed ﬁnancial instrument

or commodity on a future date at a speciﬁed

price. While futures contracts traditionally

speciﬁed a deliverable instrument, newer con-

tracts have been developed that are based on

various indexes. Futures contracts based on

indexes settle in cash and never result in deliv-

ery of an underlying instrument; some tradi-

tional contracts that formerly speciﬁed delivery

of an underlying instrument have been rede-

signed to specify cash settlement. New ﬁnancial

futures contracts are continually being proposed

and adopted for trading on various exchanges.

Futures Commission Merchant (FCM)—An

FCM functions like a broker in securities. An

FCM must register with the Commodities

Futures Trading Commission (CFTC) in order

to be eligible to solicit or accept orders to buy or

sell futures contracts. The services provided by

an FCM include a communications system for

transmittal of orders, and may include research

services, trading strategy suggestions, trade

execution, and recordkeeping services.

Financial Futures Contracts—Standardized

contracts traded on organized exchanges to pur-

chase or sell a speciﬁed security, money market

instrument, or foreign currency on a future date

at a speciﬁed price on a speciﬁed date. Futures

contracts on GNMA mortgage-backed securities

and Treasury bills were the ﬁrst interest rate

futures contracts. Other ﬁnancial futures con-

tracts have been developed, including contracts

on Eurodollars, currencies, and Euro-Rate dif-

ferentials. It is anticipated that new and similar

ﬁnancial futures contracts will continue to be

proposed and adopted for trading on various

exchanges.

Futures Exchange—Under the Commodities

Exchange Act (CEA), a ‘‘board of trade’’ desig-

nated by the Commodity Futures Trading Com-

mission as a contract market. Trading occurs on

the ﬂoor of the exchange and is conducted by

open auction in designated trading areas.

GNMA or GINNIE MAE—Either term is used

to refer to the Government National Mortgage

Association. Ginnie Mae is a government corpo-

ration within the U.S. Department of Housing

and Urban Development. In creating GNMA,

Congress authorized it to grant a full faith and

credit guaranty of the U.S. government to

mortgage-backed securities issued by private

sector organizations.

Hedge—The process of entering transactions

that will protect against loss through compensa-

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 2

tory price movement. A hedge transaction is one

which reduces the organization’s overall level

of risk.

Initial Futures Margin—In the futures mar-

ket, a deposit held by an FCM on behalf of a

client against which daily gains and losses on

futures positions are added or subtracted. A

futures margin represents a good-faith deposit

or performance bond to guarantee a partici-

pant’s performance of contractual obligations.

Interest Rate Cap—A multi-period interest

rate option for which the buyer pays the seller a

fee to receive, at predetermined future times, the

excess, if any, of a speciﬁed ﬂoating interest rate

index above a speciﬁed ﬁxed per annum rate

(cap or strike rate). Caps can be sold separately

or may be packaged with an interest rate swap.

Interest Rate Collar—the combination, in

single contract, of a simultaneous sale of a cap

and the purchase of a ﬂoor, or, a purchase of a

cap and sale of a ﬂoor. The buyer of the collar is

a buyer of a cap and the seller of a ﬂoor. By

selling the ﬂoor, the collar buyer gives up the

possibility of beneﬁting from a decline in inter-

est rates below the strike rate in the ﬂoor compo-

nent. On the other hand, the fee earned in selling

the ﬂoor lowers the cost of protection against

interest rate reversal.

Interest Rate Floor—is the reverse of an

interest rate cap. The buyer pays a premium to

obtain protection against a decline in interest

rates below a speciﬁed level.

Long Contract—A ﬁnancial contract to buy

securities or money market instruments at a

speciﬁed price on a speciﬁc future date.

Long Hedge—The long hedge, also called the

anticipatory hedge is the process by which a

market participant protects a cash or risk posi-

tion by buying a futures or forward contract, i.e.

taking a long ﬁnancial contract position.

Maintenance Margin—Maintenance margin

is the minimum level to which an equity posi-

tion can decline as a result of a price decline

before additional margin is required. In other

words, it is the minimum margin which a cus-

tomer must keep on deposit with a member at

all times. Each futures contract has speciﬁed

maintenance margin levels. A margin call is

issued when a customer’s initial margin balance

falls below the maintenance margin level speci-

ﬁed by the exchange. Maintenance margin must

be satisﬁed by the deposit of cash or agreed

upon cash equivalents. The amount of cash

required is that amount which is sufﬁcient to

restore the account balance to the initial margin

level.

Mandatory Delivery—See ‘‘Firm Forward

Contract.’’

Mark-to-market—The process by which the

carrying value (market value or fair value) of a

ﬁnancial instrument is revalued, and which is

recognized as the generally accepted accounting

principle for determining proﬁt or loss on secu-

rities positions in proprietary trading and invest-

ment accounts. Futures positions are typically

marked-to-market at the end of each trading

session.

Naked Call Option—Refers to the issuance or

sale of a call option where the option seller does

not own the underlying deliverable security or

instrument.

Open Interest—Refers to the number of

futures contracts outstanding for a given deliv-

ery month in an individual futures contracts.

The mechanics of futures trading require that

for every open long futures contract there is an

open short futures contract. For example, an

open interest of 10,000 futures contracts means

that there are 10,000 long contract holders and

10,000 short contract holders.

Options Contracts—Option contracts require

that the buyer of the option pay the seller (or

writer) of the option a premium for the right, but

not the obligation, to exercise an option to buy

(call option) or sell (put option) the instrument

underlying the option at a stated price (strike or

exercise price) on a stated date (European style

option) or at any time before or on the stated

expiration date (American style option). There

are also exchange traded options contracts:

(1) put and call options on futures contracts that

are traded on commodities exchanges; and

(2) put and call options that specify delivery of

securities or money market instruments (or that

are cash settled) that are traded on securities

exchanges. The key economic distinction

between options on futures and options on secu-

rities, is that the party who exercises an option

on a futures contract receives a long or short

futures position rather than accepting or making

delivery of the underlying security or ﬁnancial

instrument.

Pair-Off Clause—A pair-off clause speciﬁes

that if the same two parties to a forward contract

trade should subsequently execute an offsetting

trade (e.g. a long contract against an outstanding

short contract), settlement can be effected by

one party sending the other party a difference

check rather than having physical delivery and

redelivery of securities.

Par Cap—This term refers to a provision in

the contract of sale for Ginnie Mae mortgage-

backed securities which restricts delivery only

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 3

to pools which bear an interest rate sufﬁciently

high so that the securities would trade at or

below par when computed based on the agreed

to yield.

Put Option—An option contract which gives

the holder the right, but not the obligation, to

sell (put) a speciﬁed quantity of a ﬁnancial

instrument (money market) or commodity at a

speciﬁed price on or before the stated expiration

date of the contract. If price of the underlying

instrument occurs, the purchaser will exercise or

sell the option. If a decline in price of the

underlying instrument does not occur, the option

purchaser will let it expire and will lose only the

cost (premium paid) of (for) the option.

Round Turn—Commissions for executing

futures transactions are charged on a round turn

basis. A round turn constitutes opening a futures

position and closing it out with an offsetting

contract, i.e. executing a short contract and clos-

ing out the position with a long contract or

vice-versa.

Short Contract—A ﬁnancial contract to sell

securities or money market instruments at a

speciﬁed price on a speciﬁed future date.

Short Hedge—The process by which a cus-

tomer protects a cash or risk position by selling

a futures or forward contract, i.e. taking a short

ﬁnancial contract position. The purpose of the

short hedge is to lock in a selling price.

Standby Contract—Optional delivery forward

contracts on U.S. government and agency secu-

rities arranged between securities dealers and

customers that do not involve trading on orga-

nized exchanges. The buyer of a standby con-

tract (put option) acquires, upon paying a fee,

the right to sell securities to the other party at a

stated price at a future time. The seller of a

standby (the issuer) receives the fee, and must

stand ready to buy the securities at the other

party’s option. See the fuller discussion of

Standby Contracts under 2130.0.3.1.2)

TBA (To Be Announced) Trading—TBA is

the abbreviation used in trading Ginnie Mae

securities for forward delivery when the pool

number of securities bought or sold is ‘‘to be

announced’’ at a later date.

Variation Margin—is when, in very volatile

markets, additional funds are required to be

deposited to bring the account back to its initial

margin level, while trading is in progress. Varia-

tion margin requires that the needed funds be

deposited within the hour, or when reasonably

possible. If the customer does not satisfy the

variation or maintenance margin call(s), the

futures position is closed. Unlike initial margin,

variation margin must be in cash. Also refer to

‘‘Maintenance Margin’’.

Weighted Hedge—a hedge that is used to

compensate for a greater decline in the dollar

value of a cash bond as compared to a price

decline of an accessible T-bond futures contract.

Yield Maintenance Contract—This is a for-

ward contract written with terms which main-

tain the yield at a ﬁxed rate until the delivery

date. Such a contract permits the holder of a

short forward contract to deliver a different cou-

pon security at a comparable yield.

2130.0.3 FINANCIAL CONTRACT

TRANSACTIONS

Futures, forward and options contracts are

merely other tools for use in asset–liability man-

agement. These contracts are neither inherently

a panacea nor a speculative vehicle for use by

banks and bank holding companies. Rather, the

beneﬁt or harm resulting from engaging in

ﬁnancial contract activities results from the

manner in which contracts are used. Proper utili-

zation of ﬁnancial contracts can reduce the risks

of interest or exchange rate ﬂuctuations. On the

other hand, ﬁnancial contracts can serve as

leverage vehicles for speculation on rate

movements.

2130.0.3.1 Markets and Contract Trading

Forward contract (OTC) trading of Government

National Mortgage Association (‘‘GNMA’’) or

‘‘Ginnie Mae’’ Mortgage-Backed Securities pre-

ceded exchange trading of GNMA futures con-

tracts in 1975.

2130.0.3.1.1 Forward Contracts

Forward contracts are executed solely in an

over-the-counter market. The party executing a

contract to acquire securities on a speciﬁed

future date is deemed to have a ‘‘long’’ forward

contract; and the party agreeing to deliver secu-

rities on a future date is described as a party

holding a ‘‘short’’ forward contract. Each con-

tract is unique in that its terms are arrived at

after negotiation between the parties.

For purposes of illustrating a forward con-

tract, assume that SMC Corporation is an origi-

nator of government guaranteed mortgages and

issuer of GNMA securities. SMC Corporation

has a proven ability to manage and predict the

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 4

volume of its loan originations over a time

horizon of three to four months. To assure a

proﬁt or prevent a loss on current loan origina-

tions, SMC Corporation may enter binding over-

the-counter commitments to deliver 75% of its

mortgage production which will be converted

into GNMA securities three months in the

future. If SMC agrees to sell $3 million of

GNMA securities (11% coupon) to the WP

Securities Firm at par in three months, SMC

Corporation is considered to have entered a

‘‘short’’ (commitment to sell) forward contract.

Conversely, WP has entered a ‘‘long’’ (commit-

ment to buy) forward contract. The two parties

to the transaction are both now obligated to

honor the terms of the contract in three months,

unless the contract is terminated by mutual

agreement.

It should be noted that executing a ‘‘short’’

forward contract is not the same as executing

the short sale of a security. Generally, a short

sale of a security is understood to represent the

speculative sale of a security which is not owned

by the seller. The short seller either purchases

the security prior to settlement date or borrows

the security to make delivery; however, a

‘‘short’’ forward contract merely connotes the

side of the contract required to make delivery on

a future date. Short forward contracts should not

be considered inherently speculative, but must

be considered in light of the facts surrounding

the contract.

Forward trading can be done on a mandatory

delivery (sometimes referred to as ‘‘ﬁrm for-

ward’’ contracts) basis or on an optional deliv-

ery basis (‘‘standby’’ contract). With respect to

a ‘‘mandatory’’ trade, the contract can also be

written with a ‘‘pair-off’’ clause. A pair-off

clause speciﬁes that if the same two parties to a

trade should subsequently execute an off-setting

trade (e.g., the banking organization executes a

long contract against an outstanding short con-

tract), settlement can be effected by one party

sending the other party a ‘‘difference check’’

rather than having a physical delivery and rede-

livery of securities.

When a forward contract is executed by a

dealer, a conﬁrmation letter or contract is sent to

the other party to the transaction. The contract

will disclose pertinent data about the trade, such

as the size of the trade, coupon rate, the date

upon which ﬁnal delivery instructions will be

issued, and the yield at which the trade was

effected. In addition, the contract letter will

specify whether it is permissible for the ‘‘short’’

side of the trade to deliver a different coupon

security at a comparable yield (‘‘yield mainte-

nance contract’’) if the coupon speciﬁed in the

contract is not available for delivery. Contracts

which prohibit the delivery of securities requir-

ing a premium over par are considered to have a

‘‘par cap.’’ The initial contract letter generally

does not specify which speciﬁc securities (e.g.,

GNMA mortgage-backed securities identiﬁed

by a pool number) will be delivered. Instead,

such contracts generally identify the deliverable

securities as having been traded on a ‘‘TBA’’

basis (‘‘to be announced’’). Prior to settlement,

the dealer holding the short contract will send a

ﬁnal conﬁrmation to the other party specifying

the actual securities to be delivered, accrued

interest, dollar price, settlement date, coupon

rate, and the method of payment.

Forward contracts are not typically marked-

to-market. Both parties in a forward contract are

exposed to credit risk, since either party can

default on its obligation.

2130.0.3.1.2 Standby Contracts

Standby contracts are ‘‘put options’’ that trade

over-the-counter, with initial and ﬁnal conﬁrma-

tion procedures that are quite similar to those on

forward transactions. Standby contracts were

developed to allow GNMA issuers to hedge

their production of securities, especially in

instances where mortgage bankers have

extended loan commitments in connection with

the construction of new subdivisions. When a

mortgage banker agrees to ﬁnance a subdivision

with conventional and government guaranteed

mortgages it is difﬁcult to predict the actual

number of FHA and VA guaranteed loans which

will be originated. Hence, it is risky for a

GNMA issuer to enter mandatory forward con-

tracts to deliver the entire estimated amount of

loans eligible to be pooled as GNMA securities.

By entering an option contract and paying a fee

for the option to ‘‘put’’ securities to another

party, a GNMA issuer or securities dealer

obtains downside market protection, but remains

free to obtain the beneﬁts of market apprecia-

tion since it can ‘‘walk away’’ from the option

contract. In addition to the ﬂexibility of walking

away and selling securities at the prevailing

market price when GNMA prices are rising, a

GNMA issuer avoids the potential risk of pur-

chasing mortgages or GNMA securities to cover

short forward contracts in the event that produc-

tion of GNMA securities falls below anticipated

levels.

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Page 5

When a securities dealer sells a standby con-

tract granting a GNMA issuer the right ‘‘to put’’

securities to it, the dealer, in turn, will attempt to

purchase a matching standby contract from an

investor because the dealer does not want to

shoulder all of the downside market risk. There

is also potential for securities ﬁrms to deal in

standby contracts having no relationship to the

issuance of GNMA securities.

Some illustrations of standby contracts fol-

low. They are intended to illustrate the mechan-

ics of a standby contract when a banking organi-

zation has sold or issued a standby contract

granting the contra party the option to ‘‘put’’

GNMA securities to the banking organization.

Assumptions

1. Fee paid to banking organization = 1% of

contract value

2. Contract delivery price = 98

3. Coupon = 12%

Situation 1

On contract exercise date: Market Price = 100.

Therefore, the dealer would sell securities at

market rather than put them to the bank.

Dealer Banking organization

Sale price 100

Fee paid (1)

Result: Dealer sacriﬁced 1% to insure

sale price.

Purchase price N/A

Fee Received 1

Result: Banking organization earned

1% fee for ‘‘standing by.’’

Situation 2

On contract exercise date: Market price = 95.

Therefore, dealer would deliver securities pursu-

ant to the standby contract.

Dealer Banking organization

Sale price 98

Market price 95

Contract gain 3

Fee paid (1)

Actual gain 2

Result: Dealer paid 1% fee to avoid

3 point market loss.

Purchase price 98

Market price 95

Contract loss (3)

Fee received 1

Actual loss (2)

Result: Banking organization received

1% fee to compensate for purchasing

securities 3 points above market.

2130.0.3.1.3 Futures Contracts

Futures Contract transactions involve three

types of participants: customers—the buyers or

sellers of contracts, brokers, and a futures

exchange. As in the forward markets, a buyer

(party committed to take delivery of securities

speciﬁed in the futures contract) of a futures

contract has a ‘‘long’’ contract and the seller

(party committed to deliver the underlying secu-

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Page 6

rities) has a ‘‘short’’ contract. If a customer

desires to purchase (sell) a futures contract, the

broker—possibly a member of a clearing house

of an exchange—will take the order to the ex-

change ﬂoor and purchase (sell) a contract sold

(bought) by another customer (through another

broker).

All futures transactions are made

through and carried on the books of clearing

house member brokers, who are treated by the

exchange as their own customers. Hence, there

are always an equal number of long and short

contracts outstanding, referred to as the ‘‘open

interest,’’ since the auction process requires a

buyer and seller for every contract.

All futures contracts are obligations of an

exchange’s clearing association or corporation,

i.e. the clearing association is on the opposite

side of each long and short contract; and all

transactions are guaranteed within the resources

of the exchange’s clearing association (on most

futures exchanges a small fee is collected on

each transaction and placed into an insurance

fund). Should an FCM default on a futures

contract, the association pays the costs of com-

pleting the contract.

2130.0.4 MARGIN REQUIREMENTS

In order to insure the integrity of futures mar-

kets, the clearing house requires that member

brokers (clearing house members) deposit initial

margin in connection with new futures positions

carried for the ﬁrm, other brokers or FCMs for

whom the clearing house member clears trans-

actions, and public customers. The clearing

house members in turn require their customers—

whether they are other FCMs or public

customers—to deposit margin.

The FCMs gen-

erally require that public customers meet initial

margin requirements by depositing cash, pledg-

ing government securities, or obtaining irrevo-

cable standby letters of credit from substantial

commercial banking organizations. Daily main-

tenance margin or variation margin calls (depos-

its of cash required to keep a certain minimum

balance in the margin account) based upon each

day’s closing futures prices are calculated pursu-

ant to rules of the various futures exchanges,

and clearing house members are required to

meet daily variation margin calls on positions

carried for customers and the ﬁrm. In turn, the

1. Brokers in commodities are required to register as

futures commission merchants (‘‘FCMs’’) with the Commodi-

ties Futures Trading Commission (‘‘CFTC’’) in order to be

eligible to solicit or accept orders to buy or sell futures

contracts.

2. In general, the futures exchanges set different initial

margin requirements based upon the types of activity engaged

in by the customer. Margin requirements are higher for cus-

tomer contracts characterized as ‘‘speculative’’ than for those

contracts deemed to be ‘‘hedge’’ positions. The commodities

industry traditionally deﬁnes someone with a business need

for using the futures market as a hedger; others are deﬁned as

speculators. Therefore, in instances where there are different

initial hedge and speculative margin requirements, it is

assumed that banking organizations will only be required to

meet margin required for hedgers.

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FCMs require customers to reimburse them for

posting additional margin.

Once a customer has executed a futures con-

tract to make or accept delivery of securities in

the future it is obligated to fulﬁll the terms of

the contract. A futures contract cannot be resold

over-the-counter because futures contracts are

not transferable. However, a customer may ter-

minate its obligation under a futures contract

either by making or accepting delivery of the

securities as speciﬁed by the contract, or by

executing an offsetting futures contract (long

contract to cancel a short contract or vice-versa)

with the same broker to cancel the original

contract on the same exchange. The overwhelm-

ing majority of futures contracts are closed out

by the execution of an offsetting contract prior

to expiration.

The key to understanding futures transactions

is the fact that futures contract prices on U.S.

government and agency securities move in the

same manner as bond prices; e.g. rising interest

rates result in falling futures prices and falling

interest rates result in rising futures prices.

Hence, the purchase of a futures contract

(‘‘long’’ futures contract) at a price of 98 will

result in a loss if future market participants

perceive rising interest rates in the month of

contract expiration and act accordingly; then the

offsetting of a futures contract (executing a

‘‘short’’ futures contract) would have to be at a

lower price; e.g. 96. As in the case of any

commercial transaction, the participant has a

loss if the sale price is lower than the purchase

price, or a gain if the sale price is higher than

the purchase price.

2130.0.4.1 Variation Margin Calls

Variation margin calls for each contract and

expiration month are based upon the closing

futures exchange price. If there is a change from

the previous day’s closing prices, the long con-

tract holders will be required to post additional

margin which will be passed through via the

clearing house process to short contract holders

or vice-versa. Subsequent to the computation of

variation margin calls, the clearing house mem-

ber brokers are required to post variation margin

on behalf of the clearing ﬁrm and its customer

accounts prior to commencement of the next

day’s trading. Then, the clearing brokers call

their FCM and public customers requesting

more margin to bring the accounts up to the

required maintenance margin level.

Of course,

if a futures position has a gain at the end of the

day, the clearing ﬁrm receives a deposit in its

margin account. The ﬁrm, in turn, increases the

margin account balances of customers holding

contracts with gains.

For illustrative purposes, we will again

assume that a customer purchased a futures con-

tract (long contract, face value $100,000) at a

price of 98. If the next closing futures price is

97, the customer will have suffered a one point

margin loss (if the customer chose to offset the

long contract with a short contract, the transac-

tion would be closed out at a one point loss).

Conversely, the party with a short contract

executed at 98 would receive a one point margin

payment to his account.

Assuming that the initial margin requirement

is $1,500 and the variation margin requirement

is $1,000, the following summarizes the steps

followed in administering a customer’s (long

position) margin account in connection with the

previously described transaction.

Transaction

Margin

Account

Balance

1. Deposit initial margin $1,500

2. Purchase $100,000

contract @ 98 500

3. Day 1—Closing futures price 97

(Reduction of $1,000 in

margin account to reimburse

broker for posting margin with

clearing corporation).

4. FCM calls customer to request

$1,000 to bring account up to

required initial margin level.

5. Reimbursement to FCM

of $1,000 1,500

It is important to note that once the margin

account balance falls below the variation margin

level, the customer is required to deposit addi-

tional funds to replenish the account balance to

3. It should be noted that public customers generally have

more time to meet maintenance margin calls than do FCMs.

However, if a customer fails to meet a variation margin call

within three days, the FCM must take a charge against its net

capital if it fails to close out the customer’s contract (17

C.F.R. 1.17(c)5(viii)).

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Page 8

the initial margin level. If there is a drop in the

value of the contract which places the margin

account balance below the initial margin level

but above the variation margin level, the cus-

tomer is not required to deposit additional mar-

gin monies. Alternatively, if there is a positive

ﬂow of margin monies the customer is free to

withdraw any amount which exceeds the initial

margin requirement.

The entire marking-to-the-market process is

repeated at the close of the next business day

using a comparison of the previous day’s clos-

ing price (97) to the current closing price. (The

preceding example is simpliﬁed because it

implies that the customer deposits promptly the

required margin. In reality, margin is not always

deposited so quickly.)

In summary, futures trading is a ‘‘zero sum

game’’ because of the equal number of long and

short contracts outstanding, and the variation

margin payments reﬂect this fact, i.e. for every

long contract holder posting variation margin,

there is a short contract holder receiving margin.

2130.0.5 THE DELIVERY PROCESS

Futures contracts are deﬁned as ‘‘standardized

contracts traded on organized exchanges to pur-

chase or sell a speciﬁed ﬁnancial instrument or

physical commodity on a future date at a speci-

ﬁed price.’’ Even when a participant keeps a

contract open for delivery, the ‘‘speciﬁed price’’

(which corresponds to a speciﬁed yield) is actu-

ally obtained through a combination of past

futures market gains or losses (incurred through

the daily mark to market process) and the cur-

rent futures market price. For invoicing pur-

poses, the actual delivery price is based upon a

closing futures market ‘‘settlement price’’ on a

date designated by the exchange. In addition,

the ﬁnal calculation of a delivery price on a

bond contract will typically involve an adjust-

ment reﬂecting the fact that the coupon issue to

be delivered against the contract grade (8 per-

cent) futures contract is not an 8 percent bond.

For example, when current U.S. treasury bond

coupons are 12 percent it is highly unlikely that

a party with a short futures position would

deliver a bond with an 8 percent coupon.

2130.0.6 MECHANICS AND

OPERATION OF FUTURES

EXCHANGES

Certain technical factors should be noted with

respect to futures markets. First, futures markets

are not totally free markets. Rules of the

exchanges put artiﬁcial constraints—daily price

movement limits—upon the amount of daily

market movement allowed in given types of

futures contracts. For example, government

securities prices in the cash market will move as

far as the market participants deem necessary to

reﬂect the ‘‘market’’ for those securities, while

the futures market specifying delivery of the

underlying security will be constrained from

having the same potential unlimited market

movement. There have been instances where

persons desiring to close out a futures contract

by executing an offsetting contract have been

unable to do so for one or more days until the

exchange’s daily trading limits allowed futures

prices to ‘‘ratchet’’ up or down to the level that

reﬂected the true ‘‘market’’ price as perceived

by hedgers, speculators, and arbitragers.

Although the preceding illustrates the basic

nature of futures price movements, do not

assume that futures and cash market prices

always move in the same direction at the same

velocity. Futures prices by deﬁnition predict

future events, e.g., a market participant can buy

a futures contract to take delivery of a three

month Treasury bill two years in the future.

In such an instance, the holder of a long T-bill

futures contract agrees to the future purchase of

a government security which has not yet been

issued. There is no reason to assume that a

contract with a distant maturity will move in the

same manner as the cash market for a three

month Treasury bill. In addition, there is a rela-

tionship between the cash market price of an

existing security and the price of that security in

the futures market which is called the basis. The

basis can vary signiﬁcantly over the life of a

given futures contract. In the contract delivery

month, the futures market price will converge

towards the cash market price (the basis

approaches zero), adjusted for technical factors

that reﬂect the costs of processing and deliver-

ing securities. If the futures market price did not

converge towards the cash market price in the

delivery month, the arbitragers would take off-

setting futures and cash market positions to arbi-

trage away any proﬁtable discrepancies between

the two markets.

4. All ﬁnancial futures contracts have a number of contract

expiration months extending into the future. As the near term

contract expires, a contract with a more distant expiration date

is added.

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2130.0.7 COMPARISON OF FUTURES,

FORWARD, AND STANDBY

CONTRACTS

Excluding the fact that futures contracts are

traded on organized exchanges, there are many

similarities between contracts. Conceptually, the

contracts are interchangeable; each type of con-

tract can be utilized for hedging, speculating, or

arbitrage strategies, but none of the contracts are

transferable to third parties. While engaging in

contract activities allows the participants to

either assume or shift the risks of interest rate

changes associated with the security deliverable

under the contract, such contracts fail to provide

the other beneﬁts of owning the underlying

security. Speciﬁcally, ﬁnancial contracts do not

pay interest, do not have a U.S. government

guaranty of payment of principal at maturity,

and cannot be pledged to secure public deposits

or be used as collateral for repurchase agree-

ments. The forward markets are perceived to be

delivery markets wherein there is a high per-

centage of delivery of the underlying security.

As in the case of other futures markets, the

ﬁnancial futures markets were not designed to

be delivery markets. Nevertheless, there have

been a number of instances when a relatively

high percentage of ﬁnancial futures contracts

have resulted in delivery. Some persons suggest

tax reasons and the deliverable supply of securi-

ties as two factors that have contributed to the

much higher delivery of securities than delivery

of physical commodities. It is, of course, also

easier and cheaper to make delivery of securi-

ties rather than railroad carloads of grain.

Trading units on futures exchanges are stan-

dardized. The standardized trading unit in a

physical commodity which may be a railroad

car of grain; the typical trading unit in a govern-

ment or agency security futures contract may be

$100,000 or $1 million par principal at a coupon

rate (on coupon issues) ﬁxed by the exchange.

On the other hand, forward and standby con-

tracts are not traded in standardized units

with given contract maturity months. Instead,

forward and standby contracts are custom made

to suit the needs of the two parties to the

transaction.

While all contract holders are involved with

market risks, the holders of forward and standby

contracts are especially prone to credit risk.

Unlike futures contracts where the mechanics of

exchange trading provide for the futures ex-

change clearing association to guaranty perfor-

mance of each contract, forward and standby

contracts are only as good as the entity on the

other side of the contract. Anyone who reads the

ﬁnancial press should be aware that prior to the

passage of the Government Securities Act of

1986, there were a number of defaults involving

forward and standby contracts. In an effort to

bring increased integrity into the unregulated

forward contract markets, there has been a trend

by some of the major securities dealers to

require the posting of margin in connection with

forward contract trading. There are no uniform

margin requirements governing all aspects of

forward contract trading, nor is there a uniform

application of margin requirements by dealers

requiring ‘‘house’’ margin (or internal margin

requirements established and enforced by indi-

vidual securities dealers). GNMA has estab-

lished limited margin requirements (24 C.F.R.

390.52), as described below.

2130.0.8 OPTION CONTRACTS

Subsequent to the Board’s initial adoption of a

policy statement governing futures, forward,

and standby contracts, trading of interest rate

options began on organized futures and securi-

ties exchanges. Proponents of exchange traded

options argue that such instruments are attrac-

tive to users because they permit the user to

obtain down side price risk protection, yet bene-

ﬁt from favorable price movement. In contrast,

futures and forward contracts allow the user to

lock in a speciﬁc price, but the user must forgo

future participation if the market should experi-

ence an upward price movement. Furthermore,

the purchaser of an option pays a one time

premium for this protection and is spared the

contingent liabilities associated with futures

margin calls.

An option is a contract that gives the buyer,

or holder, the right, but not the obligation, to

buy or sell a speciﬁed ﬁnancial instrument at a

ﬁxed price, called the exercise or strike price,

before or at a certain future date. Some options,

however do not provide for the delivery of the

underlying ﬁnancial instrument and, instead, are

cash settled. Moreover, in some cases, the

underlying ﬁnancial instrument is an index.

Options that can be exercised before or at the

expiration date are referred to as American

options; if an option can be exercised only on

the expiration date, it is termed a European

option.

There are two basic types of options: calls

and puts. The call option is any option which

obligates the writer to deliver to the buyer at a

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Page 10

set price (exercise or strike price) within a speci-

ﬁed time limit the underlying ﬁnancial instru-

ment. When the market price of the underlying

instrument is above the exercise (strike) price of

the call, the call option is ‘‘in-the-money.’’ Con-

versely, when the market price of the underlying

ﬁnancial instrument is below the exercise

(strike) price of the call option, the call is ‘‘out-

of-the-money.’’ When the market price of the

underlying instrument is equal to the strike

price, the option is ‘‘at-the-money.’’ At expira-

tion, the buyer will exercise the option if it is

‘‘in-the-money’’ or let it expire unexercised if it

is out-of-the-money. An out-of-the-money call

option has no value at expiration, since buyers

will not purchase the underlying instrument at a

price above the current market price. Prior to

expiration, the value of an ‘‘in-the-money’’ call

option is at least equal to the market value of the

underlying instrument minus the strike price.

The ownership of a call provides signiﬁcant

leverage, but raises the breakeven price relative

to ownership of the underlying instrument.

Holding the call limits the amount of potential

loss and offers unlimited potential for gains.

A put option gives the buyer the right, but not

the obligation, to sell the underlying instrument

at a speciﬁed price (exercise or strike price),

before or at expiration. When the market price

of the underlying instrument is below the strike

price of the put option, the put is ‘‘in-the-

money,’’ and a put option is out-of-the-money

when the market price of the underlying ﬁnan-

cial instrument is above the strike price of the

put option. Ownership of a put option offers

leveraged proﬁtability if the market value of the

underlying instrument declines.

Some portfolio managers commonly employ

‘‘covered’’ call writing strategies to gain fee

income from options written on securities held

in the portfolio. If an option position is covered,

the seller owns the underlying ﬁnancial instru-

ment or commodity or has a futures position.

For example, an option position would be ‘‘cov-

ered’’ if a seller owns cash market U.S. Treasury

bonds or holds a long position on a Treasury

bond futures contract. Writing ‘‘covered calls’’

has only limited potential for gain. Writing

‘‘covered calls’’ is not a proper strategy for a

market that could rise or fall by substantial

amounts. It is generally used in a ﬂat market

environment.

Referring to the above example, if a seller

holds neither the cash market U.S. Treasury

Bonds or was not long on the Treasury bond

futures contract, the writer would have an

uncovered or ‘‘naked’’ position. In such

instances, margin would be required (by the

exchange, if an exchange traded option—not the

case for an OTC option) since the seller would

be obligated to satisfy the terms of the option

contract if the option buyer exercises the con-

tract. The risk potential for loss in writing

‘‘naked calls’’ (calls against which there are no

securities held in portfolio) is great since the

party required to deliver must purchase the

required securities at current market prices.

Naked ‘‘covered call’’ writing is generally

viewed to be speculative since the risks are

theoretically unlimited, particularly if it is done

solely to generate fee income.

Options are purchased and traded either on

organized exchanges or in the over-the-counter

(OTC) market. Option contracts follow three-

month expiration cycles (example: March/June/

September/December). The option contracts

expire on the Saturday following the third Fri-

day in the expiration month. Thus, options are

considered as ‘‘wasting assets’’ because they

have a limited life since they expire on a certain

day, even though it may be weeks, months, or

years from now. The expiration date is the last

day the option can be exercised. After that date

the option is worthless.

Option premium valuation. The price (value)

of an option premium is determined competi-

tively by open outcry auction on the trading

ﬂoor of the exchange. The premium value is

affected by the inﬂow of buy and sell orders

reaching the exchange ﬂoor. The buyer of the

option pays the premium in cash to the seller of

the option which is credited to the seller’s

account. Several factors affect the value of an

option premium, as discussed below. The option

premium consists of two parts, ‘‘intrinsic value’’

and ‘‘time value.’’ The intrinsic value is the

gross proﬁt that would be realized upon immedi-

ate exercise of the option. Stated another way, it

is the amount by which the option is in-the-

money. It is the higher of: the value of an option

if it is exercised today; or zero. For ‘‘in-the-

money’’ call options, it is the difference between

the price of the underlying ﬁnancial instrument,

and the exercise (strike) price of the option. For

‘‘in-the-money’’ put options, it is the difference

of the exercise (strike) price of the put option

and the price of the underlying ﬁnancial instru-

ment. The intrinsic value is zero for ‘‘at-the-

money’’ or ‘‘out-of-the-money’’ options. The

time value derives from the chance that an

option will gain intrinsic value in the future or

that its intrinsic value will increase before matu-

rity of the contract. Time value is determined by

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Page 11

subtracting intrinsic value from the option pre-

mium. For example,

Time value = Option premium 2 Intrinsic val-

ues

Time value = 5–10/64 2 4.00

Time value = 1.15384

The option premium is affected by several

other factors. One factor involves the compari-

son of the underlying futures price versus the

strike price of the option. An option’s price is

increased the more that it is in-the-money. A

second factor is volatility. Volatile prices of the

underlying ﬁnancial instrument can help stimu-

late demand for the options, thus increasing the

premium. A third factor that affects the pre-

mium of an option is the time until expiration.

Option premiums are subject to greater price

ﬂuctuations because the underlying value of the

futures contract changes more with a longer

time period. Other factors that affect the option

premium are the strike rate(s) and the domestic

and foreign (if applicable) interest rates.

An exchange-traded option is often referred

to as a ‘‘standardized’’ option, reﬂecting the fact

that the terms of the contract are uniform with

respect to the underlying instrument, amounts,

exercise prices, and expiration dates. OTC

options are characterized by terms and condi-

tions which are unique to each transaction.

Large ﬁnancial institutions are often dealers in

customized interest rate or foreign exchange

options. For example, a banking organization

might write a ‘‘cap,’’ or series of put option on

pounds sterling to protect the dollar value of a

sterling denominated receivable due in one year.

In this case, an option can be tailored to ﬁt the

exact needs of the buyer.

Like futures contracts, contract performance

on exchange-traded options is guaranteed by the

clearing corporation which interposes itself as a

central counterparty to all transactions. It substi-

tutes itself as a seller to all buyers and as a buyer

to all sellers. Standardization combined with the

clearing corporation’s guarantee facilitates trad-

ing and helps to insure liquidity in the market.

The buyer or seller of an exchange-traded option

may always close out an open position by enter-

ing into an offsetting transaction, with the same

strike price and expiration date, and for the

same amount. Indeed, most exchange-traded

options are liquidated prior to maturity with an

offsetting transaction, rather than by exercising

the option in order to buy or sell the underlying

instrument.

Buyers of exchange-traded options are not

required to post funds to a margin account

because their risk is limited to the premium paid

for the option. However, writers (sellers) of

options are required to maintain margin

accounts because they face substantial amounts

of risk. The amount of the margin varies

depending upon the volatility in the price of the

option. As the option moves closer and closer to

being in-the-money, the writer is required to

deposit more and more into his margin account,

in order to guarantee his performance should the

option eventually be exercised.

Options on futures contracts provide the

holder with the right to purchase (call) or sell

(put) a speciﬁed futures contract at the option’s

strike price. The difference between the strike

price on the option and the quote on the futures

contract represents the intrinsic value of the

option. Options on futures contracts differ from

traditional options in one key way: the party

who exercises an option on a futures contract

receives a long or short futures position

(depending on whether he is exercising a call or

put option) rather than accepting or making

delivery of the underlying security or ﬁnancial

instrument. When the holder of a call option on

a futures contract exercises the option and the

futures contract is delivered, the option writer

must pay the option holder the difference

between the futures contract’s current value and

the strike price of the exercised call. The buyer

takes on a long position, and the writer a short

position in the futures contract. When a futures

put option is exercised, the holder takes on a

short futures position, and the writer a long

position. The writer of the put pays the holder

the difference between the current price of the

futures contract and the strike price of the put

option. The resultant futures position, like any

other futures position, is subject to a daily

marked-to-market valuation. In order to liqui-

date the futures position, both the buyer and

the seller must undertake offsetting futures

transactions.

2130.0.8.1 Other Option Contracts

2130.0.8.1.1 Stock Index Options

A stock index option is a call or a put that is

based on a stock market index such as the S & P

500. As opposed to a regular call or put option

on equity securities where there must be a sale

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 12

and delivery of shares of stock, there is no

delivery of the underlying instrument when an

index option is exercised. Rather, settlement is

in cash.

2130.0.8.1.2 Foreign Currency Options

The right to buy (call) or sell (put) a quantity of

a foreign currency for a speciﬁed amount of the

domestic currency is a foreign currency option.

The size of the contract is standard for each

currency. The contracts are quoted in cents per

unit of foreign currency. As an example, one

call option for the British pound is 12,500

pounds.

2130.0.8.2 Caps, Floors, and Collars

Caps, ﬂoors, and collars provide risk protection

against ﬂoating interest rates. The market for

these products is an outgrowth of the OTC mar-

ket in ﬁxed income (bond) options.

An interest rate cap contract pays the buyer

cash if the short term interest index rises

above the strike rate in the contract in exchange

for a fee. In combination with a ﬂoating rate

obligation, it effectively sets a maximum level

on interest rate payments. If market rates are

below the cap rate, no payments are made

under the cap agreement. Thus, the buyer of a

cap is able to place a ceiling on his ﬂoating

rate borrowing costs without having to forego

potential gains from any decline in market

rates.

Cap agreements typically range in maturity

from 6 months to as long as 12 years, with reset

dates or frequencies that are usually monthly,

quarterly, or semiannual. The London Interbank

Offered Rate (LIBOR) is the most widely used

reference rate for caps, ﬂoors, and collars. Other

indexes used as reference rates are commercial

paper rates, the prime interest rate, Treasury bill

rates, and certain tax-exempt rates. Cap fees

depend upon the cap level, the maturity of the

agreement, the volatility of the index used as the

reference rate, and market conditions. The

higher the cap rate, the lower the premium.

The fee is usually paid up front, but can be

amortized.

An interest rate ﬂoor agreement is used to

protect the overall desired rate of return associ-

ated with a ﬂoating-rate asset. In accordance

with the agreement, the seller receives a fee for

the ﬂoor agreement from the holder of the

underlying asset. When interest rates fall, the

holder of the ﬂoor contract is protected by the

agreement, which speciﬁes the ﬁxed per annum

rate (ﬂoor rate) that will be retained on those

assets, at speciﬁed times during the life of the

agreement, even though ﬂoating interest rates

may decline further.

An interest rate collar is a variation of a

cap-only agreement. Under this arrangement the

seller of the collar, for a fee, agrees to limit the

buyer’s ﬂoating rate of interest within one

agreement by a simultaneous sale of a cap

and purchase of a ﬂoor, or purchase of a cap

and sale of a ﬂoor. When the reference rate is

above the cap rate the seller makes payments to

the buyer sufﬁcient to return the buyer’s ﬂoating

rate interest cost to the cap rate. Conversely, the

buyer makes payments to the collar provider to

bring its rate back to the ﬂoor whenever the

reference rate falls below the ﬂoor rate. In effect,

under a collar agreement the buyer is selling a

string of call options (the ﬂoor) back to the

provider of the cap. The premium received from

selling the ﬂoor reduces the overall cost of the

cap to the buyer of the collar. Thus, the pre-

mium for a ﬂoor/ceiling, or collar, agreement, is

lower than for a cap-only agreement with the

cap at the same level. This is because the ﬂoor

sold to the provider of the collar has a certain

value, which is passed along to the buyer in the

form of a lower premium.

The disadvantage to collars, of course, is that

they limit the buyer’s ability to proﬁt from

declines in market rates below the speciﬁed

ﬂoor. Clearly, one’s interest rate expectations

play an important role in determining whether

or not to use a collar agreement. It should also

be noted that collar agreements involve credit

risk on both sides of the agreement, similar to

the credit risk considerations found in interest

rate swap agreements. The buyer of the collar is

exposed to the risk that the provider may default

on payments due under the cap agreement; and

the provider of the collar is exposed to the risk

that the buyer may default on payments due

under the ﬂoor agreement.

2130.0.9 REGULATORY

FRAMEWORK

GNMA has adopted limited margin require-

ments. Speciﬁcally, the GNMA margin require-

ments (12 C.F.R. 390.52) require marking-

to-market and the posting of maintenance

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 13

margin.

However, the GNMA margin require-

ments exclude the majority of GNMA forward

contracts and only pertain to contracts involving

GNMA issuers with other parties.

The Commodities Futures Trading Commis-

sion (‘‘CFTC’’) is the agency authorized by

Congress to supervise the trading of ‘‘commodi-

ties,’’ including ﬁnancial futures. Exchanges

which trade commodities must register with

the CFTC. In addition, the various futures

exchanges must receive CFTC approval before

they can begin trading a new futures instrument.

Brokers and dealers who execute futures con-

tracts for customers must register as Futures

Commission Merchants (‘‘FCM’’) with the

CFTC. There are also CFTC registration

requirements pertaining to ﬁrms engaging in

commodities activities similar to an investment

advisor or mutual fund in the securities markets.

Finally, the surveillance activities of the various

futures exchange examiners are subject to over-

sight by the CFTC.

With the exception of reporting requirements

concerning persons or entities with large futures

positions, the CFTC’s jurisdiction generally

does not extend to ﬁnancial institutions. Rather,

the federal and state banking agencies, state

insurance commissions, and the Ofﬁce of Thrift

Supervision are responsible for supervising

regulated entities’ future activities, if permitted,

under statute or regulation.

2130.0.10 EXAMPLES OF CONTRACT

STRATEGIES

For purposes of reporting large positions to the

CFTC a market participant deﬁnes its future

activities as ‘‘speculative’’ or as ‘‘hedging.’’

Basically, CFTC rules consider a participant to

be a hedger if certain facets of such person’s

business can be hedged in the futures markets;

persons who do not have a business need for

participating are deemed to be speculators. It is

anticipated that bank holding companies charac-

terize their contract activities as ‘‘hedging’’, or

possibly as arbitrage between various markets.

Examiners must scrutinize contract positions for

purposes of evaluating risk.

The Board policy statement concerning bank

holding companies

states:

‘‘. . . the Board believes that any positions

that bank holding companies or their nonbank

subsidiaries take in ﬁnancial contracts should

reduce risk exposure, that is, not be specula-

tive.’’ It should be noted, however, that a more

liberal interpretation of the policy statement has

been permitted for dealer subsidiaries. For

example, in a government securities dealer sub-

sidiary, it is permissible to use related ﬁnancial

contracts as a substitute trading instrument for

cash market instruments. Thus, the use of ﬁnan-

cial contracts is not limited solely to reducing

the risk of dealing activities.

Some examples of contract strategies are pro-

vided which reduce risk when viewed in isola-

tion. A deﬁnition of a ﬁnancial hedge is:

‘‘to enter transactions that will protect

against loss through a compensatory price

movement.’’

In looking at a hedge transaction in isolation,

there should be certain elements present to make

a hedge workable:

1. The interest rate futures or forward con-

tract utilized should have a high positive corre-

lation (prices that tend to move in the same

direction with similar magnitude) with the cash

position being hedged. In other words, the

futures or forward position taken should be

structured so that an upward price movement in

the contract offsets a downward price move-

ment in the cash or risk position being hedged,

and vice versa.

2. The type (e.g. T-bill, T-bond, etc.) and size

of the contract position

taken should have a

proportionate relationship to the cash or risk

position being hedged, so that futures gains

(losses) will approximately offset any losses

(gains) on the hedged position.

5. Initial margin requirements necessitate the pledging of

something of value prior to initiation of a transaction. Depos-

iting maintenance margin refers to pledging something of

value in reaction to market movements; e.g. depositing cash

representing the difference between a forward contract price

and its current market value.

6. See SR-625 dated July 23, 1980.

7. The Board’s policy statement on engaging in futures,

forwards, and option contracts.

8. Futures market participants engage in a practice, some-

times known as ‘‘factorweighting’’ or ‘‘overhedging,’’ to

determine the appropriate number of futures contracts neces-

sary to have the proper amount of compensatory price move-

ment against a hedged cash or risk position. For example, it

would require 10 mortgaged-backed futures contracts (8%

coupon, $100,000 face value) to hedge an inventory of

$1,000,000 mortgage-backed (8% coupon) securities. Alterna-

tively, 14 mortgage-backed futures contracts would be

required to hedge a $1 million inventory of mortgage-backed

securities with a 13

⁄

% coupon. Overhedging or factor

weighting is necessary in hedging securities with higher cou-

pons than those speciﬁed in futures contracts (currently 8% on

bond futures) because higher coupon securities move more in

price for a given change in yield than lower coupons.

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 14

3. The contract position taken should have a

life which is equal to or greater than the end of

the period during which the hedge will be out-

standing. For example, if interest rate protection

was deemed necessary for a six-month time

span, it would not ordinarily be wise to enter a

contract expiring in three months.

2130.0.10.1 The Mortgage Banking Price

Hedge

Assume that a mortgage banking subsidiary

agrees in June to originate mortgages at a ﬁxed

yield in the following October. Unless the loan

originator has a forward commitment to sell the

loans to a permanent investor(s), it is exposed to

a decline in the principal value of mortgages

due to a rise in interest rates between the com-

mitment date and ultimate sale of the loans. An

example of a traditional ‘‘short hedge’’ would

be the sale of futures contracts in an attempt to

reduce the risk of price ﬂuctuation and insure a

proﬁtable sale of the loans. However, in follow-

ing this strategy the mortgage originator also

chooses to forfeit its ability to reap a proﬁt if

interest rates should fall.

If interest rates increased, the loss on the sale

of mortgages or a pool of mortgage-backed

securities will probably be largely offset by a

gain on the futures transaction; see example

below. If interest rates fall, the mortgage origi-

nator would gain on the resale of mortgages but

lose on the futures market transaction. Hence, in

a true hedge, the hedger’s earnings are relatively

unaffected by a change in market interest rates

in either direction.

Generally accepted accounting principles

applicable to mortgage activity require that

mortgages held for resale be periodically reval-

ued to the lower of cost or market (Financial

Accounting Standards Board Statement No. 65,

‘‘Accounting for Certain Mortgage Banking

Activities’’). Unrealized gains and losses on out-

standing futures contracts are matched against

related mortgages or mortgage commitments

when the inventory is revalued to the lower of

cost or market; i.e. the lower of cost or market

valuation is based upon a net ﬁgure including

unrealized related futures gains and losses.

2130.0.10.2 Basis

Basis is the difference between the cash (spot)

price of a security (or commodity) and its

futures price. In other words:

Basis = Spot price 2 Future price

For short-term and intermediate futures con-

tracts, the futures price is the quoted futures

price times an appropriate conversion factor.

For short-term futures contracts the quoted

futures price is 100 less the annualized futures

interest rate. The invoice price must be deter-

mined using yield-to-price conventions for the

ﬁnancial instrument involved.

Basis may be expressed in terms of prices.

Due to the complexities involved in determining

the futures price, it is thus better to redeﬁne

price basis using actual futures delivery prices

rather than quoted futures prices. Thus, the price

basis for ﬁxed income securities should be rede-

ﬁned as:

Price Basis = Spot price

2 Futures delivery price.

Basis may also be expressed in terms of inter-

est rates. The rate basis is deﬁned as:

Rate basis = Spot rate 2 Futures rate

The spot rate refers to the current rate on the

instrument that can be held and delivered on the

contract. The futures rate represents the interest

rate that corresponds to the futures delivery

price of the deliverable instrument.

The rate basis is useful in analyzing hedges of

short-term instruments since it nets out all

effects resulting from aging. For example, if a

one year T-bill has a rate of 9 percent with a

price of 85, and a 3-month T-bill has a rate of

9 percent and a price of 94, the price basis

would be 29. If a cash security ages, it does not

necessarily mean that a change in the rate basis

has taken place.

2130.0.10.3 Trading Account Short

Hedge

Another example of a short hedge pertains to

securities dealers that maintain bond trading

accounts. While bonds are held ‘‘long’’ (actu-

ally owned by the dealer) in trading accounts,

dealers are subject to two risks. First, there is

the risk that the cost can change regardless of

whether the funds are generated through repur-

chase agreement ﬁnancing or the dealer’s other

funding sources. When there is an inverted yield

curve (short-term interest rates are higher than

long-term rates), trading portfolio bonds in

inventory yield less than the cost of funds

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 15

required to carry them. Second, there is the risk

that bond market interest rates will rise, thus

forcing the dollar price of bonds down.

2130.0.10.3.1 Example 1: A Perfect Short Hedge

Month Cash Market Futures Market

June Mortgage department makes commitment to a

builder to originate $1 million of mortgages

(based on current GNMA 8’s cash price) at

98-

⁄

for $988,750

Sells 10 December mortgage-

backed futures at 96-

⁄

for $962,500 to yield

8.59 percent

October Mortgage department originates then sells $1

million of pooled mortgages to investors at a

price of 95-

⁄

, for $956,250

Loss: $32,500

Buys 10 December mortgage-

backed futures at 93,

for $930,000 to yield

8.95 percent

Gain: $32,500

1. The effects of margin and brokerage costs on the trans-

action are not considered. It should be noted that ‘‘perfect

hedges’’ generally do not occur.

The following example pertains to a bond trad-

ing account. Assume that the dealer purchases

Treasury bonds on October 4 and simultane-

ously sells a similar amount of Treasury bond

futures contracts. The illustration ignores com-

mission charges and uses futures contracts

maturing in March 19x9 because the dealer’s

technical analysis discovered an advantage in

using the March 19x9, rather than the previous

December contract as a hedge. (At that time the

previous December contract was the next avail-

able contract still trading.)

Cash Market Futures Market

10/04/1998 Purchase $5MM T-bonds maturing Aug.

2005, 8% coupon at 87-

⁄

Principal = $4,365,625

Sell $5MM T-bonds futures contracts

expiring Mar. 1999 at 86-

⁄

Contract value = $4,332,813

10/23/1998 Sell $5MM T-bonds at 79.0:

Principal = 3,950,000

Cash loss = ($415,625)

Buy $5MM T-bond futures

Mar. 1999 at 79-

⁄

Contract value = 3,951,563

Futures gain = $381,250

Although the hedge did not prevent the dealer’s

trading account from losing money, it limited

the loss to $34,375 instead of $415,625.

It is worth noting that the preceding example

also illustrates some of the dangers of using

interest rate futures contracts. Although the

futures market proved useful to the trading

department, a futures contract could have seri-

ous consequences for a dealer using an alleged

‘‘long hedge to lock-in an attractive yield.’’

2130.0.10.4 Long Hedge

In certain areas of the country, ﬁnancial institu-

tions desiring to hold public deposits are

required to bid competitively for deposits. The

case discussed below pertains to a situation

where the competitive bids must be tendered

one calendar quarter in advance of receiving the

deposit. In this example, the asset side of the

balance sheet is not discussed since it is

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 16

assumed that a banking organization paying the

prevailing one-year C.D. interest rate can utilize

the funds at a proﬁtable spread.

In this type of situation the bidding institu-

tions are generally vulnerable to falling interest

rates; one can safely assume that an institution

selected to hold public deposits would not be

dismayed to learn subsequently that interest

rates had risen and it had locked-in a funding

source at or below market rates. However, the

funds will not be received for another 3 months.

Thus, there is the possibility that interest rates

could drop in the interim, leaving a reduced or

possibly negative net interest margin when the

funds are deployed.

There are a number of approaches available

to attempt to ensure that future time deposits

can be obtained without paying higher than mar-

ket interest rates. One method is forecasting the

appropriate interest rate to be paid on a given

time deposit three months in the future. How-

ever, forecasting has become increasingly difﬁ-

cult to do with accuracy in the recent periods of

ﬂuctuating interest rates. An alternative

approach would be to quote the current C.D.

rate (adjusted slightly for competitive factors)

with an intent to hedge in the futures market if

the banking organization’s interest rate bid is

accepted. Upon receiving notiﬁcation that its

deposit bid has been accepted, the institution

can then purchase an appropriate number of

futures contracts to insure a proﬁtable invest-

ment spread three months hence when it actu-

ally receives the deposit.

The following example on June 1, 19x0; the

facts are as follows:

Size of public deposits

offered $10 million

Date of deposit September 2, 19x0

Term 1 year

Current C.D. rate 8

⁄

For purposes of this illustration, assume that a

bid was submitted to pay 8

⁄

% for one year on

$10 million. The bids were due June 1 and

notiﬁcation was given June 2 of the intention to

provide the funds on September 2; and the bank-

ing organization decided to purchase futures

contracts on June 2.

A Treasury bill futures contract, expiring in

3 months, is selected as the hedging vehicle

because it reﬂects price movement of an instru-

ment with a comparable maturity to one-year

C.D., and there was no C.D. futures contract

trading. For purposes of this illustration, it is

assumed that the contract offers sufﬁcient liquid-

ity to enable the banking organization to readily

offset its open futures position when necessary.

Using the bill contract is an example of ‘‘cross

hedging’’ which is deﬁned as the buying or

selling of an interest rate futures contract to

protect the value of a cash position of a similar,

but not identical, instrument. This type of hedg-

ing is a measured risk since the outcome of such

a transaction is a function of the price correla-

tion of the instruments being hedged. At any

given moment it is conceivable that a negative

correlation could exist between two unlike

instruments despite the presence of a strong

correlation over an extended time period.

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Page 17

Date C.D. Rate Transactions T-bill Futures

June 2, 19x0 8.25% Purchase 40 Contracts 91.84 8.16%

Sept. 2, 19x0 11.00% Sell 40 Contracts 90.05 9.95%

1. The size of the trading unit is based upon U.S. T-bills

having a face value at maturity of $250,000 (40 2 250M =

10MM). Prices are quoted in terms of an index representing

the difference between the actual T-bill yield and 100.00.

Every one basis point movement on a contract is equal to

$25.00 per contract.

2130.0.10.4.1 Evaluation of the Hedge

Total interest (not compounded)

to be paid (8

⁄

%) $ 825,000

Alternative C.D. interest

(not compounded)

at current rate (11%) 1,100,000

Difference 275,000

Futures trading loss* (179,000)

Net difference $ 96,000

*Computation—Purchase price 91.84

Sale price 90.05

1.79 or 179 basis points

(179 2 $25.00 2 40 contracts = $179,000)

In retrospect, it would have been better if the

banking organization would not have hedged.

By agreeing to an interest rate on June 2, it

obtained deposits on September 2 and will pay

approximately $275,000 less in interest pay-

ments to the municipality than is required on an

ordinary C.D.(s) issued on September 2. The

$179,000 futures trading loss, of course, reduced

the windfall interest income due the banking

organization. A net interest income spread of

approximately $96,000, instead of a $275,000,

demonstrates two principles: 1) cross hedging

can cause unexpected results; and 2) it is quite

difﬁcult to ﬁnd perfect hedges in the real world.

The hedge was structured so that a cash gain

was offset by a futures loss—incorporating the

offsetting principles of a hedge transaction. If

the general level of interest rates had fallen, a

futures gain should have occurred to offset the

higher (relative to prevailing market rates) cost

of funds obtained on September 2.

2130.0.10.5 Using Options to Create an

Interest Rate Floor

Assume that on September 28th it is decided to

rollover a $1,000,000 investment in 13-week

Treasury bills on November 28, which also hap-

pens to be the expiration date for call options on

the December Treasury bill futures contract.

The banking organization, concerned that inter-

est rates will fall between September 28 and the

rollover date, wishes to hedge the rollover of its

investment. The portfolio manager can set a

minimum yield on the rollover investment by

either buying a Treasury bill future call option,

or by buying a Treasury bill futures contract.

Further assume that the December Treasury bill

futures contract can be bought for a price of

93.70 which implies a discount yield of

6.30 percent. Treasury bill futures call options

with a strike price of 93.75, implying a discount

yield of 6.25 percent, sell for a premium of

20 basis points, or $600 (20 basis points 2

$25/basis point = $500).

If the banking organization could actually

buy a Treasury bill futures contract that expired

on exactly November 28, then there would be a

perfect hedge since the rate of return on the bills

would be explicitly ﬁxed by the futures hedging

strategy. However, the closest maturing Trea-

sury bill futures contract expires in December,

several weeks after the rollover date for the

banking organization’s investment. Uncertainty

over the actual discount yield of the Treasury

bills on the rollover date and the yield produced

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1992

Page 18

by the hedge is known as ‘‘basis risk,’’ the risk

that the yield on the hedge may differ from the

expected yield on the hedged item. For purposes

of this example, assume that the yield on the

futures contract equals the actual discount yield

on the 13-week Treasury bills at the rollover

date. Thus, the futures hedge in this example

will provide an effective discount yield of

6.30 percent on the rollover of the 13-week

Treasury bill investment.

Assume that rates fall after September 28 and

that the discount yield on Treasury bill futures

contracts declines from 6.30 percent to 6.00 per-

cent at the November 28 expiration date of the

December Treasury bill futures options con-

tract. The option to buy the Treasury bill futures

will be exercised since the strike price of 93.75

is below the market price of 94.00 for the

underlying futures contract, yielding a proﬁt of

25 basis points or $625 (25 basis points 2

$25/basis point). The proﬁt must be offset by the

20 basis point cost of the option, which reduces

the net proﬁt to 5 basis points. The effective

hedged discount yield is 6.05 percent (6.00 per-

cent on the 13-week Treasury bills—assuming

no basis risk—plus the 5 basis point proﬁt from

the hedge). The option hedge produces a yield

that is 5 basis points higher than the unhedged

yield, but 25 basis points lower than the

6.30 percent yield that would have resulted from

hedging with futures.

Although the option hedge resulted in a lower

effective yield than the futures hedge, it set an

absolute ﬂoor on the investment. This is because

any decline in the discount yield of the Treasury

bills below 6.05 percent would be offset dollar

for dollar by the additional proﬁts from the

hedge. The real advantage of the option hedge is

that, although it establishes a ﬂoor that is lower

than the rate ﬁxed by the futures hedge, it allows

the hedger to participate in any increase in inter-

est rates above the cost of the call premium. For

example, if interest rates increased such that the

price on the December Treasury bill futures

contract on November 28 falls to 93.00, imply-

ing a discount yield of 7.00 percent, the option

would expire unexercised since the strike price

is above the price of the underlying futures

contract. Again, assuming that the spot price for

the 13-week Treasury bills is equal to the futures

price, the effective discount yield is 6.80 percent

(7.00 percent minus the 20 basis point call

option premium), 50 basis points higher than the

yield that would have been provided by the

futures hedge.

2130.0.10.6 Hedging a Borrowing with

an Interest Rate Cap

In order to limit a borrower’s interest rate risk,

sophisticated banking institutions may offer cap

agreements as part of a loan package to their

clients. While such an arrangement provides

some comfort that the borrower’s ability to

repay will not be jeopardized by a sharp increase

in interest rates, it obviously transfers that inter-

est rate risk back to the lender. Nevertheless,

many banking institutions feel they are better

able to manage that risk than are some of their

clients. Cap agreements have also been utilized

to cap the rate on issued liabilities. For example,

an institution might be able to issue medium-

term ﬂoating rate notes at 3-month LIBOR plus

an eighth of a percent. Alternatively, that institu-

tion could issue a capped ﬂoating rate note at

3-month LIBOR plus three-eights of a percent.

By subsequently selling the cap separately back

into the market the institution could, achieve

sub-LIBOR funding, depending on the proceeds

from the sale of the cap.

A cap agreement is typically speciﬁed by

following terms: notional principal amount;

maturity; underlying index, frequency of reset,

strike level. As an illustration, a cap agreement

might have the following terms:

Notional Principal

Amount $10,000,000

Maturity 2 Years

Underlying Index 3-month LIBOR

Rate Fixing quarterly

Payment quarterly, in arrears, on

an actual/360-day basis

Cap Level 9%

Up Front Fee 1.11% of par

($111,000)

Under the terms of this agreement, if at any

of the quarterly rate ﬁxing dates 3-month

LIBOR exceeds the cap level then the seller of

the cap would pay the buyer an amount equal to

the difference between the two rates. For exam-

ple, if at a reset date LIBOR was set at 10 per-

cent, the payment would be:

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Page 19

10%(90/360 2 $10,000,000)

9%(90/360 2 $10,000,000)

$25,000

Thus, the writer of the cap would pay the buyer

$25,000. If 3-month LIBOR for the quarter were

set at or below the cap level of 9 percent, no

payment would be made.

2130.0.11 ASSET-LIABILITY

MANAGEMENT

Financial contracts can be used as a tool in an

overall asset-liability management strategy. In

order to use ﬁnancial contracts in this context, a

BHC or nonbank subsidiary must ﬁrst identify

where interest-rate exposure lies as indicated by

mismatches between asset and liability struc-

tures. In those instances where the BHC or

nonbank subsidiary has variable-rate assets and

variable-rate liabilities with comparable maturi-

ties, there is, in theory, no need to hedge with

ﬁnancial contracts since that portion of the

asset-liability structure is already hedged. The

same holds true for ﬁxed-rate assets and liabili-

ties (yielding a positive interest-rate margin) of

comparable maturities. Once a BHC or nonbank

subsidiary has identiﬁed the undesired mis-

matches in assets and liabilities, ﬁnancial con-

tracts can be used to hedge against the identiﬁ-

able mismatch—for example, long positions in

contracts can be used as a hedge against funding

interest-sensitive assets with ﬁxed-rate sources

of funds, and short positions in contracts can be

used as a hedge against funding ﬁxed-rate assets

with interest-sensitive liabilities.

BHCs or nonbank subsidiaries that choose to

employ ﬁnancial contracts as a tool in their

general asset-liability management program and

properly use ﬁnancial contracts are striving

towards worthwhile goals. The discipline of

identifying mismatches between assets and

liabilities tends to focus the practitioner’s atten-

tion on the entire balance sheet. Examiners

should be aware that marketing efforts on behalf

of the futures exchanges have attempted to focus

upon just one side of the balance sheet by ‘‘pair-

ing’’ a futures contract with an asset or a liabil-

ity. In considering ﬁnancial-contract activities,

examiners need to remember that ﬁnancial-

contract activities must be evaluated in light of

both sides of a balance sheet.

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BHC Supervision Manual December 1998

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One ﬁnal point should be made with respect

to ‘‘hedging’’ based upon pairing a futures con-

tract against a portfolio security. Since this type

of ‘‘hedging’’ can be done while considering

only the asset side of the balance sheet, it is

possible that such a strategy could increase

interest-rate risk rather than reduce it. For exam-

ple, assume (unrealistically) that there is a per-

fect balance between variable-rate assets and

liabilities, and the ﬁrm is evaluating ﬁxed-rate

assets and liabilities. Management determines

that there is a perfect balance between ﬁxed-rate

assets and liabilities and then isolates the last

ﬁxed-rate asset and liability. Make the further

assumption that the organization holds a six-

month note yielding 12 percent which is

ﬁnanced by funds maturing in six months which

costs the organization 10.5 percent. By execut-

ing a short futures contract ‘‘paired’’ against the

six-month note, the organization would move

from an overall ‘‘hedged’’ position to an

‘‘unhedged’’ position. In other words, the

futures contract would move the organization

from an overall neutral position and expose the

organization to interest-rate risk.

It should be evident why it is more productive

to consider the ‘‘big picture’’ in inspections

rather than focusing upon individual or

‘‘paired’’ (futures against each position) transac-

tions. The most meaningful approach is to

evaluate hedging strategies and open ﬁnancial

contract positions in light of its business needs,

operations, and asset-liability mix.

2130.0.12 INSPECTION OBJECTIVES

1. To determine the purpose of ﬁnancial-

contract positions. Any positions that bank

holding companies or their nonbank subsidi-

aries (except certain authorized dealer

subsidiaries) take in ﬁnancial contracts

should reduce risk exposure, that is, not be

speculative.

2. To determine whether prudent written poli-

cies, appropriate limitations, and internal

controls and audit programs have been estab-

lished and whether management information

systems are sufﬁciently adequate to monitor

risks associated with contracts involving

futures, forwards, and options (including

caps, ﬂoors, and collars).

3. To determine whether policy objectives con-

cerning the relationship of subsidiary bank-

ing organizations and the parent bank hold-

ing company specify that each banking

organization in a holding company system

must be treated as a separate entity.

4. To determine reporting compliance in

accordance with the Board’s bank holding

company policy statements. See section

2130.0.17 for the appropriate cites.

2130.0.13 INSPECTION PROCEDURES

The term ‘‘banking organization’’ is used gener-

ally to refer to a bank holding company, the

parent company, or nonbank subsidiary.

1. Determine if the banking organization’s

ﬁnancial-contract activities are related to the

basic business of banking.

Consider whether the ﬁnancial-contract

activities are closely related to the basic busi-

ness of banking; that is, taking deposits, mak-

ing and funding loans, providing services to

customers, and operating at a proﬁt for share-

holders without taking undue risks. Taking

ﬁnancial-contract positions solely to proﬁt

upon interest-rate forecasts is considered to

be an unsafe and unsound practice. Proﬁt-

ability of contract activities is not the crite-

rion for evaluating such activities. It is quite

probable that a bona ﬁde hedge strategy

could result in a contract loss which would

be offset by increased interest earnings or a

higher price for an asset sold, for example, a

pool of mortgages. Criticize contracts placed

solely to proﬁt upon interest-rate movements.

Verify that contract activities are conducted

in accordance with the Board’s policy state-

ment. Where contract positions are of exces-

sive size and could jeopardize the ﬁnancial

health of the entity under examination, the

gains or losses realized because of ﬁnancial-

contract activities should be criticized.

2. Ascertain whether policy objectives high-

light the circumstances under which ﬁnancial

contracts should be used.

Determine whether management and oper-

ating personnel have received sufﬁcient guid-

ance. Carefully constructed policy objectives

should be formulated with the knowledge

that although proper utilization of ﬁnancial

contracts limits loss potential, such utiliza-

tion also limits potentials for gains. Policy

objectives should be formulated to limit

required resources (margin monies, commis-

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BHC Supervision Manual December 1998

Page 21

sions, and personnel to execute, monitor, and

audit contract activities). A well-constructed

policy should be designed to preclude vari-

ous operating areas of a banking orga-

nization from taking offsetting ﬁnancial con-

tract positions. Finally, there should be

established benchmarks for determining

whether ﬁnancial contracts are meeting

desired objectives.

3. Determine if policy objectives concerning

the relationship of subsidiary banking organi-

zations and the parent bank holding company

comply with the Board’s directives.

Each banking organization in a holding

company system must be treated as a sepa-

rate entity. The policy statement accommo-

dates centralized holding companies in that

the holding companies are free to provide

guidance to subsidiary banking organizations

and execute contracts as agent on behalf of

the banking organization, provided that each

banking organization maintains responsibil-

ity for ﬁnancial contract transactions

executed on its behalf. Accordingly, a hold-

ing company that has centralized manage-

ment could, and perhaps should, consider the

interest-rate exposure of its subsidiary banks

on a consolidated basis in determining

whether future contracts can usefully be

employed to reduce that exposure, but any

future contracts that are executed must be

recorded on the books and records of a sub-

sidiary bank that will directly beneﬁt from

such contracts.

The question concerning the relationship

of a subsidiary bank to its holding company

may also lead one to consider the relation-

ship of a subsidiary bank with its correspon-

dent bank or broker. One might also query to

what extent may less sophisticated institu-

tions rely upon brokers and/or correspondent

banking organizations for advice in this area?

Less sophisticated institutions can place

only limited reliance on others for advice in

this area. The bank holding company policy

statement

emphasizes that responsibility for

ﬁnancial-contract activities rests solely with

management. Additional information on

securities transactions and the selections of

securities dealers can be found in sec-

tion 2126.1.

4. Ascertain whether policy objectives and/or

position limits require prudence on the part

of authorized personnel entering into these

new activities. If discretion is left to senior

managers, determine whether management

has issued instructions to ensure that the

level of ﬁnancial-contract activity is prudent

relative to the capabilities of persons autho-

rized to execute and monitor contracts.

A new activity such as ﬁnancial contracts

should, as a general rule, be entered slowly.

In developing expertise, management should

mandate a low level of activity until persons

authorized to execute contracts gain sufﬁ-

cient expertise or until new personnel are

employed that have sufﬁcient training and

experience to engage in ﬁnancial-contract

activities on a larger scale. Senior manage-

ment must develop the expertise to under-

stand and evaluate techniques and strategies

employed to ensure that an experienced pro-

fessional does not engage in improper or

imprudent activities.

5. If a banking organization uses ﬁnancial con-

tracts as part of its overall asset-liability man-

agement strategy, determine whether the

organization developed an adequate system

for evaluating its interest-rate risk.

Without a system for identifying and mea-

suring interest-rate risk, it is impossible to

engage in hedging activity in an informed

and meaningful manner. Failure to identify

the mismatches in the organization’s asset-

liability mix would make it difﬁcult to select

the proper number and types of ﬁnancial

contracts—for example, bond or bill ﬁnan-

cial contracts—to provide an appropriate

amount of interest-rate-risk protection.

Evaluate whether the organization’s interest-

rate-risk measurement techniques appear rea-

sonable to determine whether the ﬁnancial

contracts employed were successful in pro-

viding the proper amount of futures gains

(losses) to cover the hedged risk position.

6. Determine if the recordkeeping system is

sufﬁciently detailed to permit personnel to

document and describe in detail how

ﬁnancial-contract positions taken have con-

tributed to the attainment of the banking

organization’s stated objectives.

There is no universal, adequate record-

keeping system for this purpose. Examiners

must evaluate each individual system rela-

tive to the organization’s stated objectives

and activities. If the recordkeeping system

cannot be used to illustrate how ﬁnancial

contracts contributed to the attainment of the

banking organization’s stated objectives, the

9. The Board’s policy statement on engaging in futures,

forwards, and option contracts.

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BHC Supervision Manual December 1998

Page 22

recordkeeping system is inadequate. BHCs

with inadequate recordkeeping systems

should be instructed to make appropriate

modiﬁcations.

7. Ascertain whether the banking organization’s

board of directors has established written

limitations with respect to ﬁnancial-contract

positions.

NOTE: The bank holding company pol-

icy statement requires that the board of

directors establish written policies and posi-

tion limitations in connection with

ﬁnancial-contract activities. If a committee

has been delegated similar responsibilities

within the organization, and a committee

makes the decision, its recommendation

should be ratiﬁed by the board of directors.

8. If there is the potential to exceed the above

limitations in certain instances, determine

whether there are ﬁrm, written procedures

in place concerning the authorizations nec-

essary to exceed limits.

9. Determine whether the board of directors, a

duly authorized committee thereof, or inter-

nal auditors review at least monthly

ﬁnancial-contract positions to ascertain con-

formance with limitations. (See item (b) of

the bank holding company policy

statement.)

10. Determine if the banking organization

maintains general-ledger memorandum

accounts or commitment registers to

adequately identify and control all

ﬁnancial-contract commitments to make or

take delivery of securities or money market

instruments.

11. Determine if the banking organization

issues or writes option contracts expiring in

excess of 150 days which give the other

party to the contract the option to deliver

securities to it.

Examiners should review the facts sur-

rounding standby contracts issued by hold-

ing companies. Examiners should also

review accounting entries connected with

bank holding company standby contracts to

determine whether standbys were issued to

earn fee income ‘‘up front’’ and exploit the

lack of generally accepted accounting

principles.

12. Determine whether ﬁnancial-contract posi-

tions are properly disclosed in notes to the

statements of ﬁnancial condition and

income and that the contract positions have

been properly reported on FR Y-9C, Sched-

ule HC-F, ‘‘Off-Balance-Sheet Items.’’

13. Determine whether the banking organiza-

tion has implemented a system for monitor-

ing credit-risk exposure associated with

various customers and dealers with whom

operating personnel are authorized to trans-

act business.

All ﬁnancial-contract trading involves

market risks. However, forward and OTC

options trading, as well as swap activities,

also involve credit risk. The key concern is

whether the contra party to a transaction

will be ready, willing, and able to perform

on contract settlement and payment dates.

While maintaining control over credit-risk

exposure should ensure that a ﬁnancial

organization will not enter excessive (rela-

tive to the ﬁnancial condition of the contra

party) forward or standby contracts, moni-

toring such exposure may not prevent

default in all instances.

14. Ascertain whether the banking organization

has implemented internal controls and inter-

nal audit programs to ensure adherence to

written policies and prevent unauthorized

trading and other abuses.

15. Determine if the Reserve Bank was notiﬁed

at the inception of bank holding company

futures, forward, and option activities as

required by paragraph (f) of the holding

company policy statement (Federal Reserve

Regulatory Service 4–830).

16. Determine if the personnel engaged in

ﬁnancial-contract activities have sufﬁcient

knowledge and understanding of the mar-

kets to perform those functions.

2130.0.13.1 Evaluating the Risks of

Contract Activities

Evaluating the organization’s stated objectives

and their effects on overall risk is a difﬁcult task

involving legitimate cause for concern because

of the high degree of leverage involved in con-

tract activities. Although there is an emerging

trend towards dealers requiring margin on for-

ward trades, forward contract transactions gen-

erally have not required margin deposits, and

thus, grant users unlimited leverage. Although

the amount of margin required for futures trades

is extremely small (for example, $1,500 initial

margin to take a $1 million futures position), the

rules of the exchanges do require a daily mark

to market and a requirement that members of

the futures exchanges meet maintenance margin

calls on behalf of their customers. Customers, of

course, are generally required to promptly reim-

burse brokers for margin posted on their behalf.

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BHC Supervision Manual December 1998

Page 23

Nevertheless, engaging in contract activities

requires market participants to assume the mar-

ket risks of either owning securities or ‘‘short-

ing’’ securities. Issuing (or selling) standby con-

tracts granting the other party to the contract the

option to deliver securities is a practice which

results in the issuer functioning as an insurer

against downside market risk for the other party;

in essence, the party receiving the standby fee

assumes all of the interest-rate risks of security

ownership, but receives none of the beneﬁts.

2130.0.13.2 Reviewing

Financial-Contract Positions

The preceding questions were designed to focus

the examiner’s attention on a bank holding com-

pany’s stated objectives for engaging in ﬁnan-

cial contract activities and the manner in which

such activities are conducted. It is also vital to

review position records with respect to ﬁnancial

contracts or, if necessary, prepare a schedule

grouping similar contracts by maturity. Once

the various positions have been scheduled it

will be possible to evaluate the risk of contract

positions relative to the organization under

inspection.

2130.0.13.3 Factors to Consider in

Evaluating Overall Risk

To determine whether contract positions are rea-

sonable, an examiner must evaluate positions in

light of certain key factors: the size of the orga-

nization, its capital structure, its business needs,

and its capacity to fulﬁll its obligations. For

example, open contracts to purchase $7 million

of GNMA securities would be viewed differ-

ently in a BHC with $24 million of assets than

in a BHC with $1 billion of assets.

There is no guaranty that ﬁnancial contract

prices and cash market prices will move in the

same direction at the same velocity; however,

contract prices and cash market prices ulti-

mately move towards price convergence in the

delivery month. Keeping this fact in mind, the

risk evaluating process can be simpliﬁed by

thinking of the securities underlying the various

contracts as a frame of reference. For example,

if a BHC holds ‘‘long’’ futures contracts on

$10 million (par value) of Treasury bonds the

examiner should ﬁrst evaluate the effect

(excluding tangible beneﬁts of ownership, e.g.,

interest income, pledging, etc.) on the organiza-

tion of holding $10 million of bonds in its

portfolio and the resultant appreciation or depre-

ciation if interest rates rise or fall by a given

amount. A ‘‘short’’ contract of $10 million Trea-

sury bonds would be evaluated as if the banking

organization had executed a short sale for

$10 million. In addition, the examiner would

have to consider the positive or negative ﬂow of

funds received or disbursed as margin to reﬂect

daily contract gains and losses. While commis-

sions on futures contracts are not a major factor

in hedging transactions, they also should be

considered in this evaluation. Typically, com-

missions are charged on a ‘‘round turn’’ basis—

meaning that commissions are charged based

upon an assumption that each futures contract

will be offset prior to maturity. Since each con-

tract will have to be offset, or securities bought

or delivered, it should be determined whether

funds will be available to offset contracts or

fund delivery. In the case of certain short

contracts, a determination must be made as

to whether deliverable securities are held

or committed for purchase by the banking

organization.

2130.0.13.4 Contract Liquidity

In addition to looking at the ‘‘big picture,’’

examiners should consider a position in a given

contract maturity month relative to the volume

of contracts outstanding. For example, in futures

trading there is generally a greater open interest

in the next contract maturity month and perhaps

the following one or two contract maturity

months. As one moves away from the near term

contracts, there is generally less trading and less

‘‘open interest’’ in the more distant contracts.

‘‘Open interest’’ or the amount of contracts out-

standing is reported in ﬁnancial newspapers and

other publications. Generally, the contracts with

the largest open interest and daily trading vol-

ume are considered to be the most liquid.

To illustrate the concept discussed above, one

should consider the following example. A ‘‘red

ﬂag’’ should be apparent if a contract review

discloses that the organization has taken a size-

able position in a contract expiring in two years.

When the examiner checks ﬁnancial newspapers

and other publications, he or she may discover

that the BHC’s position represents 20 percent of

the open interest in that contract. Such a situa-

tion would clearly be unsafe and unsound

because the relatively huge position coupled

with the typically less liquid conditions in dis-

tant contracts makes it highly unlikely that the

BHC could quickly close out its position if

necessary. In addition, one should also question

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1998

Page 24

why the distant maturity was chosen since there

is no immediate reason to expect a close correla-

tion to the cash market for the underlying

security.

With respect to forward contracts, there is an

active forward market for GNMA securities

specifying delivery of the underlying securities

up to four or ﬁve months in the future. If a

banking organization is executing contracts for

more distant maturities, management should be

queried as to why it is necessary to trade outside

the normal trading cycle.

2130.0.13.5 Relationship to Banking

Activities

In evaluating contract activities, examiners

should verify that contract strategies are carried

to fruition in connection with their relationship

to overall objectives. Examiners may ﬁnd it

useful to recommend additional recordkeeping

in borderline cases when they encounter situa-

tions where ﬁnancial-contract positions are

closed out frequently during the hedge period,

but not frequently enough to be considered trad-

ing rather than hedging activities. Examiners

should suggest proper documentation with

regard to ﬁnancial contracts executed and any

additional recordkeeping as needed. Speciﬁ-

cally, users could be requested to establish writ-

ten criteria specifying what circumstances will

trigger the closing of such contracts. Then users

would be judged by how well they adhered to

the criteria as well as whether the plan reduced

risk. Hopefully, such recordkeeping would give

users the latitude to close out a ﬁnancial-

contract position working against them (as

determined by some prearranged benchmark),

yet still require sufﬁcient discipline to prevent

users from selectively executing ﬁnancial con-

tracts merely to proﬁt upon interest-rate

forecasts.

The preceding discussion should reinforce the

fact that the actual utilization of ﬁnancial con-

tracts is not a clear-cut issue in terms of hedging

verses speculation. However, certain key con-

cepts should be kept in mind. First, a decision to

hedge with futures or forward contracts involves

making a decision that one is content to lock in

an effective cost of funds, a sale price of a

speciﬁc asset, etc. However, the decision to

hedge which gives downside protection also

means forfeiting the beneﬁts which would result

from a favorable market movement. Thus, in

evaluating hedge strategies, the organization

should be judged as to whether it maintained

hedge positions long enough to accomplish its

objectives.

Caution should be employed in performing

the analysis of ﬁnancial contracts used to obtain

targeted effective interest rates. Examiners

should not evaluate transactions solely on a

‘‘paired’’ basis, that is, looking at paired cash

market and ﬁnancial-contract positions and for-

getting about ﬁnancial-contract positions rela-

tive to the organization’s entire balance sheet,

nor should examiners fail to review the overall

nature of ﬁnancial-contract activities. For exam-

ple, individual opening and closing of ﬁnancial

contracts could appear reasonable, but the

aggregate activities may be indicative of an

organization that is in reality operating a futures

trading account solely to proﬁt on interest-rate

expectations.

2130.0.13.6 Parties Executing or Taking

the Contra Side of a Financial Contract

In addition to monitoring contra-party credit

risk, serious efforts should be made to ensure

that the banking organization carefully scruti-

nizes the selection of brokers and dealers. In the

case of futures contracts, the Commodity

Exchange Act requires that an entity functioning

as a futures commission merchant be registered

with the CFTC. However, not every FCM may

be a member of a commodities exchange. Mem-

bers of an exchange are given additional super-

vision by the exchange, while nonmembers are

subject to audit by the National Futures Associa-

tion. In selecting any broker or dealer, an organi-

zation should give careful consideration to its

reputation, ﬁnancial viability, and length of time

in business. If an organization intends to deal

with a newly established FCM or broker-dealer,

special efforts should be made to verify the

reputation and integrity of its principals. (For

additional discussion, see Federal Reserve

Regulatory Service 3–1562). Although such

measures cannot ensure that problems will not

subsequently develop with an FCM or broker-

dealer, some careful forethought can tend to

ensure that relationships will not be developed

with persons or ﬁrms who had serious problems

in the past.

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BHC Supervision Manual December 1998

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2130.0.14 ACCOUNTING FOR

FUTURES CONTRACTS

All futures contracts, except for foreign-

currency futures contracts, shall be reported in

the Consolidated Financial Statements for Bank

Holding Companies in accordance with Finan-

cial Accounting Standards Board (FASB) State-

ment No. 80, ‘‘Accounting for Futures Con-

tracts.’’ Foreign-currency futures contracts shall

be reported in accordance with the guidance in

FASB Statement No. 52, ‘‘Foreign Currency

Translation.’’

2130.0.14.1 Performance Bonds under

Futures Contracts

When the reporting banking organization, as

either buyer or seller of futures contracts, has

posted a performance bond in the form of a

margin account deposited with a broker or

exchange, the current balance (as of the report

date) of that margin account shall be reported in

Other Assets. The balance in the margin account

includes the following:

1. the original margin deposit, plus (less)

2. any additions (deductions) as a result of daily

ﬂuctuations in the market value of the related

contracts (i.e., ‘‘variation margin’’), plus

3. any additional deposits made to the account

to meet margin calls or otherwise (i.e.,

‘‘maintenance margin’’), less

4. any withdrawals of excess balances from the

account

When the performance bond takes the form

of a pledge of assets with a broker rather than a

margin account, the pledged assets shall be

maintained on the books of the pledging bank-

ing organization and no other balance-sheet

entry is made for the performance bond. In this

case, gains and losses resulting from daily ﬂuc-

tuations in the market value of the related con-

tracts are generally settled with the broker in

cash. However, if the pledging banking organi-

zation also maintains a working balance with

the broker against which recognized daily mar-

ket gains and losses are posted, the working

balance should be reported in Other Assets, and

treated in the same manner as a margin account.

2130.0.14.2 Valuation of Open Positions

All open positions in futures contracts must be

reviewed at least monthly (or more often, if

material) and their current market values deter-

mined. The market value of a futures contract is

to be based on published price quotations. These

futures positions must be revalued at their cur-

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BHC Supervision Manual December 1998

Page 26

rent market values on these valuation dates and

any changes in these values reported in accor-

dance with the guidance presented below for

hedge or nonhedge contracts, as appropriate.

2130.0.14.3 Criteria for

Hedge-Accounting Treatment

A futures contract shall be accounted for as a

hedge when the following conditions are met:

1. The banking organization must have deter-

mined that the item or group of items to be

hedged (that is, the identiﬁable assets, liabili-

ties, ﬁrm commitments, or anticipated trans-

actions) will expose it to price or interest-rate

risk.

2. The futures contract must reduce the expo-

sure to risk. This will be demonstrated if, at

the inception of the hedge and throughout

the hedge period, high correlation is

expected to exist between the changes in the

prices of both the contract and the hedged

item or group of items.

In other words, the

banking organization must monitor the price

movements of both the hedge contract and

the hedged items to determine that it is prob-

able that changes in the market value of the

futures contract will offset the effects of price

changes on the hedged items.

3. The futures contract must be designated in

writing as a hedge by management at the

inception of the hedge.

In order for a futures contract to qualify as

a hedge of an anticipated transaction, the

following two additional criteria must be

met:

a. The signiﬁcant characteristics and

expected terms of the anticipated transac-

tion must be identiﬁed.

b. The occurrence of the anticipated transac-

tion must be probable.

2130.0.14.4 Gains and Losses from

Monthly Contract Valuations of Futures

Contracts That Qualify as Hedges

If the hedge criteria are met, the accounting for

the futures contract shall be related to the

10. Generally, banking practice maintains that correlation

in the changes in the market values of the futures contract and

the hedged item must be at least 80 percent for the ‘‘high

correlation’’ criteria in FASB Statement No. 80 to be met.

11. It will be particularly difﬁcult to meet this criteria when

an anticipated transaction is not expected to take place in the

near future.

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1998

Page 27

accounting for the hedged item so that changes

in the market value of the futures contract are

recognized in income when the effects of related

changes in the price or interest rate of the

hedged item are recognized. If a banking organi-

zation must include unrealized changes in the

fair value of a hedged item in income, a change

in the market value of the related futures con-

tract shall be recognized in income when the

change occurs. Otherwise, a change in the mar-

ket value of a futures contract that qualiﬁes as a

hedge of an existing asset or liability shall be

recognized as an adjustment of the carrying

amount of the hedged item. A change in the

market value of a futures contract that is a hedge

of a ﬁrm commitment shall be included in the

measurement of the transaction that satisﬁes the

commitment. A change in the market value of a

futures contract that is a hedge of an anticipated

transaction shall be included in the measure-

ment of the subsequent transaction.

Once the carrying amount of an asset or lia-

bility has been adjusted for the change in the

market value of a futures contract, the adjust-

ment must be recognized in income in the same

manner as other components of the carrying

amount of that asset or liability (for example,

using the interest method). If the item being

hedged is an interest-bearing ﬁnancial instru-

ment otherwise reported at amortized historical

cost, then the changes in the market value of the

hedge contract that have been reﬂected as

adjustments in the carrying amount of the ﬁnan-

cial instrument shall be amortized as an adjust-

ment of interest income or expense over the

expected remaining life of the hedged item.

If a futures contract that has been accounted

for as a hedge of an anticipated transaction is

closed before the date of the related transaction,

the accumulated change in value of the contract

shall be carried forward (assuming high correla-

tion continues to exist) and included in the

measurement of the related transaction. When it

becomes probable that the quantity of the antici-

pated transaction will be less than that originally

hedged, a pro rata portion of the futures results

that would have been included in the measure-

ment of the transaction shall be recognized as a

gain or loss.

When futures contracts that are hedges are

terminated, the gain or loss on the terminated

contracts must be deferred and amortized over

the remaining life of the hedged item.

2130.0.14.5 Gains and Losses from

Monthly Contract Valuations of Futures

Contracts That Do Not Qualify as Hedges

For futures contracts that are not accounted for

as hedges, the change that has occurred in the

market value of open positions since the last call

report date shall be reﬂected in current income,

either as ‘‘other noninterest income’’ for net

gains or ‘‘other noninterest expense’’ for net

losses.

If high correlation ceases to exist, the banking

organization should discontinue accounting for

a futures contract as a hedge. When this occurs,

the portion of the change in the market value of

the contract that has not offset the market value

changes of the hedged item, since the inception

of the hedge, must be reﬂected in the Report of

Income as ‘‘other noninterest income’’ or ‘‘other

noninterest expense,’’ as appropriate. The con-

tract should thereafter be accounted for as a

nonhedge contract with subsequent changes in

the contract’s market value reﬂected in current

period income.

When futures contracts that are not hedges

are terminated, the gain or loss on the termi-

nated contract must be recognized currently in

the Report of Income as ‘‘other noninterest

income’’ or ‘‘other noninterest expense,’’ as

appropriate.

There is the potential for holding companies

and nonbank subsidiaries to follow the refer-

enced accounting applications and break

‘‘hedges’’ with unrealized futures gains to rec-

ognize income, and maintain hedges with

futures losses and adjust the carrying basis of

the paired, that is, ‘‘hedged’’ asset. Examiners

should look for patterns of taking gains and

losses with a view to determining whether the

opening and closing of contracts is consistent

with the organization’s risk-reducing strategies.

2130.0.15 PREPARING INSPECTION

REPORTS

Unsatisfactory comments pertaining to a bank

holding company’s ﬁnancial-contract activities

should be noted on the ‘‘Examiner’s Com-

ments,’’ ‘‘Policies and Supervision,’’ and

‘‘Analysis of Financial Factors’’ or other appro-

priate page depending on the severity of the

comments within the bank holding company

inspection report.

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1998

Page 28

2130.0.16 INTERNAL CONTROLS

AND INTERNAL AUDIT

The following is designed to illustrate desirable

internal controls and internal audit procedures

applicable to the organization’s activities in

ﬁnancial contracts. This illustration is not

intended to serve as an absolute standard relat-

ing to contract activities, but is designed to

supplement examiners’ knowledge relating to

internal controls and internal audits in this con-

text. In evaluating internal controls and audits,

the examiner will need to evaluate the scope of

futures, forward, and options activities to deter-

mine whether internal controls and audit proce-

dures are adequate in relation to the volume and

nature of the activities.

2130.0.16.1 Internal Controls

It is a management’s responsibility to minimize

the risks inherent in ﬁnancial-contract activities

through the establishment of policies and proce-

dures covering organizational structure, segre-

gation of duties, operating and accounting sys-

tem controls, and comprehensive management

reporting. Formal written procedures should be

in place in connection with purchases and sales,

processing, accounting, clearance and safekeep-

ing activities relating to these transactions. In

general, these procedures should be designed to

ensure that all ﬁnancial contracts are properly

recorded and that senior management is aware

of the exposure and gains or losses resulting

from these activities. Some examples of desir-

able controls follow:

1. Written documentation indicating what types

of contracts are eligible for purchase by the

organization, which individual persons are

eligible to purchase and sell contracts, which

individual persons are eligible to sign con-

tracts or conﬁrmations, and the names of

ﬁrms or institutions with whom employees

are authorized to conduct business.

2. Written position limitations for each type of

contract established by the banking organiza-

tion’s board of directors and written proce-

dures for authorizing trades, if any, in excess

of those limits.

3. A system to monitor the organization’s expo-

sure with customers and those broker-

dealers and institutions eligible to do busi-

ness with it. To implement this, management

must determine the amount of credit risk

permissible with various parties and then

institute surveillance procedures to ensure

that such limits are not exceeded with-

out written authorization from senior

management.

4. Separation of duties and supervision to

ensure that persons executing transactions

are not involved in approving the accounting

media and/or making accounting entries.

Further, persons executing transactions

should not have authority to sign incoming

or outgoing conﬁrmations or contracts, rec-

oncile records, clear transactions, or control

the disbursement of margin payments.

5. A clearly deﬁned ﬂow of order tickets and

conﬁrmations. Conﬁrmations generated

should, preferably, be prenumbered. In addi-

tion to promptly recording all commitments

in a daily written commitment ledger, the

related documentation should be ﬁled sepa-

rately for purposes of audit and examination.

The ﬂow of conﬁrmations and order tickets

should be designed to verify accuracy and

enable reconciliations throughout the system,

for example, to ensure that a person could

not execute unauthorized transactions and

bypass part of the accounting system, and to

enable the reconcilement of traders’ position

reports to those positions maintained by an

operating unit.

6. Procedures to route incoming conﬁrmations

to an operations unit separate from the trad-

ing unit. Conﬁrmations received from bro-

kers, dealers, or others should be compared

to conﬁrmations (or other control records)

prepared by the banking organization to

ensure that it will not accept or make deliv-

ery of securities, or remit margin payments,

pursuant to contracts unless there is proper

authorization and documentation.

7. Procedures for promptly resolving fails to

receive or fails to deliver securities on the

date securities are due to be received or sent

pursuant to contracts.

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1998

Page 29

8. Procedures for resolving customer com-

plaints by someone other than the person

who executed the contract.

9. Procedures for verifying brokers’ reports of

margin deposits and contract positions (use

an outside pricing source), and reconciling

such reports to the records.

10. Procedures for daily review of outstanding

contracts and supervision of traders. In

addition, there should be periodic reports to

management reﬂecting the margin deposits

and contract positions.

11. Selecting and training competent person-

nel to follow the written policies and

guidelines.

2130.0.16.2 Internal Audit

The scope and frequency of the internal audit

program should be designed to review the inter-

nal control procedures and verify that the inter-

nal controls purported to be in effect are being

followed. Further, the internal auditor should

verify that there are no material inadequacies in

the internal control procedures that would per-

mit a person acting individually to perpetrate

errors or irregularities involving the records of

the organization or assets that would not be

detected by the internal control procedures in

time to prevent material loss or misstatement of

the banking organization’s ﬁnancial statements

or serious violation of applicable banking, bank

holding company, or securities rules or regula-

tions. Any weaknesses in internal control proce-

dures should be reported to management, along

with recommendations for corrective action. If

internal auditors do not report to an audit com-

mittee, the person to whom they report should

not be in a position to misappropriate assets.

In addition, auditors should occasionally spot-

check contract prices and mark-to-market

adjustments.

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BHC Supervision Manual December 1998

Page 30

2130.0.17 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Statement of policy concerning bank

holding companies engaging in

futures, forward, and options

contracts on U.S. government and

agency securities and money market

instruments

225.142 4–830

Policy Statement on Financial

Contracts

3–1535

Supervisory Policy Statement on

Investment Securities and

End-User Derivatives Activities

3–1562

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Futures, Forward, and Option Contracts 2130.0

BHC Supervision Manual December 1998

Page 31

Securities Lending

Section 2140.0

Financial institutions, including bank holding

company subsidiaries, are lending securities

with increasing frequency, and, in some

instances, a ﬁnancial institution may lend its

own investment or trading-account securities.

Financial institutions lend customers’ securities

held in custody, safekeeping, trust, or pension

accounts. Because the securities available for

lending often greatly exceed the demand for

them, inexperienced lenders may be tempted to

ignore commonly recognized safeguards. Bank-

ruptcies of broker-dealers have heightened regu-

latory sensitivity to the potential for problems in

this area.

2140.0.1 SECURITIES-LENDING

MARKET

Securities brokers and commercial banks are the

primary borrowers of securities. They borrow

securities to cover securities fails (securities sold

but not available for delivery), short sales, and

option and arbitrage positions. Securities lend-

ing, which used to involve principally corporate

equities and debt obligations, increasingly

involves loans of large blocks of U.S. govern-

ment and federal-agency securities.

Securities lending is conducted through open-

ended ‘‘loan’’ agreements, which may be termi-

nated on short notice by the lender or borrower.

Repurchase agreements are generally used by

owners of securities as ﬁnancing vehicles and,

in certain respects, are closely analogous to

securities lending. The objective of securities

lending, however, is to receive a safe return in

addition to the normal interest or dividends.

Securities loans in industry practice are gener-

ally collateralized by U.S. government or

federal-agency securities, cash, or letters of

credit.

At the outset, each loan is collateralized

at a predetermined margin. If the market value

of the collateral falls below an acceptable level

during the time a loan is outstanding, a margin

call is made by the lender institution. If a loan

becomes over-collateralized because of appreci-

ation of collateral or market depreciation of a

loaned security, the borrower usually has the

opportunity to request the return of any exces-

sive margin.

When a securities loan is terminated, the

securities are returned to the lender and the

collateral to the borrower. Fees received on

securities loans are divided between the lender

and the customer account that owns the securi-

ties. In situations involving cash collateral, part

of the interest earned on the temporary invest-

ment of cash is returned to the borrower, and the

remainder is divided between the lender and the

customer account that owns the securities.

2140.0.2 DEFINITIONS OF CAPACITY

Securities lending may be done in various

capacities and with differing associated liabili-

ties. It is important that all parties involved

understand in what capacity the lender is acting.

For the purposes of these guidelines, the rel-

evant capacities are as follows:

1. Principal. A lender offering securities from

its own account is acting as principal. A

lender institution offering customers’ securi-

ties on an undisclosed basis is also consid-

ered to be acting as principal.

2. Agent. A lender offering securities on behalf

of a customer-owner is acting as an agent.

For the lender to be considered a bona ﬁde or

‘‘fully disclosed’’ agent, it must disclose the

names of the borrowers to the customer-own-

ers (or give notice that names are available

upon request), and must disclose the names

of the customer-owner to borrowers (or give

notice that names are available upon

request). In all cases, the agent’s compensa-

tion for handling the transaction should be

disclosed to the customer-owner. Undis-

closed agency transactions, that is, ‘‘blind

brokerage’’ transactions in which partici-

pants cannot determine the identity of the

contra party, are treated as if the lender was

the principal.

3. Directed agent. A lender which lends securi-

ties at the direction of the customer-owner is

acting as a directed agent. The customer

directs the lender in all aspects of the transac-

tion, including to whom the securities are

loaned, the terms of the transaction (rebate

rate and maturity/call provisions on the loan),

acceptable collateral, investment of any cash

collateral, and collateral delivery.

4. Fiduciary. A lender which exercises discre-

tion in offering securities on behalf of and for

the beneﬁt of customer-owners is acting as a

ﬁduciary. For purposes of these guidelines,

1. Broker-dealers borrowing securities are subject to the

restrictions of the Federal Reserve’s Regulation T (12 C.F.R.

220.10), which speciﬁes acceptable borrowing purposes.

BHC Supervision Manual December 1998

Page 1

the underlying relationship may be as agent,

trustee, or custodian.

5. Finder. A ﬁnder brings together a borrower

and a lender of securities for a fee. Finders

do not take possession of the securities or

collateral. Delivery of securities and collat-

eral is direct between the borrower and the

lender, and the ﬁnder does not become

involved. The ﬁnder is simply a fully dis-

closed intermediary.

2140.0.3 GUIDELINES

All bank holding companies or their subsidi-

aries that participate in securities lending should

establish written policies and procedures gov-

erning these activities. Other than commercial

banks with trust departments, the bank holding

company subsidiaries most likely to be engaged

in securities lending are non-deposit-taking trust

companies and certain discount brokers which

provide custody services and make margin

loans. At a minimum, policies and proce-

dures should cover each of the topics in these

guidelines.

2140.0.3.1 Recordkeeping

Before establishing a securities-lending pro-

gram, a ﬁnancial ﬁrm or institution must estab-

lish an adequate recordkeeping system. At a

minimum, the system should produce daily

reports showing which securities are available

for lending, and which are currently lent, out-

standing loans by borrower, outstanding loans

by account, new loans, returns of loaned securi-

ties, and transactions by account. These records

should be updated as often as necessary to

ensure that the lender institution fully accounts

for all outstanding loans, that adequate collat-

eral is required and maintained, and that policies

and concentration limits are being followed.

2140.0.3.2 Administrative Procedures

All securities lent and all securities standing as

collateral must be marked to market daily. Pro-

cedures must ensure that any necessary calls for

additional margin are made on a timely basis.

In addition, written procedures should outline

how to choose the customer account that will be

the source of lent securities when they are held

in more than one account. Possible methods

include loan volume analysis, automated queue,

a lottery, or some combination of these. Securi-

ties loans should be fairly allocated among all

accounts participating in a securities-lending

program.

Internal controls should include operating

procedures designed to segregate duties and

timely management reporting systems. Periodic

internal audits should assess the accuracy of

accounting records, the timeliness of manage-

ment reports, and the lender’s overall compli-

ance with established policies and the ﬁrm’s

procedures.

2140.0.3.3 Credit Analysis and Approval

of Borrowers

In spite of strict standards of collateralization,

securities-lending activities involve risk of loss.

Such risks may arise from malfeasance or fail-

ure of the borrowing ﬁrm or institution. There-

fore, a duly established management or super-

visory committee of the lender should formally

approve, in advance, transactions with any

borrower.

Credit and limit approvals should be based

upon a credit analysis of the borrower. A review

should be performed before establishing such a

relationship and reviews should be conducted at

regular intervals thereafter. Credit reviews

should include an analysis of the borrower’s

ﬁnancial statement, and should consider capital-

ization, management, earnings, business reputa-

tion, and any other factors that appear relevant.

Analyses should be performed in an indepen-

dent department of the lender, by persons who

routinely perform credit analyses. Analyses per-

formed solely by the person(s) managing the

securities-lending program are not sufﬁcient.

2140.0.3.4 Credit and Concentration

Limits

After the initial credit analysis, management of

the lender should establish an individual credit

limit for the borrower. That limit should be

based on the market value of the securities to be

borrowed, and should take into account possible

temporary (overnight) exposures resulting from

a decline in collateral values or from occasional

inadvertent delays in transferring collateral.

Credit and concentration limits should take into

account other extensions of credit by the lender

to the same borrower or related interests.

Securities Lending 2140.0

BHC Supervision Manual December 1998

Page 2

Procedures should be established to ensure

that credit and concentration limits are not

exceeded without proper authorization from

management.

2140.0.3.5 Collateral Management

Securities borrowers generally pledge and main-

tain collateral at a level equal to at least 100 per-

cent of the value of the securities borrowed.

The minimum amount of excess collateral, or

‘‘margin,’’ acceptable to the lender should relate

to price volatility of the loaned securities and

the collateral (if other than cash).

Generally,

the minimum initial collateral on securities loans

is at least 102 percent of the market value of the

lent securities plus, for debt securities, any

accrued interest.

Collateral must be maintained at the agreed

margin. A daily ‘‘mark-to-market’’ or valuation

procedure must be in place to ensure that calls

for additional collateral are made on a timely

basis. The valuation procedures should take into

account the value of accrued interest on debt

securities.

Securities should not be lent unless collateral

has been received or will be received simultane-

ously with the loan. As a minimum step toward

perfecting the lender’s interest, collateral should

be delivered directly to the lender or an indepen-

dent third-party trustee.

2140.0.3.6 Cash as Collateral

When cash is used as collateral, the lender is

responsible for making it income productive.

Lenders should establish written guidelines for

selecting investments for cash collateral. Gener-

ally, a lender will invest cash collateral in repur-

chase agreements, master notes, a short-term

investment fund (STIF), U.S. or Eurodollar cer-

tiﬁcates of deposit, commercial paper, or some

other type of money market instrument. If the

lender is acting in any capacity other than as

principal, the written agreement authorizing the

lending relationship should specify how cash

collateral is to be invested.

Using cash collateral to pay for liabilities of

the lender or its holding company would be an

improper conﬂict of interest unless that strategy

was speciﬁcally authorized in writing by the

owner of the lent securities.

2140.0.3.7 Letters of Credit as Collateral

If a lender plans to accept letters of credit as

collateral, it should establish guidelines for their

use. Those guidelines should require a credit

analysis of the banks issuing the letter of credit

before securities are lent against that collateral.

Analyses must be periodically updated and

reevaluated. The lender should also establish

concentration limits for the banks issuing letters

of credit, and procedures should ensure they are

not exceeded. In establishing concentration lim-

its on letters of credit accepted as collateral, the

lender’s total outstanding credit exposures from

the issuing bank should be considered.

2140.0.3.8 Written Agreements

Securities should be lent only pursuant to a

written agreement between the lender and the

owner of the securities, speciﬁcally authorizing

the institution to offer the securities for loan.

The agreement should outline the lender’s

authority to reinvest cash collateral (if any) and

responsibilities with regard to custody and valu-

ation of collateral. In addition, the agreement

should detail the fee or compensation that will

go to the owner of the securities in the form of a

fee schedule or other speciﬁc provision. Other

items which should be covered in the agreement

have been discussed earlier in these guidelines.

A lender must also have written agreements

with the parties who wish to borrow securities.

These agreements should specify the duties and

responsibilities of each party. A written agree-

ment may detail acceptable types of collateral

(including letters of credit); standards for collat-

eral custody and control, collateral valuation

and initial margin, accrued interest, marking to

market, and margin calls; methods for transmit-

ting coupon or dividend payments received if a

security is on loan on a payment date; condi-

tions which will trigger the termination of a loan

2. Employee beneﬁt plans subject to the Employee Retire-

ment Income Security Act are speciﬁcally required to collater-

alize securities loans at a minimum of 100 percent of the

market value of loaned securities (see section 2140.0.3.10

below).

3. The level of margin should be dictated by level of risk

being underwritten by the securities lender. Factors to be

considered in determining whether to require margin above

the recommended minimum include the type of collateral, the

maturity of collateral and lent securities, the term of the

securities loan, and the costs which may be incurred when

liquidating collateral and replacing loaned securities.

Securities Lending 2140.0

BHC Supervision Manual December 1998

Page 3

(including events of default); and acceptable

methods of delivery for loaned securities and

collateral.

2140.0.3.9 Use of Finders

Some lenders may use a ﬁnder to place securi-

ties, and some ﬁnancial institutions may act as

ﬁnders. A ﬁnder brings together a borrower and

a lender for a fee. Finders should not take pos-

session of securities or collateral. The delivery

of securities loaned and collateral should be

direct between the borrower and the lender. A

ﬁnder should not be involved in the delivery

process.

The ﬁnder should act only as a fully disclosed

intermediary. The lender must always know the

name and ﬁnancial condition of the borrower of

any securities it lends. If the lender does not

have that information, it and its customers are

exposed to unnecessary risks.

Written policies should be in place concern-

ing the use of ﬁnders in a securities-lending

program. These policies should cover circum-

stances in which a ﬁnder will be used, which

party pays the fee (borrower or lender), and

which ﬁnders the lender institution will use.

2140.0.3.10 Employee Beneﬁt Plans

The Department of Labor has issued two class

exemptions which deal with securities-lending

programs for employee beneﬁt plans covered by

the Employee Retirement Income Security Act

(ERISA): Prohibited Transaction Exemption

81-6 (46 FR 7527 (January 23, 1981) and cor-

rection (46 FR 10570 (February 3, 1981))), and

Prohibited Transaction Exemption 82-63 (47 FR

14804 (April 6, 1982)). The exemptions autho-

rize transactions which might otherwise consti-

tute unintended ‘‘prohibited transactions’’ under

ERISA. Any ﬁrm engaged in the lending of

securities for an employee beneﬁt plan subject

to ERISA should take all steps necessary to

design and maintain its program to conform

with these exemptions.

Prohibited Transaction Exemption 81-6 per-

mits the lending of securities owned by

employee beneﬁt plans to persons who could be

‘‘parties in interest’’ with respect to such plans,

provided certain conditions speciﬁed in the

exemption are met. Under those conditions,

neither the borrower nor an afﬁliate of the bor-

rower can have discretionary control over the

investment of plan assets, or offer investment

advice concerning the assets, and the loan must

be made pursuant to a written agreement. The

exemption also establishes a minimum accept-

able level for collateral based on the market

value of the loaned securities.

Prohibited Transaction Exemption 82-63 per-

mits compensation of a ﬁduciary for services

rendered in connection with loans of plan assets

that are securities. The exemption details certain

conditions which must be met.

2140.0.3.11 Indemniﬁcation

Certain lenders offer participating accounts

indemniﬁcation against losses in connection

with securities-lending programs. Such indem-

niﬁcations may cover a variety of occurences

including all ﬁnancial loss, losses from a bor-

rower default, or losses from collateral default.

Lenders that offer such indemniﬁcation should

obtain a legal opinion from counsel concerning

the legality of their speciﬁc form of indemniﬁ-

cation under federal and/or state law.

A lender which offers an indemnity to its

customers may, in light of other related factors,

be assuming the beneﬁts and, more importantly,

the liabilities of a principal. Therefore, lenders

offering indemniﬁcation should also obtain writ-

ten opinions from their accountants concerning

the proper ﬁnancial statement disclosure of their

actual or contingent liabilities.

Securities Lending 2140.0

BHC Supervision Manual December 1998

Page 4

2140.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Securities Lending policy

statement of the Federal

Financial Institutions

Examination Council,

adopted by the Federal

Reserve Board on May 6,

1985

3–1579.5

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Securities Lending 2140.0

BHC Supervision Manual December 1998

Page 5

Repurchase Transactions

Section 2150.0

Depository institutions and others involved with

the purchase of United States Government and

Agency obligations under agreements to resell

(reverse repurchase agreements),

have some-

times incurred signiﬁcant losses. The most

important factors causing these heavy losses

have been inadequate credit risk management

and the failure to exercise effective control over

securities collateralizing the transactions.

The following minimum guidelines address

the need for managing credit risk exposure to

counterparties under securities repurchase

agreements and for controlling the securities in

those transactions, and should be followed when

entering into repurchase agreements with securi-

ties dealers and others.

Depository institutions and nonbank subsidi-

aries that actively engage in repurchase agree-

ments are encouraged to have more comprehen-

sive policies and controls to suit their particular

circumstances. The examining staffs of the Fed-

eral Reserve should review written policies and

procedures of dealers to determine their

adequacy in light of these minimum guidelines

and the scope of each subsidiary’s operations.

2150.0.1 CREDIT POLICY

GUIDELINES

The apparent safety of short-term repurchase

agreements which are collateralized by highly

liquid, U.S. Government and Federal agency

obligations has contributed to an attitude of

complacency. Some portfolio managers have

underestimated the credit risk associated with

the performance of the counterparty to the trans-

actions, and have not taken adequate steps to

assure control of the securities covered by the

agreement.

All ﬁrms that engage in securities repurchase

agreement transactions should establish written

credit policies and procedures governing these

activities. At a minimum, those policies and

procedures should cover the following:

Written policies should establish ‘‘know your

counterparty’’ principles. Engaging in repur-

chase agreement transactions in volume and in

large dollar amounts frequently requires the ser-

vices of a counterparty who is a dealer in the

underlying securities. Some ﬁrms which deal in

the markets for U.S. Government and Federal

agency securities are subsidiaries of, or related

to, ﬁnancially stronger and better known ﬁrms.

However, these stronger ﬁrms may be indepen-

dent of their U.S. Government securities subsid-

iaries and afﬁliates and may not be legally obli-

gated to stand behind the transactions of related

companies. Without an express guarantee, the

stronger ﬁrm’s ﬁnancial position cannot be

relied upon in assessing the creditworthiness of

a counterparty.

It is important to know the legal entity that is

the actual counterparty to each repurchase

agreement transaction. Know about the actual

counterparty’s character, integrity of manage-

ment, activities, and the ﬁnancial markets in

which it deals. Be particularly careful in con-

ducting repurchase agreements with any ﬁrm

that offers terms that are signiﬁcantly more

favorable than those currently prevailing in the

market.

In certain situations ﬁrms may use, or serve

as, brokers or ﬁnders in order to locate repur-

chase agreement counterparties or particular

securities. When using or acting as this type of

agent the names of each counterparty should be

fully disclosed. Do not enter into undisclosed

agency or ‘‘blind brokerage’’ repurchase trans-

actions in which the counterparty’s name is not

disclosed.

2150.0.1.1 Dealings with Unregulated

Securities Dealers

A dealer in U.S. Government and Federal

agency obligations is not necessarily a Federally

insured bank or thrift, or a broker/dealer regis-

tered with the Securities and Exchange Com-

1. A repurchase agreement is a transaction involving the

sale of assets by one party to another, subject to an agreement

by the seller to repurchase the assets at a speciﬁed date or in

speciﬁed circumstances.

2. In order to avoid confusion among market participants

who sometimes use the same term to describe different sides

of the same transaction, the term ‘‘repurchase agreement’’

will be used in the balance of this statement to refer to both

repurchase and reverse repurchase agreements. A repurchase

agreement is one in which a party that owns securities

acquires funds by transferring the securities to another party

under an agreement to repurchase the securities at an agreed

upon future date. A reverse repurchase (resale) agreement is

one in which a party provides funds by acquiring securities

pursuant to an agreement to resell them at an agreed upon

future date.

3. Throughout this document repurchase agreements are

generally discussed in terms of secured credit transactions.

This usage should not be deemed to be based upon a legal

determination.

BHC Supervision Manual December 1992

Page 1

mission. Therefore, the dealer ﬁrm may not

be subject to any Federal regulatory oversight.

A ﬁrm doing business with an unregulated

securities dealer should be certain that the dealer

voluntarily complies with the Federal Reserve

Bank of New York’s minimum capital guide-

line, which currently calls for liquid capital to

exceed measured risk by 20 percent (that is, the

ratio of a dealer’s liquid capital to risk of 1.2:1).

This ratio can be calculated by a dealer using

either the Securities and Exchange Commis-

sion’s Net Capital Rule for Brokers and Dealers

(Rule 15c31) or the Federal Reserve Bank of

New York’s Capital Adequacy Guidelines for

United States Government Securities Dealers.

To ensure that an unregulated dealer complies

with either of those capital standards, it should

certify its compliance with the capital standard

and provide the following three forms of

certiﬁcation:

1. A letter of certiﬁcation from the dealer

that the dealer will adhere on a continuous basis

to the capital adequacy standard;

2. Audited ﬁnancial statements which dem-

onstrate that as of the audit date the dealer was

in compliance with the standard and the amount

of liquid capital; and

3. A copy of a letter from the ﬁrm’s certiﬁed

public accountant stating that it found no mate-

rial weaknesses in the dealer’s internal sys-

tems and controls incident to adherence to the

standard.

Periodic evaluations of counterparty credit-

worthiness should be conducted by individuals

who routinely make credit decisions and who

are not involved in the execution of repurchase

agreement transactions.

Prior to engaging in initial transactions with a

new counterparty, obtain audited ﬁnancial state-

ments and regulatory ﬁlings (if any) from coun-

terparties, and insist that similar information be

provided on a periodic and timely basis in the

future. Recent failures of government securities

dealers have typically been foreshadowed by

delays in producing these statements. Many

ﬁrms are registered with the Securities and

Exchange Commission as broker/dealers and

have to ﬁle ﬁnancial statements and should be

willing to provide a copy of these ﬁlings.

The counterparty credit analysis should con-

sider the ﬁnancial statements of the entity that is

to be the counterparty as well as those of any

related companies that could have an impact on

the ﬁnancial condition of the counterparty.

When transacting business with a subsidiary,

consolidated ﬁnancial statements of a parent are

not adequate. Repurchase agreements should not

be entered into with any counterparty that is

unwilling to provide complete and timely dis-

closure of its ﬁnancial condition. As part of this

analysis, the ﬁrm should make inquiry about the

counterparty’s general reputation and whether

there have been any formal enforcement actions

against the counterparty or its afﬁliates by State

or Federal securities regulators.

Maximum position and temporary exposure

limits for each approved counterparty should be

established based upon credit analysis per-

formed. Periodic reviews and updates of those

limits are necessary.

Individual repurchase agreement counterparty

limits should consider overall exposure to the

same or related counterparty. Repurchase agree-

ment counterparty limitations should include the

overall permissible dollar positions in repur-

chase agreements, maximum repurchase agree-

ment maturities and limits on temporary expo-

sure that may result from decreases in collateral

values or delays in receiving collateral.

2150.0.2 GUIDELINES FOR

CONTROLLING REPURCHASE

AGREEMENT COLLATERAL

Repurchase agreements can be a useful asset

and liability management tool, but repurchase

agreements can expose a ﬁrm to serious risks if

they are not managed appropriately. It is pos-

sible to reduce repurchase agreement risk by

negotiating written agreements with all repur-

chase agreement counterparties and custodian

banks. Compliance with the terms of these writ-

ten agreements should be monitored on a daily

basis. If prudent management control require-

ments of repurchase agreements are too burden-

some, other asset/liability management tools

should be used.

The marketplace perceives repurchase agree-

ment transactions as similar to lending transac-

tions collateralized by highly liquid Govern-

ment securities. However, experience has shown

that the collateral securities will probably not

serve as protection if the counterparty becomes

insolvent or fails, and the purchasing ﬁrm does

not have control over the securities. Ultimate

responsibility for establishing adequate control

procedures rests with management of the ﬁrm.

Management should obtain a written legal opin-

4. This letter should be similar to that which must be given

to the SEC by registered broker/dealers.

Repurchase Transactions 2150.0

BHC Supervision Manual December 1992

Page 2

ion as to the adequacy of the procedures utilized

to establish and protect the ﬁrm’s interest in the

underlying collateral.

A written agreement speciﬁc to a repurchase

agreement transaction or master agreement gov-

erning all repurchase agreement transactions

should be entered into with each counterparty.

The written agreement should specify all the

terms of the transaction and the duties of both

the buyer and seller. Senior managers should

consult legal counsel regarding the content of

the repurchase and custodial agreements. The

repurchase and custodial agreements should

specify, but should not be limited to, the

following:

• Acceptable types and maturities of collateral

securities;

• Initial acceptable margin for collateral securi-

ties of various types and maturities

• Margin maintenance, call, default and sellout

provisions;

• Rights to interest and principal payments;

• Rights to substitute collateral; and

• The persons authorized to transact business

on behalf of the ﬁrm and its counterparty.

2150.0.2.1 Conﬁrmations

Some repurchase agreement conﬁrmations may

contain terms that attempt to change the ﬁrm’s

rights in the transaction. The ﬁrm should obtain

and compare written conﬁrmations for each

repurchase agreement transaction to be certain

that the information on the conﬁrmation is con-

sistent with the terms of the agreement. The

conﬁrmation should identify speciﬁc collateral

securities.

2150.0.2.2 Control of Securities

As a general rule, a ﬁrm should obtain posses-

sion or control of the underlying securities and

take necessary steps to protect its interest in the

securities. The legal steps necessary to protect

its interest may vary with applicable facts and

law and accordingly should be undertaken with

the advice of counsel. Additional prudential

management controls may include:

• delivery of either physical securities to, or in

the case of book entry securities, making

appropriate entries in the books of a third

party custodian designated under a written

custodial agreement which explicitly recog-

nizes the ﬁrm’s interest in the securities as

superior to that of any other person; or

• appropriate entries on the books of a third

party custodian acting pursuant to a tripartite

agreement with the ﬁrm and the counterparty,

ensuring adequate segregation and identi-

ﬁcation of either physical or book-entry

securities.

Where control of the underlying securities is

not established, the ﬁrm may be regarded only

as an unsecured general creditor of the insolvent

counterparty. In such instance, substantial losses

are likely to be incurred. Accordingly, a ﬁrm

should not enter into a repurchase agreement

without obtaining control of the securities unless

all of the following minimum procedures are

observed: (1) it is completely satisﬁed as to the

creditworthiness of the counterparty; (2) the

transaction is within credit limitations that have

been pre-approved by the board of directors, or

a committee of the board, for unsecured transac-

tions with the counterparty; (3) periodic credit

evaluations of the counterparty are conducted;

and (4) the ﬁrm has ascertained that collateral

segregation procedures of the counterparty are

adequate. Unless prudential internal procedures

of these types are instituted and observed, the

ﬁrm may be cited for engaging in unsafe or

unsound practices.

All receipts and deliveries of either physical

or book-entry securities should be made accord-

ing to written procedures, and third party deliv-

eries should be conﬁrmed in writing directly by

the custodian. It is not acceptable to receive

conﬁrmation from the counterparty that the

securities are segregated in a ﬁrm’s name with a

custodian; the ﬁrm should, however, obtain a

copy of the advice of the counterparty to the

custodian requesting transfer of the securities to

the ﬁrm. Where securities are to be delivered,

payment for securities should not be made until

the securities are actually delivered to the ﬁrm

or its agent. The custodial contract should pro-

vide that the custodian takes delivery of the

securities subject to the exclusive direction of

the ﬁrm.

Substitution of securities should not be

allowed without the prior consent of the ﬁrm.

The ﬁrm should give its consent before the

delivery of the substitute securities to it or a

third party custodian. Any substitution of securi-

ties should take into consideration the following

discussion of ‘‘margin requirements.’’

Repurchase Transactions 2150.0

BHC Supervision Manual December 1992

Page 3

2150.0.2.3 Margin Requirements

The amount paid under the repurchase agree-

ment should be less than the market value of the

securities, including the amount of any accrued

interest, with the difference representing a pre-

determined margin. Factors to be considered in

establishing an appropriate margin include the

size and maturity of the repurchase transaction,

the type and maturity of the underlying securi-

ties, and the creditworthiness of the counter-

party. Margin requirements on U.S. Government

and Federal agency obligations underlying

repurchase agreements should allow for the

anticipated price volatility of the security until

the maturity of the repurchase agreement. Less

marketable securities may require additional

margin to compensate for less liquid market

conditions. Written repurchase agreement poli-

cies and procedures should require daily mark-

to-market of repurchase agreement securities to

the bid side of the market. Repurchase agree-

ments should provide for additional securities or

cash to be placed with the ﬁrm or its custodian

bank to maintain the margin within the predeter-

mined level.

Margin calculations should also consider

accrued interest on underlying securities and the

anticipated amount of accrued interest over the

term of the repurchase agreement, the date of

interest payment and which party is entitled to

receive the payment. In the case of pass-through

securities, anticipated principal reductions

should also be considered when determining

margin adequacy.

Prudent management procedures should be

followed in the administration of any repurchase

agreement. Longer term repurchase agreements

require management’s daily attention to the

effects of securities substitutions, margin main-

tenance requirements (including consideration

of any coupon interest or principal payments)

and possible changes in the ﬁnancial condition

of the counterparty. Engaging in open repur-

chase agreement transactions without maturity

dates may be regarded as an unsafe and unsound

practice unless the ﬁrm has retained rights to

terminate the transaction quickly to protect itself

against changed circumstances. Similarly, auto-

matic renewal of short-term repurchase agree-

ment transactions without reviewing collateral

values and adjusting collateral margin may

be regarded as an unsafe and unsound practice.

If additional margin is not deposited when

required, the ﬁrm’s rights to sell securities or

otherwise liquidate the repurchase agreement

should be exercised without hesitation.

2150.0.2.4 Overcollateralization

A ﬁrm should use current market values, includ-

ing the amount of any accrued interest, to deter-

mine the price of securities that are sold under

repurchase agreements. Counterparties should

not be provided with excessive margin. Thus,

the written repurchase agreement contract

should provide that the counterparty must make

additional payment or return securities if the

margin exceeds agreed upon levels. When

acquiring funds under repurchase agreements it

is prudent business practice to keep at a reason-

able margin the difference between the market

value of the securities delivered to the counter-

party and the amount borrowed. The excess

market value of securities sold may be viewed

as an unsecured loan to the counterparty subject

to the unsecured lending limitations for the ﬁrm

and should be treated accordingly for credit

policy and control purposes.

2150.0.3 OPERATIONS

A ﬁrm’s operational functions should be

designed to regulate the custody and movement

of securities and to adequately account for trad-

ing transactions. Because of the dollar volume

and speed of trading activities, operational inef-

ﬁciencies can quickly result in major problems.

In some cases, a ﬁrm may not receive or

deliver a security by settlement date. When a

ﬁrm fails to receive a security by the settlement

date, a liability exists until the transaction is

consummated or cancelled. When the security is

not delivered to the contra-party by settlement

date, a receivable exists until that ‘‘fail’’ is

resolved. ‘‘Fails’’ to deliver for an extended

time, or a substantial number of cancellations,

are sometimes characteristic of poor operational

control or questionable trading activities.

Fails should be controlled by prompt report-

ing and follow-up procedures. The use of multi-

copy conﬁrmation forms enables operational

personnel to retain and ﬁle a copy by settlement

date and should allow for prompt fail reporting

and resolution.

Repurchase Transactions 2150.0

BHC Supervision Manual December 1992

Page 4

2150.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Federal Financial

Institutions Examination

Council policy statement,

adopted by the Federal

Reserve Board on

November 12, 1985, on

repurchase agreements

3–1579

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Repurchase Transactions 2150.0

BHC Supervision Manual December 1992

Page 5

Recognition and Control of Exposure to Risk

Section 2160.0

Risk management is an important responsibility

of any bank holding company. The objective of

this responsibility is to determine and limit the

extent of the holding company organization’s

vulnerability to uncontrollable variables. While

all companies perform risk evaluation in some

form and exercise some degree of control over

its magnitude, the precise processes used differ

considerably across organizations in terms of

formality, extensiveness, and effectiveness. It

should be recognized that many organizations

have only an implicit risk evaluation process,

and that it may be appropriate to recommend

that this process be formalized. Ultimately, the

board of directors of the parent company should

be held accountable for the consolidated risk

evaluation and control.

Risk management at any level involves two

basic elements: evaluation and control. Risk

evaluation involves three steps: determination

of exposures; speciﬁcation of uncontrollable

variables that have an impact on each exposure;

and quantiﬁcation of the expected effect of each

variable on exposure. After the extent of exist-

ing or potential risk is determined, decisions to

limit or control risk are made. This procedure is

ever present, since most transactions create

exposure, and every exposure has some element

of risk. The following two sections discuss the

risk evaluation and the risk control processes in

very broad terms in an attempt to provide a

framework that can be applied to most organiza-

tions.

2160.0.1 RISK EVALUATION

The risk identiﬁcation process begins with a

determination of exposures that an institution

has to the environment.

Exposure conceptually occurs in every trans-

action undertaken by a banking organization.

Because of the magnitude of the list of potential

exposures, institutions generally limit their

efforts to extremely large exposures, to areas

where losses appear likely, and to activities

where the market is changing and new expo-

sures are created. The size of an exposure gener-

ally is dependent on the size of a transaction.

This is true both for transactions recorded on

accounting balance sheets and for those which

occur off balance sheet. Exposure is not neces-

sarily determined by the likelihood of loss. For

example, many holding company organizations

have a large ‘‘exposure’’ in Treasury bills, but

do not consider these transactions to be risky.

The list of exposures that banks commonly

identify has increased dramatically in the past

decade. Historically, the primary focus has been

on the exposure of the loan portfolio centering

on the ﬁnancial security of each individual loan;

recently industry and geographical exposure of

loans has increased in importance. The exposure

of ﬁxed assets, such as buildings, to ﬁres, ﬂoods

and other problems also has been recognized. In

more recent years, exposure of mismatched

maturities of assets and liabilities to interest rate

movements has increased in importance as

interest-rate movements have sharply ﬂuctu-

ated. While this exposure had always existed, it

had not been recognized as particularly danger-

ous until recently. Another example of an expo-

sure that historically was considered safe is

repurchase agreements backed by government

securities. When Drysdale Government Securi-

ties, Inc. failed, several risks were brought to

light—whether the instrument is a loan (that

would be tied up in case of bankruptcy) or a sale

and potential liability when serving as an agent

of a government securities ﬁrm that fails. A

particularly difﬁcult area to evaluate is exposure

to legal action. For example, a suit against a

bank over lending terms and representations is

difﬁcult to anticipate and the exposure could be

signiﬁcant.

Numerous exposures exist that many holding

company organizations may not recognize. For

example, the Federal Reserve System encour-

ages evaluation of wire transfer exposure. This

exposure is very large and theoretically a break-

down on the framework or compromise of inter-

nal systems could result in major failures. Expo-

sure from foreign exchange contracts also can

be large, and may not always be recognized.

Fraud and exposure of management to kidnap-

ping continue to increase in importance. And

ﬁnally, some major holding company organiza-

tions have found that dependence on short-term

market funds creates a risky exposure. When

access to a funding market may be suddenly

withdrawn, the exposure of the entire funding

process is an issue.

The second step of the risk identiﬁcation pro-

cess is speciﬁcation of the variables that could

affect an exposure and determination of what

the impact would be.

This process is difﬁcult, since any number of

variables may inﬂuence an exposure. Further-

more, as the environment changes new variables

BHC Supervision Manual December 1992

Page 1

may appear relevant and the effects of variables

may change. For example, the recent problems

of public sector lending to foreign countries

with loans denominated in dollars having ﬂoat-

ing interest rates during inﬂationary periods may

not have been fully evaluated at the time of the

lending process.

Determining inﬂuential variables is particu-

larly difﬁcult with new products. A historical

examination cannot be made of these new prod-

ucts and questions may go unanswered regard-

ing the stability of the new markets. For exam-

ple, problems have occurred in hedging

operations as underlying instruments did not

move as expected, thus negating the hedging

contract. Consequently, the hedge created an

exposure rather than reducing an exposure.

The ﬁnal step of the risk identiﬁcation process

is risk quantiﬁcation.

Conceptually, this involves calculation of an

expected loss of value related to variance of a

particular environmental factor. This has two

parts: (1) estimation of the probability that a

given variance will occur; and (2) determination

of the cost impact of each potential variance.

Probabilities are often drawn up in general

terms. In some cases historical records facilitate

estimation of probabilities. Measurement of

credit risk in an organization that specializes by

industry or geography may be an example of

this. In the most recent recession, however,

many past records have proven not to be accu-

rate predictors. In other situations, the holding

company organization may evaluate the effect

of a change but be unwilling to estimate prob-

abilities of the change occurring. An example

of this is managing asset and liability maturi-

ties. The effect of a change in interest rates on

proﬁts may be determined; but, in many cases,

institutions will not derive probabilities on the

direction and/or magnitude of interest rate

movements.

The difﬁculty of quantifying costs and prob-

abilities is exacerbated by emergence of new

products and by environmental changes. With a

new product, it is particularly difﬁcult to deter-

mine the cost of a variance. For example, atten-

tion to interest rate risk has induced organiza-

tions to resort to hedging to reduce exposure.

Innovative instruments are difﬁcult to hedge,

however, since the issuer may inaccurately

gauge price movements. In this case, the expo-

sure results not from price movements, but from

inability to predict the relationship between

market and price ﬂuctuations. Furthermore, as

the environment changes, the effect of a variable

on an exposure changes as does the cost and

probability of the occurrence. For example, in

the 1970’s the impact of inﬂation on the bank-

ing system would have been very different with-

out the concurrent economic downturn and the

technological advances.

2160.0.2 RISK CONTROL

After management has identiﬁed and evaluated

risk, they may decide the risk or cost of an

action is sufﬁciently low (and management is

conﬁdent all possible variables have been identi-

ﬁed) that the holding company can take on the

risk as it is; if not there are a number of options

that can be used to control the risk. Attempts to

control risk can be accomplished through a com-

bination of three general techniques: purchase

of insurance, limitation of exposure size, and

reduction of the expected cost associated with a

variance. The use of insurance to decrease the

effect of a loss on the corporation is common for

exposure to ﬁre, theft, kidnapping, and internal

fraud. Various types of loans are underwritten

by third parties. The innovative use of insurance

may prove to have various applications to risk

control in the banking industry. As with other

contracts, the ﬁnancial strength and reputation

of the counterparty (the insurer) are important,

and the organization’s method of selecting and

monitoring underwriters should be evaluated.

Management generally limits the level of

exposure in relationship to the size of assets,

capital or earnings. In most situations, relating

the level of exposure to capital would appear

appropriate. Reduction of exposure will auto-

matically reduce risk, assuming other variables

remain constant. Constraints should be deter-

mined by line management at a seniority level

commensurate with the degree of perceived risk.

Depending on the degree of risk, there may be a

need for the board of directors to approve the

constraints.

The third method of reducing the potential

loss to the corporation involves decreasing the

probability of a variance occurring or decreas-

ing the probable effect when a variance occurs.

This is exempliﬁed by the exposure to ﬁre.

Installation of ﬁre alarms and other precautions

could reduce the expected loss substantially.

Similarly, hedging with ﬁnancial futures is a

method used to reduce the effect of interest rate

movement on the proﬁts of the holding com-

pany organization when the maturities of assets

and liabilities are not equal.

Recognition and Control of Exposure to Risk 2160.0

BHC Supervision Manual December 1992

Page 2

The ﬁnal option management has, after risk

has been evaluated, is simply not to participate

in the activity if the risk is determined to be too

high for the expected return.

The inspection procedures should include a

broad-based evaluation of parent level risk man-

agement. Management’s effectiveness in identi-

fying risk, its willingness to accept risk, and its

ability to control risk should be regularly evalu-

ated. In an environment of rapid change and

emerging ﬁnancial instruments, there needs to

be sufﬁcient expertise to recognize the existence

of ‘‘new’’ sources of risk concentration to evalu-

ate the company’s command of those sources.

2160.0.3 INSPECTION OBJECTIVES

1. To review the risk evaluation and control

process.

2. To determine if management’s system of

identifying risks is effective, and if the parent

company is adequately informed of risks

throughout the organization.

3. To determine management’s recognition

of new risks that may arise from the changing

environment.

4. To determine the reasonableness of the

holding company’s exposure-risk ﬁgures.

5. To assess the effect on the holding com-

pany’s ﬁnancial condition if the risk ﬁgures are

realized.

6. To determine what actions are necessary

to rebalance transactions of a holding company

organization to a prudent level.

2160.0.4 INSPECTION PROCEDURES

1. Review the ﬁnancial condition and the

operations of the holding company organization

to detect substantive exposure-risk situations.

2. Review management’s policies, proce-

dures, and practices in recognizing exposure-

risk factors.

3. Determine awareness that all management

levels need to be cognizant of exposures related

to transactions of their respective operations.

4. Review the holding company’s exposure-

risk ﬁgures, or constraints placed on types of

transactions.

5. Discuss with management the signiﬁcance

of exposure-risks facing the holding company

and whether or not those risks are set at seem-

ingly prudent levels.

6. Recommend that the organization address

any areas where the holding company is per-

ceived to have assumed an imprudent level of

risk.

Recognition and Control of Exposure to Risk 2160.0

BHC Supervision Manual December 1992

Page 3

Sale of Uninsured Annuities

Section 2175.0

2175.0.1 INTRODUCTION

Banking organizations have become increas-

ingly involved in marketing third-party unin-

sured annuities to their retail customers either

directly or through third-party companies. As

annuity sales have grown, so have concerns that

some methods used to sell these instruments

could give purchasers the impression that the

annuities are federally insured deposits or that

they are obligations of a bank. In the event of

default by an annuities underwriter, this impres-

sion could cause a loss of public conﬁdence in a

depository institution, leading to unexpected

withdrawals and liquidity pressures. Moreover,

a bank or bank holding company that advertises

or markets annuities in a way viewed as mis-

leading could potentially be held liable for

losses sustained by annuity holders.

This manual section provides guidelines to

examiners for reviewing the sale of uninsured

annuities by bank holding companies and banks

that have legal authority to act as agent in the

sale of annuities. State member banks and bank

holding companies should not market, sell, or

issue uninsured annuities or allow third parties

to market, sell, or issue uninsured annuities on

depository-institution premises in a manner that

conveys the impression or suggestion that such

instruments are either (1) federally insured

deposits or (2) obligations of or guaranteed by

an insured depository institution. Consequently,

state member banks should not sell these instru-

ments at teller windows or other areas where

retail deposits are routinely accepted.

2175.0.2 PERMISSIBILITY OF

UNINSURED ANNUITY SALES

The legal status of annuities under the Bank

Holding Company Act is somewhat uncertain at

the present time. The Ofﬁce of the Comptroller

of the Currency has authorized national banks to

act as agent in the sale of annuities on the basis

that variable-rate annuities are securities and

ﬁxed-rate annuities are ﬁnancial investment

instruments.

These determinations, however,

have been challenged by insurance associations

on the basis that annuities are insurance prod-

ucts and, therefore, may be sold by national

banks only in a town of less than 5,000.

State member banks generally have been per-

mitted to engage in the brokerage of both

variable- and ﬁxed-rate annuities consistent with

their general corporate powers. In order to

engage in this activity without ﬁling a formal

application, staff has advised interested banks

that the brokerage of annuities must be

expressly authorized under state law (or by the

state banking regulatory agency on a case-by-

case basis) and constitute an activity incidental

to the bank’s banking activities.

The authority of state member banks to con-

tinue to engage in this activity, in the same

manner and subject to the conditions discussed

above, does not appear to depend on a resolu-

tion of the issues.

State member banks have

been permitted to engage in general insurance

agency activities since 1937,

and to engage in

brokerage activities under the same limitations

applicable to bank holding companies. In addi-

tion, the Board has determined that the nonbank-

ing restrictions in the Bank Holding Company

Act do not apply to the direct activities of banks

owned by a bank holding company.

The authority of bank holding companies to

engage directly or through a nonbanking subsid-

iary in the sale of annuities has not yet been

determined. In Norwest Corporation,

the Board

considered a proposal by a nonbanking afﬁliate

to engage in the sale of variable- and ﬁxed-rate

annuities. The Board concluded that, under the

speciﬁc facts of that case, it was unnecessary to

reach the question of whether the sale of annui-

ties is an insurance agency activity because Nor-

west is one of a small number of bank holding

companies entitled to act as agent in the

1. Interpretive Letter No. 331, April 4, 1985, reprinted in

[1985–1987 Transfer Binder] Fed. Banking L. Rep. (CCH)

¶ 85,501; OCC Interpretive Letter No. 499 (February 12,

1990), reprinted in [1989–1990] Fed. Banking L. Rep. (CCH)

¶ 83,090. National banks are authorized to buy and sell securi-

ties for the account of customers and broker ﬁnancial invest-

ment instruments.

2. The Variable Annuity Life Insurance Company v. Clarke,

No. H-91-1016 (S.D. Tex. ﬁled Apr. 16, 1991) (‘‘NCNB

litigation’’).

3. NCNB litigation.

4. Prior to 1937, the Board imposed as a condition of

membership in the Federal Reserve System that a bank dis-

continue all insurance activities other than insurance activities

in a town of less than 5,000. The purpose of this restriction

was to conform insurance activities allowed for state member

banks to those allowed for national banks.

5. Merchants National Corp., 75 Federal Reserve Bulletin

388 (1989), aff’d, 890 F.2d 1275 (2d Cir. 1989), cert. denied,

111 S. Ct. 44 (1990).

6. 76 Federal Reserve Bulletin 873 (1990).

BHC Supervision Manual June 1996

Page 1

sale of any type of insurance pursuant to

Exemption G of the Garn Act.

2175.0.3 CHARACTERISTICS OF

ANNUITY INSTRUMENTS

An annuity is an investment from which a per-

son receives periodic payments based on earlier

payments made to the obligor. Annuities are

commonly underwritten by insurance compa-

nies, then marketed and sold either directly or

through third parties, such as banks. Insurance

companies retain the actuarial and underwriting

risks on these annuities.

Annuities may be either variable or ﬁxed-

rate. An investor in a variable annuity contract

purchases a share in an investment portfolio and

then receives payments that vary according to

the performance of the portfolio. A purchaser

of a ﬁxed-rate annuity contract, in contrast,

receives a ﬁxed-rate payment or minimum level

of payments. Annuity payments can usually be

received monthly, quarterly, semi-annually, or

annually.

Variable- and ﬁxed-rate annuities may be pur-

chased in a single lump sum (‘‘single pre-

mium’’) or in periodic contributions (‘‘ﬂexible

premium’’). Minimum and maximum contribu-

tions to annuities vary among vendors. Some

single-premium annuities have ‘‘bail-out’’ fea-

tures which allow holders to withdraw all funds

if the rate of return on the annuity contract falls

below a speciﬁed rate.

The ability to take money out of an annuity

prior to maturity varies by product, as does the

imposition of a surrender penalty by the insurer

when withdrawal occurs prior to maturity. When

a penalty is imposed, the insurer generally cal-

culates the penalty as a percentage of the annu-

ity product’s accumulated value. The penalty

for withdrawal generally declines with the

annuity’s age. Normally, funds may not be with-

drawn prior to the ﬁrst anniversary date of the

annuity.

Annuities sold at depository institutions often

include rate guarantees over the life of the

instrument. They also frequently mature in one,

three, or ﬁve years, similar to maturity ranges

on certiﬁcates of deposit.

Insurance companies arrange for the sale of

annuities on the premises of depository institu-

tions in different ways. Some insurance compa-

nies approach banks directly. At other times,

wholesalers (who market the products of a

number of different insurance companies) may

approach a bank. Depending on state restric-

tions on insurance activities, sales might be

conducted by bank employees, employees of

bank subsidiary insurance agencies, or by third-

party insurance agents leasing space on the

bank’s premises.

Sales commissions on annuities vary by the

type of annuity. Commissions earned on single-

premium products generally vary from 4 percent

to 6 percent, but they decline sharply when the

product sold includes a ‘‘bail-out’’ provision.

Wholesalers may also give retailers a commis-

sion when the annuity is renewed, based on the

accumulated value of the annuity. Commissions

in some instances are paid on a variable basis,

rising as the volume of sales increases.

2175.0.4 IMPROPER MARKETING

PRACTICES

Banks have become involved in the sale of

uninsured annuities through marketing programs

designed to appeal speciﬁcally to their retail

customers. It is important that these programs

not employ marketing practices that could mis-

lead the bank’s customers. For example, the use

in annuities advertisements of terms such as

‘‘CD,’’ ‘‘deposit,’’ and ‘‘interest plan’’ to imply

that the instruments are insured deposits would

be inappropriate. Also, advertisements that

prominently display the bank’s name and logo

in a way that suggests the product is an obliga-

tion of the bank are similarly inappropriate.

Disclosure that the annuities are not federally

insured and are not obligations of the bank

should be displayed prominently in annuity con-

tracts and related documentation, on printed

7. The Garn Act amended section 4(c)(8) of the Bank

Holding Company Act to prohibit generally bank holding

companies from engaging in insurance activities as a princi-

pal, agent, or broker with certain exceptions. Under the

express language of the Garn Act, the sale of insurance is not

‘‘closely related to banking’’ and is not permissible for a bank

holding company unless it qualiﬁes under one of the seven

speciﬁed exceptions (Exemptions A–G) in the Garn Act.

Exemption G applies to a limited number of bank holding

companies that received approval from the Board prior to

January 1, 1971, to conduct insurance agency activities. In

order to utilize Exemption G or any other Garn Act exemp-

tions that may be applicable, the bank holding company must

ﬁle an application and would be subject to the proposed

restrictions through the application process.

8. If an investor withdraws tax-deferred income from an

annuity before the investor is 59

⁄

years old, the IRS levies a

tax penalty on the person equal to 10 percent of the amount of

tax-deferred income withdrawn. This penalty may be avoided

only if the person reinvests annuity proceeds in another tax-

deferred investment within 60 days of the withdrawal.

Sale of Uninsured Annuities 2175.0

BHC Supervision Manual June 1996

Page 2

advices, and verbally emphasized in telemarket-

ing contacts. Finally, personnel selling unin-

sured annuities should be distinguishable from

bank employees conducting normal retail

deposit-taking operations.

2175.0.5 INSPECTION OBJECTIVES

1. To review the marketing and sale of unin-

sured annuities sold by the bank holding com-

pany and its member banks, or those sold

through a third party.

2. To determine whether the bank holding

company and its banks have adequate policies

and procedures in place and if they are moni-

tored by the parent company.

3. To determine if, prior to agreeing to sell

annuities, a comprehensive ﬁnancial analysis is

made of the ﬁnancial condition of the annuities

underwriter and whether products of only ﬁnan-

cially secure underwriters are sold.

4. To determine whether the contract and

advertising and related documents disclose

prominently that the annuities do not represent

deposits or obligations of an insured depository

institution and that they are not insured by the

Federal Deposit Insurance Corporation.

5. To ascertain that annuities are not sold at

teller windows or other areas where deposits are

routinely accepted.

2175.0.6 INSPECTION PROCEDURES

1. Determine whether the bank holding com-

pany and its banks have adequate policies and

procedures in place:

a. to assess the ﬁnancial condition of the

annuities underwriter;

Banking organizations engaged in the

sale of annuities are expected to sell only prod-

ucts of ﬁnancially secure underwriters. Prior

to agreeing to sell annuities, a comprehensive

ﬁnancial analysis of the obligor should be per-

formed and reviewed with the banking organiza-

tion’s directors. The policies should also include

a program to evaluate the underwriter’s ﬁnan-

cial condition at least annually and to review the

credit ratings assigned to the underwriter by

the independent agencies evaluating annuity

underwriters.

b. to ensure that the marketing and sale of

uninsured annuities is not misleading and is

separated and distinguished from routine retail

deposit-taking activities.

(1) With regard to the sale of annuities,

determine whether the contract, advertising, and

all related documents disclose prominently in

bold print that the annuities:

(a) are not deposits or obligations of

an insured depository institution; and

(b) are not insured by the Federal

Deposit Insurance Corporation.

(2) State member banks should not sell

annuity instruments at teller windows or other

areas where retail deposits are routinely

accepted. In assessing the adequacy of disclo-

sures and the separation of the marketing and

sale of uninsured annuities from the retail

deposit-taking function, examiners should take

into account whether:

(a) advertisements do not contain

words, such as ‘‘deposit’’, ‘‘CD’’, etc., or a logo

that could lead an investor to believe an annuity

is an insured deposit instrument;

(b) the obligor of the annuity contract

is prominently disclosed, and names or logos of

the insured depository institution are not used in

a way that might suggest the insured depository

institution is the obligor;

made during telemarketing contacts and at the

time of sale;

(d) retail deposit-taking employees of

the insured depository institution are not

engaged in the promotion or sale of uninsured

annuities;

(e) information on uninsured annui-

ties is not contained in retail deposit statements

of customers or in the immediate retail deposit-

taking area;

(f) account information on annuities

owned by customers is not included on insured

deposit statements; and

(g) ofﬁcer or employee remuneration

associated with selling annuities is limited to

reasonable levels in relation to the individual’s

salary.

(3) If a bank allows a third-party entity

to market annuities on depository institution

premises, examiners should take into account

whether:

(a) the depository institution has

assured itself that the third-party company is

properly registered or licensed to conduct this

activity;

(b) depository institution personnel

are not involved in sales activities conducted by

the third party;

Sale of Uninsured Annuities 2175.0

BHC Supervision Manual December 1992

Page 3

market or sell annuities, are separate and dis-

tinctly identiﬁed as being used by an outside

party; and

(d) depository institution personnel

do not normally use desks or ofﬁces used by a

third party for annuities sales.

2. Determine that advertisements do not

prominently display the bank’s name and logo

that suggests the product is an obligation of a

BHC bank.

3. Determine whether the banks obtain a

signed statement from the customer indicating

that the customer understands that the annuity is

not a deposit or any other obligation of the

depository institution, that the depository insti-

tution is only acting as an agent for the insur-

ance company (underwriter), and that the annu-

ity is not FDIC insured.

Sale of Uninsured Annuities 2175.0

BHC Supervision Manual December 1992

Page 4

Support of Bank-Afﬁliated Investment Funds Section 2178.0

On January 5, 2004, the federal banking and

thrift agencies (the agencies) issued an inter-

agency policy to alert banking organizations,

including their boards of directors and senior

management, of the safety-and-soundness

implications of and the legal impediments to a

bank providing ﬁnancial support to investment

funds advised by the bank, its subsidiaries, or

afﬁliates (that is, afﬁliated investment funds).

banking organization’s investment advisory ser-

vices can pose material risks to the bank’s

liquidity, earnings, capital, and reputation and

can harm investors, if the associated risks are

not effectively controlled. In addition, bank-

afﬁliated investment advisers are encouraged to

establish alternative sources of ﬁnancial support

to avoid seeking support from afﬁliated banks.

(See SR letter 04-1, “Interagency Policy on

Banks/Thrifts Providing Financial Support to

Funds Advised by the Banking Organization,”

and SR letter 94-53, “Investment Adviser

Activities.”)

Banks are under no statutory requirement to

provide ﬁnancial support to the funds they

advise; however, circumstances may motivate

banks to do so for reasons of reputation risk and

liability mitigation. This type of support by

banking organizations to funds they advise

includes credit extensions, cash infusions, asset

purchases, and the acquisition of fund shares. In

very limited circumstances, certain arrange-

ments between banks and the funds they advise

have been expressly determined to be legally

permissible and safe and sound when properly

conducted and managed. However, the agencies

are concerned about other occasions when emer-

gency liquidity needs may prompt banks to sup-

port their advised funds in ways that raise pru-

dential and legal concerns. Federal laws and

regulations place signiﬁcant restrictions on

transactions between banks and their advised

funds. In particular, sections 23A and 23B of the

Federal Reserve Act and the Board’s Regula-

tion W (12 CFR part 223) place quantitative

limits and collateral and market-terms require-

ments on many transactions between a bank and

certain of its advised funds.

2178.0.1 POLICY ON BANKS

PROVIDING FINANCIAL SUPPORT

TO ADVISED FUNDS

To avoid engaging in unsafe and unsound bank-

ing practices, banks should adopt appropriate

policies and procedures governing routine or

emergency transactions with bank-advised

investment funds.

Such policies and procedures

should be designed to ensure that the bank will

not (1) inappropriately place its resources and

reputation at risk for the beneﬁt of the funds’

investors and creditors; (2) violate the limits and

requirements contained in sections 23A and 23B

of the Federal Reserve Act and Regulation W,

other applicable legal requirements, or any spe-

cial supervisory condition imposed by the agen-

cies; or (3) create an expectation that the bank

will prop up the advised fund. Further, the agen-

cies expect banking organizations to maintain

appropriate controls over investment advisory

activities that include:

• Establishing alternative sources of emergency

support from the parent holding company,

nonbank afﬁliates, or external third parties

prior to seeking support from the bank.

• Instituting effective policies and procedures

for identifying potential circumstances trig-

gering the need for ﬁnancial support and the

process for obtaining such support. In the

1. The federal banking and thrift agencies include the

Board of Governors of the Federal Reserve System (Board),

the Ofﬁce of the Comptroller of the Currency (OCC), the

Federal Deposit Insurance Corporation (FDIC), and the Ofﬁce

of Thrift Supervision (OTS). Title III of the Dodd-Frank Wall

Street Reform and Consumer Protection Act (Dodd-Frank

Act) abolished the OTS, which had been responsible for

regulating state and federal savings associations and their

holding companies. See 12 USC 5413 (Dodd-Frank Act 313).

The OTS’s functions and powers were transferred to the

OCC, FDIC, and the Board. The Board acquired regulatory

and rulemaking authority over savings and loan holding com-

panies. See 12 USC 5412 (Dodd-Frank Act 312). The OCC

acquired supervisory and rulemaking authority over federal

savings associations. The FDIC acquired supervisory and

rulemaking authority over state-chartered savings associa-

tions. Bank-advised investment funds include mutual funds,

alternative strategy funds, collective investment funds, and

other funds where the bank, its subsidiaries, or afﬁliates is the

investment adviser and receives a fee for its investment

advice. For purposes of the guidance, “banks” includes banks

and savings associations.

Bank-advised investment funds include mutual funds, alter-

native strategy funds, collective investment funds, and other

funds where the bank, its subsidiaries, or afﬁliates is the

investment adviser and receives a fee for its investment

advice. For purposes of the guidance, “banks” includes banks

and savings associations.

2. For more information on examination objectives and

procedures in reviewing banks providing ﬁnancial support to

advised funds, see the appropriate “Investment-Funds Sup-

port” sections of the Commercial Bank Examination Manual.

BHC Supervision Manual February 2019

Page 1

limited instances that the bank provides ﬁnan-

cial support, the bank’s procedures should

include an oversight process that requires for-

mal approval from the bank’s board of direc-

tors, or an appropriate board-designated com-

mittee, independent of the investment

advisory function. The bank’s audit commit-

tee also should review the transaction to

ensure that appropriate policies and proce-

dures were followed.

• Implementing an effective risk-management

system for controlling and monitoring risks

posed to the bank by the organization’s invest-

ment advisory activities. Risk controls should

include establishing appropriate risk limits,

liquidity planning, performance measurement

systems, stress testing, compliance reviews,

and management reporting to mitigate the

need for signiﬁcant bank support.

• Implementing policies and procedures that

ensure that the bank is in compliance with

existing disclosure and advertising require-

ments to clearly differentiate the investments

in advised funds from obligations of the bank

or insured deposits.

• Ensuring proper regulatory reporting of con-

tingent liabilities arising out of its investment

advisory activities in the banking organiza-

tion’s published ﬁnancial statements in accor-

dance with Accounting Standards Codiﬁca-

tion (ASC) subtopic 450-20, Contingencies:

Loss Contingencies, and ﬁduciary settlements,

surcharges, and other losses arising out of its

investment advisory activities in accordance

with the instructions for completing Call

Report Schedule RC-T (Fiduciary and Related

Services).

2178.0.2 NOTIFICATION AND

CONSULTATION WITH THE

PRIMARY FEDERAL REGULATOR

Because of the potential risks posed by the

provision of ﬁnancial support to advised funds,

bank management should notify and consult

with its appropriate federal banking agency prior

to the bank providing material ﬁnancial support

to its advised funds. The appropriate federal

banking agency will closely scrutinize the cir-

cumstances surrounding the transaction and will

address situations that raise supervisory con-

cerns.

Support of Bank-Afﬁliated Investment Funds 2178.0

BHC Supervision Manual February 2019

Page 2

Securities Activities in Overseas Markets Section 2180.0

Existing regulations permit banks and bank

holding companies to engage in a wide range of

securities activities in overseas markets. For a

number of years these activities were not con-

sidered to be signiﬁcant in the context of total

bank and bank holding company assets. Indig-

enous rules and market practice served to con-

strain to a degree securities activities of U.S.

banking organizations overseas.

Changes in local rules now make it possible

for members of the London stock exchange to

be wholly-owned by non-member companies

and by year-end 1986 will allow stockbrokers to

act as principals or market makers in securities.

These new rules are expected to change signiﬁ-

cantly the complexion of the London securities

market. In this context, U.S. banking organiza-

tions are making substantial investments in U.K.

securities ﬁrms, and are also signiﬁcantly

expanding their securities business in other for-

eign and international markets.

The Board has expressed its concerns, in con-

nection with an application by a banking organi-

zation to expand its securities activities over-

seas, that proper safeguards, limits, and controls

will be exercised to protect the organization

from undue risk. Applications generally state

the methods through which the banking organi-

zation plans to control risk and establish over-

sight over securities operations. While these

safeguards are initially evaluated at the time the

application is made, nevertheless, examinations

of bank holding companies and Edge corpora-

tions should incorporate an assessment of all

overseas securities activities in order to deter-

mine the degree to which these activities con-

form to high standards of banking and ﬁnancial

prudence. The afﬁliation of a securities com-

pany, especially one engaged in corporate debt

and equities transactions, with a banking organi-

zation raises a potential for conﬂict of interest

and in some cases could pose substantial addi-

tional risk to the institution.

In those U.S. banking organizations where

overseas securities trading and brokering are

signiﬁcant in scope or are prominent in the scale

of the local market, examination procedures

must incorporate an assessment of the controls,

limits, and safeguards implemented by the orga-

nization to monitor and contain risk. Securities

activities should be subject to the same degree

of scrutiny and rigorous assessment of risk as

bank lending activities. In addition, examiners

should monitor the substance and nature of all

transactions.

In particular, the following kinds of activities

should be reviewed to determine whether they

raise considerations of safety and soundness or

otherwise do not conform to standards of pru-

dence required of U.S. banking organizations:

• The degree of lending by a bank holding

company to its securities afﬁliate, especially

when loans are extended to support or

enhance the obligations underwritten by the

securities afﬁliate;

• The extent to which securities underwritten

by an afﬁliate are purchased by the bank hold-

ing company as principal or trustee; and,

• The extent to which the parent is liable to an

exchange for any losses incurred by the afﬁli-

ate due to failure to deliver securities or settle

contracts.

BHC Supervision Manual December 1992

Page 1

Violations of Federal Reserve Margin Regulations Resulting

from “Free-Riding” Schemes Section 2187.0

Targeted examinations and investigations by the

Federal Reserve and the Enforcement Division

of the Securities Exchange Commission (SEC),

as well as court actions, have found banks in

violation of Regulation U, Credit by Banks for

the Purpose of Purchasing or Carrying Margin

Stock, (12 C.F.R. 221) when their trust depart-

ments, using bank or other ﬁduciary funds, have

extended credit to individuals involved in illegal

day trading or free-riding schemes. These activi-

ties also involved the aiding and abetting of

violations of two other securities credit regula-

tions: Regulation T, Credit by Brokers and Deal-

ers (12 C.F.R. 220), and Regulation X, Borrow-

ers of Securities Credit, (12 C.F.R. 224).

Day trading and free-riding schemes involve

the purchase and sale of stock on the same day

(or within a very short period of time) and the

funding of the purchases with the proceeds of

the sale. Banking organizations

engaging in

such illegal activities may subject themselves to

disciplinary proceedings, as well as to substan-

tial credit risk.

Federal Reserve examiners should ensure that

banks and bank holding companies (including

the broker-dealer and trust activities of banking

and nonbanking subsidiaries of state member

banks and bank holding companies) are not

engaged in such illegal activities. Examiners

must make certain that these entities have taken

all steps necessary to prevent their customers

from involving them in free-riding. Prompt

enforcement action may be needed to eliminate

free-riding activities. (See SR-93-13.)

2187.0.1 TYPICAL DAY TRADING OR

FREE-RIDING ACTIVITIES

The free-riding conduct in question typically

involves trading large amounts of securities

without depositing the necessary money or

appropriate collateral in their customer

accounts. The customer seeks to free-ride, that

is, purchase and sell the same securities and pay

for the purchase with the proceeds of the sale.

Often, free-riding schemes involve initial public

offerings because broker-dealers are prohibited

from ﬁnancing these new issues. If the money to

pay for the securities is not in the account when

the securities are delivered in a delivery-versus-

payment (DVP) transaction, a bank that permits

completion of the transaction creates a tempo-

rary overdraft in the customer’s account. This

overdraft is an extension of credit that subjects

the banks to Regulation U.

The typical free-riding scheme involves a

new customer’s opening a custodial agency

account into which a number of broker-dealers

will deliver securities or funds in DVP transac-

tions. Although a deposit may be made into the

custodial agency account, the amount of trading

is greatly in excess of the original deposit, caus-

ing the ﬁnancial institution to extend its own

credit to meet the payment and delivery obliga-

tions of the account. Therefore, although the

ﬁnancial institution may be earning fees as a

result of the activity in these accounts, it is

subjecting itself to substantial losses if the mar-

ket prices for the purchased securities fall or the

transactions otherwise fail. In addition, other

liabilities under federal banking and securities

laws may be involved.

2187.0.2 SECURITIES CREDIT

REGULATIONS

2187.0.2.1 Regulation U, Credit by

Banks or Persons Other Than Brokers or

Dealers for the Purpose of Purchasing or

Carrying Margin Stocks

Any extension of credit in the course of settling

customer securities transactions, including those

occuring in a trust department or trust subsidi-

ary of a bank holding company, must comply

with all of the provisions of Regulation U.

Regulation U requires all extensions of credit

for the purpose of buying or carrying margin

1. The use of the term ‘‘banking organization’’ in this

section, with regard to Regulation U, means a bank, trust

department of a bank, or trust company of a bank holding

company that is subject to Regulation U. Regulation U

includes any nondealer nonbank subsidiary of a bank holding

company that extends purpose credit by margin stock. With

regard to Regulation T, it refers to any nonbank company that

conducts broker-dealer activities.

2. For purposes of the regulation, the deﬁnition of ‘‘bank’’

speciﬁcally includes institutions ‘‘exercising ﬁduciary pow-

ers.’’ (See 12 C.F.R. 221.2, 15 U.S.C. 78(c)(a)(6), and Federal

Reserve Regulatory Service at 5–795 (1946).) When used in

discussing a bank’s trust department or any other type of

ﬁnancial institution exercising ﬁduciary powers, the term

‘‘extension of credit’’ includes overdrafts in settling cus-

tomer’s accounts that may be covered by advances from the

banking organization, from other ﬁduciary customers, or from

a combination of both.

BHC Supervision Manual December 1998

Page 1

stock that are secured by margin stock to be

within the 50 percent limit. To avoid violations

of the Board’s securities credit regulations, on

settlement date, the customer’s account must

hold sufﬁcient funds, excluding the proceeds of

the sale of the security, to pay for each security

purchased. Although Regulation U applies only

to transactions in margin stock, free-riding in

nonmargin stocks in custodial agency accounts

could result in a banking organization’s aiding

and abetting violations of Regulations T and X

and other securities laws, and could raise ﬁnan-

cial safety-and-soundness issues.

2187.0.2.2 Regulation T, Credit by

Brokers and Dealers, and Regulation X,

Borrowers of Securities Credit

Because the custodial agency accounts are used

to settle transactions effected by the customer at

broker-dealers, a banking organization that

opens this type of account should have some

general understanding of how Regulation T

restricts the customer’s use of the account at the

institution. Regulation T requires the use of a

cash account for customer purchases or sales on

a DVP basis. Section 220.8(a) of Regulation T

speciﬁes that cash-account transactions are

predicated on the customer’s agreement that the

customer will make full cash payment for secu-

rities before selling them and does not intend to

sell them before making such payment. There-

fore, free-riding is prohibited in a cash account.

A customer who instructs his or her agent ﬁnan-

cial institution to pay for a security by relying

on the proceeds of the sale of that security in a

DVP transaction is causing, or aiding or abet-

ting, the broker-dealer to violate the credit

restrictions of Regulation T. Regulation X,

which generally prohibits borrowers from will-

fully causing credit to be extended in violation

of Regulations T or U, also applies to the cus-

tomer in such cases.

As described above, banking organizations

involved in customer free-riding schemes may

be aiding and abetting violations of Regulation

T by the broker-dealers who deliver securities

or funds to the banking organization’s custom-

ers’ accounts. As long as a ﬁnancial institution

uses its funds to complete a customer’s transac-

tions, broker-dealers may not discover that they

are selling securities to the customer in violation

of Regulation T. A similar aiding and abetting

violation of Regulation X could occur if a cus-

tomer used the ﬁnancial institution to induce a

broker-dealer to violate Regulation T.

2187.0.3 NEW-CUSTOMER INQUIRIES

AND WARNING SIGNALS

Examiners should make certain that all banks

and other ﬁnancial-institution subsidiaries of a

bank holding company are administering and

following appropriate written policies and pro-

cedures concerning the establishment of custo-

dial agency accounts or any new account involv-

ing customer securities transactions. Such

policies and procedures should address, among

other things, ways an institution can protect

itself against free-riding schemes. One way is to

obtain adequate background and credit informa-

tion from new clients, including whether the

customer intends to obtain credit to use with the

account. This type of activity requires more

extensive monitoring than the typical DVP

account in which no credit is extended. It would

be prudent to inquire why a new customer is not

using the margin-account services of its broker-

dealers. If the account is to be used as a margin

account, a ﬁnancial institution must obtain Form

FR U-1 from the customer and must sign and

constantly update the form.

The ﬁnancial institution should obtain from

the customer a list of broker-dealers that will be

sending securities to or receiving funds from the

account in DVP transactions. If a number of

broker-dealers may be used, the institution

should obtain from the customer a written state-

ment that all transactions with the broker-dealer

will conform with Regulations T and X and that

the customer is aware that a security purchased

in a cash account is not to be sold until it is paid

for. Similarly, when obtaining instructions for

settling DVP transactions for a customer, the

ﬁnancial institution should clarify that it will not

rely upon the proceeds from the sale of those

securities to pay for the purchase of the same

securities.

2187.0.4 SCOPE OF THE INSPECTION

FOR FREE-RIDING ACTIVITIES

Examiners, bank holding companies, state mem-

ber banks, and ﬁnancial-institution and trust

subsidiaries owned by bank holding companies

(also U.S. branches and agencies of foreign

3. For a discussion of Regulation T as it applies to a bank

holding company’s broker-dealer nonbank subsidiary, see sec-

tion 3230.0.

Violations of Federal Reserve Margin Regulations Resulting from “Free-Riding” Schemes 2187.0

BHC Supervision Manual December 1998

Page 2

banks exercising trust powers) should ensure

that their banking organizations monitor

accounts closely for an initial period to detect

patterns typical of free-riding, including intra-

day overdrafts, and to ensure that sufﬁcient

funds or margin collateral are on deposit at all

times. Frequent transactions in securities being

offered in an initial public offering may suggest

an avoidance of Regulations T and X. If it

appears that a customer is attempting to free-

ride, the ﬁnancial institution should immedi-

ately alert the broker-dealers involved in trans-

ferring securities and take steps to minimize its

own credit risk and legal liability.

At a minimum, examiners should also evalu-

ate a trust institution’s ability to ensure that it

does not extend to a customer more credit on

behalf of a bank or other ﬁnancial institution

than is permitted under Regulation U. If there

are any questions in this regard, examiners

should consult with their Reserve Bank’s trust

examiners. Any overdraft that is related to a

purchase or sale of margin stock, and that is

secured by margin stock, is an extension of

credit subject to the regulation, including over-

drafts that are outstanding for less than a day.

Board staff have published a number of opin-

ions discussing the application of Regulation U

to various transactions relating to free-riding.

Free-riding violations that could endanger the

banking organization (for example, fraudulent

activities that could subject the organization to

losses or lawsuits), as well as signiﬁcant viola-

tions that were previously noted but have not

yet been corrected, should be noted in the

inspection report. Violations of the Board’s

Regulation T, U, or X, as applicable to the

inspection, should be reported on the Examin-

er’s Comments and Violations report pages. The

report should discuss what action has or will be

taken to correct those violations.

2187.0.5 SEC AND FEDERAL

RESERVE SANCTIONS AND

ENFORCEMENT ACTIONS

The SEC, in exercising its broad authority to

enforce the Board’s securities credit regulations,

requires banks to (1) establish credit compliance

committees to formulate written policies and

procedures concerning the extension of purpose

credit in their securities-clearance business,

(2) establish training programs for bank person-

nel responsible for the conduct of their

securities-clearance business, and (3) submit to

outside audits to verify their compliance with

the conditions of injunctions. The Board may

also institute enforcement proceedings against

the banking organizations it supervises and

against any institution-afﬁliated parties involved

in these activities, including cease-and-desist

orders, civil money penalty assessments, and

removal and permanent-prohibition actions.

2187.0.6 INSPECTION OBJECTIVES

1. To make certain that policies of the bank

holding company’s board, and the supervi-

sory operating procedures, internal controls,

and audit procedures will ensure, in the

course of settling customers’ securities

transactions—

a. that bank extensions of credit within the

holding company comply with the provi-

sions of Regulation U (including the

requirement that initial extensions of

credit that are secured by margin stock are

within the initial 50 percent margin limit)

and

b. that customer accounts hold sufﬁcient

funds on the settlement date for each secu-

rity purchased.

2. To determine—

a. whether the banking organizations of the

bank holding company can adequately

monitor compliance with Regulation U

through systems of internal controls, train-

ing, and compliance procedures (i.e., use

of credit compliance committees) that

address free-riding activities within the

‘‘back-ofﬁce function’’

and

b. whether noncompliance is properly

reported.

3. To initiate corrective action when policies,

practices, procedures, or internal controls are

not sufﬁcient to prevent free-riding schemes,

and when violations of the Board’s regula-

tions have been noted by bank examiners or

self-regulatory organizations.

2187.0.7 INSPECTION PROCEDURES

1. Review the bank holding company’s board

of directors’ policies for its banking institu-

tion subsidiaries regarding supervisory

operational policies, procedures, and internal

controls for loans extended for the purpose

4. Refers to the movement of cash and securities relating to

trades and to the processing and recording of trades. This

process is also called the ‘‘securities-clearance cycle.’’

Violations of Federal Reserve Margin Regulations Resulting from “Free-Riding” Schemes 2187.0

BHC Supervision Manual December 1998

Page 3

of buying or carrying margin stock and

secured directly or indirectly by margin

stock.

a. Determine whether the policies require,

for each extension of credit not speciﬁ-

cally exempted under Regulation U, that a

Form FR U-1 be executed and signed by

the customer and accepted and signed by

a duly authorized ofﬁcer of the banking

organization acting in good faith.

b. Determine whether the policies limit

extensions of credit to no more than the

maximum allowed loan value of the col-

lateral, as set by section 221.7 of Regula-

tion U, and whether those policies require

adherence to margin requirements.

2. Review the bank holding company’s board

of directors’ credit policies and operating

policies, internal controls, and internal audit

procedures to determine if they provide

adequate safeguards against customers’ free-

riding practices. In so doing—

a. determine if new-customer accounts are

required to be approved by appropriate

personnel; and

b. establish whether the bank holding com-

pany’s credit-system policies require—

• controlling securities positions and

ﬁnancial-instrument contracts that serve

as collateral for loans;

• monitoring established restrictions and

limits placed on the amounts and types

of transactions to be executed with each

customer and the dollar amounts placed

on unsettled trades;

• obtaining appropriate documentation

consisting of essential facts pertaining

to each customer, and in particular,

ﬁnancial information evidencing the

customer’s ability to pay for ordered

securities, repay extensions of credit,

and meet other ﬁnancial commitments;

• monitoring the location of all collateral;

• ensuring that there are no overdrawn

margin accounts; and

• monitoring the status of failed transac-

tions for the purpose of detecting free-

riding schemes.

3. Determine if the bank holding company’s

audit committee or its internal or external

auditors are required to review a selected

random sample of individual or custodial

agency accounts for customer free-riding

activities.

2187.0.8 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Credit by brokers

and dealers

220

(Reg. T)

Regulation U, Credit by Banks

or Persons Other Than

Brokers or Dealers for

the Purpose of Purchasing

or Carrying Margin Stocks

221

(Reg. U)

Purpose credit—

delivery-versus-

payment transactions

5–942.15,

5–942.18,

5–942.2,

5–942.21,

5–942.22

Borrowers of

securities credit

224

(Reg. X)

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

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BHC Supervision Manual December 1998

Page 4

Note Issuance and Revolving Underwriting

Credit Facilities Section 2220.3

2220.3.1 NOTE ISSUANCE FACILITY

(NIF)

One type of off-balance-sheet activity is the

note issuance facility (NIF). The ﬁrst public

facility was arranged in 1981. A NIF is a

medium-term arrangement under which a bor-

rower can issue short-term paper. The paper is

issued on a revolving basis, with maturities

ranging from as low as 7 days to up to one year.

Underwriters are committed either to purchas-

ing any unsold notes or to providing standby

credit. Bank borrowing usually involves com-

mercial paper consisting of short-term certiﬁ-

cates of deposit and for nonbank borrowers it

would generally be promissory notes (Euro-

notes). NIF is the most common term used for

this type of arrangement. Other terms include

the revolving underwriting facility (RUF), and

the standby note issuance facility (SNIF). NIFs,

RUFs, and SNIFs are essentially the same credit

product. The NIF is usually structured for 5 to

7 years.

Euronotes are denominated in US dollars and

are issued with high face values (often $500,000

or more), being intended for the more sophisti-

cated investor (professional or institutional

investors). Holders of the notes show them as an

asset on their balance sheets. The underwriting

commitment represents an off-balance sheet

item. The NIF allows the various functions per-

formed by a single institution in a syndicated

credit to be separated and performed by differ-

ent institutions.

Instead of lending money, as in a syndicated

credit, the NIF arranger provides a mechanism

for placing notes with other investors when

funds are needed. The underwriting commit-

ment transforms the maturity, assuring the bor-

rower access to short-term funds over the

medium term, which remains off-balance sheet,

unless drawn upon. The underwriters take the

short-term credit risk since they face the risk of

lending to a borrower that has difﬁculty in

obtaining full conﬁdence from investors.

NIFs can be arranged with an issuer-set mar-

gin whereby the issuer determines the margin

over LIBOR (the London Interbank Offered

Rate), or some other index at which notes will

be offered. The issuer thus beneﬁts from any

improvement in market conditions. The notes

are placed by the placing agent, but senior

underwriters have the option of purchasing a

prearranged share of any notes issued. Any

notes not taken up at the issuer-set margin are

distributed to underwriters at the pre- estab-

lished maximum (cap) rate.

2220.3.2 REVOLVING

UNDERWRITING FACILITY (RUF)

Another type of facility, a revolving underwrit-

ing facility (RUF), was introduced in 1982. A

revolving underwriting facility is a medium-

term revolving commitment to guarantee the

overseas sale of short-term negotiable promis-

sory notes (usually a ﬁxed-spread over LIBOR)

issued by the borrower at or below a predeter-

mined interest rate. RUFs separate the roles of

the medium-term risk-taker and the providers of

the funding (the short-term investors). RUFs

and NIFs allow access to capital sources at

interest rates considerably below conventional

ﬁnancing rates. The savings in interest cost are

derived because the borrower obtains the lower

interest costs prevailing in the short-term mar-

kets, while still retaining the security of longer

term ﬁnancing commitments. The notes issued

under RUFs are attractive for institutional inves-

tors since they permit greater diversiﬁcation of

risk than the certiﬁcates of deposit of only one

bank. Underwriters favor them because their

commitments do not appear on the statement of

ﬁnancial condition. RUFs are usually structured

for periods of four to seven years.

A revolving underwriting facility (RUF) dif-

fers from a (NIF) in that it separates the func-

tions of underwriting and distribution. With a

RUF, the lead bank (manager or arranger) acts

as the only placing agent. The arranger retains

total control over the placing of the notes. The

lead bank provides assistance to a borrower who

forms a lending group of banks. The borrower,

assisted by a lead bank (arranger), obtains a

medium term revolving commitment that guar-

antees the sale of short-term negotiable promis-

sory notes at or below a pre-determined interest

rate. The participating group of banks arrange

the funding, subject to certain lending condi-

tions and rates, for the duration of the facility. In

return, the borrower pays a facility fee to the

revolving credit banks.

BHC Supervision Manual December 1992

Page 1

When the borrower desires funds, a place-

ment agent or tender panel

places short-term

notes with other banks and institutional inves-

tors (usually having maturities of 90 days, 180

days or 12 months). The short term notes can be

issued to these investors at signiﬁcantly lower

interest rates than would be available from a

revolving credit facility that the same banks

would have been willing to provide. The note

purchasers generally have a rollover option at

maturity and new note purchasers are added as

needed. The note purchasers bear the risk of loss

in the event of default by the borrower. New

note purchasers are added as needed. In the

event the full line of credit is not placed with the

note purchasers on any rollover date, the revolv-

ing credit banks must make funding available

for the difference at the previously committed

revolving credit interest rates, subject to the

terms and conditions within the agreement.

With the RUF, and the use of a sole placing

agent, the underwriters are not assured of secur-

ing any notes that they could place themselves

nor can they beneﬁt from any improvement in

terms available in the market. The hindrance is

removed by the use of NIFs with an issuer-set

margin whereby the issuer determines the mar-

gin over an index at which notes will be offered.

Another form of a RUF is a transferable

revolving underwriting facility (TRUF). With

this arrangement the underwriter is able, with

the borrower’s approval, to transfer all rights

and obligations under the underwriting commit-

ment to another institution at any time during

the life of the facility.

2220.3.3 RISK

The loan commitments involved in NIF and

RUF transactions contain substantially the same

terms as other loan commitments extended to

similar borrowers. The failure of the borrower

to satisfy the revolving standby agreement

relieves the banks of any obligation to fund the

transaction. The major source of risk is thus the

liquidity risk that is derived from the uncer-

tainty of the timing or amount of required fund-

ing. If the underlying notes cannot be marketed

at or below the interest rate speciﬁed in the

agreement, the bank would need to discount the

notes to whatever rate would be necessary to

make the notes attractive to investors, perhaps

taking an up-front loss to avoid funding a low

margin loan.

NIFs and RUFs involve less credit risk than

extensions of credit because of the additional

step that is required before funding takes place,

a step that is not present with a revolving credit

agreement. In other words, no funding is

required until: (1) a decision is made by the

borrower to issue notes; and (2) the placing

agent becomes unable to place the short-term

notes with short-term investors. Further, the risk

of loss rests with the note investors. The under-

writer’s risk of nonpayment is not present until

the rollover date. If there has been a signiﬁcant

deterioration in the issuer/borrower’s ﬁnancial

condition on that date, the issuer/borrower may

be prevented from drawing under the facility.

This would be dependent on the funding condi-

tions or the cancellation provisions stipulated in

the agreement.

2220.3.4 PRICING AND FEES

The forms of compensation involving a NIF and

RUF are: the underwriting and commitment fee;

the one-time arrangement fee, and the periodic

placement fees. An annual ﬁxed underwriting

fee is paid by the borrower on the amount of

underlying commitment. This fee must be paid

regardless of the frequency of usage of the

facility or whether or not the underwriters are

required to make any purchases of the short-

term paper. This compensation is for the com-

mitment to underwrite the issuance of the notes.

The arranger receives a one-time arrangement

fee based on a percentage of the amount of the

facility. The issuer pays the borrowing costs on

the notes issued, usually at a spread above or

below an index. A portion of this borrowing fee

is retained by the placement agent or the tender

panel members as compensation for placing the

paper.

Competitive pricing on NIFs and RUFS

causes them to be very thinly margined. Com-

mitment fees may be as low as 5 basis points for

blue chip customers, while ‘‘BBB’’ credit-rated

or equivalent borrowers might be charged as

much as 20 basis points. Because of the thin

spread some banks may only be serving as an

1. The tender panel was introduced in 1983. It is usually

made up of several commercial investment banks and other

institutional investors. The panel members bid for any notes

issued, up to a predetermined maximum spread. The revolv-

ing credit banks can bid as part of the tender panel, but they

are not required to do so. Any notes not bid for are purchased

by the revolving credit banks or they extend credit of an equal

amount. The tender panel may be a continuous tender panel

whereby the underwriters are entitled to purchase notes from

the lead manager up to their pro rata share at any time during

the offer period, if available, at the market price.

Note Issuance and Revolving Underwriting Credit Facilities 2220.3

BHC Supervision Manual December 1992

Page 2

arranger, preferring to not participate in the mar-

ket. Typical fees for this service may consist of:

an up-front arrangement fee of 20 basis points

on the total principal amount of the facility, and

an annual placement fee such as 12.5 basis

points on the short-term notes sold. Revolving

credit banks usually receive facility fees and

annual maintenance fees.

If the underwriters have to purchase the notes,

the backup rate of interest may be the index plus

10 to 15 basis points for blue chip companies to

plus 37.5 basis points over the index for ‘‘BBB’’

rated borrowers. The interest rates charged (if

funded) are usually lower because of market-

pricing conventions (lower spreads) and the

intense competition within the market.

2220.3.5 STANDBY RUFS

Some RUFS may provide for a utilization fee or

may provide for a higher yield on the notes in

the event that more than a nominal amount of

paper is allocated to the underwriters. Such a

provision would more likely be found in a

standby facility. Standby facilities are backup

commitments under which notes are not

expected to be issued. This provision essentially

protects the underwriter from having to book

loans that are earning an insufﬁcient yield. The

structure of the facility generally determines its

pricing depending upon the requirements of the

issuer/borrower.

Standby RUFs substitute for committed bank

lines which may be used, for example, as

backup commitments for issuance of U.S. com-

mercial paper. Commitment fees will be low

because of the low probability that funds will

need to be advanced. A standby facility will

make borrowing from the underwriter very

expensive in relation to what the issuer might

have to pay. Otherwise, the underlying notes are

issued on a regular basis, the maximum yield on

the notes is set to approximate the normal mar-

ket level for the issuer’s short term borrowing-

s.This facility would have a higher underwriting

fee than a standby facility, because the regular

issuances of notes increase the likelihood that

the underwriting bank will have to purchase

notes that cannot be placed.

2220.3.6 RUF DOCUMENTS

The revolving credit agreement is the primary

document in a RUF. It includes the principal

agreement of the transaction, executed by the

revolving credit banks and the borrower. It con-

tains the terms and conditions under which the

borrower can draw on the facility. The docu-

ment includes the ﬁnancial covenants and events

of default.

An agency agreement between the borrower

and the placement agent designates the place-

ment agent for the notes and sets forth the

conditions of the agent’s obligations for arrang-

ing the sale of the notes. Included are represen-

tations and warranties of the borrower regarding

the authority to enter into the agreement and to

issue the notes.

A description of the terms and conditions of

the facility is contained within an information

memorandum. Detail is provided with regard to

the use of the proceeds, current and historical

ﬁnancial information, a description of the

company, its ﬁnances and operations. It is dis-

tributed to prospective credit banks and note

purchasers.

The note is the last document involving a

RUF. Usually the notes will be unsecured obli-

gations of the borrower and will include rep-

resentations and warranties of the company

regarding authorization and the absence of

material litigation and bankruptcy proceedings.

It will also contain a statement that a revolving

credit facility is available to the borrower.

Note Issuance and Revolving Underwriting Credit Facilities 2220.3

BHC Supervision Manual December 1992

Page 3

Real Estate Appraisals and Evaluations

Section 2231.0

2231.0.1 INTRODUCTION

This manual section provides a brief summary

of the Board’s appraisal regulations and directs

readers to the key pieces of guidance that the

Board and other banking agencies have issued

relating to real estate appraisals and evaluations.

The Board’s real estate appraisal regulation is

found in Regulation Y, subpart G (12 CFR

225.61–67), and applies to bank holding compa-

nies, nonbank subsidiaries of bank holding com-

panies, and state member banks. For state mem-

ber banks, there is a cross reference to the

Board’s appraisal regulations in Regulation H

(12 CFR 208.50–51). Appraisals are also dis-

cussed in the Interagency Guidelines for Real

Estate Lending Policies, which are found in

appendix C to Regulation H, (appendix C to

12 CFR part 208).

Regulation H’s real estate lending standards

(12 CFR part 208, subpart E) direct state mem-

ber banks to adopt and maintain written real

estate lending policies that are consistent with

safe and sound lending practices. Such policies

should reﬂect consideration of applicable regu-

lations and guidance pertaining to real estate

appraisals when developing a loan-to-value esti-

mate.

Although Regulation H applies only to

state member banks, bank holding companies

and their nonbank subsidiaries are expected to

conduct their real estate lending activities in a

prudent manner consistent with safe and sound

lending standards.

2231.0.2 REGULATORY

BACKGROUND FOR APPRAISALS

The Board’s policy on real estate appraisals

emphasizes the importance of sound appraisal

policies and collateral-valuation procedures as

part of a supervised ﬁnancial institution’s real

estate lending activity.

The Board and other

federal ﬁnancial regulatory agencies adopted

regulations in August 1990 on the performance

and use of appraisals by federally regulated

ﬁnancial institutions to implement statutory

changes due to the passage of title XI of the

Financial Institutions Reform, Recovery, and

Enforcement Act of 1989 (FIRREA) (12 USC

3331 et seq.).

The Board’s appraisal regulation requires, at

a minimum, that real estate appraisals for feder-

ally related transactions be performed in accor-

dance with the Uniform Standards of Profes-

sional Appraisal Practice (USPAP) promulgated

by the Appraisal Standards Board (ASB) of the

Appraisal Foundation, and that appraisals be in

writing.

The regulation also sets forth addi-

tional appraisal standards, including that the

appraisal contain sufﬁcient information and

analysis to support the supervised ﬁnancial insti-

tution’s decision to engage in the transaction;

provide the real property’s market value; be

performed by state certiﬁed or licensed apprais-

ers as required by the regulations; and analyze

deductions and discounts for proposed construc-

tion projects, partially leased buildings, nonmar-

ket lease terms, and tract developments with

unsold units.

The intent of title XI and the Board’s

appraisal regulation is to protect federal ﬁnan-

cial and public policy interests in federally

related transactions.

Federally related transac-

tions are deﬁned as those real estate-related

ﬁnancial transactions that an agency engages in,

contracts for, or regulates and that require the

services of an appraiser.

Appraisals are required under the appraisal

regulation for all real estate-related ﬁnancial

transactions unless an exemption applies. The

regulation contains a set of exemptions, includ-

ing dollar value thresholds at or below which an

appraisal is not required. The exemptions are

1. 12 CFR part 208, appendix C, deﬁnes “value” when

used to refer to “loan-to-value” as an opinion or estimate set

forth in an appraisal or evaluation, whichever may be appro-

priate, of the market value of real property, prepared in

accordance with the agency’s appraisal regulations and guid-

ance.

2. The Ofﬁce of the Comptroller of the Currency (OCC),

the Board of Governors of the Federal Reserve System

(Board), and the Federal Deposit Insurance Corporation

(FDIC) (the agencies) have promulgated appraisal regulations

pursuant to Title XI. See 12 USC 3339. The agencies’ title XI

appraisal regulations apply to transactions entered into by the

agencies or by institutions regulated by the agencies that are

depository institutions or bank holding companies or subsidi-

aries of depository institutions or bank holding companies.

OCC: 12 CFR part 34, subpart C; Board: 12 CFR part 225,

subpart G; 12 CFR part 208, subpart E; and FDIC: 12 CFR

part 323, subpart A. Unless otherwise stated, “supervised

ﬁnancial institutions” include state member banks, bank hold-

ing companies, and nonbank subsidiaries of bank holding

companies.

3. In June 1994, the agencies’ appraisal regulations were

materially revised to clarify, amend, and add several exemp-

tions to the appraisal requirement.

4. See 12 CFR 225.64.

5. See 12 USC 3331.

6. See 12 USC 3350(4).

BHC Supervision Manual February 2020

Page 1

identiﬁed as categories of real estate-related

ﬁnancial transactions that do not require the

services of an appraiser in order to protect fed-

eral ﬁnancial and public policy interests or to

satisfy principles of safe and sound banking. As

such, the exempted transactions are not feder-

ally related transactions under the statutory and

regulatory deﬁnitions. Exempted transactions

are not subject to title XI nor the provisions of

the agencies’ regulations governing appraisals.

Certain exemptions, however, require the use of

an evaluation consistent with safe and sound

banking practices. Interagency guidance has

been issued to assist ﬁnancial institutions in

performing evaluations consistent with such

practices.

In addition to federal regulations, each state

has established a program for certifying and

licensing real estate appraisers who are qualiﬁed

to perform appraisals in connection with feder-

ally related transactions. Title XI designated the

Appraiser Qualiﬁcations Board and the ASB of

the Appraisal Foundation, a nonproﬁt appraisal

industry group, as the authority for establishing

qualiﬁcations criteria for appraiser certiﬁcation

and licensing and the standards for the prepara-

tion of an appraisal. Title XI established the

Appraisal Subcommittee (ASC) of the Federal

Financial Institutions Examination Council. The

ASC monitors state requirements for certifying

and licensing appraisers who can perform

appraisals for federally related transactions,

state supervision, and registration of appraisal

management companies, as well as certain title

XI-related requirements established by the fed-

eral ﬁnancial regulatory agencies. The ASC also

monitors the Appraisal Foundation and its enti-

ties. If the ASC issues a ﬁnding that the policies,

practices, or procedures of a state appraiser cer-

tifying and licensing agency are inconsistent

with title XI, the services of licensed or certiﬁed

appraisers from that state may not be used in

connection with federally related transactions.

The ASC also maintains the national registry of

appraisers and appraisal management compa-

nies.

2231.0.3 THE APPRAISAL

REGULATION

Regulation Y, 12 CFR part 225,

Subpart G, Appraisal Standards for

Federally Related Transactions

The appraisal regulation sets standards for

appraisals in connection with federally related

transactions and also contains a lists of transac-

tions that do not require the services of an

appraiser and, therefore, are exempt from the

appraisal requirement of the regulation. In

reviewing a real estate loan, examiners assess

whether the appraisal supports the real estate

value used by the supervised ﬁnancial institu-

tion in its credit decision and whether the

appraisal complies with the appraisal regulation.

Further, examiners assess the adequacy of an

institution’s appraisal program to support its

real estate lending activity. There are several

key sections in the appraisal regulation, which

are described in greater detail below. The regu-

lation contains the following:

• Minimum appraisal standards, section 225.64

The regulation establishes minimum standards

necessary for all appraisals that are prepared

for federally related transactions. Those

appraisals must

— conform to generally accepted appraisal

standards in USPAP.

— be subject to appropriate review for com-

pliance with USPAP.

— be written and contain sufﬁcient informa-

tion and analysis to support the credit

decision.

— analyze and report deductions and dis-

counts for proposed construction or reno-

vation, partially leased buildings, nonmar-

ket lease terms and tract developments

with unsold units.

— be based upon the deﬁnition of market

value set forth in the deﬁnition section of

the regulation.

— be performed by state-licensed or state-

certiﬁed appraisers in accordance with the

regulation.

• Independence standards for staff appraisers

and fee appraisers, section 225.65

— Staff appraisers must be independent of

the lending, investment, and collection

functions of the institution and not

involved, except as an appraiser, in the

federally related transaction and have no

direct or indirect interest, ﬁnancial or oth-

erwise, in the property.

7. Several provisions in title XI of FIRREA were amended

by the Dodd-Frank Wall Street Reform and Consumer Protec-

tion Act of 2010 (Dodd-Frank Act), providing additional

authority to the ASC in its oversight of states’ appraiser

regulatory programs. (See sections 1471–1473 of Pub. L. 111-

203, 124 Stat. 1376 (2010).)

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— Fee appraisers must be engaged directly

by the institution or its agent and have no

direct or indirect interest, ﬁnancial or oth-

erwise, in the property or the transaction.

— The regulation allows an institution to

accept an appraisal prepared by an

appraiser engaged by another ﬁnancial

services institution if the appraiser has no

direct or indirect interest, ﬁnancial or oth-

erwise, in the property or transaction, and

the appraisal complies with the require-

ments of the regulation.

• Exemptions from the regulation, sec-

tion 225.63

— The regulation provides a list of transac-

tions that do not require appraisals. These

transactions do not require the services of

an appraiser and are, therefore, not feder-

ally related transactions. Certain of these

exceptions require an evaluation in lieu of

an appraisal.

• Standards for professional association mem-

bership and competency, section 225.66

— A state-certiﬁed or state-licensed appraiser

may not be excluded from consideration

of an assignment based on membership or

lack of membership in a particular

appraisal organization.

— All staff and fee appraisers performing

appraisals in connection with federally

related transactions must be state-certiﬁed

or state-licensed as appropriate. However,

any determination of competency shall be

based on the individual’s experience and

educational background as they relate to a

particular appraisal assignment.

• Enforcement actions, section 225.67

— Institutions and their afﬁliates, including

staff and fee appraisers, may be subject to

removal and/or prohibition orders, cease

and desist orders, and the imposition of

civil money penalties.

2231.0.4 SUPERVISORY

EXPECTATIONS AND FINDINGS

In conjunction with assessing the overall

adequacy of a supervised ﬁnancial institution’s

appraisal and evaluation program to support safe

and sound real estate lending, examiners may

cite the appropriate supervised ﬁnancial institu-

tion with the following possible ﬁndings.

1. Examiners may make a ﬁnding regarding the

supervised ﬁnancial institution’s compliance

with the Board’s appraisal regulation. When

citing a violation of the appraisal regulation

for a state member bank, an examiner should

note the matter as a violation of Regula-

tion H (12 CFR part 208, subpart E) citing

the provision as codiﬁed in Regulation Y.

2. In some instances, the ﬁnding may indicate

that a state member bank has failed to com-

ply with the Board’s real estate lending stan-

dards regulation. Examiners may refer to 12

CFR part 208, appendix C, “Interagency

Guidelines for Real Estate Lending Poli-

cies,” for guidance related to the use of

appraisals in developing loan-to-value esti-

mates according to the real estate lending

standards.

3. Examiners should consider the supervisory

expectations in the Interagency Appraisal

and Evaluation Guidelines for guidance on

safe and sound valuation policies and prac-

tices. If the institution’s valuation policies

and practices pose safety-and-soundness con-

cerns for the institution, examiners could

refer to 12 CFR part 208, Appendix D-1,

“Interagency Guidelines Establishing Stan-

dards for Safety and Soundness,” for guid-

ance on consideration of the value of under-

lying collateral.

The following provides examples of possible

examination ﬁndings and references to the

applicable provisions in the Board’s regulations.

Examples of violations of the appraisal regula-

tion, 12 CFR 208.50 as set forth in 12 CFR

225.61–67, include

• failure to obtain an appraisal (12 CFR

225.63);

— not obtaining an appraisal as required by

the regulation

— using an outdated appraisal for an existing

transaction without meeting the regulatory

criteria

— not obtaining an appraisal due to the mis-

application of an exemption, or when the

transaction does not meet the speciﬁc

requirements of the exemption

— Remedy: Examiners should require the

supervised ﬁnancial institution to obtain a

new appraisal.

• appraisal fails to comply with the minimum

appraisal standards in the appraisal regula-

tion;

— violation of 12 CFR 208.50, subpart E as

set forth in 12 CFR 225.64 (minimum

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appraisal standards) or 12 CFR 225.65

(appraiser independence)

— Remedy: Examiners should require the

supervised ﬁnancial institution to obtain a

new appraisal.

• failure to use a state-licensed or state-certiﬁed

appraiser (12 CFR 225.63);

— engaging an appraiser with an expired

license or certiﬁcation

— engaging a state-licensed appraiser when a

state-certiﬁed appraiser is required

— Remedy: Examiners should require the

supervised ﬁnancial institution to obtain a

new appraisal.

• failure to maintain appraiser independence

(12 CFR 225.65);

— using a staff appraiser that is not indepen-

dent of the lending function

— allowing the borrower to hire the appraiser

(the regulation requires that fee appraisers

be engaged directly by the institution or

its agent)

— using an appraisal prepared by an

appraiser that has an interest in the real

estate

— Remedy: Examiners should require the

bank to obtain a new appraisal.

• failure to obtain an evaluation for certain

exempt transactions (12 CFR 225.63(b)).

— not obtaining an evaluation for a renewed

loan

— not obtaining an evaluation for a commer-

cial or residential transaction at or under

the appropriate threshold

— not obtaining an evaluation for a business

loan at or under $1 million

— For further background, refer to the Inter-

agency Guidelines and the section on

“Transactions That Require Evaluations”

as well as Appendix A—Appraisal

Exemptions.

— Remedy: Examiners should require the

supervised ﬁnancial institution to obtain

an evaluation.

Examples of violations of the real estate lending

regulation 12 CFR part 208, subpart E that

pertain to appraisals or evaluations:

• The bank does not have adequate procedures

for monitoring market conditions for its com-

mercial real estate lending.

— A bank must monitor real estate market

conditions in its lending area and have

credit administration policies that address

the type and frequency of collateral valua-

tions. Violation of 12 CFR part 208, sub-

part E (real estate lending standards regu-

lation).

• Bank does not have appropriate policies estab-

lishing loan-to-value limits for real estate col-

lateral. Violation of 12 CFR part 208, sub-

part E (real estate lending standards

regulation).

— Remedy: Examiners should require the

bank to implement policies and proce-

dures to promote compliance with the real

estate lending regulation.

Examples of possible safety and soundness

violations:

• The supervised ﬁnancial institution’s overall

appraisal function is weak.

— The supervised ﬁnancial institution’s

appraisal and evaluation programs are

inconsistent with safe and sound practices.

Guidance on developing appraisal and

evaluation programs in a safe and sound

manner is provided in the Interagency

Appraisal and Evaluation Guidelines.

— The supervised ﬁnancial institution’s

approach to monitoring collateral values

raises safety-and-soundness concerns, as

an institution needs to have sufﬁcient

information to assess the real estate collat-

eral risk in its real estate loan portfolio.

• The evaluation is inadequate.

— The supervised ﬁnancial institution has

failed to satisfy supervisory expectations

for evaluations.

— For further guidance, refer to the Inter-

agency Guidelines, the “Evaluation Devel-

opment” and “Evaluation Content” sub-

sections, and Appendix B — Evaluations

Based on Analytical Methods or Techno-

logical Tools.

— Remedy: Depending upon the noted deﬁ-

ciencies, examiners should require the

supervised ﬁnancial institution to perform

a new evaluation or, alternatively, the

institution may obtain an appraisal.

• The supervised ﬁnancial institution has failed

to meet independence expectations for its

appraisal and evaluation program. Guidance

for meeting independence expectations is set

forth in the section on the Independence of the

Appraisal and Evaluation Program in the

Interagency Guidelines.

— Evaluations are prepared by persons who

are not independent of loan production.

— Reporting lines of valuation program staff

are not independent of loan production.

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2231.0.5 INTERAGENCY APPRAISAL

AND EVALUATION GUIDELINES

Over the years, the Board and the other federal

banking regulatory agencies (the Ofﬁce of the

Comptroller of the Currency and the Federal

Deposit Insurance Corporation (the agencies))

have issued several appraisal-related guidance

documents to assist institutions in implementing

and complying with the appraisal regulation.

December 2010, the agencies issued the Inter-

agency Appraisal and Evaluation Guidelines

(Interagency Guidelines) to clarify their

appraisal regulations and to promote best prac-

tices in institutions’ appraisal and evaluation

programs. (See

SR-10-16.) The Interagency

Guidelines pertain to all real estate-related

ﬁnancial transactions originated or purchased by

a regulated institution or its operating subsidiary

for its own portfolio or as assets held for sale,

including activities of commercial and residen-

tial real estate mortgage operations, capital mar-

kets groups, and asset securitization and sales

units. The Interagency Guidelines provide a

comprehensive discussion of the Board’s super-

visory expectations for a supervised ﬁnancial

institution’s appraisal and evaluation program

as well as background information on the tech-

nical aspects of appraisals.

The Interagency Guidelines more fully

explain and clarify the requirements of the

appraisal regulation. The Interagency Guide-

lines also contain supervisory guidance for

developing and maintaining a safe and sound

appraisal and evaluation program. Expectations

for evaluations are addressed in the guidelines

to clarify the requirement in the regulation that

evaluations be performed in a safe and sound

manner. For example, the appraisal regulation

allows for the substitution of an “appropriate

evaluation” for an appraisal under certain trans-

actions; however, the regulation does not deﬁne

what is an appropriate evaluation. The Inter-

agency Guidelines provide guidance to assist

regulated institutions in determining what an

“appropriate evaluation” is. A violation of the

appraisal regulation should be cited if the insti-

tution failed to obtain an evaluation, where one

was required. The Interagency Guidelines may

be used as guidance, for example, in determin-

ing the appropriate type of content in an evalua-

tion. However, in making determinations about

the adequacy of an institution’s evaluation con-

tent, an assessment of the impact on the safety

and soundness of the institution should be made

and if it is determined that the evaluation was

not conducted in a safe and sound manner, the

evaluation requirement of the appraisal regula-

tion should be cited. The Interagency Guide-

lines serve two main purposes:

1. Provides guidance regarding supervisory

expectations for a supervised ﬁnancial insti-

tution’s appraisal and evaluation program

including that

• the institution’s board of directors should

provide for an effective appraisal and

evaluation program;

• the program should be independent;

• the program should have a criteria for

selection of appraisers and evaluators;

• appraisals and evaluations should be

appropriately reviewed;

• there should be appropriate oversight of

third-party arrangements;

• the lender should have an appropriate com-

pliance program; and

• the lender should report appraisers that are

involved in USPAP violations to state

appraisal regulatory agencies.

2. Clariﬁes and provides guidance to assist

ﬁrms in complying with the appraisal regula-

tion, such as

• the content expectations of an evaluation;

• independence expectations for evaluations;

• transactions that are exempt from the

appraisal requirement;

• situations where a real estate loan does not

qualify for an exemption;

• assessing the validity of existing appraisals

and evaluations;

• the importance of a scope of work and

valuation approach in appraisal develop-

ment; and

• appraisal report options.

The Interagency Guidelines also discuss other

uses for appraisals and evaluations. For exam-

ple, a supervised ﬁnancial institution’s

collateral-valuation program should consider

when an appraisal or evaluation should be

obtained to monitor ongoing collateral risk and

to support credit analysis, including for pur-

poses of updating risk ratings or classifying the

credit. Also, when a credit becomes troubled,

the primary source of repayment often shifts

from the borrower’s cash ﬂow and income to

the expected proceeds from the sale of the real

estate collateral. Therefore, it is important that

supervised ﬁnancial institutions have a sound

8. For more information, see the “Real Estate” supervisory

policy and guidance topic page.

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and independent basis for determining the ongo-

ing value of the real estate collateral. (See

SR-09-7, “Prudent Commercial Real Estate

Loan Workouts.”)

2231.0.5.1 Appendixes of Interagency

Appraisal and Evaluation Guidelines

Below are summaries of the four appendixes

included with the guidelines found in the

attach-

ment to SR-10-16

Appendix A—Appraisal Exemptions. A com-

mentary on the 12 exemptions from the agen-

cies’ appraisal regulations. The appendix pro-

vides an explanation of the agencies’ statutory

authority to provide for appraisal regulatory

exemptions and the application of these exemp-

tions. In addition to these exemptions, note that

the appraisal regulation has been amended to

exempt commercial real estate transactions

below $500,000 and residential real estate trans-

actions below $400,000.

Appendix B—Evaluations Based on Analytical

Methods and Technological Tools. A discussion

of the agencies’ expectations for evaluations

that are based on analytical methods and techno-

logical tools, including the use of automated

valuation models and tax assessment valuations.

Appendix C—Deductions and Discounts Mini-

mum. A discussion on appraisal standards for

determining the market value of a residential

tract development, including an explanation of

the requirement to analyze and report appropri-

ate deductions and discounts for proposed con-

struction or renovation, partially leased build-

ings, nonmarket lease terms, and tract

developments with unsold units.

Appendix D—Glossary. Deﬁnitions of terms

related to real estate lending, appraisals, and

regulations to aid in reading the guidelines.

2231.0.6 ASSESSING THE

ADEQUACY OF AN APPRAISAL

When assessing the adequacy of an appraisal

and its compliance with the minimum appraisal

standards, examiners should assess whether the

appraisal conforms to USPAP Standard Rule

1—Real Property Appraisal Development, and

USPAP Standard Rule 2—Real Property

Appraisal Reporting. The Interagency Guide-

lines discuss the importance of the appraiser

developing an appropriate “scope of work” con-

sistent with USPAP’s Scope of Work rule. An

appraisal’s scope of work should be clearly

developed and explained in the appraisal report.

Further, the appraisal report should include a

copy of the supervised ﬁnancial institution’s

engagement letter with the appraiser for the

appraisal assignment.

It is important to note that some of the

USPAP standards differ from aspects of the

appraisal regulation, and, in such cases, the

appraisal regulation should be followed with

respect to appraisals for federally related trans-

actions. For example, USPAP does not require

appraiser independence and allows for apprais-

als to address deﬁnitions of value other than

market value.

In reviewing a real estate loan and the related

appraisal, examiners should consider whether

the type of appraisal report is acceptable, the

valuation approach is appropriate for the trans-

action, and the appraisal contains an estimate

based on the market value deﬁnition. The

appraisal should contain a clear development of

the market value of the collateral and should

contain sufﬁcient information to support the real

estate’s market value and the supervised ﬁnan-

cial institution’s credit decision. The USPAP

standards discuss all of the basic components of

an appraisal. Residential appraisals are com-

monly completed in a report format that con-

forms to the Uniform Residential Appraisal

Report, which was developed by Fannie Mae

and Freddie Mac.

Examiners should also conﬁrm that the bank

has procedures for reviewing appraisals and

evaluations to determine that an appraisal or

evaluation complies with the appraisal regula-

tion and provides sufﬁcient information to sup-

port the supervised ﬁnancial institution’s credit

decision. The Appraisal Regulation was

amended to require supervised ﬁnancial institu-

9. In addition, the regulation was amended to cross refer-

ence a self-effectuating statutory exemption for rural residen-

tial real estate transactions under $400,000 that meet certain

requirements, which was enacted by the Economic Growth,

Regulatory Relief, and Consumer Protection Act

(EGRRCPA). Supervised ﬁnancial institutions are unlikely to

rely on this exemption because all transactions within its

scope are also exempt under the broader residential threshold

exemption, which does not require the institution to meet any

other criteria. An evaluation is required regardless of whether

the institution relies on the general residential threshold or

rural exemption. For more information on the effective dates

of this amendment, see 84 Fed. Reg. 53,579 (October 8,

2019).

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tions to subject appraisals to appropriate review

for compliance with USPAP. The Interagency

Guidelines provide further guidance on appro-

priate reviews. Not all appraisal reviews need to

include the content of a USPAP Standard 3—

Appraisal Review, Development, and Report-

ing. The depth of the appraisal review per-

formed by the bank should consider the

complexity and risk of the transaction. If deﬁ-

ciencies are noted in the supervised ﬁnancial

institution’s review process, a supervised ﬁnan-

cial institution should obtain a USPAP compli-

ant review completed by an appraiser or obtain

a new compliant appraisal. Supervised ﬁnancial

institutions are encouraged to report to the state

appraiser regulatory agency any appraiser that

violates USPAP standards.

2231.0.7 APPRAISAL VALUATION

APPROACHES

An appraiser typically utilizes three market-

value approaches to analyze the value of prop-

erty:

• cost approach

• sales comparison approach

• income approach

Appraisers should consider all three

approaches to value when completing an

appraisal assignment. All three approaches have

particular merits depending upon the type of

real estate being appraised. For example, for

single-family residential property, the cost and

comparable sales approaches are most fre-

quently used since the common use of the prop-

erty is the personal residence of the owner.

However, if a single-family residential property

were intended to be used as a rental property,

the appraiser would have to consider the income

approach as well. Commercial properties are

typically valued using all three approaches to

value, whereas the income approach is heavily

favored for property whose primary source of

income is derived from rents. The appraiser then

correlates the results of the value considerations

to determine a market value for the subject real

estate. For special-use commercial properties,

the appraiser may have difﬁculty obtaining sales

data on comparable properties and may have to

base the value estimate on the cost and income

approaches.

If an approach is not used in the appraisal, the

appraiser should disclose the reason the

approach was not used and whether this affects

the value estimate.

2231.0.7.1 Cost Approach

The cost approach is commonly used to value

construction or improvements to an existing

building. In the cost approach to value estima-

tion, the appraiser obtains a preliminary indica-

tion of value by adding the estimated depreci-

ated reproduction cost of the improvements to

the estimated land value. This approach is based

on the assumption that the reproduction cost is

the upper limit of value and that a newly con-

structed building would have functional and

mechanical advantages over an existing build-

ing. The appraiser would evaluate any func-

tional depreciation (disadvantages or deﬁcien-

cies) of the existing building in relation to a new

structure.

The cost approach consists of four basic

steps: (1) estimate the value of the land as

though vacant, (2) estimate the current cost of

reproducing the existing improvements, (3) esti-

mate depreciation and deduct from the repro-

duction cost estimate, and (4) add the estimate

of land value and the depreciated reproduction

cost of improvements to determine the value

estimate.

2231.0.7.2 Sales Comparison Approach

The essence of the sales comparison approach is

to determine the price at which similar proper-

ties have recently sold on the local market.

Through an appropriate adjustment for differ-

ences in the subject property and the selected

comparable properties, the appraiser estimates

the market value of the subject property based

on the sales price of the comparable properties.

The process used in determining the degree of

comparability of two or more properties

involves judgment about their similarity with

respect to age, location, condition, construction,

layout, and equipment. The sales price or list

price of those properties deemed most compa-

rable tends to set the range for the value of the

subject property.

10. The standards and application of valuation approaches

are contained in the USPAP published by the Appraisal Stan-

dards Board of the Appraisal Foundation.

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2231.0.7.3 Income Approach

The income approach estimates the real estate

project’s expected income over time converted

to an estimate of its present value. The income

approach is typically used to determine the mar-

ket value of income-producing properties that

receive rent, such as ofﬁce buildings, apartment

complexes, hotels, and shopping centers. In the

income approach, the appraiser can apply sev-

eral different capitalization or discounted cash-

ﬂow techniques to arrive at a market value.

These techniques include the band-of-

investments method, mortgage-equity method,

annuity method, and land-residual method.

Which method is used depends on whether there

is project ﬁnancing, whether there are long-term

leases with ﬁxed-level payments, and whether

the value is being rendered for a component of

the project, such as land or buildings.

The accuracy of the income-approach method

depends on the appraiser’s skill in estimating

the anticipated future net income of the property

and in selecting the appropriate capitalization

rate and discounted cash ﬂow. The following

data are assembled and analyzed to determine

potential net income and value:

• Rent schedules and the percentage of occu-

pancy for the subject property and for compa-

rable properties for the current year and sev-

eral preceding years. This provides gross

rental data and shows the trend of rentals and

occupancy, which are then analyzed by the

appraiser to estimate the gross income the

property should produce.

• Expense data, such as taxes, insurance, and

operating costs paid from revenues derived

from the subject property and by comparable

properties. Historical trends in these expense

items are also determined.

• A time frame for achieving stabilized, or nor-

mal, occupancy and rent levels (also referred

to as a holding period).

Basically, 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 used to value income

properties. This method calculates the value of a

property by dividing an estimate of its stabilized

annual income by a factor called a capitalization

rate or “cap rate.” Stabilized income is generally

deﬁned as the yearly net operating income pro-

duced by the property at normal occupancy and

rental rates; it may be adjusted upward or down-

ward from today’s actual market conditions.

The cap rate—usually deﬁned for each property

type in a market area—is viewed by some ana-

lysts as the required rate of return stated as a

percentage of current income.

The use of this technique assumes that the use

of either the stabilized income or the cap rate

accurately captures all relevant characteristics

of the property relating to its risk and income

potential. If the same risk factors, required rate

of return, ﬁnancing arrangements, and income

projections are used, explicit discounting and

direct capitalization should yield the same

results. For special-use properties, new projects,

or troubled properties, the discounted cash ﬂow

(net present value) method is the more typical

approach to analyzing a property’s value. In this

method, a time frame for achieving a stabilized,

or normal, occupancy and rent level is pro-

jected. Each year’s net operating income during

that period is discounted to arrive at the present

value of expected future cash ﬂows. The proper-

ty’s anticipated sales value at the end of the

period until stabilization (its terminal or rever-

sion value) is then estimated. The reversion

value represents the capitalization of all future

income streams of the property after the pro-

jected occupancy level is achieved. The termi-

nal 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.

Most importantly, the analysis should be

based on the ability of the project to generate

income over time based upon reasonable and

supportable assumptions. Additionally, the dis-

count rate should reﬂect reasonable expectations

about the rate of return that investors require

under normal, orderly, and sustainable market

conditions.

2231.0.7.4 Value Correlation

The three value estimates—cost, sales compari-

son, and income—must be evaluated by the

appraiser and correlated into a ﬁnal value esti-

mate based on the appraiser’s judgment. Corre-

lation does not imply averaging the value esti-

mates obtained by using the three different

approaches. Where these value estimates are

relatively close together, correlating them and

setting the ﬁnal market value estimate presents

no special problem. It is in situations where

widely divergent values are obtained by using

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BHC Supervision Manual February 2020

Page 8

the three appraisal approaches that the examiner

must exercise judgment in analyzing the results

and determining the estimate of market value.

2231.0.7.5 Other Deﬁnitions of Value

While the Board’s appraisal regulation requires

that the appraisal contain the market value of

the real estate collateral, there are other deﬁni-

tions of value that are encountered in appraising

and evaluating real estate transactions. These

include the following:

Fair value. This is an accounting term that is

generally deﬁned as the amount in cash or cash-

equivalent value of other consideration that a

real estate parcel would yield in a current sale

between a willing buyer and a willing seller (the

selling price), that is, other than in a forced or

liquidation sale.

According to accounting lit-

erature, fair value is generally used in valuing

assets in nonmonetary transactions, troubled

debt restructuring, quasi-reorganizations, and

business combinations accounted for by the pur-

chase method. An accountant generally deﬁnes

fair value as market value; however, depending

on the circumstances, these values may not be

the same for a particular property.

Investment value. This is based on the data

and assumptions that meet the criteria and

objectives of a particular investor for a speciﬁc

property or project. The investor’s criteria and

objectives are often substantially different from

participants’ criteria and objectives in a broader

market. Thus, investment value can be signiﬁ-

cantly higher than market value in certain cir-

cumstances and should not be used in credit

analysis decisions.

Liquidation value. This assumes that there is

little or no current demand for the property but

the property needs to be disposed of quickly,

resulting in the owner sacriﬁcing potential prop-

erty appreciation for an immediate sale.

Going-concern value. This is based on the

value of a business entity rather than the value

of just the real estate. The valuation is based on

the existing operations of the business that has a

proven operating record, with the assumption

that the business will continue to operate.

Tax-assessed value. This represents the value

on which a taxing authority bases its assess-

ment. The assessed value and market value may

differ considerably due to tax assessment laws,

timing of reassessments, and tax exemptions

allowed on properties or portions of a property.

Net realizable value (NRV). This is recog-

nized under generally accepted accounting prin-

ciples as the estimated selling price in the ordi-

nary course of business less estimated costs of

completion (to the stage of completion assumed

in determining the selling price), holding, and

disposal. The NRV is generally used to evaluate

the carrying amount of assets being held for

disposition and properties representing collat-

eral. While the market value or future selling

price are generally used as the basis for the

NRV calculation, the NRV also reﬂects the cur-

rent owner’s costs to complete the project and to

hold and dispose of the property. For this rea-

son, the NRV will generally be less than the

market value.

11. See Accounting Standards Codiﬁcation (ASC)

Topic 820, “Fair Value Measurements and Disclosures” (for-

merly FASB Statement No. 157, “Fair Value Measurements”).

It deﬁnes fair value and establishes a framework for measur-

ing fair value. ASC Topic 820 should be applied when other

accounting topics require or permit fair value measurements.

Fair value is deﬁned as the price that would be received to sell

an asset or paid to transfer a liability in an orderly transaction

between market participants in the asset’s or liability’s princi-

pal (or most advantageous) market at the measurement date.

This value is often referred to as an “exit” price. An orderly

transaction is a transaction that assumes exposure to the

market for a period prior to the measurement date to allow for

marketing activities that are usual and customary for transac-

tions involving such assets or liabilities; it is not a forced

liquidation or distressed sale.

Real Estate Appraisals and Evaluations 2231.0

BHC Supervision Manual February 2020

Page 9

Guidelines for the Review and Classiﬁcation

of Troubled Real Estate Loans Section 2240.0

These guidelines are designed to in ensure that

troubled real estate loans receive consistent

treatment nationwide. The guidelines are not

intended to be a substitute for the examiner’s

judgment or for careful analysis of applicable

credit and collateral factors. Use of the word

‘‘institution’’ in these guidelines refers to any

lending source within the bank holding com-

pany organization, whether the lender is the

parent company, a bank, thrift, or nonbanking

subsidiary.

2240.0.1 EXAMINER REVIEW OF

COMMERCIAL REAL ESTATE LOANS

2240.0.1.1 Loan Policy and

Administration Review

As part of the analysis of an institution’s com-

mercial real estate loan portfolio, examiners

review lending policies, loan administration pro-

cedures, and credit risk control procedures. The

maintenance of prudent written lending policies,

effective internal systems and controls, and

thorough loan documentation are essential to

the institution’s management of the lending

function.

The policies governing an institution’s real

estate lending activities must include prudent

underwriting standards that are periodically

reviewed by the board of directors and clearly

communicated to the institution’s management

and lending staff. The institution must also have

credit risk control procedures that include, for

example, prudent internal limits on exposure, an

effective credit review and classiﬁcation pro-

cess, and a methodology for ensuring that the

allowance for loan and lease losses is main-

tained at an adequate level. The complexity and

scope of these policies and procedures should

be appropriate to the size of the institution and

the nature of the institution’s activities, and

should be consistent with prudent banking prac-

tices and relevant regulatory requirements.

2240.0.1.2 Indicators of Troubled Real

Estate Markets and Projects, and Related

Indebtedness

In order to evaluate the collectibility of an insti-

tution’s commercial real estate portfolio, exam-

iners should be alert for indicators of weakness

in the real estate markets served by the institu-

tion. They should also be alert for indicators of

actual or potential problems in the individual

commercial real estate projects or transactions

ﬁnanced by the institution.

There are several warning signs that real

estate markets or projects are experiencing prob-

lems that may result in real estate values

decreasing from original appraisals or projec-

tions. Adverse economic developments and/or

an overbuilt market can affect a project’s eco-

nomic feasibility and may cause a real estate

project and the loan to become troubled. Avail-

able indicators, such as permits for—and the

value of—new construction, absorption rates,

employment trends, and vacancy rates, are use-

ful in evaluating the condition of commercial

real estate markets. Weaknesses disclosed by

these types of statistics may indicate that a real

estate market is experiencing difﬁculties that

may result in cash ﬂow problems for individual

real estate projects, declining real estate values,

and ultimately, in troubled commercial real

estate loans.

Indicators of potential or actual difﬁculties in

commercial real estate projects may include:

• An excess of similar projects under

construction.

• Construction delays or other unplanned

adverse events resulting in cost overruns that

may require renegotiation of loan terms.

• Lack of a sound feasibility study or analysis

that reﬂects current and reasonably antici-

pated market conditions.

• Changes in concept or plan (for example, a

condominium project converted to an apart-

ment project because of unfavorable market

conditions).

• Rent concessions or sales discounts resulting

in cash ﬂow below the level projected in the

original feasibility study or appraisal.

• Concessions on ﬁnishing tenant space, mov-

ing expenses, and lease buyouts.

• Slow leasing or lack of sustained sales activ-

ity and increasing sales cancellations that may

reduce the project’s income potential, result-

ing in protracted repayment or default on the

loan.

• Delinquent lease payments from major

tenants.

• Land values that assume future rezoning.

• Tax arrearages.

As the problems associated with a commer-

cial real estate project become more pro-

BHC Supervision Manual December 1992

Page 1

nounced, problems with the related indebted-

ness may also arise. Such problems include

diminished cash ﬂow to service the debt and

delinquent interest and principal payments.

While some commercial real estate loans

become troubled because of a general downturn

in the market, others become troubled because

they were originated on an unsound or a liberal

basis. Common examples of these types of prob-

lems include:

• Loans with no or minimal borrower equity.

• Loans on speculative undeveloped property

where the borrowers’ only source of repay-

ment is the sale of the property.

• Loans based on land values that have been

driven up by rapid turnover of ownership, but

without any corresponding improvements to

the property or supportable income projec-

tions to justify an increase in value.

• Additional advances to service an existing

loan that lacks credible support for full repay-

ment from reliable sources.

• Loans to borrowers with no development

plans or noncurrent development plans.

• Renewals, extensions and reﬁnancings that

lack credible support for full repayment from

reliable sources and that do not have a reason-

able repayment schedule.

2240.0.1.3 Examiner Review of

Individual Loans, Including the Analysis

of Collateral Value

The focus of an examiner’s review of a commer-

cial real estate loan, including binding commit-

ments, is the ability of the loan to be repaid. The

principal factors that bear on this analysis are

the income-producing potential of the under-

lying collateral and the borrower’s willingness

and capacity to repay under the existing loan

terms from the borrower’s other resources if

necessary. In evaluating the overall risk associ-

ated with a commercial real estate loan, examin-

ers consider a number of factors, including the

character, overall ﬁnancial condition and

resources, and payment record of the borrower;

the prospects for support from any ﬁnancially

responsible guarantors; and the nature and

degree of protection provided by the cash ﬂow

and value of the underlying collateral.

How-

ever, as other sources of repayment for a

troubled commercial real estate loan become

inadequate over time, the importance of the

collateral’s value in the analysis of the loan

necessarily increases.

The appraisal regulations of the federal bank

and thrift regulatory agencies require institu-

tions to obtain appraisals when certain criteria

are met.

Management is responsible for review-

ing each appraisal’s assumptions and conclu-

sions for reasonableness. Appraisal assumptions

should not be based solely on current conditions

that ignore the stabilized income-producing

capacity of the property.

Management should

adjust any assumptions used by an appraiser in

determining value that are overly optimistic or

pessimistic.

An examiner analyzes the collateral’s value

as determined by the institution’s most recent

appraisal (or internal evaluation, as applicable).

An examiner reviews the major facts, assump-

tions, and approaches used by the appraiser

(including any comments made by management

on the value rendered by the appraiser). Under

the circumstances described below, the exam-

iner may make adjustments to this assessment

of value. This review and any resulting adjust-

ments to value are solely for purposes of an

examiner’s analysis and classiﬁcation of a credit

and do not involve actual adjustments to an

appraisal.

A discounted cash ﬂow analysis is an appro-

priate method for estimating the value of

income-producing real estate collateral.

This

analysis should not be based solely on the cur-

rent performance of the collateral or similar

properties; rather, it should take into account, on

1. As discussed more fully in Manual section 2240.0.2, the

reﬁnancing or renewing of loans to sound borrowers would

not result in a supervisory classiﬁcation or criticism unless

well-deﬁned weaknesses exist that jeopardize repayment of

the loans. Consistent with sound banking practices, institu-

tions should work in an appropriate and constructive manner

with borrowers who may be experiencing temporary

difﬁculties.

2. The treatment of guarantees in the classiﬁcation process

is discussed in subsection 2240.0.3.

3. Department of the Treasury, Ofﬁce of the Comptroller

of the Currency, 12 CFR Part 34 (Docket No. 90–16); Board

of Governors of the Federal Reserve System, 12 CFR Parts

208 and 225 (Regulation H and Y; Docket No. R–0685);

Federal Deposit Insurance Corporation, 12 CFR 323 (RIN

3064–AB05); Department of the Treasury; Ofﬁce of Thrift

Supervision, 12 CFR Part 564 (Docket No. 90–1495).

4. Stabilized income generally is deﬁned as the yearly net

operating income produced by the property at normal occu-

pancy and rental rates; it may be adjusted upward or down-

ward from today’s actual market conditions.

5. The real estate appraisal regulations of the federal bank

and thrift regulatory agencies include a requirement that an

appraisal (a) follow a reasonable valuation method that

addresses the direct sales comparison, income, and cost

approaches to market value; (b) reconcile these approaches;

and (c) explain the elimination of each approach not used. A

discounted cash ﬂow analysis is recognized as a valuation

method for the income approach.

Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans 2240.0

BHC Supervision Manual December 1992

Page 2

a discounted basis, the ability of the real estate

to generate income over time based upon rea-

sonable and supportable assumptions.

When reviewing the reasonableness of the

facts and assumptions associated with the value

of the collateral, examiners may evaluate:

• Current and projected vacancy and absorption

rates;

• Lease renewal trends and anticipated rents;

• Volume and trends in past due leases;

• Effective rental rates or sale prices (taking

into account all concessions);

• Net operating income of the property as com-

pared with budget projections; and

• Discount rates and direct capitalization

(‘‘cap’’) rates.

The capacity of a property to generate cash

ﬂow to service a loan is evaluated based upon

rents (or sales), expenses, and rates of occu-

pancy that are reasonably estimated to be

achieved over time. The determination of the

level of stabilized occupancy and rental rates

should be based upon an analysis of current and

reasonably expected market conditions, taking

into consideration historical levels when appro-

priate. The analysis of collateral values should

not be based upon a simple projection of current

levels of net operating income if markets are

depressed or reﬂect speculative pressures but

can be expected over a reasonable period of

time to return to normal (stabilized) conditions.

Judgment is involved in determining the time

that it will take for a property to achieve stabi-

lized occupancy and rental rates.

Examiners do not make adjustments to

appraisal assumptions for credit analysis pur-

poses based on worst case scenarios that are

unlikely to occur. For example, an examiner

would not necessarily assume that a building

will become vacant just because an existing

tenant who is renting at a rate above today’s

market rate may vacate the property when the

current lease expires. On the other hand, an

adjustment to value may be appropriate for

credit analysis purposes when the valuation

assumes renewal at the above-market rate,

unless that rate is a reasonable estimate of the

expected market rate at the time of renewal.

When estimating the value of income-

producing real estate, discount rates and ‘‘cap’’

rates should reﬂect reasonable expectations

about the rate of return that investors require

under normal, orderly and sustainable market

conditions. Exaggerated, imprudent, or unsus-

tainably high or low discount rates, ‘‘cap’’ rates,

and income projections should not be used.

Direct capitalization of nonstabilized income

ﬂows should also not be used.

Assumptions, when recently made by quali-

ﬁed appraisers (and, as appropriate, by institu-

tion management) and when consistent with the

discussion above, should be given a reasonable

amount of deference. Examiners should not

challenge the underlying assumptions, including

discount rates and ‘‘cap’’ rates used in apprais-

als, that differ only in a limited way from norms

that would generally be associated with the

property under review. The estimated value of

the underlying collateral may be adjusted for

credit analysis purposes when the examiner can

establish that any underlying facts or assump-

tions are inappropriate and can support alterna-

tive assumptions.

2240.0.2 CLASSIFICATION

GUIDELINES

As with other types of loans, commercial real

estate loans that are adequately protected by the

current sound worth and debt service capacity

of the borrower, guarantor, or the underlying

collateral generally are not classiﬁed. Similarly,

loans to sound borrowers that are reﬁnanced or

renewed in accordance with prudent underwrit-

ing standards, including loans to creditworthy

commercial or residential real estate developers,

should not be classiﬁed or criticized unless well-

deﬁned weaknesses exist that jeopardize repay-

ment. An institution will not be criticized for

continuing to carry loans having weaknesses

that result in classiﬁcation or criticism as long

as the institution has a well-conceived and effec-

tive workout plan for such borrowers, and effec-

tive internal controls to manage the level of

these loans.

In evaluating commercial real estate credits

for possible classiﬁcation, examiners apply stan-

dard classiﬁcation deﬁnitions. In determining

the appropriate classiﬁcation, consideration

should be given to all important information on

repayment prospects, including information on

the borrower’s creditworthiness, the value of,

and cash ﬂow provided by, all collateral support-

ing the loan, and any support provided by ﬁnan-

cially responsible guarantors.

The loan’s record of performance to date is

important and must be taken into consideration.

As a general principle, a performing commer-

cial real estate loan should not automatically be

classiﬁed or charged-off solely because the

Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans 2240.0

BHC Supervision Manual December 1992

Page 3

value of the underlying collateral has declined

to an amount that is less than the loan balance.

However, it would be appropriate to classify a

performing loan when well-deﬁned weaknesses

exist that jeopardize repayment, such as the lack

of credible support for full repayment from reli-

able sources.

These principles hold for individual credits,

even if portions or segments of the industry to

which the borrower belongs are experiencing

ﬁnancial difﬁculties. The evaluation of each

credit should be based upon the fundamental

characteristics affecting the collectibility of the

particular credit. The problems broadly associ-

ated with some sectors or segments of an indus-

try, such as certain commercial real estate mar-

kets, should not lead to overly pessimistic

assessments of particular credits that are not

affected by the problems of the troubled sectors.

2240.0.2.1 Classiﬁcation of Troubled

Project-Dependent Commercial Real

Estate Loans

The following guidelines for classifying a

troubled commercial real estate loan apply when

the repayment of the debt will be provided

solely by the underlying real estate collateral,

and there are no other available and reliable

sources of repayment. The guidelines are not

intended to address loans that must be treated as

‘‘Other Real Estate Owned’’ for bank and BHC

reporting purposes.

As a general principle, for a troubled project-

dependent commercial real estate loan, any por-

tion of the loan balance that exceeds the amount

that is adequately secured by the value of the

collateral, and that can clearly be identiﬁed as

uncollectible, should be classiﬁed ‘‘loss.’’

The

portion of the loan balance that is adequately

secured by the value of the collateral should

generally be classiﬁed no worse than ‘‘substan-

dard.’’ The amount of the loan balance in excess

of the value of the collateral, or portions thereof,

should be classiﬁed ‘‘doubtful’’ when the poten-

tial for full loss may be mitigated by the out-

comes of certain pending events, or when loss is

expected but the amount of the loss cannot be

reasonably determined.

If warranted by the underlying circumstances,

an examiner may use a ‘‘doubtful’’ classiﬁca-

tion on the entire loan balance. However, this

would occur infrequently.

2240.0.2.2 Guidelines for Classifying

Partially Charged-off Loans

Based upon consideration of all relevant factors,

an evaluation may indicate that a credit has

well-deﬁned weaknesses that jeopardize collec-

tion in full, but that a portion of the loan may be

reasonably assured of collection. When an insti-

tution has taken a charge-off in an amount sufﬁ-

cient that the remaining recorded balance of the

loan (a) is being serviced (based upon reliable

sources) and (b) is reasonably assured of collec-

tion, classiﬁcation of the remaining recorded

balance may not be appropriate. Classiﬁcation

would be appropriate when well-deﬁned weak-

nesses continue to be present in the remaining

recorded balance. In such cases, the remaining

recorded balance would generally be classiﬁed

no more severely than ‘‘substandard.’’

A more severe classiﬁcation than ‘‘substan-

dard’’ for the remaining recorded balance would

be appropriate if the loss exposure cannot be

reasonably determined, e.g., where signiﬁcant

risk exposures are perceived, such as might be

the case for bankruptcy situations or for loans

collateralized by properties subject to environ-

mental hazards. In addition, classiﬁcation of the

remaining recorded balance would be appropri-

ate when sources of repayment are considered

unreliable.

2240.0.2.3 Guidelines for Classifying

Formally Restructured Loans

The classiﬁcation treatment previously dis-

cussed for a partially charged off loan would

also generally be appropriate for a formally

restructured loan when partial charge-offs have

been taken. For a formally restructured loan, the

focus of the examiner’s analysis is on the ability

of the borrower to repay the loan in accordance

with its modiﬁed terms. Classiﬁcation of a for-

mally restructured loan would be appropriate, if,

after the restructuring, well-deﬁned weaknesses

exist that jeopardize the orderly repayment of

the loan in accordance with reasonable modiﬁed

6. The discussion in this section is not intended to address

loans that must be treated as ‘‘other real estate owned’’ for

bank regulatory reporting purposes or ‘‘real estate owned’’ for

thrift regulatory reporting purposes. Guidance on these assets

is presented in supervisory and reporting guidance of the

agencies.

7. For purposes of this discussion, the ‘‘value of the collat-

eral’’ is the value used by the examiner for credit analysis

purposes, as discussed in a previous section of this policy

statement.

Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans 2240.0

BHC Supervision Manual December 1992

Page 4

terms.

Troubled commercial real estate loans

whose terms have been restructured should

be identiﬁed in the institution’s internal credit

review system, and closely monitored by

management.

2240.0.3 TREATMENT OF

GUARANTEES IN THE

CLASSIFICATION PROCESS

Initially, the original source of repayment and

the borrower’s intent and ability to fulﬁll the

obligation without reliance on third party guar-

antors will be the primary basis for the review

and classiﬁcation of assets.

The federal bank

and thrift regulatory agencies will, however,

consider the support provided by guarantees in

the determination of the appropriate classiﬁca-

tion treatment for troubled loans. The presence

of a guarantee from a ‘‘ﬁnancially responsible

guarantor,’’ as described below, may be sufﬁ-

cient to preclude classiﬁcation or reduce the

severity of classiﬁcation.

For purposes of this discussion, a guarantee

from a ‘‘ﬁnancially responsible guarantor’’ has

the following attributes:

• The guarantor must have both the ﬁnancial

capacity and willingness to provide support

for the credit;

• The nature of the guarantee is such that it can

provide support for repayment of the indebt-

edness, in whole or in part, during the remain-

ing loan term; and

• The guarantee should be legally enforceable.

The above characteristics generally indicate

that a guarantee may improve the prospects for

repayment of the debt obligation.

2240.0.3.1 Considerations Relating to a

Guarantor’s Financial Capacity

The lending institution must have sufﬁcient

information on the guarantor’s ﬁnancial condi-

tion, income, liquidity, cash ﬂow, contingent

liabilities, and other relevant factors (including

credit ratings, when available) to demonstrate

the guarantor’s ﬁnancial capacity to fulﬁll the

obligation. Also, it is important to consider the

number and amount of guarantees currently

extended by a guarantor, in order to determine

that the guarantor has the ﬁnancial capacity to

fulﬁll the contingent claims that exist.

2240.0.3.2 Considerations Relating to a

Guarantor’s Willingness to Repay

Examiners normally rely on their analysis of the

guarantor’s ﬁnancial strength and assume a will-

ingness to perform unless there is evidence to

the contrary. This assumption may be modiﬁed

based on the ‘‘track record’’ of the guarantor,

including payments made to date on the asset

under review or other obligations.

Examiners give due consideration to those

guarantors that have demonstrated their ability

and willingness to fulﬁll previous obligations in

their evaluation of current guarantees on similar

assets. An important consideration will be

whether previously required performance under

guarantees was voluntary or the result of legal

or other actions by the lender to enforce the

guarantee. However, examiners give limited cre-

dence, if any, to guarantees from obligors who

have reneged on obligations in the past, unless

there is clear evidence that the guarantor has the

ability and intent to honor the speciﬁc guarantee

obligation under review.

Examiners also consider the economic incen-

tives for performance from guarantors:

• Who have already partially performed under

the guarantee or who have other signiﬁcant

investments in the project;

• Whose other sound projects are cross-

collateralized or otherwise intertwined with

the credit; or

• Where the guarantees are collateralized by

readily marketable assets that are under the

control of a third party.

8. An example of a restructured commercial real estate

loan that does not have reasonable modiﬁed terms would be a

‘‘cash ﬂow’’ mortgage which requires interest payments only

when the underlying collateral generates cash ﬂow but pro-

vides no substantive beneﬁts to the lending institution.

9. Some loans are originated based primarily upon the

ﬁnancial strength of the guarantor, who is, in substance, the

primary source of repayment. In such circumstances, examin-

ers generally assess the collectibility of the loan based upon

the guarantor’s ability to repay the loan.

10. Some guarantees may only provide for support for

certain phases of a real estate project. It would not be appro-

priate to rely upon these guarantees to support a troubled loan

after the completion of these phases.

Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans 2240.0

BHC Supervision Manual December 1992

Page 5

2240.0.3.3 Other Considerations as to the

Treatment of Guarantees in the

Classiﬁcation Process

In general, only guarantees that are legally

enforceable will be relied upon. However, all

legally enforceable guarantees may not be

acceptable. In addition to the guarantor’s ﬁnan-

cial capacity and willingness to perform, it is

expected that the guarantee will not be subject

to signiﬁcant delays in collection, or undue com-

plexities or uncertainties about the guarantee.

The nature of the guarantee is also considered

by examiners. For example, some guarantees for

real estate projects only pertain to the develop-

ment and construction phases of the project. As

such, these limited guarantees would not be

relied upon to support a troubled loan after the

completion of those phases.

Examiners also consider the institution’s

intent to enforce the guarantee and whether

there are valid reasons to preclude an institution

from pursuing the guarantee. A history of timely

enforcement and successful collection of the full

amount of guarantees will be a positive consid-

eration in the classiﬁcation process.

Guidelines for the Review and Classiﬁcation of Troubled Real Estate Loans 2240.0

BHC Supervision Manual December 1992

Page 6

Retail Credit Classiﬁcation

Section 2241.0

In June 2000, the Federal Financial Institutions

Examination Council (FFIEC), on behalf of the

Board of Governors of the Federal Reserve Sys-

tem (Federal Reserve), the Federal Deposit

Insurance Corporation (FDIC), and the Ofﬁce of

the Comptroller of the Currency (OCC), collec-

tively referred to as “the agencies,” published

revisions to the Uniform Retail Credit Classiﬁ-

cation and Account Management Policy.

The

purpose of the 2000 revision was to clarify

certain provisions, especially regarding the

re-aging of open-end accounts and extensions,

deferrals, renewals, and rewrites of closed-end

loans. The revised policy provides supervisory

guidance for residential and home equity loans;

fraudulent loans; loans to deceased persons;

loans to borrowers in bankruptcy; treatment of

partial payments involving past-due loans; and

re-aging, deferrals, renewals, or rewrites of

open-end and closed-end credit. The agencies

are to use this expanded supervisory guidance

when applying the uniform classiﬁcations to

retail-credit loans extended by depository insti-

tutions. See

SR-00-8, “Revised Uniform Retail

Credit Classiﬁcation and Account Management

Policy.”

While the terms of the revised policy apply

only to federally insured depository institutions,

the Federal Reserve believes the guidance is

broadly relevant to bank holding companies

(BHCs) and their nonbank lending subsidiaries,

as well as savings and loan holding companies

(SLHCs).

Accordingly, examiners should con-

sider the revised policy, as appropriate, in the

inspection of consumer ﬁnance subsidiaries of

BHCs and SLHCs.

The following subsection presents the Uniform

Retail Credit Classiﬁcation and Account Man-

agement Policy with minor clarifying edits and

updated references. See 65 Fed. Reg. 36,903,

(June 12, 2000) for the original statement issued

by the FFIEC.

2241.0.1 UNIFORM RETAIL CREDIT

CLASSIFICATION AND ACCOUNT

MANAGEMENT POLICY

The Uniform Retail Credit Classiﬁcation and

Account Management Policy establishes stan-

dards for the classiﬁcation and treatment of

retail credit in ﬁnancial institutions. The agen-

cies’ classiﬁcations used for retail credit are

Substandard, Doubtful, and Loss.

These are

deﬁned as follows:

• Substandard: A Substandard asset is inad-

equately 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 weak-

nesses that jeopardize the liquidation of the

debt. They are characterized by the distinct

possibility that the institution will sustain

some loss if the deﬁciencies are not corrected.

• Doubtful: An asset classiﬁed Doubtful has all

the weaknesses inherent in one classiﬁed Sub-

standard 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.

• Loss: Assets classiﬁed Loss are considered

uncollectible, and of such little value that their

continuance as bankable assets is not war-

ranted. This classiﬁcation does not mean that

the asset has absolutely no recovery or sal-

vage 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.

Retail credit consists of open- and closed-end

credit extended to individuals for household,

family, and other personal expenditures, includ-

ing consumer loans and credit cards. For pur-

poses of this policy, retail credit also includes

loans to individuals secured by their personal

residence, including ﬁrst mortgage, home

equity, and home-improvement loans. Because a

retail-credit portfolio generally consists of a

large number of relatively small-balance loans,

evaluating the quality of the retail-credit port-

1. While the former Ofﬁce of Thrift Supervision also

adopted the Uniform Retail Credit Classiﬁcation and Account

Management Policy, the National Credit Union Administra-

tion, also a member of the FFIEC, did not.

2. See

SR-14-9, “Incorporation of Federal Reserve Policies

into the Savings and Loan Holding Company Supervision

Program.”

3. Although the Federal Reserve, FDIC, and OCC do not

require institutions to adopt identical classiﬁcation deﬁnitions,

institutions should classify their assets using a system that can

be easily reconciled with the regulatory classiﬁcation system.

BHC Supervision Manual February 2023

Page 1

folio on a loan-by-loan basis is inefﬁcient and

burdensome for the institution being examined

and for examiners.

Actual credit losses on individual retail cred-

its should be recorded when the institution

becomes aware of the loss, but in no case should

the charge-off exceed the time frames stated in

this policy. This policy does not preclude an

institution from adopting a more conservative

internal policy. Based on collection experience,

when a portfolio’s history reﬂects high losses

and low recoveries, more conservative stan-

dards are appropriate and necessary.

The quality of retail credit is best indicated by

the repayment performance of individual bor-

rowers. Therefore, in general, retail credit

should be classiﬁed based on the following

criteria:

1. Open- and closed-end retail loans past due

90 cumulative days from the contractual due

date should be classiﬁed as Substandard.

2. 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

classiﬁed as Loss and charged off.

In lieu of

charging off the entire loan balance, a loan

with non-real estate collateral may be written

down to the value of the collateral, less cost

to sell, if repossession of collateral is assured

and in process.

3. One- to four-family residential real estate

loans and home equity loans that are past due

90 days or more with loan-to-value ratios

greater than 60 percent should be classiﬁed

as Substandard. Properly secured residential

real estate loans with loan-to-value ratios

equal to or less than 60 percent are generally

not classiﬁed based solely on delinquency

status. Home equity loans to the same bor-

rower at the same institution as the senior

mortgage loan with a combined loan-to-value

ratio equal to or less than 60 percent need not

be classiﬁed. However, home equity loans

where the institution does not hold the senior

mortgage, that are past due 90 days or more,

should be classiﬁed as Substandard, even if

the loan-to-value ratio is equal to or less than

60 percent.

For open- and closed-end loans secured by

residential real estate, a current assessment

of value should be made no later than 180

days past due. Any outstanding loan balance

in excess of the value of the property, less

cost to sell, should be classiﬁed as Loss and

charged off.

4. Loans in bankruptcy should be classiﬁed as

Loss and charged off within 60 days of

receipt of notiﬁcation of ﬁling from the bank-

ruptcy court or within the time frames speci-

ﬁed in this classiﬁcation policy, whichever is

shorter, unless the institution can clearly

demonstrate and document that repayment is

likely to occur. Loans with collateral may be

written down to the value of the collateral,

less cost to sell. Any loan balance not

charged off should be classiﬁed as Substan-

dard until the borrower re-establishes the

ability and willingness to repay for a period

of at least six months.

5. Fraudulent loans should be classiﬁed as Loss

and charged off no later than 90 days of

discovery or within the time frames adopted

in this classiﬁcation policy, whichever is

shorter.

6. Loans of deceased persons should be classi-

ﬁed as Loss and charged off when the loss is

determined or within the time frames adopted

in this classiﬁcation policy, whichever is

shorter.

2241.0.1.1 Other Considerations for

Classiﬁcation

If an institution can clearly document that a

past-due 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, includ-

ing securities with an estimable value, less cost

to sell, sufﬁcient to recover the recorded invest-

ment 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.

4. For operational purposes, whenever a charge-off is nec-

essary under this policy, it should be taken no later than the

end of the month in which the applicable time period elapses.

Any full payment received after the 120- or 180-day charge-

off threshold, but before month-end charge-off, may be con-

sidered in determining whether the charge-off remains appro-

priate. Open-end retail accounts that are placed on a ﬁxed

repayment schedule should follow the charge-off time frame

for closed-end loans.

Retail Credit Classiﬁcation 2241.0

BHC Supervision Manual February 2023

Page 2

2241.0.1.2 Partial Payments on Open-

and Closed-End Credit

An institution should use one of two methods to

recognize partial payments. A payment equiva-

lent to 90 percent or more of the contractual

payment may be considered a full payment in

computing past-due status. Alternatively, an

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

institution could aggregate the payments

received ($150 × 6 payments, or $900). The

institution could then give credit for three full

months ($300 x 3 payments) and thus treat the

loan as three full months past due. An institution

may use either or both methods in its portfolio,

but may not use both methods simultaneously

with a single loan.

2241.0.1.3 Re-aging, Extensions,

Deferrals, Renewals, and Rewrites

Re-aging of open-end accounts, and extensions,

deferrals, renewals, and rewrites of closed-end

loans can 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.

permissive policy on re-agings, extensions,

deferrals, renewals, or rewrites can cloud the

true performance and delinquency status of the

portfolio. However, prudent use is acceptable

when it is based on a renewed willingness and

ability to repay the loan, and when it is struc-

tured and controlled in accordance with sound

internal policies.

Management should ensure that comprehen-

sive and effective risk management and internal

controls are established and maintained so that

re-ages, extensions, deferrals, renewals, and

rewrites can be adequately controlled and moni-

tored by management and veriﬁed by examin-

ers. The decision to re-age, extend, defer, renew,

or rewrite 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

re-aged, extended, deferred, renewed, or rewrit-

ten, including the number of times such action

has been taken. Documentation normally shows

that the institution’s personnel communicated

with the borrower, the borrower agreed to pay

the loan in full, and the borrower has the ability

to repay the loan. To be effective, management

information systems should also monitor and

track the volume and performance of loans that

have been re-aged, extended, deferred, renewed,

or rewritten and/or placed in a workout program.

2241.0.1.4 Open-End Accounts

Institutions that re-age open-end accounts

should establish a reasonable written policy and

adhere to it. To be considered for re-aging, an

account should exhibit the following:

1. The borrower has demonstrated a renewed

willingness and ability to repay the loan.

2. The account has existed for at least nine

months.

3. The borrower has made at least three con-

secutive minimum monthly payments or the

equivalent cumulative amount. Funds may

not be advanced by the institution for this

purpose.

Open-end accounts should not be re-aged

more than once within any 12-month period and

no more than twice within any 5-year period.

Institutions may adopt a more conservative

re-aging standard; for example, some institu-

tions allow only one re-aging in the lifetime of

an open-end account. Additionally, an over-

limit account may be re-aged at its outstanding

balance (including the over-limit balance, inter-

est, and fees), provided that no new credit is

extended to the borrower until the balance falls

below the predelinquency credit limit.

Institutions may re-age an account after it

enters a workout program, including internal

and third-party debt-counseling services, but

5. These terms are deﬁned as follows. Re-age: Returning a

delinquent, open-end account to current status without collect-

ing (at the time of aging) the total amount of principal,

interest, and fees that are contractually due. Extension:

Extending monthly payments on a closed-end loan and rolling

back the maturity by the number of months extended. The

account is shown current upon granting the extension. If

extension fees are assessed, they should be collected at the

time of the extension and not added to the balance of the loan.

Deferral: Deferring a contractually due payment on a closed-

end loan without affecting the other terms, including maturity,

(or the due date for subsequently scheduled payments,) of the

loan. The account is shown current upon granting the deferral.

Renewal: Underwriting a matured, closed-end loan generally

at its outstanding principal amount and on similar terms.

Rewrite: Underwriting an existing loan by signiﬁcantly

changing its terms, including payment amounts, interest rates,

amortization schedules, or its ﬁnal maturity.

Retail Credit Classiﬁcation 2241.0

BHC Supervision Manual February 2023

Page 3

only after receipt of at least three consecutive

minimum monthly payments or the equivalent

cumulative amount, as agreed upon under the

workout or debt-management program.

Re-aging for workout purposes is limited to

once in a 5-year period and is in addition to the

once-in-12-months/twice-in-5-years limitation

described above. To be effective, management

information systems should track the principal

reductions and charge-off history of loans in

workout programs by type of program.

2241.0.1.5 Closed-End Loans

Institutions should adopt and adhere to explicit

standards that control the use of extensions,

deferrals, renewals, and rewrites of closed-end

loans. The standards should exhibit the

following:

1. The borrower should show a renewed will-

ingness and ability to repay the loan.

2. The standards should limit the number and

frequency of extensions, deferrals, renewals,

and rewrites.

3. Additional advances to ﬁnance unpaid inter-

est and fees should be prohibited.

Management should ensure that comprehen-

sive and effective risk management, reporting,

and internal controls are established and main-

tained to support the collection process and to

ensure timely recognition of losses. To be effec-

tive, management information systems should

track the subsequent principal reductions and

charge-off history of loans that have been

granted an extension, deferral, renewal, or

rewrite.

2241.0.1.6 Examination Considerations

Examiners should assess whether an institution

adheres to this policy. Nevertheless, there may

be instances that warrant exceptions to the gen-

eral classiﬁcation policy. Loans need not be

classiﬁed if the institution can document clearly

that repayment will occur irrespective of delin-

quency 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.

The Uniform Retail Credit Classiﬁcation and

Account Management Policy does not preclude

examiners from classifying individual retail-

credit loans that exhibit signs of credit weakness

regardless of delinquency status. Similarly, 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.

In addition to reviewing loan classiﬁcations,

the examiner should assess whether the institu-

tion’s allowance provides adequate coverage for

probable losses inherent in the portfolio. Sound

risk- and account-management systems, includ-

ing a prudent retail-credit lending policy, mea-

sures to ensure and monitor adherence to stated

policy, and detailed operating procedures,

should also be implemented. A bank’s internal

controls should also conﬁrm adherence to its

retail-credit lending policies. Institutions that

lack sound policies or fail to implement or effec-

tively adhere to established policies will be sub-

ject to criticism as an unsafe and unsound

practice.

Retail Credit Classiﬁcation 2241.0

BHC Supervision Manual February 2023

Page 4

Domestic and Other Reports to Be Submitted

to the Federal Reserve Section 2250.0

In carrying out its regulatory and supervisory

responsibilities, the Board requires the submis-

sion of various reports from bank holding com-

panies. These reports are an integral part of the

Board’s supervision, monitoring, and surveil-

lance functions. Information from these reports

is used to evaluate the performance of bank

holding companies, appraise their ﬁnancial con-

dition, and determine their compliance with

applicable laws and regulations. The examiner

must review the reports (submitted to the Fed-

eral Reserve System) for accuracy and timeli-

ness and insist on their being amended if mate-

rial errors are found. If inaccurate data are

submitted, the resulting ratios could conceal

deteriorating trends in the company’s ﬁnancial

condition and performance. Bank holding com-

panies should maintain sufﬁcient internal sys-

tems and procedures to ensure that reporting is

accomplished according to appropriate regula-

tory requirements. Clear, concise, and orderly

workpapers should support the data presented

and provide a logical tie between report data

and the ﬁnancial records. For detailed current

information on who must submit reports and

what the reporting requirements are, see

the Board’s public site on the Internet at the

following address: www.federalreserve.gov/

boarddocs/reportforms.

2250.0.1 PENALTIES FOR ERRORS IN

REPORTS

Section 8 of the Bank Holding Company Act

(the act) was amended to provide for the assess-

ment of civil money penalties for the submis-

sion of late, false, or misleading reports ﬁled by

bank holding companies that are required by the

act and Regulation Y and for the failure to ﬁle

the required regulatory reports. Financial institu-

tions that have adequate procedures to avoid

any inadvertent errors but that unintentionally

submit incorrect information or are minimally

late in publishing or transmitting the reports can

be ﬁned up to $2,000 per day. The ﬁnancial

institution has the burden of proving that the

error was inadvertent. If the error was not inad-

vertent, a penalty of up to $20,000 per day can

be assessed. If the submission was done in a

knowing manner or with reckless disregard for

the law, a ﬁne of up to $1 million or 1 percent of

the institution’s assets can be assessed for each

day of the violation. Institution-afﬁliated parties

who participate in any manner in the ﬁling of an

institution’s false or misleading required regula-

tory report, or who cause the failure to ﬁle or a

late ﬁling of a required regulatory report, may

be assessed a civil money penalty of up to

$25,000 per day.

2250.0.2 APPROVAL OF DIRECTORS

AND SENIOR OFFICERS OF

DEPOSITORY INSTITUTIONS

The Federal Deposit Insurance Act (12 U.S.C.

1811) was amended to require each insured

depository institution and depository institution

holding company to give 30 days’ prior notiﬁca-

tion to the federal banking authority of (1) the

proposed addition of any individual to its board

of directors or (2) the employment of any indi-

vidual as a senior executive ofﬁcer. This require-

ment applies to the following institutions:

1. institutions that have been chartered less than

two years

2. institutions that have undergone a change in

control within the preceding two years

3. institutions that are in a troubled condition or

whose capital is below minimum standards

The agencies have the authority to issue a notice

of disapproval to stop the appointment or

employment of an individual if they feel that

appointing or employing the person would not

be in the interests of the public, taking into

account that individual’s competence, experi-

ence, character, and integrity.

2250.0.3 INSPECTION OBJECTIVES

1. To determine that required reports are being

ﬁled on time.

2. To determine that the contents of reports are

accurate and complete.

3. To recommend corrective and, if needed, for-

mal enforcement action when ofﬁcial report-

ing practices, policies, or procedures are

deﬁcient.

2250.0.4 INSPECTION PROCEDURES

1. A bank holding company’s historical record

concerning the timely submission of reports

should be ascertained by reviewing relevant

BHC Supervision Manual June 1999

Page 1

Reserve Bank ﬁles. The examiner should

determine, from documentation in the ﬁles,

which reports should have been ﬁled because

of the passage of time or the occurrence of an

event. If a report is delinquent, the bank

holding company should be instructed to pre-

pare and submit the report expeditiously.

2. Copies of regulatory reports ﬁled since the

prior inspection should be reviewed and

compared with company records on a ran-

dom, line-by-line basis, using a signiﬁcance

test. In some cases, the review will necessar-

ily extend to supporting schedules and work-

papers that substantiate the data reﬂected in

the reports. If the initial reports reviewed are

found to be substantially correct, then the

scope of subsequent reviews may be cur-

tailed. If the reports are found to be incorrect,

the overall review procedures should be

intensiﬁed. When an error or misstatement is

considered signiﬁcant, the matter should be

brought to management’s attention and the

bank holding company should be required to

submit adjusted data. Improper methods used

in preparing reports should be called to man-

agement’s attention. The examiner should

explain all changes carefully and assist bank

holding company personnel in whatever way

possible to ensure proper reporting in future

reports.

3. At the conclusion of the review process, the

examiner should discuss the following with

management, when applicable:

a. inaccuracies found in reports and the need

for submission of amended pages or

reports

b. violations of law, rulings, or regulations

c. recommended corrective action when

policies or procedures have contributed to

deﬁciencies noted in the reports or the

untimely submission of report(s)

4. Details concerning the late or inaccurate

preparation of reports should be listed in the

inspection report on the Other Supervisory

Issues report page. If the matter is considered

signiﬁcant, it should be noted on the Examin-

er’s Comments and Matters Requiring Spe-

cial Board Attention report page, as well.

When the exceptions are considered minor

and have been discussed with management

and corrected, it will sufﬁce to state this on

the Other Supervisory Issues workpaper sup-

porting page.

5. When it is determined that false, misleading,

or inaccurate information is contained in

ﬁnancial statements or reports, consider

whether formal enforcement action is needed

to ensure that the offending bank holding

company, ﬁnancial institution, or other entity

under the holding company structure will

correct the statements and reports.

Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0

BHC Supervision Manual June 1999

Page 2

2250.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Submission of reports concerning

compliance with the act, or

regulations or orders under it

1844(c)

Annual reports 1844(c) 225.5(b)

Report on intercompany

transactions

1844(c) 225.5(b)

Reports emanating from

inspection report

recommendations

1844(c) 225.5(b)

Reports emanating from cease-

and-desist orders

1818(b), (c)

Civil money penalties for errors

on bank call and BHC Reports

324

1847

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0

BHC Supervision Manual June 1999

Page 3

Venture Capital

Section 2260.0

2260.0.1 INTRODUCTION

Venture capital activities are usually conducted

through one or more of the following types of

entities: Small Business Investment Companies

(SBIC); Minority Enterprise Small Business

Investment Companies (MESBIC); Non-

licensed Venture Capital Companies; and Part-

nerships or Venture Capital Funds. SBIC’s and

MESBIC’s are licensed and regulated by the

Small Business Administration (SBA); the other

types are not. Both SBIC’s and MESBIC’s are

limited by regulation to investing in and lending

to small businesses; whereas, non-licensed ven-

ture capital companies and partnerships have

greater latitude. The activities of MESBIC’s

(section 103d companies) are speciﬁcally lim-

ited to small ﬁrms owned by socially or eco-

nomically disadvantaged persons. Most banks

and bank holding companies engage in venture

capital activities through an SBIC because of its

broad ability to take equity positions in other

companies. SBIC’s are permitted to own up to

49.9 percent of the voting shares of a company.

By contrast, a non-licensed venture capital com-

pany that is a subsidiary of a bank holding

company may not own more than 4.9 percent of

the voting shares of a business. To escape from

this limitation some bank holding companies

have formed partnerships or venture capital

funds. However, a bank holding company can

only participate as a limited partner with an

ownership interest not to exceed 24.9 percent.

Limited partnerships are preferred by those bank

holding companies who do not possess the

expertise for this type of activity but seek the

potential opportunity for high returns.

Through the use of private capital and, in

some cases, borrowed money, venture capital

companies invest in and lend to new and grow-

ing business enterprises. They prefer to invest in

and lend to companies that exhibit strong man-

agement talent and clearly deﬁned strategies.

Many of the companies are yet unknown to the

public. Their products either have been intro-

duced to the market or are due to arrive in the

next few years. Venture capital companies do

not favor pioneering research. Instead, they are

interested in ﬁnancing innovative products, i.e.,

those next in generation to existing ones, that

have a wide market appeal and the potential for

strong growth. Such products are preferred

because of their shorter development time and

possible faster realization of proﬁts. One of the

ways a venture capital company makes money

is by purchasing the common stock of an emerg-

ing company and selling it when the company

has grown and the stock has appreciated in

value. It also generates earnings by making con-

vertible preferred stock investments and by

lending money in the form of subordinated

debentures and term loans. Usually lending

agreements contain provisions which enable a

venture capital company to acquire shares or

increase existing holdings through the exercise

of warrants or stock options at a later date.

Although in most cases some equity interest is

taken, venture capital companies, generally, do

not acquire a controlling interest in a business

they ﬁnance.

Once ﬁnancing commences, venture capital

companies typically take an active role in the

management of the companies. They usually

receive representation on the company’s board

of directors, which enables them to review bud-

gets and assist in structuring the company’s

long-range strategic plan. Guiding a company

through its developing stages is considered

essential for the achievement of equity apprecia-

tion and realization of the high returns sought

by venture capital companies.

2260.0.2 LOANS AND INVESTMENTS

Investments and lending philosophy may differ

among venture capital companies. Some choose

to be equity-oriented; that is, they look for

higher returns on investments through capital

appreciation, while others favor lending in the

form of loans or convertible debt securities

which provide cash ﬂow to fund operations and

service debt. However, most companies will

strive for a diversiﬁed portfolio in terms of the

type of investment and industry mix. The range

of ﬁnancing possibilities associated with lend-

ing and/or investing is as follows:

BHC Supervision Manual December 1992

Page 1

First Step Financing Funds needed for seed capital to help develop an idea.

Start-up Financing Funds needed to cover the cost of preparing a business plan,

conducting market studies and opening a business.

First Stage Financing Funds needed to start manufacturing and selling the product(s).

Second Stage Financing Funds needed for working capital to expand production and build

inventories. Company is operating but not yet proﬁtable.

Third Stage Financing Funds needed to improve the product, build working capital and

expand marketing and production facilities. At this point, the com-

pany should be generating a proﬁt.

Fourth Stage Financing Additional working capital funds needed prior to initial public

offering which may be as much as a year later.

In addition to the above, venture capital com-

panies will consider ﬁnancing leveraged buy-

outs and turnaround situations.

The degree of risk assumed varies according

to the stage of ﬁnancing, i.e., lower stages con-

tain greater risk because of the requirement for

longer-term investment discipline than higher

stages. Investments in start-up companies typi-

cally take ﬁve to seven years or more to mature.

Because of the high risk involved, most bank-

afﬁliated venture capital companies will avoid

the earlier or lower stages of ﬁnancing. Newly

established venture capital companies and espe-

cially those that use leverage tend to focus on

the intermediate and latter stages of ﬁnancing.

These stages are represented primarily by

debenture ﬁnancing, preferred stock invest-

ments, and straight term loans. In structuring a

portfolio, a venture capitalist should consider

both liquidity and capital protection. The ideal

ﬁnancing mix might entail a limited amount of

money invested in common stock with the

remainder distributed between debentures,

loans, and preferred stock. These instruments

will provide income to cover operating expenses

and service debt as well as give some protection

should the business start to decline. Limited

holdings of common stock give the company

the opportunity to enhance earnings through

capital gains without adversely effecting cash

ﬂow. Regardless of the type of ﬁnancing

offered, the ability to exist from an investment

or loan through either the issuance of public

stock or a cash buyout by a larger company is

the goal of a venture capital company.

2260.0.3 FUNDING

A venture capital company may use private

capital, leverage, or a combination of both to

fund its portfolio of loans and investments. Ven-

ture capital companies obtain private capital

from their parent organization, either banks or

bank holding companies. Generally, private

capital is used to fund high-risk, lower-stage

investments, although some companies may

diversify their portfolio and deploy a portion of

capital in loans, debentures and preferred stock.

Leverage may be derived from internal and

external borrowings. SBIC’s that are banking

subsidiaries may receive funding in the form of

loans from their parent bank. For those compa-

nies that are a subsidiary of a bank holding

company, internal funding may be provided by

the bank holding company from internal cash

ﬂow or its external borrowing sources. A bank

holding company might borrow from its avail-

able bank lines or other borrowing sources to

fund venture capital operations. There is, how-

ever, one exception; that is, the use of commer-

cial paper proceeds to fund venture capital

investments and loans does not appear to qualify

under the exemptive provisions of section

3(a)(3) of the Securities Act of 1933. SBIC’s

and MESBIC’s can obtain external ﬁnancing

from the U.S. government and the private sector,

while, non-licensed venture capital companies

are limited to only private sources for their

external ﬁnancing. Under current SBA regula-

tions, an SBIC can borrow up to $35 million

from the federal ﬁnancing bank with no limit as

to the aggregate amount of private debt. Because

of the investment restrictions on MESBIC’s, the

SBA allows them to incur higher leverage.

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 2

MESBIC’s are permitted to borrow up to four

times their capital base and issue preferred stock

to the SBA up to two times their capital base.

MESBIC’s also have no limit on the aggregate

amount of private debt. All government borrow-

ings ings are through the federal ﬁnancing bank

and carry the guarantee of the SBA. Such bor-

rowings are classiﬁed as senior debt.

2260.0.4 PROFITABILITY

Earnings of venture capital companies can ﬂuc-

tuate widely depending on the nature of their

activities. Those companies that blend their

portfolios with loans, debentures and preferred

stock investments tend to be more predictable

and less erratic in earnings performance than

companies that are strictly equity-oriented. The

difference being that loans, debentures and pre-

ferred stock provide income to cover operating

expenses and debt service requirements, while

common stock investments may not yield posi-

tive returns for several years. Portfolio diversiﬁ-

cation tends to smooth out earnings, although

the potential for major ﬂuctuations in earnings

exists in the future should capital gains be real-

ized on equity investments. In measuring earn-

ings performance, one should consider the com-

bination of net realized earnings (net investment

income plus net realized gains (losses) on sale

of investments) and net unrealized appreciation

or depreciation on investment holdings found in

the capital structure of the balance sheet. It is

not uncommon to see aggregate returns on capi-

tal reach 50

or more. Typically, returns of this magnitude

are inﬂuenced by either large gains realized on

the sale of investments or a substantial amount

of unrealized appreciation on investments held

or a combination of both. Appreciation or depre-

ciation in portfolio investments represents

potential realized gains or losses and, therefore,

should be considered in evaluating the com-

pany’s earnings performance. Speciﬁcally, the

change in year-to-year net unrealized apprecia-

tion or depreciation is a factor that should be

considered in analyzing results. When measur-

ing the company’s contribution to consolidated

earnings, net unrealized appreciation or depre-

ciation should be ignored.

2260.0.5 CAPITALIZATION

In addition to the usual equity components of

capital stock, surplus and retained earnings, the

capital structure of a venture capital company

includes a separate category for net unrealized

appreciation (depreciation) on equity interests.

Net unrealized appreciation (depreciation) on

equity interests represents the gross amount

reported under loans and investments less an

appropriate provision for taxes. Since unreal-

ized appreciation (depreciation) on equity inter-

ests represents future proﬁts (losses) they are

measured separately in the equity account rather

than in earnings.

There are no industry norms with which to

measure capital adequacy. What is known, how-

ever, is that the SBA requires a minimum capital

investment of $1,000,000 to establish an SBIC.

Moreover, regulations governing SBIC’s limit

the dollar amount of investments and/or loans to

a single customer to 20 percent of an SBIC’s

capital base. Although banks are limited by

statute to a maximum capital investment in an

SBIC of 4.9 percent of their primary capital,

statistics show that SBIC’s have substantially

less than this limit. By contrast, there are no

restrictions as to the amount of capital that a

bank holding company may invest in a nonbank

afﬁliated venture capital company. Dependence

on capital to fund portfolio loans and invest-

ments seems to be preferred as the cost of

leverage, at present, cannot provide meaningful

spreads. It can be assumed that the larger the

capital position the higher the dollar amount

available for investing and/or lending to a single

customer.

Sustained proﬁtability and satisfactory asset

quality are required to maintain ﬁnancial sound-

ness and capital adequacy. The SBA will con-

sider an SBIC’s capital as impaired if net unreal-

ized depreciation and/or operating losses equal

50 percent or more of its capital base. It would

seem appropriate to use this guideline for mea-

suring the adequacy of capital of non-licensed

venture capital companies that are afﬁliated with

a bank holding company.

2260.0.6 INSPECTION OBJECTIVES

1. To determine whether the company is

operating within the scope of its approved

activities and within the provisions of the Act

and Regulation Y.

2. To determine whether transactions with

afﬁliates, especially banks, are in accordance

with applicable statutes and regulations.

3. To determine the quality of the asset port-

folios and whether the allowance for losses is

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 3

adequate in relation to portfolio risk and

whether the nonaccrual policy is appropriate.

4. To determine the viability of the company

as a going concern, and whether its afﬁliate

status represents a potential or actual adverse

inﬂuence upon the parent holding company and

its afﬁliated bank and nonbank subsidiaries and

the condition of the consolidated corporation.

5. To determine whether the company has

formal written policies and procedures relating

to lending and investing.

6. To determine if such policies and proce-

dures are adequate and that management is

operating in conformance with the established

policies.

7. To assess management’s ability to operate

the company in a safe and sound manner.

8. To suggest corrective action when poli-

cies, practices or procedures are deﬁcient, or

when asset quality is weak, or when violations

of laws or regulations have been noted.

2260.0.7 INSPECTION PROCEDURES

2260.0.7.1 Pre-Inspection

All SBIC’s and MESBIC’s are subject to com-

prehensive regulations and annual examinations

administered by the SBA. Therefore, it is not

necessary to conduct a full scope inspection of

these subsidiaries. The bank holding company

inspection should focus on the quality of assets,

as disclosed in the annual director’s valuation

and ﬁnancial statements submitted to the SBA

on an annual basis, transactions with afﬁliates

and an overall ﬁnancial evaluation.

The decision whether the operations of a

non-licensed venture capital company will be

inspected ‘‘on-site’’ is based on the availability

and adequacy of data from either the parent

holding company or that which is obtained upon

request from the subsidiary. The following

information should be obtained and thoroughly

reviewed prior to making a decision to go ‘‘on-

site’’:

1. Minutes of the board and executive com-

mittee meetings since inception of company or

the date of the previous inspection;

2. Comparative interim and ﬁscal ﬁnancial

statements containing value accounting adjust-

ments, including the year-end ﬁling with the

SBA;

3. Listing of contingent liabilities, including

any pending material litigation;

4. Latest director’s valuation of loans and

investments and results of latest internal loan or

credit review;

5. Copies of the most recent internal and

external audit reports;

6. Trial balance of all loans and investments,

indicating the percent ownership of a company

involving an equity interest;

7. Listing of loans, debentures and preferred

stock on which scheduled payments are in

arrears 30 days or more or on which payments

are otherwise not being made according to origi-

nal terms;

8. Details of internal and external borrowing

arrangements; and

9. Any agreements, guarantees or pledges

between the subsidiary and its parent holding

company or afﬁliates.

After reviewing the above information, a

decision whether or not to conduct an on-site

inspection must be made. Some of the determi-

nants of this decision would include: relative

size; current level and trend of earnings; asset

quality as indicated in the director’s valuation of

loans and investments; and the condition of the

company when last inspected. From the infor-

mation provided, it might be determined that the

company is operating properly and is in sound

condition. In such a case, an on-site inspection

may not be warranted. Conversely, a deteriorat-

ing condition might be detected which would

warrant a visit even though a satisfactory condi-

tion had been determined during the previous

inspection. All non-licensed venture capital

companies should be inspected on-site at least

once every three years.

2260.0.7.2 On-Site Inspection

If the decision was made to conduct an ‘‘on-

site’’ inspection of the subsidiary, the examiner

should expand the scope of the review to include

these additional procedures:

1. Hold a brief meeting with the chief execu-

tive ofﬁcer of the company to establish contact

and present a brief indication of the scope of the

inspection;

2. Review the company’s policy statements

for loans, investments, nonaccruals, and charge-

offs;

3. Review the latest internal review by the

company’s directors or the loan review depart-

ment of the bank afﬁliate or bank holding

company;

4. Conduct an independent review of the

portfolio;

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 4

a. Establish the minimum dollar of loans

and investments to be reviewed to achieve at

least 70 percent coverage of the portfolio;

b. Review loans and investments in

sample, giving consideration to the following:

• Latest balance sheet and income data;

• Proﬁtability projections;

• Product(s) being produced by customer

and their market acceptance;

• Business plan;

• Extent of relationship with customer;

• Funding sources; and

• Ultimate source of repayment.

c. Discuss the more serious problem loans

and investments with management;

d. Classify, if necessary, those loans and

investments that exhibit serious weaknesses

where collectibility is problematical or worse.

Lower classiﬁcation criteria must accompany

these assets, which possess a higher degree of

credit risk than found in other types of nonbank

lending;

e. Determine the diversiﬁcation of risk

within the portfolio, i.e., the mix of loans and

investments and the type of industries ﬁnanced;

f. Review the adequacy of the allowance

for loan losses and determine the reasonableness

of the amount of unrealized appreciation or

depreciation reported on the balance sheet in

conjunction with the asset evaluation; and

g. Determine whether the board of direc-

tors or parent holding company has established

credit limits for the maximum amount of loans

and investments to be extended to a single cus-

tomer. Verify adherence to the limits.

5. Review equity investments for compliance

with the 4.9 percent maximum limitation to any

one customer;

6. Verify ofﬁce locations and activities with

system approvals;

7. Compare company’s general ledger with

statements prepared for the latest FR Y–6;

8. Review the quality and liquidity of other

investment holdings;

9. Review and classify, if necessary, assets

acquired in liquidation of a customer’s business

due to default. Determine compliance of divesti-

ture period with section 4(c)(2) of The Bank

Holding Company Act;

10. Review the manner and frequency in

which subsidiary management reports to the

parent holding company;

11. Follow-up on matters criticized in the

most recent audit reports and the previous

inspection report on the subsidiary; and

12. Assess the expertise of subsidiary man-

agement and awareness of subsidiary directors.

2260.0.7.3 Matters Warranting

Recommendation in Inspection Report

Deﬁciencies or concerns that warrant citation in

the inspection report for the attention of man-

agement are:

1. Lack of policies and/or controls in the

lending and investing functions;

2. Improper diversiﬁcation of risk in the loan

and investment portfolio;

3. Adverse tie-in arrangements with the

afﬁliate bank(s):

4. Lack of management expertise;

5. Impairment of capital as a result of operat-

ing losses or high unrealized depreciation on

equity interests or a combination of both; and

6. Lack of adequate reporting procedures to

parent holding company management.

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 5

2260.0.8 LAWS, REGULATIONS, INTERPRETATIONS AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Acquisition of SBIC by a

bank holding company

1843(c)(8)

1843(c)(5)

225.111 4–173

4–175

4–174

Limitations of an SBIC’s

control over business

enterprises

13 C.F.R. 107.901(a)

Criteria for various types of

business investments of an

SBIC

13 C.F.R. 121.3–10

13 C.F.R. 121.3–11

Acquisition of a non-licensed

venture capital company by a

bank holding company

1843(c)(8) 225.112

Formation of joint ventures

(limited partnerships) for

purpose of conducting

venture capital activities

1843(c)(6)

Limitation on equity interests

of a non-licensed venture

capital company afﬁliated

with a bank holding company

1843(c)(6)

Loans to afﬁliates—

Section 23A of FR Act

371c

Restrictions on

transactions with afﬁliates

371c

Acquisition of shares

acquired DPC

1843(c)(2)

Acquisition of assets

acquired DPC

1843(c)(2) 225.132 4–175.1

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 6

2260.0.9 APPENDIX 1—VENTURE CAPITAL COMPANY SAMPLE BALANCE

SHEET

December 31, 19XX

ASSETS

Cash XXXX

Money Market investments XXXX

Loans and investments XXXX

Loans XXXX

Debt securities XXXX

Equity interests XXXX

Total loans and investments XXXX

Less: Allowance for losses on loans and investments XXXX

Plus: Unrealized appreciation (depreciation) on equity interests XXXX

Net loans and investments XXXX

Interest and dividends receivable XXXX

Assets acquired in liquidation of loans and investments XXXX

Other assets XXXX

Total assets XXXX

LIABILITIES

Notes payable—afﬁliates XXXX

Notes payable—others XXXX

Accrued taxes payable XXXX

Deferred tax credits XXXX

Other liabilities XXXX

Total liabilities XXXX

STOCKHOLDER’S EQUITY

Common stock (par value XXX) XXXX

Surplus XXXX

Retained earnings XXXX

Net unrealized appreciation (depreciation) of equity interests XXXX

Total stockholder’s equity XXXX

Total liabilities and stockholder’s equity XXXX

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 7

2260.0.10 APPENDIX 2—VENTURE CAPITAL COMPANY—SAMPLE INCOME

STATEMENT

For Fiscal Year Ended

December 31, 19XX

INTEREST INCOME

Interest on loans and debt securities XXX

Dividends on equity interests XXX

Interest on money market investments XXX

Total interest income XXX

INTEREST EXPENSE

Interest on notes payable to afﬁliates XXX

Interest on notes payable to others XXX

Total interest expense XXX

NET INTEREST INCOME XXX

PROVISION FOR LOAN LOSSES XXX

Net interest after provision for loan losses XXX

OTHER REVENUE

Income from assets acquired in liquidation of loans and investments XXX

Management Fees XXX

Total other revenue XXX

Net interest and other revenue XXX

NONINTEREST EXPENSE

Salaries and beneﬁts XXX

Management and service fees XXX

Other expenses XXX

Total noninterest expense XXX

Income before taxes XXX

Applicable taxes XXX

Net investment income XXX

Realized gain (loss) on sale of securities, net of tax XXX

Net income XXX

Venture Capital 2260.0

BHC Supervision Manual December 1992

Page 8

Introduction to BHC Nonbanking and FHC Activities

Section 3000.0

WHAT’S NEW IN THIS REVISED

SECTION

Section 604(e) of the Dodd-Frank Wall Street

Reform and Consumer Protection Act of 2010,

Pub. L. No. 111–203, 124 Stat. 1601 (2010),

(Dodd-Frank Act), added the “...risk to the sta-

bility of the United States banking or ﬁnancial

system...” to the example listing of possible

adverse effects. The amendment is included

below. See 12 U.S.C. 1843(j)(2)(A).

The Bank Holding Company Act of 1956 (BHC

Act) was enacted to limit the expansion of bank-

ing institutions into nonbanking activities. A

bank holding company was deﬁned in the BHC

Act as an entity that owned or controlled 25 per-

cent or more of the voting shares of two or

more banks; companies owning only one bank

were exempted from regulation under the BHC

Act.

During the 1960s, the number of commercial

enterprises that purchased one bank, engaged in

nonbanking activities, and remained exempt from

regulation grew dramatically. As a result of this

change in the structure of bank ownership, Con-

gress enacted the Bank Holding Company Act

Amendments of 1970. Of these amendments,

the most signiﬁcant is the extension of the act to

grant to the Federal Reserve Board the authority

to regulate the activities of one-bank holding

companies.

In 1978, Congress passed the International

Banking Act (IBA). Section 8 of theIBA expanded

the nonbanking prohibitions of the BHC Act to

foreign banks that engage in the business of

banking in the United States directly through a

branch or agency or indirectly through a subsid-

iary commercial lending company. This expanded

the nonbanking restrictions beyond simply cov-

ering foreign banks that own or control U.S.

banks or bank holding companies. However,

section 2(h) of the BHC Act provides foreign

organizations that are principally engaged in the

business of banking outside the United States

with exemptions from the nonbanking prohibi-

tions of the BHC Act. Further exemptions have

been granted by the Board’s discretionary author-

ity under section 4(c)(9) when such exemptions

were in the public interest and were consistent

with the purposes of the BHC Act.

Under section 4(c) of the BHC Act, Congress

exempted a limited number of investments from

the general prohibition against owning or con-

trolling shares of nonbank concerns. Section

4(c)(8) permitted investment in shares of any

company the activities of which the Board

after due notice and opportunity for hearing

has determined—pursuant to section 225.28 of

Regulation Y or Board order issued prior to

November 12, 1999—to be so closely related to

banking or managing or controlling banks as to

be a proper incident thereto. The act also pro-

vided that any bank holding company might

apply to the Board for permission to engage in

an activity that had not yet been determined to

be permissible if the applicant was of the opin-

ion that the activity in its particular circum-

stances was closely related to banking or man-

aging or controlling banks. Section 225.28(b) of

the Board’s Regulation Y lists permissible non-

banking activities that the Board has deemed to

meet these criteria. (See appendix 1.) The list of

permissible nonbanking activities has been

expanded at various times.

The Board also has permitted by order, on an

individual basis, certain activities that it has

considered to be closely related to banking

under section 4(c)(8) of the BHC Act. In doing

so, the Board did not expand the list of permis-

sible activities under section 225.28(b) of Regu-

lation Y. (For a list of such activities, see appen-

dix 2.)

In determining whether the performance of a

nonbank activity by a bank holding company or

the acquisition of a nonbank ﬁrm by a bank

holding company was a proper incident to bank-

ing, the Board applies a ‘‘public interest test.’’

The Board must consider whether performance

of a nonbank activity by a bank holding com-

pany or a subsidiary of such company can rea-

sonably be expected to produce beneﬁts to the

public, such as greater convenience, increased

competition, or gains in efﬁciency, that out-

weigh possible adverse effects, such as undue

concentration of resources, decreased or unfair

competition, conﬂicts of interest, unsound bank-

ing practices, or risk to the stability of the

United States banking or ﬁnancial system. (See

12 U.S.C. 1843(j)(2)(A).)

An interpretation of Regulation Y (12 C.F.R.

225.126) dated April 28, 1972, and amended

September 20, 1972, listed activities that the

Board determined do not satisfy the ‘‘so closely

related’’ test under section 4(c)(8). The Board

subsequently determined that a number of other

activities do not satisfy the closely related test.

(For a complete list of these impermissible

activities, see appendix 3, and, for a brief

BHC Supervision Manual July 2012

Page 1

description of a selected number of the activities

denied by the Board, see section 3700.0 et seq.)

As the primary regulator for bank holding

companies and their directly held nonbank sub-

sidiaries, the Federal Reserve System conducts

inspections of their operations, ﬁnancial condi-

tion, and compliance with appropriate banking

and other related statutes and regulations. Inspec-

tion personnel are called upon to evaluate the

current condition of the organizations, as well as

their future prospects.

On August 10, 1987, the Competitive Equal-

ity Banking Act of 1987 was signed into law.

This act redeﬁned the deﬁnition of ‘‘bank’’ in

section 2 of the BHC Act so that an FDIC-

insured institution is deemed a bank. An ‘‘in-

sured bank’’ is deﬁned in section 3(h) of the

Federal Deposit Insurance Act (12 U.S.C.

1813(h)).

State-Authorized Activities of Savings

Banks

A special rule was established for qualiﬁed

savings banks (state-chartered, FDIC-insured

institutions organized before March 5, 1987)

that are subject to the BHC Act. (See section

2090.7.) In accordance with section 3 of the

BHC Act, a qualiﬁed savings bank may engage

in any nonbanking activity, except insurance

activities, either directly or through a subsidiary,

that it is permitted to conduct directly as a

state-chartered savings bank, even if those

activities are not otherwise permissible for bank

holding companies. To engage in those activi-

ties, however, a qualiﬁed savings bank must

remain a savings bank and a subsidiary of a

savings bank holding company (a company that

controls one or more qualiﬁed savings

banks whose total aggregate assets, upon forma-

tion and at all times thereafter, constitute at

least 70 percent of the assets of the holding

company). With respect to insurance activities,

qualiﬁed savings banks may engage in under-

writing and selling savings bank life insurance

if the savings bank is located in Connecticut,

Massachusetts, or New York, and if certain other

conditions are met.

BHCs Engaging in Nonbanking Activities

in Foreign Countries

A bank holding company has greater leeway to

perform nonbanking activities abroad than in

the United States in that it may engage in non-

banking activities abroad that would not be per-

missible in the United States. However, activi-

ties abroad are subject to limitations. Section

211.8 of Regulation K requires a bank holding

company to limit its direct and indirect activities

abroad to those usual in connection with bank-

ing and ﬁnancial activities and to necessary

related activities. Section 211.10 also lists par-

ticular activities that are permissible abroad and

provides rules regarding when a bank holding

company must submit an application to engage

in such activities directly or through investments.

Edge Act or Agreement Corporations

A bank holding company may own an Edge Act

or agreement corporation. The Federal Reserve

Act and Regulation K govern the permissible

activities of Edge Act or agreement corpora-

tions. An Edge Act or agreement corporation is

an international banking vehicle that may only

engage in listed or approved activities that are

incidental to international or foreign business.

(See 12 C.F.R. 211.6) The restriction generally

permits an Edge Act or agreement corporation

to engage only in international banking or ﬁnan-

cial activities. (See 12 C.F.R. 211.8.)

Companies that own only an Edge Act or agree-

ment corporation. Any company, other than a

bank, that acquired an Edge Act or agreement

corporation after March 5, 1987, must conform

its activities to section 4 of the BHC Act.

Underwriting and Dealing in Debt and

Equity Securities

Beginning in January 1989, certain nonbanking

subsidiaries of bank holding companies were

approved to underwrite and deal in debt or

equity securities (excluding open-end invest-

ment companies), subject to the prohibition on

afﬁliation with an organization dealing in securi-

ties under section 20 of the Glass-Steagall Act.

(See 1989 FRB 192.) The Board delayed com-

mencement of the activity by each applicant

until it determined that the applicant had estab-

lished the necessary managerial and operational

infrastructure to commence the expanded under-

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual July 2012

Page 2

writing and dealing activity and to comply with

the Board order. The applicant’s capital plan

had to be determined to be adequate along with

the necessary policies and procedures needed to

comply with the Board’s order. The Board’s

order requires that loans to and capital invest-

ments in the underwriting subsidiary be deducted

from the bank holding company’s capital, as

provided for in the Board’s capital adequacy

guidelines. The Board further conﬁrmed that the

activities could not be conducted in any other

subsidiary other than the Board-approved sec-

tion 20 subsidiary. (See section 3600.21.4.)

As for underwriting and dealing in equity

securities, the Board stated in the order that it

would review within a year whether applicants

could commence the activity. The ﬁrst Board

authorization to commence underwriting and

dealing in equity securities was given on Sep-

tember 20, 1990, subject to the commitments

given by the bank holding company in connec-

tion with its respective Board order, including

its commitment to maintain the capital of its

section 20 subsidiary at levels necessary to sup-

port its activities and commensurate with indus-

try standards, and to increase the capital of the

section 20 subsidiary accordingly as it grew.

Modiﬁcations to the Board’s Orders

Authorizing BHC Subsidiaries to

Underwrite and Deal in Bank-Ineligible

Securities Consistent with Section 20 of

the Glass-Steagall Act

The Board announced its approval of modiﬁca-

tions to its previous section 20 authorizations by

order on September 21, 1989 (1989 FRB 751).

The modiﬁcations (1) raised from 5 percent to

10 percent (currently 25 percent) the revenue

limit on the amount of total revenues a section

20 subsidiary might derive from bank-ineligible

securities underwriting and dealing activities,

and (2) permitted underwriting and dealing in

the securities of afﬁliates, consistent with sec-

tion 20 of the Glass-Steagall Act, if the securi-

ties were rated by an unafﬁliated, nationally

recognized statistical rating organization or were

issued or guaranteed by the Federal National

Mortgage Association (Fannie Mae), the Fed-

eral Home Loan Mortgage Corporation

(FHLMC), or the Government National Mort-

gage Association (GNMA), or if they repre-

sented interests in such obligations.

Acting as Agent in the Private Placement

of All Types of Securities and Acting as

Riskless Principal in Buying and Selling

Securities

In another Board order, the Board authorized a

bank holding company to transfer its private-

placement activities from its commercial bank

subsidiary to its section 20 subsidiary. The sec-

tion 20 subsidiary would act as agent in the

private placement of all types of securities,

including the provision of related advisory ser-

vices, and would buy all types of securities on

the order of investors as a ‘‘riskless principal.’’

The Board concluded that the section 20 subsid-

iary’s private placement of debt and equity secu-

rities within the limits proposed did not involve

the underwriting or public sale of securities for

the purposes of section 20 of the Glass-Steagall

Act. The revenues derived therefrom should not

be subject to the 25 percent revenue limitation

placed on bank-ineligible securities activities.

(See section 3230.4.)

Foreign Banks Authorized to Operate

Section 20 Subsidiaries to Underwrite

and Deal in Corporate Debt, Commercial

Paper, and Other Securities

In a Board order (1990 FRB 158), the Board

authorized a foreign bank to operate a section

20 subsidiary under the bank to underwrite and

deal in corporate debt, commercial paper, and

other securities. (Securities issued by open-end

investment companies are not included.) The

foreign bank operated outside the United States

but owned a subsidiary bank in the United

States. To achieve equality between the domes-

tic and foreign banking operations in the United

States and in an effort to negate any advantages

that a foreign bank might have over a domestic

bank, the Board considered the foreign bank as

a bank holding company even though the bank

was not part of a bank holding company struc-

ture. In so doing, the Board imposed restrictions

on the section 20 subsidiary. The foreign bank

might fund the section 20 subsidiary, but that

action required prior Board approval. In addi-

tion, the section 20 subsidiary might not borrow

from its parent bank. Any loans to, transfers of

assets to, or investments in the section 20 sub-

sidiary also required Board approval. (See 1990

FRB 158, 455, 554, 568, 573, 652, and 683.)

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual July 2012

Page 3

Financial Institutions Reform, Recovery,

and Enforcement Act of 1989 (FIRREA)

FIRREA became law on August 9, 1989. The

law revised section 4(c)(8) of the BHC Act and

authorized the Board to approve applications

from bank holding companies for the acquisi-

tions of savings associations. The Board thus

revised section 225.28(b)(4)(i) of Regulation Y

to include as a permissible nonbanking activity

the owning, controlling, or operating of a sav-

ings association, if the savings association

engaged only in deposit-taking, lending, and

other activities permissible for bank holding

companies. The legislation required the Board

to remove tandem restrictions found in previous

Board orders that were not prohibited by FIRREA

and, in approving applications, to conﬁne limita-

tions on transactions between the savings asso-

ciation and its bank holding company afﬁliates

to those required by sections 23A and 23B of

the Federal Reserve Act. FIRREA made sec-

tions 23A and 23B applicable to savings asso-

ciations as though they were member banks.

Two exceptions apply: (1) no extensions of

credit may be granted by a savings association

to an afﬁliate unless the afﬁliate is engaged only

in activities permissible for bank holding com-

panies under the BHC Act, and (2) savings

associations may not purchase or invest in secu-

rities of an afﬁliate other than shares of a subsid-

iary. The legislation also provided for a ‘‘sister-

bank’’ exemption from the provisions of sec-

tions 23A and 23B of the Federal Reserve Act.

(See sections 2020.1.1.6 and 2090.8.1.)

1992 Revisions to the Regulation Y List

of Nonbanking Activities—the ‘‘Laundry

List’’

During 1992, the Board initiated several actions

that affected certain nonbanking activities. The

ﬁrst action, effective May 18, 1992, amended

section 225.28(b) of Regulation Y with regard

to tangible personal property leases. Subject to

the stated limitations, a bank holding company

can rely on estimated residual values of up to

100 percent of the acquisition costs of the leased

property in order to recover the bank holding

company’s leasing costs. Previously, the non-

banking activity had only been approved by

Board order. (See the initial Board order at 1990

FRB 462 and the subsequent Board orders at

1990 FRB 960 and 1991 FRB 187 and 490.)

The Board issued a revised interpretive rule,

effective August 10, 1992, regarding investment

advisory activities of bank holding companies

to expressly provide that a bank holding com-

pany or its nonbank subsidiary may act as agent

for customers in the brokerage of shares of an

investment company advised by the holding

company or any of its subsidiaries. In addition,

the revision provided that a bank holding com-

pany or its nonbank subsidiary may provide

investment advice to customers regarding the

purchase or sale of shares of an investment

company advised by an afﬁliate. In both instances,

the Board requires certain disclosures to be

made to address potential conﬂicts of interest or

adverse effects. (See 12 C.F.R. 225.125(h) of

Regulation Y.)

Effective September 10, 1992, the Board added

two nonbanking activities to Regulation Y that

were previously approved by Board order. The

two activities dealt with full brokerage services

and ﬁnancial advisory services. (See 12 C.F.R.

225.28(b)(6) and (7).)

Comprehensive Revision of Regulation Y

In August 1996, the Board proposed compre-

hensive revisions to Regulation Y that were

designed to signiﬁcantly reduce regulatory bur-

den, improve efﬁciency, and eliminate unwar-

ranted constraints on credit availability. The pro-

posal followed a Board review of its regulations

that was required by the Riegle Community

Development and Regulatory Improvement Act

of 1994. The changes (1) removed a number of

restrictions on the permissible nonbanking

activities of BHCs, (2) expanded and reorga-

nized the regulatory list of permissible nonbank-

ing activities to include numerous nonbanking

activities that had been previously approved

only by Board order,

(3) streamlined the

application/notice process for BHCs and the

procedures governing change in bank control

notices, and (4) revised the tying rules to enhance

banking organizations’ ability to provide cus-

tomer discounts on services. Included were

changes that streamlined the procedures for

well-run BHCs to seek Federal Reserve System

approval to acquire additional banks within cer-

tain limits. The Board approved these revisions

to Regulation Y, effective April 21, 1997.

1. See subsection 3000.0.2, appendix 1. See also section

225.28(b) of Regulation Y. In addition to these activities,

other activities have been approved by Board order. For a list

of those activities, see subsection 3000.0.3, appendix 2.

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2003

Page 4

Limitation on Board-Approved

Nonbanking Activities

The Gramm-Leach-Bliley Act (the GLB Act)

amended the BHC Act to limit bank holding

companies that are not ﬁnancial holding compa-

nies to engaging only in ‘‘activities which had

been determined by the Board by regulation or

order under section 4(c)(8) of the BHC Act and

section 225.28 of Regulation Y before Novem-

ber 12, 1999 (the approval date of the GLB

Act), to be so closely related to banking as to be

a proper incident thereto (subject to such terms

and conditions contained in such regulation or

order, unless modiﬁed by the Board)’’ (12 U.S.C.

1843(c)(8)). Prior to November 12, 1999, the

Board had determined that ‘‘[a]ny activity usual

in connection with making, acquiring, broker-

ing, or servicing loans or other extensions of

credit, as determined by the Board’’ is closely

related to banking. Accordingly, the Board

retains authority after the GLB Act to deﬁne the

scope of this section 4(c)(8) activity and to

modify the terms and conditions that apply to

the activity.

Financial Holding Companies

The GLB Act, approved in November 1999,

amended section 4 of the BHC Act and expanded

the powers of qualifying BHCs and foreign

banks that elect to become ﬁnancial holding

companies (FHCs). An FHC is deﬁned in the

GLB Act as a BHC that meets certain eligibility

requirements. The law repealed those provisions

of the Glass-Steagall Act and the BHC Act that

restricted the ability of BHCs to afﬁliate with

securities ﬁrms and insurance companies. For a

bank holding company to become an FHC and

be eligible to engage in new activities autho-

rized under the GLB Act, the GLB Act requires

that all depository institutions controlled by the

BHC be well capitalized and well managed.

With regard to a foreign bank that operates a

branch or agency or that owns or controls a

commerciallendingcompany in the UnitedStates,

the GLB Act requires the Board to apply compa-

rable capital and management standards that

give due regard to the principle of national treat-

ment and equality of competitive opportunity.

Qualifying BHCs that elect to become FHCs

can engage in a broad array of ﬁnancially related

activities, including (1) securities underwriting

and dealing, (2) insurance agency and insurance

underwriting activities, and (3) merchant bank-

ing activities. With respect to merchant banking,

the GLB Act (1) permits an FHC to retain a

merchant banking investment only as long as

necessary to dispose of the investment on a

reasonable basis consistent with the ﬁnancial

viability of its merchant banking activities, and

(2) provides that an FHC may not routinely

manage or operate a company held as a mer-

chant banking investment except as necessary to

obtain a reasonable return on the investment.

The statute also sets forth parameters for the

relationships between the Federal Reserve and

otherregulators. The statute differentiatesbetween

the Federal Reserve’s relations with regulators

of depository institutions and functional regula-

tors, such as those for nonbanking or nonﬁnan-

cial activities such as insurance, securities, and

commodities activities.

An FHC may engage in any other activities

that the Board and the Secretary of the Treasury

jointly determine to be ﬁnancial in nature or

incidental to ﬁnancial activities. An FHC may

also engage in any nonﬁnancial activity that the

Board determines (1) is complementary to a

ﬁnancial activity and (2) does not pose a sub-

stantial risk to the safety and soundness of

depository institutions or the ﬁnancial system

generally. The activities of BHCs and foreign

banks that are not FHCs continue to be limited

to activities currently authorized under section

4(c) of the BHC Act to be closely related to

banking and permissible for BHCs. No addi-

tional activities may be found to be so closely

related to banking as to be a proper incident

thereto after November 11, 1999, thus limiting

the ability of BHCs and foreign banks that are

not FHCs to expand their activities.

In this manual, the sections in the 3900 series

have been designated for FHCs. Those sections

discuss FHC qualiﬁcation requirements (domes-

tic and foreign); permissible nonbanking FHC

activities designated by statute (for example,

merchantbanking activities)or regulation,includ-

ing activities jointly approved by the Board and

the Secretary of the Treasury; and the supervi-

sory approach and guidance for FHCs.

To implement the provisions of the GLB Act

that govern FHCs, the Board amended Regula-

tion Y by adding subpart I for FHCs. The provi-

sions of an interim rule became effective March

11, 2000, and the Board approved a ﬁnal rule

effective December 21, 2000. Key provisions of

the ﬁnal rule are discussed within the 3900

sections of this manual. With respect to permis-

sible activities of FHCs, the rule includes activi-

ties that previously were determined to be closely

related to banking under section 225.28 of Regu-

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2003

Page 5

lation Y, activities that are usual in connection

with transactions of banking abroad (including

those in section 211.10 of Regulation K), and

other activities deﬁned as ﬁnancial in nature by

the GLB Act.

3000.0.1 CATEGORIES OF

NONBANKING ACTIVITIES

Section 4(c)(8) of the BHC Act authorizes bank

holding companies to engage directly or through

a subsidiary in activities that the Board deter-

mined before November 12, 1999, to be so

closely related to banking or managing or con-

trolling banks as to be a proper incident thereto.

The Board and the courts established the follow-

ing guidelines for determining whether a non-

banking activity is closely related to banking:

1. whether banks have generally provided the

service

2. whether banks generally provide services

that are operationally or functionally so simi-

lar to the proposed service as to equip them

particularly well to provide the proposed ser-

vice

3. whether banks generally provide services

that are so integrally related to the proposed

service as to require their provision in spe-

cialized form

In addition, before November 12, 1999, the

Board considered other factors in deciding what

activities were closely related to banking.

For

those activities found to be closely related to

banking or to managing or controlling banks,

the Board also must ﬁnd that the proposed activ-

ity is a ‘‘proper incident’’ to banking and that

performance of an activity by a bank holding

company could reasonably be expected to pro-

duce beneﬁts to the public (such as greater

convenience, increased competition, or gains in

efﬁciency) that outweigh possible adverse

effects (such as undue concentration of resources,

decreased or unfair competition, conﬂicts of

interest, or unsound banking practices). The fol-

lowing describes three categories of bank hold-

ing company nonbanking activities:

1. those that have been found to be permissible

and are listed in Regulation Y, the so-called

laundry list activities (see appendix 1)

2. those that are permissible by Board order

only (see appendix 2)

3. those that have been denied by the Board

(see appendix 3)

2. National Courier Association v. Board of Governors,

516 F. 2d 1229 (D.C. Cir. 1975).

3. Alabama Association of Insurance Agents v. Board of

Governors, 533 F.2d 224 (5th Cir. 1976), cert. denied, 435

U.S. 904 (1978).

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2003

Page 6

3000.0.2 APPENDIX 1—Activities Approved by the Board as Being Considered

‘‘Closely Related to Banking’’ Under Section 4(c)(8) of the Bank Holding Company

Act (Section 225.28(b) of Regulation Y)

Year Added

Permitted by Regulation

to Regulation Y

Note: The bulleted items in this appendix are provided for historical reference

only. The narrative before the bulleted items reﬂects the current Regulation Y

authorization.

1. Extending credit and servicing loans 1971

Making, acquiring, brokering, or servicing loans or other extensions

of credit (including factoring, issuing letters of credit, and accepting

drafts) for the company’s account or the account of others.

2. Activities related to extending credit

a. Appraising

(1) Real estate appraising 1980

(2) Personal property appraising 1986

b. Arranging commercial real estate equity ﬁnancing 1983

c. Check-guaranty services 1986

d. Collection agency services 1986

e. Credit bureau services 1986

f. Asset management, servicing, and collection activities 1997

g. Acquiring debt in default 1995

h. Real estate settlement servicing 1997

3. Leasing personal or real property or acting as agent, broker,

or adviser in leasing such property

• Personal property leasing

1971

• Real property leasing 1974

4. Operating nonbank depository institutions

a. Owning, controlling, or operating an industrial bank, Morris Plan 1971

bank, or industrial loan company so long as the institution is not

a bank

b. Owning, controlling, or operating a savings association, if the savings 1989

association engages in deposit-taking activities, lending, and other

activities that are permissible for bank holding companies

5. Trust company functions or activities 1971

6. Financial and investment advisory activities: acting as an investment adviser 1971

or ﬁnancial adviser to any person, including (without limiting these activities

in any way)—

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2003

Page 7

Year Added

Permitted by Regulation

to Regulation Y

a. Serving as an investment adviser to an investment company registered 1972

under the Investment Company Act of 1940, including sponsoring,

organizing, and managing a closed-end investment company

• Investment or ﬁnancial advising 1971

• Advisory services to open-end (mutual fund) investment companies 1972

b. Furnishing general economic information and advice, general economic 1984

statistical forecasting services, and industry studies

c. Providing advice in connection with mergers, acquisitions, divestitures, 1992

investments, joint ventures, leveraged buyouts, reorganizations,

recapitalizations, capital structurings, ﬁnancing transactions, and similar

transactions,

and conducting ﬁnancial feasibility studies

• Financial futures and options on futures 1986

d. Providing information, statistical forecasting, and advice with respect to 1992

any transaction in foreign exchange, swaps and similar transactions,

commodities, and any forward contract, option, future, option on a

future, and similar instruments

• Financial futures and options on futures 1986

• Providing ﬁnancial advice to—

— state and local governments and 1973

— foreign governments, including foreign municipalities and agencies 1992

of foreign governments, such as with respect to the issuance of their

securities

• Inclusion of any investment or ﬁnancial advisory activity without restriction 1997

• Discretionary investment advice to be provided to any person (includes 1997

investment advice regarding derivative transactions to institutional or

retail customers as an investment, commodity trading, or other adviser)

regarding contracts related to ﬁnancial or nonﬁnancial assets (such

advice is no longer restricted to institutional customers)

• Financial and investment advice (or any permissible nonbanking activity) 1997

can be provided in any combination of permissible nonbanking activities

listed in Regulation Y

e. Providing educational courses and instructional materials to consumers on 1986

individual ﬁnancial-management matters

f. Providing tax-planning and tax-preparation services 1986

7. Agency transactional services for customer investments (principal positions)

a. Securities brokerage services (including securities clearing and/or

securities execution services on an exchange) for the account of cus-

tomers and does not include securities underwriting or dealing

(1) Securities brokerage services (including securities clearing and/or 1982

securities execution services on an exchange), whether alone or

(2) In combination with advisory services and incidental activities 1992

(including related securities credit activities and custodial services)

b. Riskless-principal transactions 1997

c. Private-placement services 1997

d. Futures commission merchant activities 1984

• A nonbanking subsidiary may act as an FCM with respect to any 1997

exchange-traded futures contract and options on a futures

contract based on a ﬁnancial or nonﬁnancial commodity

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2003

Page 8

Year Added

Permitted by Regulation

to Regulation Y

e. Other transactional services such as providing to customers as 1997

agent transactional services with respect to the following:

(1) Swaps and similar transactions

(2) Investment transactions as principal

(3) Transactions permissible for a state member bank

(4) Any other transaction involving a forward contract, an option, futures,

an option on a futures or similar contract (whether traded on an exchange

or not) relating to a commodity that is traded on an exchange

8. Investment transactions as principal

a. Underwriting and dealing in government obligations and money market 1984

instruments

b. Investing and trading activities. Engaging as principal in the following:

(1) Foreign exchange 1984

(2) Forward contracts, options, futures, options on futures, swaps, 1997

and similar contracts, whether traded on exchanges or not,

based on any rate, price, ﬁnancial asset (including gold, silver,

platinum, palladium, copper, or any other metal approved by

the Board), nonﬁnancial asset, or group of assets, other than

a bank-ineligible security, if the transaction meets certain require-

ments (A bank-ineligible security is any security that a state member

bank is not permitted to underwrite or deal in under 12 U.S.C. 24 and 335.)

(3) Forward contracts, options, futures, options on futures, swaps, and 1997

similar contracts, whether traded on exchanges or not, based on an

index of a rate, a price, or the value of any ﬁnancial asset, nonﬁnancial

asset, or group of assets, if the contract requires cash settlement

9. Management consulting and counseling activities

a. Providing management consulting advice on any matter (ﬁnancial,

economic, accounting, or audit) to any other company

• Unafﬁliated banks (depository institutions) 1974

• Nonbank depository institutions 1982

• Other unafﬁliated depository institutions 1997

• Any ﬁnancial, economic, account, or audit matter to any other company 1997

b. Employee beneﬁts consulting services 1997

c. Career counseling services 1997

10. Support services

a. Courier services 1973

b. Printing and selling MICR-encoded checks and related documents 1997

11. Insurance agency and underwriting

a. Credit insurance: acting as principal, agent, or broker for insurance

(including home mortgage redemption insurance)

• Acting as insurance agent or broker primarily in connection with credit 1971

extensions

• Underwriting credit life and credit accident and health insurance 1972

related to an extension of credit

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual December 2003

Page 9

Year Added

Permitted by Regulation

to Regulation Y

b. Finance company subsidiary: insurance agent or broker for extension 1982

of credit by ﬁnance company subsidiary

c. Insurance agency activities in small towns 1984

d. Insurance agency activities conducted on May 1, 1982 1984

e. Supervision of retail insurance agents 1984

f. Insurance agency activities by small bank holding companies 1984

g. Insurance agency activities conducted before 1971 1984

12. Community development

a. Financing and investment in community development activities 1971

b. Advisory and related services designed to promote community welfare 1997

13. Issuance and sale of payment instruments

a. Issuance and sale of retail money orders 1984

b. Sale of savings bonds 1979

c. Issuance and sale of traveler’s checks 1981

14. Data processing

a. Providing data processing and data transmission services; facilities

(including data processing and data transmission hardware,

software,

documentation, or operating personnel); databases; advice; and access

to services, facilities, or databases by any technological means

• Providing bookkeeping and data processing 1971

• Data processing and transmission services 1982

• Providing data processing and transmission advice to anyone on 1997

processing and transmitting banking, ﬁnancial, and economic data

b. Conducting data processing and data transmission activities not described 1997

in ‘‘a.’’ that are not ﬁnancial, banking, or economic

1. See section 225.28(b) of Regulation Y for the details of

the regulatory authorizations.

2. A Board staff opinion, issued July 9, 2002, concluded

that a BHC’s certain proposed ﬂood zone–determination ser-

vices are usual in connection with making mortgage loans and

that these activities are within the scope of permissible activi-

ties related to extending credit under section 225.28(b)(2) of

Regulation Y.

3. The provision of higher residual value leasing for tan-

gible personal property was added to Regulation Y in 1992,

including acting as agent, broker, or adviser in leasing such

property.

4. The words ‘‘and similar transactions’’ were added in

1997.

5. Feasibility studies do not include assisting management

with the planning or marketing for a given project or provid-

ing general operational or management advice.

6. Transactions described in section 225.28(b)(8) of Regu-

lation Y.

7. Management consulting services may be provided to

other customers not described in section 225.28(b)(9) of the

rule, but the revenues derived therefrom are subject to a

30 percent annual revenue limitation.

8. Scope narrowed to conform to court decisions in 1979

and 1981; in 1982, it was further narrowed by title VI of the

Garn–St Germain Depository Institutions Act.

9. Beginning in April 1997, the general-purpose hardware

may not constitute more than 30 percent (previously 10 per-

cent) of the cost of any package offering.

10. The total revenue may not exceed 30 percent (increased

to 49 percent, effective January 8, 2004) of the company’s

total annual revenues derived from data processing, data

storage, and data transmission activities.

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual December 2003

Page 10

3000.0.3 APPENDIX 2—Activities Considered ‘‘Closely Related to Banking’’ Under

Section 4(c)(8) of the Bank Holding Company Act

Manual

Section

3600.Permitted by Order on an Individual Basis Year Approved

1. Operating a ‘‘pool-reserve plan’’ for the pooling of loss reserves 1971 1

of banks with respect to loans to small businesses

2. Operating an article XII New York investment company 1977 5.1

3. Underwriting and dealing in commercial paper to a limited extent 1987 21.1

4. Underwriting and dealing in, to a limited extent, municipal revenue 1987 21.2

bonds, mortgage-related securities, and commercial paper

5. Underwriting and dealing in, to a limited extent, municipal revenue

bonds, mortgage-related securities, consumer receivable–related

securities, and commercial paper

1987 21.3

6. Issuing and selling mortgage-related securities backed by the

guarantees of the Government National Mortgage Association

1988 23

7. Engaging in title insurance agency activities (approved under

exemption G of the Garn–St Germain Depository Institutions

Act of 1982)

1988 17.1

8. Underwriting and dealing in, to a limited extent, corporate

debt and equity securities

1989 21.4

9. Acting as a sales-tax refund agent 1990 24.1

10. Providing real estate settlement activities through a permissible

title insurance agency (exemption G companies only)

1990 26

11. Providing administrative and certain other services to mutual funds 1993 27

12. Acting as a dealer-manager in connection with cash-tender

and exchange-offer transactions

1993 21.5

13. Privately placing limited partnership interests 1994 8

14. Engaging in real estate title abstracting 1995 30

15. Providing employment histories to third parties 1995 29

16. Underwriting ‘‘private ownership’’ industrial development

bonds by a section 20 company

1995 21.6

17. Serving as a commodity pool operator of investment funds

engaged in purchasing and selling futures and options on futures

on certain ﬁnancial and nonﬁnancial commodities

1996 13.1

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2001

Page 11

Manual

Section

3600.Permitted by Order on an Individual Basis Year Approved

18. Development of broader marketing plans and advertising,

sales literature, and marketing materials for mutual funds

(see 1997 FRB 678)

1997 28

19. Sale of government services involving (see 1998 FRB 481)— 1998 25

a. postage stamps and postage-paid envelopes

b. public transportation tickets and tokens

c. vehicle registration services (including the sale and distribution

of license plates and license tags for motor vehicles)

d. notary public services

20. Operating a securities exchange 1999 6

21. Acting as a certiﬁcation authority for digital signatures 1999 7

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2001

Page 12

3000.0.4 APPENDIX 3—Activities Considered Not to Be ‘‘Closely Related to

Banking’’ Under Section 4(c)(8) of the Bank Holding Company Act

Activities Denied by the Board Year Denied

1. Insurance premium funding (‘‘equity funding’’) (combined sales of mutual

funds and insurance)

1971

2. Underwriting general life insurance not related to credit extension 1971

3. Real estate brokerage 1972

4. Land investment and development 1972

5. Real estate syndication 1972

6. General management consulting 1972

7. Property management 1972

8. Trading in platinum and palladium coin and bullion

1973

9. Armored car service

1973

10. Sale of level term credit life insurance 1974

11. Underwriting mortgage guarantee insurance 1974

12. Computer output microﬁlm services

1975

13. Operating a travel agency 1976

14. Underwriting property and casualty insurance 1978

15. Real estate advisory activities 1980

16. Certain contract key entry services 1980

17. Offering investment notes with transactional features 1982

18. Engaging in ‘‘pit arbitrage’’ spread transactions on commodities

exchanges to generate trading proﬁts

1982

19. Engaging in the publication and sale of personnel tests

and related materials

1984

20. Providing credit ratings on bonds, preferred stock, and commercial paper 1984

21. Providing independent expert actuarial opinions of a general nature

for purposes such as divorce action and personal injury litigation

1984

22. Acting as a specialist in foreign-currency options on a securities exchange 1985

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2001

Page 13

Activities Denied by the Board Year Denied

23. Title insurance activities (See the Board letter dated March 17, 1986,

re: Independence Bancorp, Inc. and the Board order

at 1989 FRB 31)

24. Acting as a broker for customers in the purchase and sale of forward contracts 1991

based on certain ﬁnancial and nonﬁnancial commodities, and acting as the

primary clearing ﬁrm for professional ﬂoor traders

1. Authorized by the Board in 1995 FRB 190 (platinum)

and 1996 FRB 571 (palladium).

2. On June 18, 1990, the Board determined that the activity

of providing armored car services to the general public is

closely related to banking (see 1990 FRB 676). In order for

the Board to approve a nonbank activity for a bank holding

company, the Board must also ﬁnd that the activity is a

‘‘proper incident thereto.’’ On February 10, 1993, the Board

denied the application (1993 FRB 352), ﬁnding that the pro-

posed transactions posed potential violations of section 23B

of the Federal Reserve Act and that the applicant had failed to

prove that the activity is a proper incident to banking.

3. The Board’s interpretation of Regulation Y at 12 C.F.R.

225.123 was amended on November 25, 1987, by deleting

item (e)(4) relating to the impermissibility of the activity (see

52 Federal Register 45160–45161 and 1987 FRB 933).

4. The Board subsequently approved this activity by Board

order. (See 1997 FRB 138.)

Introduction to BHC Nonbanking and FHC Activities 3000.0

BHC Supervision Manual June 2001

Page 14

Section 2(c) of the BHC Act (Savings Bank Subsidiaries

of BHCs Engaging in Nonbanking Activities) Section 3001.0

As an FDIC insured institution, a savings bank

qualiﬁes as a ‘‘bank’’ under section 2(c) of the

BHC Act, as amended by section 101(a) of the

Competitive Equality Banking Act of 1987

(‘‘CEBA’’). CEBA amended the BHC Act, in

section 3(f), stating that any qualiﬁed savings

bank, which is a subsidiary of a bank holding

company, could engage directly, or through a

subsidiary, in any nonbanking activity, except

for certain insurance activities, that it is permit-

ted to engage in by State law—including activi-

ties which are not otherwise permitted for bank

holding companies under section 4(c)(8) of the

BHC Act. In order for a qualiﬁed savings bank,

that is a subsidiary of a bank holding company,

to engage in such activities, however, the bank

holding company must be a savings bank hold-

ing company as deﬁned in section 2(l) of the

BHC Act, in other words, 70 percent of the

assets of the bank holding company must con-

sist of one or more savings banks at the time of

formation.

Insurance activities of any qualiﬁed savings

bank which is a subsidiary of a bank holding

company are limited to the insurance activities

allowed under section 4(c)(8) of the BHC Act.

A qualiﬁed savings bank that was authorized to

engage in the sale or underwriting of savings

bank life insurance, as of March 5, 1987, can

sell or underwrite such insurance directly, pro-

vided that it is permitted to underwrite and

engage in the sale of savings bank life insurance

as that activity is authorized for savings banks

by state law, and is located in Massachusetts,

Connecticut, or New York. Should the bank

holding company parent of the qualiﬁed savings

bank cease to be a savings bank holding com-

pany, the savings bank must cease engaging in

these activities within two years.

In a separate application a nonoperating com-

pany, which was formed for the purpose of

acquiring a savings bank, insured by the Federal

Deposit Insurance Corporation, applied for the

Board’s approval to become a bank holding

company pursuant to section 3(a)(1) of the Bank

Holding Company Act, acquiring all of the vot-

ing shares of the savings bank. The savings

bank engages through subsidiaries in real estate

investment and development activities autho-

rized pursuant to State law.

As part of the Board’s analysis in this case,

including its evaluation of the capital and ﬁnan-

cial resources of the bank holding company and

the bank involved, the Board considered the risk

to the Applicant and to the savings bank of the

real estate development activities to be con-

ducted by the savings bank through its nonbank

subsidiaries. The Board expressed serious reser-

vations with regard to this application and simi-

lar applications by bank holding companies to

acquire savings banks engaged directly or through

subsidiaries in real estate development activi-

ties. In the Board’s view the conduct of real

estate development activities through a holding

company subsidiary rather than a bank sub-

sidiary would provide more effective corporate

separateness.

The Board approved the application by Order

on October 30, 1987 (1987 FRB 925), relying

on the Applicant’s commitments.

BHC Supervision Manual December 1992

Page 1

Section 2(c)(2)(F) of the BHC Act (Credit Card Bank

Exemption from the Deﬁnition of a Bank) Section 3005.0

WHAT’S NEW IN THIS SECTION

Effective January 2006, this section has been

revised to incorporate a table of Laws, Regula-

tions, Interpretations, and Orders concerning a

credit card bank exemption found in section

2(c)(2)(F) of the Bank Holding Company Act.

(See the discussion below of the Board staff

legal interpretation dated February 18, 2005.)

3005.0.1 SECTION 2(c)(2)

Section 2(c)(2) of the Bank Holding Company

Act (the BHC Act) provides 10 exemptions

from the deﬁnition of a bank for purposes of the

BHC Act. Section 2(c)(2)(F) sets forth the crite-

ria that an institution must meet in order to

qualify for the so-called credit card bank exemp-

tion. The credit card bank exemption applies to

any ‘‘institution, including an institution that

accepts collateral for extensions of credit by

holding deposits under $100,000, and by other

means which—

1. engages only in credit card operations;

2. does not accept demand deposits or deposits

that the depositor may withdraw by check or

similar means for payment to third parties or

others;

3. does not accept any savings or time deposit

of less than $100,000;

4. maintains only one ofﬁce that accepts depos-

its; and

5. does not engage in the business of making

commercial loans.’’

3005.0.2 SECTION 2(c)(2)(F)

On February 18, 2005, Board staff issued an

interpretation in responseto a bank’s (MB Bank’s)

legal counsel, who had requested a determina-

tion that (1) MB Bank would qualify for the

‘‘credit card bank exemption’’ from the deﬁni-

tion of bank in section 2(c)(2)(F) of the BHC

Act and that (2) no application to the Board

would be required under the BHC Act either for

the proposed acquisition of control of MB Bank

(the acquisition) by Financial Group (a joint

venture), or for the proposed redemption of

shares of common stock of MB Bank’s parent,

MB BHC—a bank holding company for the

purposes of the BHC Act—in connection with

the acquisition.

Financial Group proposed to acquire substan-

tially all of the outstanding stock of MB BHC

and, indirectly, MB Bank. Prior to the acquisi-

tion, MB Bank planned to convert itself to a

depository institution that would qualify for the

credit card bank exemption under the BHC Act.

Before the acquisition, but after MB Bank’s

conversion to a credit card bank, MB BHC also

proposed to redeem approximately 50 percent of

its common stock.

To comply with the provisions of the credit

card bank exemption under the BHC Act, other

representations and commitments were made by

and on behalf of MB Bank and MB BHC.

Under these commitments, MB Bank would—

1. engage only in credit card operations

as of

and after the acquisition, including selling

advertisingspacein monthlystatements mailed

to account holders (‘‘statement stuffers’’);

2. provide, as agent, limited debt-protection ser-

vices to its credit card customers—services

in which, for a fee, customers can receive

debt relief from MB Bank during certain

unexpected hardships (the limited debt-

protection coverage provides for the pay-

ment of MB Bank’s outstanding credit card

balance in the event of the borrower’s death,

disability, or involuntary unemployment); and

3. not engage in the business of making com-

mercial loans as of and after the acquisition.

MB Bank also agreed to cease providing cer-

tain ancillary services within three months of

the acquisition by (1) selling a credit report–

monitoring service offered by an unafﬁliated

third party and (2) selling a membership-based

roadside-assistance product offered by an unaf-

ﬁliated third party. In addition, MB Bank com-

mitted to restricting the scope of its deposit

operations as of, and after, the acquisition to

comply with the credit card bank exemption

provisions of the BHC Act. MB Bank agreed to

not accept demand deposits or deposits that the

depositor may withdraw by check or similar

means for payment to third parties or others.

1. 12 U.S.C. 1841(c)(2)(F).

2. The Senate report accompanying S. 790 states that the

‘‘engage only in credit card operations’’ language was in-

tended to limit a qualifying institution to engage ‘‘only in the

business of issuing and processing credit cards for individuals

and in transactions that are necessary and incident to that

business.’’

BHC Supervision Manual January 2006

Page 1

Moreover, except for deposits that serve as col-

lateral for MB Bank’s credit card loans (collat-

eral deposits), MB Bank will not accept savings

or time deposits of less than $100,000. MB

Bank also represented that each collateral deposit

held by MB Bank will be no greater than the

amount of the relevant customer’s line of credit

with the bank. Any deposit not conforming to

the credit card bank exemption requirements or

the representations and commitments within the

letter of interpretation and not transferred to an

unafﬁliated third party prior to the acquisition

would be liquidated by MB Bank prior to the

acquisition through a wire transfer to the rel-

evant depositor. MB Bank would maintain only

one ofﬁce that accepts deposits.

At the time of the determination request, MB

Bank was issuing debit cards and holding related

deposits that were not permissible for a deposi-

tory institution that qualiﬁes for the credit card

bank exemption under the BHC Act. Therefore,

to qualify for the credit card bank exemption,

MB Bank committed to transferring, before the

acquisition, its current debit card accounts and

related deposits to another bank (the issuing

bank), which would issue new debit cards under

the issuing bank’s name to the current holders

of MB Bank’s debit card accounts. MB Bank

also committed that it would cease all debit

card–related activity, including origination, ser-

vicing, and marketing services provided to the

issuing bank, within three months of the acquisi-

tion. MB Bank would also cease engaging in

any account-servicing activities for debit card or

credit card accounts of afﬁliated or unafﬁliated

banks within three months of the acquisition

(except on a temporary basis in connection with

acquisitions of credit card accounts by MB Bank

from other credit card lenders).

Various other speciﬁc representations and

commitments regarding MB Bank’s investment

activity were also made, including a commit-

ment to divest within two years of the acquisi-

tion certain reverse-mortgage-loan participations.

Based on all the facts of record and subject to

the commitments and representations stated in

the Board staff’s February 18, 2005, interpreta-

tion and in letters to the Board’s Legal Division,

the Board’s Legal Division informed MB Bank’s

legal counsel that it would not recommend that

the Board ﬁnd MB Bank to be a bank for

purposes of the BHC Act as of and after the

acquisition, or that the Board require Financial

Group or its parent companies to ﬁle an applica-

tion with the Board under section 3 of the BHC

Act for the acquisition. Because MB Bank would

cease to be a bank, the Board also determined

that it would not require MB BHC to provide

notice to the Board to redeem MB Bank shares

pursuant to 12 C.F.R. 225(4)(b).

3005.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Credit card bank exemption

under section 2(c)(2)(F)

of the BHC Act

1841(c)(2)(F) 225.104 Staff interpretation

dated February 18

2005

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 2(c)(2)(F) of the BHC Act (Credit Card Bank Exemption) 3005.0

BHC Supervision Manual January 2006

Page 2

Section 4(c)(i) and (ii) of the BHC Act (Exemptions From

Prohibitions on Acquiring Nonbank Interests) Section 3010.0

3010.0.1 INTRODUCTION

The prohibitions against a bank holding com-

pany having or acquiring nonbank interests do

not apply to bank holding companies meeting

the requirements of section 4(c)(i) and (ii) of the

Act.

3010.0.2 LABOR, AGRICULTURAL OR

HORTICULTURAL ORGANIZATIONS

Section 4(c)(i)—“Any company that was on

January 4, 1977, both a bank holding company

and a labor, agricultural or horticultural organi-

zation exempt from taxation under section 501

of the Internal Revenue Code of 1954, or

. . . any labor, agricultural or horticultural orga-

nization to which all or substantially all of the

assets of such company are hereafter trans-

ferred.”

Exemption under this section was amended

when the Financial Institutions Regulatory and

Interest Rate Control Act of 1978 became effec-

tive early in 1979. The effect of the amendment

was to repeal exemption under this section for

labor, agricultural or horticultural organizations

becoming BHCs after January 4, 1977, except

for those organizationsbecoming BHCs by means

of acquiring all or substantially all of the assets

of a company that was both a BHC and a labor,

agricultural or horticultural oganization exempt

from taxation on January 4, 1977. In order for a

holding company to be entitled to this exemp-

tion, net income derived from the organization

cannot inure to the beneﬁt of any individual.

Organizations must be formed primarily for the

betterment of the working conditions of the

labor organization’s members, or improvement

in the grade of agricultural or horticultural prod-

ucts for an agricultural or horticultural organiza-

tion. The growing of products for proﬁt by

agricultural or horticultural organizations would

disqualify them for exemption. Thus the phrase

“any labor, agricultural or horticultural organi-

zation” is intended to include only such organi-

zations that are also exempt from taxation under

section 501 of the Internal Revenue Code of

1954.

In order for a labor, agricultural or horticul-

tural organization to receive exemption from

taxation under section 501(c)(5) of the Internal

Revenue Code of 1954, it must ﬁle an applica-

tion (form 1024) with the IRS. In response to

the application, the organization receives a

determination letter which should be reviewed

to assure that exemption was allowed and to

verify the date the company became exempt

under section 501. The date of exemption is

determined as follows. A company which ﬁles

for exemption within 18 months after its organi-

zation is considered exempt as of the date of its

organization. The date of IRS approval is the

date of exemption if application for exemption

is ﬁled more than 18 months after organization.

The date of exemption must be no later than

January 4, 1977, for the company to be entitled

to exemption from section 4 of the Act. The fact

that an organization pays income taxes annually

does not disallow its exemption under section

501 of the tax code. Despite its tax exemption,

an organization is subject to tax on its unrelated

business income.

3010.0.3 FAMILY-OWNED

COMPANIES

Section 4(c)(ii)—“A company covered in 1970

more than 85 percentum of the voting stock of

which was collectively owned on June 30, 1968,

and continuously thereafter, directly or indi-

rectly, by or for members of the same family, or

their spouses, who are lineal descendants of

common ancestors.”

The phrase “voting stock” does not limit the

form of an organization to an incorporated entity.

Exemption under this section extends to other

forms of business associations which meet the

deﬁnition of a company. For example, for a

partnership, the 85 percent rule applies to “gen-

eral partnership interest” and for a trust which

meets the deﬁnition of a company, the 85 per-

cent rule applies to “beneﬁcial ownership.” A

company must continue to control the same

subsidiary bank that it controlled on June 30,

1968, to retain its exemption under this section.

Lineal descendants of common ancestors include

descendants by half as well as full blood and

legally adopted children.

In January 1980, the Board approved an appli-

cation of a one-bank holding company covered

by the exemption in 4(c)(ii) to acquire an addi-

tional bank, but stated that the holding company

could no longer rely on that section for conduct-

ing its nonbanking activities. Based upon its

review of the legislative intent of Congress in

providing this exemption, it was the Board’s

judgment that the exceptionally broad exemp-

BHC Supervision Manual December 1992

Page 1

tion afforded by section 4(c)(ii) must be limited

to family-owned one-bank holding companies

that are not engaged in the management of

banks. Moreover, in the Board’s view, upon the

acquisition of an additional bank, a one-bank

holding company that is exempt under section

4(c)(ii) of the Act, would become engaged in

the management of banks, and would thereby

terminate its eligibility for the exemption. In

addition, the Board believed that to permit unsu-

pervised nonbank expansion by a multibank

holding company would constitute an evasion

of the Act, which the Board is authorized to

prevent pursuant to section 5(b) of the Act.

3010.0.4 INSPECTION OBJECTIVES

1. To verify that a holding company qualiﬁes

for exemption from the prohibitions of section 4

by virtue of either section 4(c)(i) or 4(c)(ii).

2. Review the activities conducted by a com-

pany qualifying for an exemption under section

4(c)(ii) of the BHC Act, which may be faced

with revocation of the exemption, and deter-

mine if there may be eligibility for permanent

grandfathering under section 4(a)(2) of the BHC

Act.

3010.0.5 INSPECTION PROCEDURES

1. Although bank holding companies qualify-

ing for a section 4(c)(i) or 4(c)(ii) exemption are

not routinely inspected on a periodic basis, when

inspected their exempt status should be veriﬁed.

All nonbank activities of exempt organizations

should be examined in the inspection. The nature

of all such activities and the dates they were

commenced should be documented in the work

papers to establish their current permissibility

in the event the organization should lose its

exemption from section 4.

2. For BHCs exempt under section 4(c)(i),

the examiner should ascertain the date the com-

pany became exempt under section 501 of the

tax code. Also, the stock books of the subsidiary

bank or other pertinent documents should be

reviewed to assure that the company was a BHC

on January 4, 1977.

3. When verifying a company’s exemption

under section 4(c)(ii), the stock records of the

subsidiary bank and the stock records, partner-

ship agreements, trust agreements and other re-

cords of the bank holding company should be

reviewed to assure that the following conditions

have been satisﬁed:

a. 25 percent or more of the voting stock

of the subsidiary bank has been continuously

owned by the BHC since June 30, 1968;

b. Members of the same family have con-

tinuously held an 85 percent or more interest in

the holding company since June 30, 1968.

3010.0.6 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Acquisition of an additional

bank by a company exempt

under 4(c)(ii)

1980 FRB 165

“Successor” to a Company

Exempt under 4(c)(ii)

1980 FRB 349

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(i) and (ii) (Exemptions for Acquiring Nonbank Interests) 3010.0

BHC Supervision Manual December 1992

Page 2

Section 4(c)(1) of the BHC Act (Investment in Companies

Whose Activities are Incidental to Banking) Section 3020.0

3020.0.1 INTRODUCTION

By virtue of section 4(c)(1) of the Act, a bank

holding company may invest, without supervi-

sory approval, in the shares of companies engaged

in activities that Congress felt were incidental to

the business of banking. The following activi-

ties are permissible investments for bank hold-

ing companies under this section.

3020.0.2 PROVIDING BANKING

QUARTERS

Section 4(c)(1)(A) provides that a BHC may

invest in a company engaged in holding or

operating properties used wholly or substan-

tially by any banking subsidiary of such bank

holding company in the operations of such bank-

ing subsidiary or acquired for such future use.

Normally, bank utilization of 50 percent or

more of the property would meet the require-

ments of this section. Investments in property

where usage of such property by subsidiary

banks is less than 50 percent will be reviewed

on an ad hoc basis to determine its permissibil-

ity under this section. Future needs of the bank

holding company and its bank subsidiaries will

be considered when reviewing these cases.

In acquiring property, a bank holding com-

pany must have deﬁnite plans for use of the

property as a subsidiary bank’s premises within

a reasonable period of time. Property may not

be acquired and indeﬁnitely warehoused until a

need develops for the property.

This section of the BHC Act does not provide

the authority for a BHC to invest in the shares

of a company engaged in holding or operating

properties used by nonbank subsidiaries. Di-

rectly holding or operating properties used by a

nonbank subsidiary is considered an incidental

activity necessary to carry on the main business

activity of the subsidiary and thus is exempt

under section 4(a)(2)(A) of the Act and section

225.22(a)(2)(vi) of Regulation Y.

3020.0.3 SAFE DEPOSIT BUSINESS

Section 4(c)(1)(B) of the Act provides that a

holding company may invest in the shares of a

company whose activities are limited to con-

ducting a safe deposit business. Refer to Section

225.22(b) of Regulation Y.

3020.0.4 FURNISHING SERVICES TO

BANKING SUBSIDIARIES

Section 4(c)(1)(C) of the BHC Act provides that

a BHC may invest in a company which fur-

nishes services to or performs services for the

bank holding company or its banking subsidi-

aries. Section 225.22(a) of Regulation Y pro-

vides that a bank holding company may, without

the Board’s prior approval, furnish services to

or perform services for its banking and non-

banking subsidiaries either directly or indirectly

through a subsidiary. Generally, a BHC may

only provide services related to the internal op-

erations of the BHC or its subsidiaries. A bank

holding company or its subsidiaries may not

rely on the servicing exemption to deal with the

public as principal, but may deal with outside

parties provided they are acting only as agent

for the holding company or its subsidiaries.

The term ‘‘services’’ implies servicing opera-

tions a bank may carry on itself, but which the

BHC chooses to have done through a nonbank

subsidiary. Section 225.22(a)(2) states that

services for the internal operations of the bank

holding company or its subsidiaries include:

accounting, auditing, appraising, advertising,

public relations, data processing, data transmis-

sion services, data bases or facilities, personnel

services, courier services, holding or operating

property used wholly or substantially by a sub-

sidiary in its operations or for its future use, and

selling, purchasing or underwriting insurance

such as blanket bond insurance, group insurance

for employees, and property and casualty insur-

ance. For the later insurance activities, bank

holding companies are permitted under the

servicing exemption to act as agent or to

underwrite insurance on their own risks (e.g.

blanket bond insurance or employee group

insurance plans). Refer to section 225.22(a)(2)

of Regulation Y for other services permissible

for the internal operations of the BHC or its

subsidiaries.

The servicing exemption extends to services

that are normally performed by a bank for its

customers or correspondent banks. These activi-

ties generally include computerized billing, pay-

roll, accounting, ﬁnancial records maintenance

and other similar data processing services as

long as the subsidiary bank is permitted under

applicable State or federal law to provide the

service. These services may be provided only

BHC Supervision Manual December 1992

Page 1

upon request by the customers to the subsidiary

bank. Furthermore, the contractual arrangements

must be made between the customer and the

bank. The company can service existing service

contracts the bank has originated but is prohib-

ited from purchasing the contracts or entering

into contracts to provide services directly to the

public.

The purchasing of participations by the parent

in loans from subsidiary banks generally is not

considered an exempt activity under the author-

ity of sections 4(a)(2) or 4(c)(1). Holding com-

panies that engage in the purchase of participa-

tions from their subsidiary banks should ﬁle an

application pursuant to Section 4(c)(8) of the

BHC Act. Purchasing participations in loans for

the purpose of providing liquidity or acquiring a

portion of a line of credit to facilitate the needs

of the bank’s customers (overlines) provides a

service or beneﬁt to the bank and is considered

an acceptable purchase under the services

exemption. In all cases where a participation in

a loan is purchased, the loan must be made in

the name of the bank and serviced by the respec-

tive bank. The purchasing of a loan for reasons

other than those set forth above may be viewed

as a direct lending activity.

3020.0.5 FURNISHING SERVICES TO

NONBANK SUBSIDIARIES

The Bank Holding Company Act of 1956 pro-

hibited a BHC itself from engaging in any busi-

ness except (1) banking, (2) managing or con-

trolling banks, and (3) furnishing services to its

bank subsidiaries. In 1970, Congress amended

section 4 of the BHC Act to expressly authorize

a BHC to furnish services to or perform services

for its nonbank subsidiaries as well as its bank

subsidiariesunder exemption A of section 4(a)(2).

While section 4(c)(1) authorizes a BHC to in-

vest in shares of a company engaged in certain

activities, exemption A provides the authority

for a BHC to engage in those activities directly.

The Board issued an interpretation (12 C.F.R.

225.141), effective August 1980, which stated

that it will permit, without any regulatory ap-

proval, a bank holding company to form a

wholly-owned subsidiary to perform servicing

activities for both banking and nonbanking sub-

sidiaries that the holding company itself could

perform directly or through a department or a

division under section 4(a)(2)(A) of the BHC

Act. In addition, an approved section 4(c)(8)

company may form a wholly-owned subsidiary

to engage in activities that such company could

itself engage in.

3020.0.6 LIQUIDATING ASSETS

Section 4(c)(1)(D) provides that a BHC may

own shares of a company which engages in

liquidating assets acquired from such BHC (not

including its nonbank subsidiaries) or its bank-

ing subsidiaries or which were acquired from

any other source prior to May 9, 1956, or the

date on which such company became a BHC,

whichever is later.

Assets acquired for liquidation by a section

4(c)(1)(D) subsidiary are subject to the same

time limitations as shares acquired D.P.C. pursu-

ant to section 4(c)(2) of the Act.

BHCs seeking to hold the shares of a liquidat-

ing or nominee subsidiary organized to dispose

of assets acquired D.P.C. by a BHC nonbank

subsidiary, can rely on the Board’s August 1980

interpretation permitting, without prior regula-

tory approval, a BHC to form a subsidiary to

perform activities which itself could perform

under exemption A of section 4(a)(2).

3020.0.7 INSPECTION OBJECTIVES

1. To determine whether the activities con-

ducted by companies in which the BHC has a

greater than 5 percent investment in the com-

pany and for which the BHC claims exemption

under section 4(c)(1) of the BHC Act, are the

types of permissible activities contemplated by

that section—activities claimed under the prem-

ises exemption under 4(c)(1)(A), the safe de-

posit business exemption under 4(c)(1)(B), the

services exemption under (4)(c)(1)(C), or the

liquidating subsidiary exemption (4)(c)(1)(D).

3020.0.8 INSPECTION PROCEDURES

The inspection of a nonbank subsidiary exempt

under section 4(c)(1) of the Act should center

on a review of the activities to assure that those

activities are the types permissible under section

4(c)(1) subsections A, B, C and D.

3020.0.8.1 Section 4(c)(1)(A)—Bank

Premises

The following procedural steps should be per-

formed in connection with an inspection of a

bank premises company.

4(c)(1) (Investment in Companies Whose Activities are Incidental to Banking) 3020.0

BHC Supervision Manual December 1992

Page 2

1. Obtain a list of all real estate held by the

company including the following information:

a. Property description and location;

b. Date acquired;

c. Current utilization;

d. Extent of utilization by banking subsid-

iaries and others indicating percentage of square

feet leased to subsidiaries.

2. When use of the property by a subsidiary

bank(s) is less than 50 percent, discuss future

plans for the use of the property with manage-

ment. Note any related discussion contained in

the minutes of directors’ and committee meet-

ings, and action taken to date to implement

these plans. Lease agreements with other ten-

ants should be reviewed to determine the term

of a lease including options to renew.

3. Evaluate the permissibility of holding each

property under the premises exemption.

4. Review and evaluate other activities

engaged in and assets held by the company to

establish their permissibility under the premises

exemption. Such activities could include leasing

property and providing a general maintenance

service to other tenants.

3020.0.8.2 Section 4(c)(1)(B)—Safe

Deposit Business

Activities exempt under this section are re-

stricted to conducting a safe deposit business.

All activities engaged in and assets held by

companies for which the BHC is claiming ex-

emption under this section should be reviewed

and evaluated to determine their permissibility

under this exception.

3020.0.8.3 Section 4(c)(1)(C)—Services

The following procedural steps should be per-

formed when inspecting service companies.

1. List and describe all services provided to

subsidiaries in the inspection report.

2. Review and evaluate the types of services

provided to the banking and nonbanking subsid-

iaries to determine their permissibility.

3. Obtain from management any written bank

holding company policies concerning the provi-

sion of services and the assessment of fees or

discuss with management the basis on which

service fees are established.

4. Comment on the reasonableness of fees

relative to the fair market value, cost, volume,

or quality of such services rendered.

5. Indicate if all service contracts have been

approved by each subsidiary’s board of directors.

6. When reviewing services provided to bank-

ing subsidiaries for their customers:

a. List and describe all services provided;

b. Determine that the company is operat-

ing as an adjunct to its afﬁliated banks for the

purpose of facilitating the bank’s operations,

and not as a separate, self-contained organization;

c. Review contractual arrangements to as-

sure that the company has not purchased any

service contracts from a subsidiary bank and has

not entered directly into agreements to provide

services to any party other than the bank;

d. Review and evaluate all services to

determine whether they are services that the

subsidiary bank is permitted to provide under

applicable State or federal law.

3020.0.8.4 Section 4(c)(1)(D)—

Liquidating Subsidiary

The following procedural steps should be fol-

lowed in connection with an inspection of a

liquidation company in which the BHC holds an

investment.

1. Obtain a list of all assets acquired by the

company for the purpose of liquidation includ-

ing the following information:

a. Asset description and location;

b. Date acquired;

c. Source of acquisition;

d. Liquidation plans, including timetable

and selling price;

e. Cost of assets and book value, including

detail on any improvements.

2. Verify that assets acquired from sources

other than the parent or its subsidiary banks

were acquired prior to May 9, 1956, or the date

on which the holding company became a BHC,

whichever is later.

3. Verify that assets acquired for liquidation

did not originate in a nonbank subsidiary. If a

section 4(c)(1)(D) liquidating subsidiary is hold-

ing a material amount of assets acquired from a

nonbank subsidiary, discuss the propriety of

these holdings with the Reserve Bank ofﬁce

staff and, if necessary, Board staff in the Divi-

sion of Banking Supervision and Regulation or

the Legal Division.

4. Review the bank holding company’s poli-

cies, practices and procedures concerning the

liquidation of assets and determine if the subsid-

iary is in compliance with the time limits indi-

cated above.

5. Discuss with management and note the

4(c)(1) (Investment in Companies Whose Activities are Incidental to Banking) 3020.0

BHC Supervision Manual December 1992

Page 3

liquidation plans and progress to date in liqui-

dating assets that have been held in excess

of 12 months. Note any related discussion found

in the minutes of directors’ and committee

meetings.

6. Comment on whether management is mak-

ing a bona ﬁde effort to dispose of all assets for

fair value.

7. Check improvements made to property by

the company to assure that the nature and use of

the asset has not substantially changed. The

investment of funds to change substantially the

nature of the asset (such as undeveloped real

estate) to increase its value would generally be

viewed as engaging in real estate development,

an activity which is not permissible.

3020.0.9 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Purchase of instalment paper for

subsidiary banks as furnishing of

services

225.104 4–192

Furnishing insurance not ‘‘services’’ 225.109 4–193

Services for banks that are not

subsidiaries

225.113 4–194

Computer services for customers of

subsidiary banks

225.118 4–195

Applicability of Bank Service Corp.

Act in certain BHC situations

225.115 4–174.1

Mortgage company services 225.122 4–196

Insurance and sale of short-term debt

obligations by BHCs

250.221,

225.130

4–867

Operations subsidiaries of a BHC 225.141

Shares held by a subsidiary bank in a

bank premises company and the

applicability of section 4(c)(1)(A)

225.101(g)

225.141

4–185

Investment in an asset liquidation

subsidiary

1843(c)(1)(D)

Providing services to bank and

nonbank subsidiaries

1843(a)(2)(A) 225.22(a)

BHC dealing for a BHC’s own account

in futures, and options on futures,

on gold and silver bullion to limit price

risks in trading

1987 FRB 61

BHC subsidiaries performing services

that BHC could itself perform

1980 FRB 774

4(c)(1) (Investment in Companies Whose Activities are Incidental to Banking) 3020.0

BHC Supervision Manual December 1992

Page 4

Subject Laws

Regulations

Interpretations

Orders

Approved 4(c)(8) subsidiary forming an

operations subsidiary to perform

activities it could itself perform

1979 FRB 566

footnote 1

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(1) (Investment in Companies Whose Activities are Incidental to Banking) 3020.0

BHC Supervision Manual December 1992

Page 5

Section 4(c)(2) and (3) of the BHC Act (Acquisition

of DPC Shares, Assets, or Real Estate) Section 3030.0

Section 4(c)(2) of the Bank Holding Company

Act permits a bank holding company or any of

its subsidiaries to acquire shares in satisfaction

of debts previously contracted (DPC) in good

faith. The shares must be disposed of within two

years from the date they were acquired, except

that the Board is authorized upon application of

a company to grant additional exemptions if, in

its judgment, the extension would not be detri-

mental to the public interest and either the bank

holding company has made a good faith attempt

to dispose of those shares during the ﬁve-year

period, or the disposal of the shares would have

been detrimental to the company. The aggregate

duration of the extensions cannot extend beyond

10 years.

Even though the statute refers speciﬁcally to

shares, the Board has taken the position, in

section 225.22(d) of its Regulation Y and in an

interpretation (12 C.F.R. 225.140), that the con-

gressional policy evidenced by section 4(c)(2)

should apply to DPC acquisitions of other assets,

other than shares (assets), and real estate by

bank holding companies and their nonbanking

subsidiaries. Section 225.22(d)(1) provides the

same holding periods (including provision for

extensions) for other DPC assets or real estate

as are provided by statute for DPC shares.

Regulation Y, section 225.22(d), addresses

nonbanking acquisitions that do not require prior

Board approval. With respect to DPC acquisi-

tions, voting securities, or other assets or real

estate acquired by foreclosure or otherwise, in

the ordinary course of collection of a debt previ-

ously contracted (DPC property) in good faith,

Regulation Y does not require the Board’s prior

approval if the DPC property is divested within

two years of acquisition. Regulation Y further

states that the Board may, upon request, extend

the two-year period for up to three additional

years. Further, the Board may permit additional

extensions for up to ﬁve years (for a total of

10 years). This provision applies to shares, real

estate, or other assets in which the holding com-

pany demonstrates that each extension would

not be detrimental to the public interest and

either the bank holding company has made good

faith attempts to dispose of such shares, real

estate, or other assets, or the disposal of the

shares, real estate, or others assets during the

initial period would have been detrimental to

the company. Transfers within the bank holding

company system do not extend any period for

divestiture of the property.

Under the Board’s delegated authority, the

Reserve Banks may approve a BHC’s requests

for extensions beyond the two-year divestiture

period.

In accordance with a Board interpreta-

tion (12 C.F.R. 225.138), extensions should not

be granted except under compelling circum-

stances, and periodic progress reports on dives-

titure plans are generally required. When these

permissible extension periods expire, the Board

no longer has discretion to grant further exten-

sions. A BHC would be in violation of the act if

shares, other assets, or real estate acquired DPC

is not disposed of within the prescribed time

frame.

In July 1980, the Board issued an interpreta-

tion of Regulation Y (12 C.F.R. 225.140) that

provided for a possible approval for an addi-

tional ﬁve-year period for the divestiture of real

estate acquired DPC. With respect to DPC real

estate, this interpretation requires that (1) the

value of the real estate on the books of the

company be written down to fair market value,

(2) the carrying costs cannot be signiﬁcant in

relation to the overall ﬁnancial position of the

company, and (3) the company must make good

faith efforts to effect divestiture. Fair market

value should be derived from appraisals, compa-

rable sales, or some other reasonable method.

Companies holding real estate for this extended

period are expected to make active efforts to

dispose of it, and they should advise the Reserve

Bank regularly concerning their ongoing efforts.

In accordance with the Board’s interpretation

(12 C.F.R. 225.140), after two years from the

date of acquisition of DPC assets, the holding

company is to report annually to the Federal

Reserve on its efforts to accomplish divestiture

of the assets. The Reserve Bank will monitor the

efforts of the company to effect an orderly dives-

titure. Divestiture may be ordered before the

end of the authorized holding period (beyond

the initial two-year period that requires no Board

authorization) if supervisory concerns warrant

such action.

Section 4(c)(1)(D) allows a bank holding

company to establish a subsidiary to hold real

estate acquired by itself or by any of its banking

subsidiaries for debts previously contracted, for

the purpose of disposing of the real estate in an

orderly manner. Permissible activities of this

1. Each Federal Reserve Bank has been delegated the

authority (12 C.F.R. 265.2(f)(12)) to extend the time within

which a bank holding company or any of its subsidiaries must

divest itself of interests acquired in satisfaction of a debt

previously contracted.

BHC Supervision Manual June 1997

Page 1

liquidating subsidiary include completion of a

real estate development project and other activi-

ties necessary to make the real estate saleable.

The ‘‘date of acquisition’’ is the date the bank

holding company (or subsidiary of the bank

holding company) acquired the DPC asset. Sec-

tion 4(c)(1)(D) may not be used to extend the

time under which a bank holding company

may indirectly hold DPC property under sec-

tion 4(c)(2). In most cases where a subsidiary

bank has held property for the statutory holding

period, a BHC may not shift the property to

another subsidiary or to the parent to avoid

disposing of the property. However, due to the

complexity and potential impact on the organi-

zation of a forced divestment at the end of the

holding period, inspection personnel and Reserve

Bank staff are encouraged to discuss the situa-

tion with Board staff to tailor the supervisory

response to the particular situation.

With respect to the transfer by a subsidiary of

other DPC shares, other assets, or real estate to

another company in the holding company sys-

tem, including a section 4(c)(1)(D) liquidating

subsidiary, or to the holding company itself,

such transfers would not alter the original dives-

titure period applicable to such shares or assets

at the time of their acquisition. Moreover, to

ensure that assets are not carried at inﬂated

values for extended periods of time, the Board

expects, in the case of all such intercompany

transfers, that the shares or assets will be trans-

ferred at a value no greater than the fair market

value at the time of transfer and that the transfer

will be made in a normal arm’s-length trans-

action. With regard to DPC assets (except for

DPC shares as described above) acquired by a

banking subsidiary of a holding company, as

long as the assets continue to be held by the

bank itself, the Board will regard them as being

solely within the authority of the primary super-

visor of the bank.

Section 4(c)(3) of the Bank Holding Com-

pany Act permits a bank holding company to

acquire shares or real estate from any of its

subsidiaries if a subsidiary had been requested

to dispose of the shares by any federal or state

authority having power to examine the respec-

tive subsidiary. The Board does not have author-

ity to extend the two-year disposition period

under section 4(c)(3) of the act. Section 4(c)(3)

may not be used to extend the statutory period

in which a bank must dispose of DPC assets

(10 years in the case of DPC real estate assets,

ﬁve years for all other).

3030.0.1 EXEMPTION TO

SECTION 4(c)(2) DISPOSITION

REQUIREMENTS OF DPC SHARES

Section 4(c)(5) of the Bank Holding Company

Act allows a bank to own shares in certain

nonbanking companies, speciﬁcally, the kinds

and amounts eligible for investment by national

banking associations under the provisions of

section 5136 of the Revised Statutes (see

section 3050.0 for a detailed explanation of

section 4(c)(5)). The exemption provided by

section 4(c)(5) covers any shares, including

shares acquired DPC, that meet the conditions

set forth in that exemption. Therefore, DPC

shares held by a banking subsidiary of a bank

holding company which meet section 4(c)(5)

conditions are not subject to the disposition

requirement prescribed in section 4(c)(2); how-

ever, such shares would continue to be subject

to requirements for disposition as may be pre-

scribed by provisions of any other applicable

banking laws or by the appropriate bank super-

visory authorities.

Section 4(c)(6) of the act allows a bank hold-

ing company to own shares, including those

acquired DPC, of any nonbank company that

does not exceed 5 percent of the outstanding

voting shares of such company. The Board has

expressed an opinion (12 C.F.R. 225.101(f)) that

any shares acquired DPC under this section,

whether by a holding company or a bank subsid-

iary, are not subject to the disposition require-

ments of section 4(c)(2) of the act.

Real property is often shown on an entity’s

books as other real estate (ORE). Possession of

ORE usually results from a distressed loan col-

lateralized by a lien on real estate. In addition,

in attempting to salvage other types of credit, an

entity may have obtained title to real property

through process of law or by voluntary deed.

Acquisition costs for other real estate acquired

for debts previously contracted usually consist

of the principal amount that was due on the

defaulted loan at the time the entity took posses-

sion, unpaid interest, legal fees and other fore-

closure costs, accrued and unpaid taxes, and

mechanic’s liens. Property acquired DPC may

be recorded on the company’s books by capital-

izing the loan amount and acquisition costs.

Advances to complete the project can be included

in the capitalized investment if the ORE is an

unﬁnished project. The fact that the additional

investment is being used to improve the prop-

erty and make the property more saleable should

be evident.

A company owning a DPC asset should main-

tain records documenting its efforts to dispose

Section 4(c)(2) and (3) (Acquisition of DPC Shares or Assets, Including Real Estate) 3030.0

BHC Supervision Manual June 1997

Page 2

of the asset. Because an ORE asset is normally a

nonliquid,nonproductiveasset of uncertain value,

a company should attempt to dispose of the

asset at the earliest date possible. Unless special

circumstances are present, a company should

sell the ORE asset when a price offer sufﬁcient

to cover the acquisition, investment, and carry-

ing costs is obtained.

3030.0.2 INSPECTION OBJECTIVES

1. To determine compliance with applicable

laws, rulings, and regulations, and to initiate

corrective action when violations appear in these

areas.

2. To determine whether policies, practices,

and internal controls regarding DPC shares,

other assets, or real estate are adequate and to

recommend correction when deﬁciencies are

noted.

3. To evaluate the quality of DPC shares,

other assets, or real estate and the progress

toward their disposition.

4. To determine whether the DPC shares,

other assets, or real estate acquired are recorded

at fair market value.

3030.0.3 INSPECTION PROCEDURES

1. During the preinspection review, compile

a list of shares, other assets, and real estate

known to have been acquired DPC by the bank

holding company and its nonbank subsidiaries,

as well as a list of shares known to have been

acquired DPC by the BHC’s bank subsidiaries.

Information on this list should include—

a. a description of the shares or asset(s);

b. the fair market value of the shares and

asset(s), and the method of valuation, if available;

c. the name of the company owning the

shares and asset(s); and

d. the date the shares and asset(s) were

acquired.

2. If the shares or asset has been held longer

than the initial holding period, determine whether

the BHC has requested an extension of time.

3. In the Ofﬁcer’s Questionnaire, request a

list of DPC shares, other assets, or real estate

owned by the holding company and its nonbank-

ing subsidiaries, and a list of DPC shares owned

by the holding company’s bank subsidiaries,

including a detailed description of the shares or

asset, the value of the shares or asset on the

entity’s books, the date the shares or asset was

acquired, and plans for disposal of the shares or

asset. In addition, a list of DPC shares, other

assets, or real estate which has been disposed of

since the previous inspection or within the past

year should be obtained. Compare these lists

with the list compiled during the preinspection

review.

4. Review other real estate owned accounts

to evaluate—

a. the fair market value of the property (A

qualiﬁed appraiser should appraise the property

at the time of acquisition, and subsequent timely

appraisals should be conducted to determine the

current fair market value of the property.);

b. the carrying costs of the property; and

c. the company’s efforts to dispose of the

property (Information on ﬁle should include

documentation showing a record of offers made

by potential buyers and other information

reﬂecting efforts to sell the property (i.e., adver-

tisement brochures)).

5. Determine whether additional advances

have been made on an unﬁnished project and

whether evidence supports that the advances are

making the property more saleable.

6. Determine whether a ﬁrst-lien status exists

and whether there are any tax liens or other

encumbrances against the property.

7. Discuss DPC shares, other assets, or real

estate and their values with management who is

familiar with the history and current status of

the shares or asset and assign classiﬁcation, if

warranted. A substandard classiﬁcation may be

applied when a company is sustaining losses in

maintaining the property, and prospects for sale

are not evident or encouraging. A company’s

acquisition of property through foreclosure often

indicates a lack of demand and, as time elapses,

the value of the real estate may become more

questionable if the lack of demand persists. If

the carrying amount of the investment exceeds

the estimated value of the property, an adequate

allowance reserve for any difference should be

established and maintained. Property that is in

the process of being sold for an amount in

excess of the carrying value should not be clas-

siﬁed if it appears that ultimate payment will be

forthcoming.

8. List shares, other assets, and real estate

acquired DPC under ‘‘other assets’’ in the

inspection report. For signiﬁcant shares and

assets, the examiner may choose to present in

the inspection report or in the workpapers, which-

ever is deemed appropriate, the following

information:

Section 4(c)(2) and (3) (Acquisition of DPC Shares or Assets, Including Real Estate) 3030.0

BHC Supervision Manual June 1997

Page 3

a. a brief description sufﬁcient to identify

the property, the manner in which the property

was acquired, and the reasons for its acquisition

b. the value of the shares or assets on the

books of the company, the method used to deter-

mine the booked value, and whether it is the fair

market value

c. a brief statement as to management’s

efforts to sell the property, its opinion of the

likelihood of sale, and the anticipated sales price

d. a summary of the carrying costs subse-

quent to assumption and income generated from

the property

e. the date when the holding company or

its subsidiary must dispose of the property or

request an extension to continue to hold the

DPC shares or asset

f. the amount classiﬁed, if appropriate

g. any apparent discrepancies with rules or

regulations

3030.0.4 Laws, Regulations, Interpretations, and Orders

Subject Laws

Regulations

Interpretations

Orders

Transactions not requiring

Board approval:

1. Acquisition of securities by

a BHC with majority control

1843(c)(2) 225.12(b)

2. Acquisition of securities by a

BHC with majority control

225.12(c) 4–020 1980 FRB 654

Required disposal by

Regulatory Agency

1843(c)(3)

Section 4(c)(5) and 4(c)(6)

shares with respect to

Section 4(c)(2)

225.101 4–187

Delegation of Authority to extend

time to dispose of DPC shares

and assets

265.2(f)(12)

Policy statement concerning

divestitures by BHCs

225.138

Disposition of property acquired

in satisfaction of debts

previously contracted

225.22,

225.140

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(2) and (3) (Acquisition of DPC Shares or Assets, Including Real Estate) 3030.0

BHC Supervision Manual June 1997

Page 4

Section 4(c)(2) and (3) of the BHC Act (Rental of Other

Real Estate Owned Residential Property) Section 3032.0

The Federal Reserve issued a policy statement

on April 5, 2012, indicating that banking organi-

zations

may rent one- to four-family residential

‘‘Other Real Estate Owned’’ (OREO) properties

without having to demonstrate continuous active

marketing of the properties, provided that suit-

able policies and procedures are followed.

Key

risk-management considerations are described

for banking organizations that engage in the

rental of residential OREO, including compli-

ancewithholding-period requirements for OREO,

compliance with landlord-tenant and associated

requirements, and accounting according to gen-

erally accepted accounting principles (GAAP).

Rental OREO properties with leases in place

and demonstrated cash ﬂow from rental opera-

tions sufﬁcient to generate a reasonable rate of

return should generally not be classiﬁed.

The statement establishes speciﬁc supervi-

sory expectations for banking organizations that

undertake large-scale residential OREO rentals

(generally, 50 properties or more available for

rent). Such organizations should have formal

policies and procedures governing the operation

and administration of OREO rental activities,

including property-speciﬁc rental plans, policies

and procedures for compliance with applicable

laws and regulations, a risk-management frame-

work, and oversight of third-party property man-

agers. (See SR-12-5/CA-12-3 and their

attachments.)

3032.0.1 POLICY STATEMENT ON

RENTAL OF RESIDENTIAL OTHER

REAL ESTATE OWNED PROPERTIES

In light of the large volume of distressed resi-

dential properties and the indications of higher

demand for rental housing in many markets,

some banking organizations may choose to make

greater use of rental activities in their disposi-

tion strategies than in the past. This policy state-

ment reminds banking organizations and exam-

iners that the Federal Reserve’s regulations and

policies permit the rental of residential OREO

properties to third-party tenants as part of an

orderly disposition strategy within statutory and

regulatory limits.

The general policy of the Federal Reserve is

that banking organizations should make good-

faith efforts to dispose of OREO properties at

the earliest practicable date. Consistent with this

policy, in light of the extraordinary market con-

ditions that currently prevail, banking organiza-

tions may rent residential OREO properties

(within statutory and regulatory holding-period

limits) without having to demonstrate continu-

ous active marketing of the property, provided

that suitable policies and procedures are fol-

lowed. Under these conditions and circum-

stances, banking organizations would not con-

travene supervisory expectations that they show

‘‘good-faith efforts’’ to dispose of OREO by

renting the property within the applicable hold-

ing period. Moreover, to the extent that OREO

rental properties meet the deﬁnition of commu-

nity development under the Community Rein-

vestment Act (CRA) regulations, they would

receive favorable CRA consideration.

In all

respects, banking organizations that rent OREO

properties are expected to comply with all appli-

cable federal, state, and local statutes and

regulations.

Home prices have been under considerable

downward pressure since the ﬁnancial crisis

began, in part due to the large volume of houses

for sale by creditors, whether acquired through

foreclosure or voluntary surrender of the prop-

erty by a seriously delinquent borrower (dis-

tressed sales). Creditors, in turn, often seek to

liquidate their inventories of such properties

quickly. Since 2008, it is estimated that millions

of residential properties have passed through

lender inventories. These distressed sales repre-

sent a signiﬁcant proportion of all home sales

transactions, despite some ebb and ﬂow, and

thus are a contributing element to the downward

pressure on home prices. With mortgage delin-

quency rates remaining stubbornly high, the

continued inﬂow of new real estate owned prop-

1. The policy statement applies to state member banks,

BHCs, nonbank subsidiaries of BHCs, savings and loan hold-

ing companies, non-thrift subsidiaries of savings and loan

holding companies, and U.S. branches and agencies of foreign

banking organizations (collectively, banking organizations).

2. This policy statement supplements other relevant Fed-

eral Reserve guidance, including the Board’s policy statement

on the disposition of property acquired in satisfaction of debts

previously contracted. See 12 CFR 225.140. Also see sections

3020.0.6, 3030.0, and 3090.2.4.6 of this manual and section

2200.0 of the Commercial Bank Examination Manual.

3. The term ‘‘residential properties’’ in this policy state-

ment encompasses all one-to-four family properties and does

not include multi-family residential or commercial properties.

4. The Federal Reserve’s CRA regulations deﬁne commu-

nity development to include activities that provide affordable

housing to low- and moderate-income individuals as well as

those activities that revitalize or stabilize low- and moderate-

income areas (see 12 CFR 228.12(g)(1) and (4)).

BHC Supervision Manual July 2012

Page 1

erties to the market—expected to be millions

more over the coming years—will continue to

weigh on house prices for some time.

Banking organizations include their holdings

of such properties in OREO on regulatory reports

and other ﬁnancial statements.

Existing federal

and state laws and regulations limit the amount

of time banking organizations may hold OREO

property.

In addition, there are established

supervisory expectations for management of

OREO properties and the nature of the efforts

banking organizations should make to dispose

of these properties during that period.

3032.0.1.1 Risk-Management

Considerations for Residential OREO

Property Rentals

In all circumstances, the Federal Reserve expects

a banking organization considering such rentals

to evaluate the overall costs, beneﬁts, and risks

of renting. The banking organization’s decision

to rent OREO might depend signiﬁcantly on the

condition of individual properties, local market

conditions for rental and owner-occupied hous-

ing, and its capacity to engage in rental activity

in a safe and sound manner and consistent with

applicable laws and regulations.

Banking organizations should have an opera-

tional framework for their residential OREO

rental activities that is appropriate to the extent

to which they rent OREO properties. In general,

banking organizations with relatively small hold-

ings of residential OREO properties—fewer than

50 individual properties rented or available for

rent—should use a framework that appropri-

ately records the organizations’ rental decisions

and transactions as they take place, preserves

key documents, and is otherwise sufﬁcient to

safeguard and manage the individual OREO

assets.

In contrast, banking organizations with

large inventories of residential OREO

properties

—50 or more individual properties

available for rent or rented—should utilize a

framework that systematically documents how

they meet the supervisory expectations described

in the next section. All banking organizations

that rent OREO properties, irrespective of the

size of their holdings, should adhere to the guid-

ance set forth in this section.

3032.0.1.1.1 Compliance with Maximum

OREO Holding-Period Requirements

Banking organizations should pursue a clear and

credible approach for ultimate sale of the rental

OREO property within the applicable holding-

period limitations. Exit strategies in some cases

may include special transaction features to

facilitate the sale of OREO, potentially includ-

ing prudent use of seller-assisted ﬁnancing or

rent-to-own arrangements with tenants.

3032.0.1.1.2 Compliance with

Landlord-Tenant and Other Associated

Requirements

Banking organizations’ residential property

rental activities are expected to comply with all

applicable federal, state, and local laws and

regulations, including landlord-tenant laws;

landlord licensing or registration requirements;

property maintenance standards; eviction

protections (such as under the Protecting Ten-

ants at Foreclosure Act); protections under the

Servicemembers Civil Relief Act;

and anti-

discrimination laws, including the applicable

provisions of the Fair Housing Act and the

Americans with Disabilities Act. Prior to

undertaking the rental of OREO properties,

5. For further discussion of housing market conditions and

the obstacles to conversions of OREO properties to rental, see

‘‘The U.S. Housing Market: Current Conditions and Policy

Considerations,’’ Federal Reserve staff white paper, January 4,

2012 (housing white paper).

6. ‘‘Other real estate owned’’ is comprised of all real estate

other than (1) bank premises owned or controlled by the bank

and its consolidated subsidiaries and (2) direct and indirect

investments in real estate ventures.

7. Generally, the Federal Reserve allows BHCs to hold

OREO property for up to ﬁve years, with an additional

ﬁve-year extension subject to certain circumstances (see 12

CFR 225.140). National banks are subject to similar restric-

tions. State member banks and licensed branches of foreign

banks are subject to the holding periods and other limitations

on OREO activity established by their respective licensing

authorities, which vary. Savings and loan holding companies

generally may acquire real estate for rental (see 12 USC

1467a(c)(2) and 12 CFR 238.53(b)).

8. A preliminary analysis of the Consolidated Reports of

Condition and Income (Call Report) data suggests that roughly

98 percent of community banks held 50 or fewer residential

OREO properties.

9. For purposes of this guidance, the supervisory expecta-

tions for OREO rentals and the number of properties available

for rent should include those properties for which tenants

were already in place at the time of foreclosure or transfer of

ownership, and for which tenants are afforded certain protec-

tions under the Protecting Tenants at Foreclosure Act of 2009.

See the Federal Reserve’s Consumer Compliance Handbook,

section IV, for further information.

10. See CA-09-5, ‘‘Information and Examination Proce-

dures for the ‘Protecting Tenants at Foreclosure Act of 2009,’’’

July 30, 2009, and CA-05-3, ‘‘Servicemembers Civil Relief

Act of 2003,’’ May 6, 2005.

Section 4(c)(2) and (3) (Rental of Other Real Estate Owned Residential Property) 3032.0

BHC Supervision Manual July 2012

Page 2

banking organizations should determine

whether such activities are legally permissible

under applicable laws, including state laws.

When applicable, banking organizations should

review homeowner and condominium associa-

tion bylaws and local zoning laws for prohibi-

tions on renting a property. Banking organiza-

tions may use third-party vendors to manage

properties but should provide necessary

oversight to ensure that property managers fully

understand and comply with these federal, state,

and local requirements.

3032.0.1.1.3 Other Considerations

Banking organizations should account for

OREO assets in accordance with GAAP and

applicable regulatory reporting instructions.

Banking organizations should also provide the

appropriate classiﬁcation treatment for their

residential OREO holdings. Residential OREO

is typically treated as a substandard asset, as

deﬁned by the interagency classiﬁcation

guidelines. (See section 5010.10.1 which

discusses the Uniform Agreement on the Clas-

siﬁcation of Assets and Appraisal of Securities

Held by Banks and Thrifts, as revised June 15,

2004.) It sets forth the deﬁnitions of the clas-

siﬁcation categories and the speciﬁc examina-

tion procedures and information that are to be

used for classifying bank assets, including

securities. (See SR-04-9.) See also section

2060.1 of the Commercial Bank Examination

Manual. Residential properties, however, with

leases in place and demonstrated cash ﬂow from

rental operations sufﬁcient to generate a reason-

able rate of return

should generally not be

classiﬁed.

3032.0.1.2 Speciﬁc Expectations for

Large-Scale Residential OREO Rentals

Banking organizations with large inventories of

residentialOREO properties that decide to engage

in rental activities should have in place a docu-

mented rental strategy, including formal policies

and procedures for OREO rental activities, and

a documented operational framework. Policies

and procedures should clearly describe how the

banking organization will comply with all appli-

cable laws and regulations. Policies and proce-

dures should include processes for determining

whether the properties meet local building code

requirements and are otherwise habitable, and

whether improvements to the properties are

needed in order to market them for rent. In

addition, policies and procedures should estab-

lish operational standards for the banking orga-

nization’s rentalactivities,includingthatadequate

insurance policies are in place, that property and

other tax obligations are met on a timely basis,

and that expenditures on improvements are

appropriate to the value of the property and to

prevailing norms in the local market.

Policies and procedures should also require

plans for rental of residential OREO properties,

down to the individual property level, that cover

the full holding period from the time the bank

received title to ultimate sale by the bank. Plans

should identify which properties would be eli-

gible for rental. Plans also should establish crite-

ria by which properties are chosen for market-

ing as rental properties, and the process by

which rental decisions should be made and

implemented. Plans should describe the general

conditions under which the organization believes

a rental approach is likely to be successful,

including appropriate consideration of rental

market and economic conditions in respective

local markets.

Finally, policies and procedures should address

all risk-management issues that arise in renting

residential OREO properties. Some risk ele-

ments parallel those found in other banking

activities, for example, the credit risk associated

with tenants’ potential failure to make timely

11. See the instructions for the Call Report as to the

reporting of OREO transactions and to the Consolidated

Financial Statements for Bank Holding Companies (FR Y-9C).

See more generally this manual’s section 2200.1, ‘‘Other Real

Estate Owned.’’

12. Whether a rate of return is reasonable depends on a

number of considerations including local market conditions,

the time horizon of the rental, and the nature of the property.

Commonly used measures include a capitalization rate (known

as a ‘‘cap rate,’’ which generally is the expected annual cash

ﬂows from renting the property relative to the price at which

the property holder could expect to sell it in the owner-

occupied market), as discussed in the housing white paper, or

other measures of internal rate of return. Depending on the

circumstances and risks associated with the property, valid

indications that a level of return is reasonable could include

(but would not be limited to) comparisons with normal returns

for single-family rentals in the relevant local market; rates of

return on other similar local real estate investments; or cap

rates or other measures of internal rate of return on invest-

ments with similar risk proﬁles. For example, in many mar-

kets a cap rate above 8 percent would likely represent a

reasonable rate of return. Large one-time expenditures that are

idiosyncratic to a given year but are normal to residential

properties over their lifetime, such as replacement cost for

worn-out appliances, should generally not be the reason that a

property would be classiﬁed. Costs of improvement should be

treated as capital expenditures with a corresponding effect on

properties’ carrying value to the extent the improvements

improve the properties’ values.

Section 4(c)(2) and (3) (Rental of Other Real Estate Owned Residential Property) 3032.0

BHC Supervision Manual July 2012

Page 3

rent payments, or potential conﬂict of interest

issues such as the use of a ﬁrm by a banking

organization to both provide information on a

property’s value and list that property for sale

on behalf of the banking organization. Other

risks unique to such rental include

• dealing with vacancy, marketing, and re-rental

of previously occupied properties;

• liability risk arising from rental activities,

along with the use and management of liabil-

ity insurance or other approaches to mitigate

that liability and risk; and

• legal requirements arising from the potential

need to take action against tenants for rent

delinquency, potentially including eviction.

Such requirements may include notice periods.

Banking organizations may need to develop new

policies and risk-management processes to

address properly these categories of risk.

In many cases, banking organizations will use

third-party vendors (for example, real estate

agents or professional property managers) to

manage their OREO properties. Policies and

procedures should provide that such individuals

or organizations have appropriate expertise in

property management, be in sound ﬁnancial

condition, and have a good track record in man-

aging similar properties. Policies and proce-

dures should also call for contracts with such

vendors to carry appropriate terms and provide,

among other key elements, for adequate man-

agement information systems and reporting to

the banking organization, including rent rolls

(along with actual lease agreements), mainte-

nance logs, and security deposits and charges to

these deposits. Banking organizations should

provide for adequate oversight of vendors.

3032.0.1.3 Additional Materials for

Reference

• AccountingStandards Codiﬁcation (ASC) 310-

40, Receivables-Troubled Debt Restructur-

ings by Creditors (formerly known as FAS 15,

‘‘Accounting by Debtors and Creditors for

Troubled Debt Restructurings’’).

• ASC 360-10-30, Property, Plant and

Equipment-Initial Measurement (formerly

included in FAS 144, ‘‘Accounting for the

Impairment or Disposal of Long-Lived

Assets’’).

• ASC 360-10-35, Property, Plant and

Equipment-Subsequent Measurement.

• The disposition of other real estate is ad-

dressed in ASC 360-20-40, Property, Plant

and Equipment-Real Estate Sales-

Derecognition (formerly within FAS 66,

‘‘Accounting for Sales of Real Estate’’), which

includes speciﬁc criteria for the recognition of

proﬁt.

• SR-10-16, ‘‘Interagency Appraisal and Evalu-

ation Guidelines,’’ December 2, 2010 and this

manual’s section 4140.1. For the sale of OREO

property with a value of $250,000 or less, a

BHC or state member bank may obtain an

evaluation in lieu of an appraisal.

• SR-95-16, ‘‘Real Estate Appraisal Require-

ments for Other Real Estate Owned (OREO),’’

March 28, 1995.

13. Various jurisdictions may apply speciﬁc requirements

to landlords in their marketing and re-rental activities (for

example, an obligation to offer potential tenants an initial

lease term of two years).

14. See Federal Financial Institutions Examination Council

statement on Risk Management of Outsourced Technology

Services (November 28, 2000, SR-00-17 and the appendix of

section 4060.1 of the Commercial Bank Examination

Manual), which provides illustrative guidance on constructing

outsourcing risk assessments, due diligence in selecting a

service provider, contract review, and monitoring of a third

party that provides services to a regulated institution.

Section 4(c)(2) and (3) (Rental of Other Real Estate Owned Residential Property) 3032.0

BHC Supervision Manual July 2012

Page 4

Section 4(c)(4) of the BHC Act

(Interests in Nonbanking Organizations) Section 3040.0

Section 4(c)(4) of the Bank Holding Company

Act (the act) provides that nonbank shares held

or acquired by a bank in good faith in a ﬁdu-

ciary capacity are exempt from the general pro-

hibitions of section 4 of the act. This exemption

is provided to allow banks to continue their

normal ﬁduciary operations without signiﬁcant

interference and without being subject to the

limitations of the Bank Holding Company Act.

Without this exemption, a subsidiary bank could

act as trustee for up to only 5 percent of a

nonbank company’s shares, as provided by sec-

tion 4(c)(6) of the act.

Certain exceptions were included within the

body of the section 4(c)(4) exemption to prevent

use of the trust vehicle to circumvent the intent

of the act. The section 4(c)(4) exemption is not

applicable when shares acquired are held by a

trust that is considered a ‘‘company’’ under sec-

tion 2(b) of the act. Under section 2(b), a trust is

deﬁned as a company if it does not terminate

within 25 years or within 21 years and 10

months after the death of individuals living on

the effective date of the trust. Such trusts are

generally referred to as perpetual trusts and

include employee beneﬁts and charitable trusts

that can operate in perpetuity.

Another exception to the exemption implies

that no more than 5 percent of the shares of a

nonbank company may be held by a subsidiary

bank as trustee under a trust established for the

beneﬁt of the bank itself; the bank’s parent

company or any of its subsidiaries; or the share-

holders or employees of the bank, the parent

company, or its subsidiaries, as indicated in

section 2(g)(2) of the act. Employee beneﬁt

trusts have become a principal source of banks’

trust assets. As strictly applied, section 4(c)(4)

would limit acquisition of stock of a nonbank

company to 5 percent of its shares for employee

trust accounts of banks that are subsidiaries of

bank holding companies.

3040.0.1 TRANSFER OF SHARES TO

A TRUSTEE

Under section 4(c)(4), if a bank holding com-

pany transfers nonbank shares to a trustee and

the trustee has one or more directors in common

with the bank holding company, the nonbank

shares are deemed to be controlled by the bank

holding company until the Board determines

otherwise.

3040.0.2 TRUST COMPANY

SUBSIDIARIES

Even though section 4(c)(4) refers to shares

held or acquired by a bank in good faith in a

ﬁduciary capacity, the exemption also applies to

shares held or acquired in a ﬁduciary capacity

by a trust company subsidiary of a bank holding

company.

3040.0.3 QUALIFYING FOREIGN

BANKING ORGANIZATION OWNING

OR CONTROLLING SHARES OF A

COMPANY IN A FIDUCIARY

CAPACITY

A foreign bank that maintains branches in the

United States is subject to the provisions of the

BHC Act in the same manner and to the same

extent as a U.S. bank holding company.

Section

4 of the BHC Act prohibits a bank holding

company and its subsidiaries from owning or

controlling nonbanking assets or shares or

engaging in any nonbanking activity unless it

qualiﬁes for an exemption.

Accordingly, such a

foreign bank may not own nonbanking assets or

shares (such as real estate), directly or through

any company it controls, unless it qualiﬁes for

an exemption from the nonbanking prohibitions

of section 4 of the BHC Act.

Under section 211.23(f)(4) of Regulation K,

a qualifying foreign banking organization may

‘‘[o]wn or control voting shares of any company

in a ﬁduciary capacity under circumstances that

would entitle such shareholding to an exemp-

tion under section 4(c)(4) of the [BHC

Act] . . .’’

Section 225.22(d)(3) of the Board’s

Regulation Y (which implements section 4(c)(4)

of the BHC Act) provides that the BHC Act’s

nonbanking prohibitions shall not apply to ‘‘vot-

ing securities or assets acquired by a bank or

other company (other than a trust that is a com-

pany) in good faith in a ﬁduciary capacity, if the

voting securities or assets are . . . held in the

ordinary course of business and not acquired for

the beneﬁt of the company or its shareholders,

employees, or subsidiaries.’’

1. 12 U.S.C. 3106(a).

2. 12 U.S.C. 1843.

3. 12 C.F.R. 211.23(f)(4).

4. 12 C.F.R. 225.22(d)(3).

BHC Supervision Manual July 2005

Page 1

Two subsidiaries of the foreign bank CMB

AG (the foreign bank) that are located in Ger-

many currently invest in non-U.S. real estate for

the beneﬁt of third-party investors. One of the

subsidiaries, IGC, manages only retail invest-

ment trusts (beneﬁcial interests in which are

typically sold widely to retail investors); the

other subsidiary, SGC, manages only institu-

tional investment trusts (beneﬁcial interests in

which are sold to 30 or fewer institutional inves-

tors). Through its legal counsel, the foreign bank

requested an interpretation of section 4 of the

BHC Act (12 U.S.C. 1843) and section

211.23(f)(4) of the Board’s Regulation K (12

C.F.R. 211.23(f)(4)) that would permit its two

asset-management subsidiaries, IGC and SGC,

to sponsor and manage German-based invest-

ment trusts that invest in U.S. real estate.

The powers and duties of the asset-

management services provided by IGC and SGC

to their investment trusts are governed by the

German Investment Law and a trust agreement

entered into between IGC or SGC, on the one

hand, and the investor, on the other hand (the

trust agreement). IGC and SGC are subject to

the supervision and regulation of the German

bank supervisory authority (BaFin). Compli-

ance by IGC and SGC with the German Invest-

ment Law and the trust agreement would be

monitored and enforced by BaFin. Amendments

in 2002 to the German Investment Law liberal-

ized the ability of companies to sponsor, man-

age, and serve as distributor for one or more

retail or institutional investment trusts, allowing

investment in real estate outside the European

Economic Area, including in the United States.

In light of the 2002 changes in German law,

IGC established a retail investment trust (the

retail trust) to invest in real estate located in the

United States, Europe, and Asia. In addition,

SGC is established as an investment trust for

institutional investors (the institutional trust,

and, together with the retail trust, the trusts) to

invest in U.S. real estate. The trusts proposed to

invest in existing commercial real estate proper-

ties in major U.S. cities (the properties), but not

in undeveloped U.S. real estate. As required by

the German Investment Law, title to each of the

properties would be held either directly by IGC

or SGC or by a special-purpose entity estab-

lished and controlled by IGC or SGC.

Interests in the trusts would be sold only to

non-U.S. persons. All property management,

leasing, real estate brokerage, and refurbishment

services obtained by the properties would be

obtained from parties that are unafﬁliated with

the foreign bank or any of its subsidiaries. For

their services to the trusts, IGC and CGS would

receive an annual management fee based prima-

rily on the net asset value of the trusts. The

foreign bank’s legal counsel contended that the

proposed ownership of U.S. real estate by IGC

and SGC for the account of the trusts would

qualify for the ﬁduciary exemptions available in

Regulation K and Regulation Y.

Under the arrangement, the two subsidiaries

aresubject toﬁduciary dutiesthatclosely resemble

those of a trustee in the United States. Under the

German Investment Law, the investment trusts

would not be legal entities separate from the

two subsidiaries, IGC and SGC. The foreign

bank made several representations and commit-

ments in support of its inquirer’s interpretation

that the proposed ownership of U.S. real estate

by IGC and SGC for the account of the trusts

would qualify for the ﬁduciary exemptions under

section 211.23(f)(4) of Regulation K and sec-

tion 225.22(d)(3) of Regulation Y. In particular,

the foreign bank committed that neither it nor its

subsidiaries or employee beneﬁt plans would

own any beneﬁcial interests in the investment

trusts.

Based on all the facts, including all the repre-

sentations and commitments made by or on

behalf of the foreign bank, IGC, and SGC,

Board legal staff stated that it would not recom-

mend that the Board disagree with the inquirer’s

interpretation of the availability of the ﬁduciary

exemptions in section 211.23(f)(4) of Regula-

tion K and section 225.22(d)(3) of Regulation Y

to the foreign bank. The ﬁduciary exemptions in

the Board’s Regulations K and Y (12 CFR

211.23(f)(4) and 225.22(d)(3)) would, therefore,

permit the two subsidiaries of the foreign bank

to take title to U.S. real estate on behalf of the

investment trusts and for the beneﬁt of the

investors in the trusts. (See the Board staff’s

legal interpretation dated November 24, 2004.

See also the summary of the interpretation in the

Federal Reserve Regulatory Service at 3-744.13

and 4-305.2.)

3040.0.4 OTHER REPORTING

REQUIREMENTS

In certain circumstances, holdings in ﬁduciary

capacities of nonbank stock over 5 percent may

also trigger reporting requirements under the

federal securities laws.

4(c)(4) (Interests in Nonbanking Organizations) 3040.0

BHC Supervision Manual July 2005

Page 2

3040.0.5 INSPECTION OBJECTIVES

To determine that nonbank shares held by a

bank in a ﬁduciary capacity are in compliance

with section 4(c)(4).

3040.0.6 INSPECTION PROCEDURES

Review the holding company’s internal report-

ing procedures to establish that bank trust de-

partments report 5 percent holdings in nonbank

companies. In multibank companies, determine

that controls are in place to aggregate nonbank

shares held by each bank so that if an aggregate

of 5 percent is held, it is reported in the Y-6.

3040.0.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Interests in nonbanking organiza-

tions

1843

1843(c)(4)

225.12(a)

225.22(d)(3)

3–744.13

A qualifying foreign banking

organization may own or control

voting shares of any company in

a ﬁduciary capacity

211.23(f)(4) 4–305.2

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(4) (Interests in Nonbanking Organizations) 3040.0

BHC Supervision Manual July 2005

Page 3

Section 4(c)(5) of the BHC Act (Investments Under Section

5136 of the Revised Statutes) Section 3050.0

Section 4(c)(5) of the Bank Holding Company

Act permits (without prior approval) invest-

ments by a bank holding company in shares of

the kinds and amounts eligible for investment

by national banks under the provisions of sec-

tion 5136 of the Revised Statutes (12 U.S.C.

24(7)).

National banks are prohibited by section 5136

of the Revised Statutes from purchasing and

holding shares of any corporation except those

corporations whose shares are speciﬁcally made

eligible by federal statute. This prohibition is

made applicable to State member banks by sec-

tion 9, paragraph 20 of the Federal Reserve Act

(12 U.S.C. 335).

In 1968, the Board interpreted section 5136

as permitting a member bank to purchase shares

of a corporation engaging in business (at loca-

tions the bank is authorized to engage in busi-

ness) and carrying out functions the bank is

empowered to perform directly. Section 5136 is

a broad statute with types of permissible activi-

ties both explicitly deﬁned and implied indi-

rectly without express deﬁnition. Therefore, to

limit the need for constant Board interpretation

regarding the implied areas of section 5136, the

Board curtailed the authority of a bank holding

company to acquire shares on the basis of sec-

tion 4(c)(5) through section 225.22(d) of Regu-

lation Y. As a result, effective June 30, 1971,

permissible shares for bank holding company

acquisition under section 4(c)(5) are limited to

those explicitly authorized by any federal stat-

ute. Additional reasons for limiting the scope of

activities to those explicitly deﬁned by statute,

are that section 4(c)(5) acquisitionsrequire neither

prior Board approval, nor the opportunity for

interested parties to express their views, nor any

prior regulatory consideration of anti-trust and

related matters.

3050.0.1 COMPANIES IN WHICH

BHC’S MAY INVEST

The following is a list of permissible compa-

nies expressly authorized by federal statute. The

list includes the companies most frequently

encountered.

1. Small business investment companies

(‘‘SBICs’’).

2. Agriculture credit companies.

3. Edge and agreement corporations.

4. Bank premises companies (usually exempt

under section 4(c)(1)(A)).

5. Bank service corporations (usually exempt

under section 4(c)(1)(C)).

6. Safe deposit companies.

7. Obligations of student loan marketing

associations.

8. State housing corporations.

3050.0.2 LIMITATIONS

On most 5136 authorizations, share investments

are limited in some form, usually based on a

percentage of the bank’s capital and surplus.

Under section 4(c)(5), a holding company’s

investment in such shares is also limited by

amount and type to those permitted for a na-

tional bank to prevent avoidance of these limita-

tions by a bank holding company.

3050.0.3 INSPECTION OBJECTIVES

1. To determine the permissibility of each

activity encountered during the inspection which

claims a section 4(c)(5) exemption.

2. To determine if the operations and ﬁnanc-

ing of the section 4(c)(5) activity is not to the

detriment of the bank(s).

3050.0.4 INSPECTION PROCEDURES

1. Review compliance with section 5136 of

the Revised Statutes to determine if the activity

is expressly permitted by any federal statute.

2. Determine the ﬁnancial condition of the

activity and its impact on the bank afﬁliate.

BHC Supervision Manual December 1992

Page 1

3050.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Permissible investments

for a national bank

(Section 5136 of

the Revised

Statutes)

Investment in bank

premise corporation

371d 250.200 4–185

Investment in bank service

corporation

1861–65 250.301 1–329

Investment in small

business investment

corporation (SBIC)

15 USC 682b 225.107

225.111

225.112

4–173

4–175

4–174

Operating subsidiaries/

loan production ofﬁces

250.141 3–415.4

Section 23A

Section 23B

371c

250.240 3–1133

1–206.1

Mortgage company 225.122 4–196

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(5) (Investments Under Section 5136 of the Revised Statutes) 3050.0

BHC Supervision Manual December 1992

Page 2

Section 4(c)(6) and (7) of the BHC Act (Ownership of Shares in

Any Nonbank Company of 5 Percent or Less) Section 3060.0

3060.0.1 SECTION 4(c)(6)

This section provides an exemption for owner-

ship of shares of any nonbank company that do

not exceed 5 percent of the outstanding voting

shares of such company. The exemption is de-

signed to permit diversiﬁcation of investments

by a bank holding company and its subsidiaries

which do not result in control of a nonbanking

organization. The Board has indicated through

an interpretation of 12 U.S.C. 225.101, that in

its opinion, the 5 percent limitation applies to

the aggregate amount of voting stock in a partic-

ular nonbank company held by the entire bank

holding company organization including the

parent company and all of its direct and indirect

bank and nonbank subsidiaries. This is to pre-

vent a holding company from acquiring a con-

trolling interest in a nonbank company through

ownership of small blocks of stock by numerous

subsidiaries in circumvention of the provisions

of section 4 of the BHC Act.

3060.0.1.1 D.P.C. Shares

The same interpretation (12 C.F.R. 225.101)

also addresses the question of the applicability

of section 4(c)(6) to nonbank shares acquired

in satisfaction of debts previously contracted

(D.P.C.) by a subsidiary bank, any nonbank

subsidiaries, or the parent company. In this

instance, the Board expressed the opinion that

the 5 percent exemption provided by section

4(c)(6) covers any nonbank shares, including

those acquired D.P.C. Consequently, shares which

meet such conditions are not subject to the

disposition requirements of section 4(c)(2) of

the Act. It is important to remember that the

exemption provided by section 4(c)(6) applies

only to shares of any nonbank company. Acqui-

sitions of any bank shares are subject to the

provisions contained in section 3(a) of the Act.

Although the 5 percent limitation of this sec-

tion applies, by its language, to ‘‘voting shares’’

rather than ‘‘any class of voting shares’’ as used

elsewhere in the Act, the Board has indicated in

12 C.F.R. 225.137 that it applies to ‘‘any class

of voting shares’’ rather than to the aggregate of

all classes of voting shares held. Thus section

4(c)(6) is not available to a group of BHCs each

owning a ‘‘class of voting securities’’ even if

each BHC owns less than 5 percent of all shares

outstanding. Further, section 4(c)(6) must be

viewed as permitting ownership of 5 percent of

a company’s voting stock only when that owner-

ship does not constitute ‘‘control’’ as otherwise

deﬁned in section 2 of the Act.

Note that section 4 prohibits engaging in non-

bank activities other than those permitted by

section 4(c)(8). Thus, if a BHC may be deemed

to be ‘‘engaging in an activity’’ through the

medium of a company in which it owns less

than 5 percent of the voting stock it may never-

theless require Board approval, despite the sec-

tion 4(c)(6) exemption.

3060.0.1.2 Acquisition of Nonbank

Interests—Royalties as Compensation

A bank holding company requested an opinion

on the permissibility of its subsidiary’s receiv-

ing limited overriding royalty interests in oil,

gas, and other hydrocarbon leasehold interests

as partial compensation for investment advisory

services in connection with those properties.

The bank holding company was not acquiring

more than 5 percent interest in any project. The

subsidiary was to place the assigned royalties in

a compensation plan for assignment to certain

professional employees. Neither the subsidiary

nor any afﬁliate were to acquire, hold, locate,

sponsor, develop, organize, or manage any other

energy property investment or in any other man-

ner control the investment. The subsidiary was

to hold interest in energy properties only if the

interest had not yet been reassigned to an

employee, or if an employee terminates service

with the subsidiary and is required to reassign

his or her energy properties to the subsidiary.

The bank holding company’s proposal was con-

sistent with section 4(c)(6) of the Bank Holding

Company Act, which exempts passive invest-

ments of 5 percent or less from the prohibitions

of section 4 of the Bank Holding Company Act.

3060.0.2 SECTION 4(c)(7)

This section provides bank holding companies

the opportunity to own, directly or indirectly,

shares of an investment company (any amount

up to 100 percent of outstanding shares) pro-

vided that each of the following conditions is

met:

1. The investment company is not itself a

bank holding company;

2. The investment company is not engaged in

BHC Supervision Manual December 1992

Page 1

any business other than investing in securities;

and

3. Securities in which the investment com-

pany invests do not include more than 5 percent

of the outstanding voting securities of any

company.

4. As in section 4(c)(6), the 5 percent limita-

tion applies, by its language, to ‘‘voting shares’’

rather than ‘‘any class of voting shares,’’ as used

elsewhere in the Act. However, the criterion

applies to ‘‘any class of voting shares’’ for pur-

poses of this section.

The 5 percent restriction does not prevent an

investment company from having direct or indi-

rect subsidiaries of its own, provided that own-

ership of such subsidiaries is permitted under

another provision of the Act. Rather, the limita-

tion is intended to apply only to securities pur-

chased in the ordinary course of investing by the

investment company.

The legislative history of this provision of the

Act does not provide a clear indication as to the

type of institutions encompassed under the term

‘‘investment company’’ as used in this section.

It appears, however, that any company primarily

engaged in the purchasing and ownership of

securities may be regarded as an investment

company for purposes of this section. Section

4(c)(7) can be viewed, more or less, as an exten-

sion of section 4(c)(6) which permits a bank

holding company to directly or indirectly through

subsidiaries own up to 5 percent of the voting

stock of any nonbank company. In fact, until the

Amendments of 1966, the Bank Holding Com-

pany Act incorporated both section 4(c)(6) and

section 4(c)(7) under one section. From a practi-

cal standpoint, the parent company is allowed,

under section 4(c)(6), to directly engage in the

same activities as an investment company. Ac-

cordingly, most holding companies conduct these

activities through the parent company, rather

than through an investment company subsidiary.

Such an arrangement prevents duplicate pay-

ment of certain taxes and provides more ﬂexi-

bility for utilizing funds in other areas of the

organization.

3060.0.3 INSPECTION OBJECTIVES

3060.0.3.1 Section 4(c)(6)

1. To determine that the investments held

pursuant to section 4(c)(6) comply with the Act

and 12 C.F.R. 225.101 and 225.137.

2. To determine that no more than 5 percent

of the voting shares of any nonbank company

(other than those owned pursuant to other provi-

sions of the Act) is held by the bank holding

company and its subsidiaries.

3060.0.3.2 Section 4(c)(7)

1. To determine the overall quality of the

investments held.

2. To determine the ﬁnancial impact of the

ownership of such shares upon the bank holding

company and its subsidiaries.

3. To determine if policies, practices and pro-

cedures regarding investments are adequate.

4. To suggest corrective action where neces-

sary in the areas of policies, procedures, or laws

and regulations.

3060.0.4 INSPECTION PROCEDURES

3060.0.4.1 Section 4(c)(6)

1. Review investments held to determine that

the BHC has a total interest of no more than

5 percent.

2. Determine that 5 percent does not consti-

tute control.

3. Determine that the BHC is not ‘‘engaged’’

in any nonbank activity through its 5 percent

ownership.

3060.0.4.2 Section 4(c)(7)

1. Where section 4(c)(7) applies, compare

the investment company’s general ledgers with

statements prepared for the latest FR Y–6.

2. Obtain schedules of investments in voting

shares of any companies. Review quality of

such shares (utilizing rating service publica-

tions, etc.) and check for ownership interests

exceeding 5 percent.

3. Review policies (written or oral) regarding

purchase and sale of stocks.

4. Obtain and evaluate documentation relat-

ing to credit review for securities held. Deter-

mine adequacy of procedures to maintain credit

updates.

5. Compare carrying value of stocks to cur-

rent market value to determine market deprecia-

tion, if any and determine adequacy of any

established reserves.

6. Perform veriﬁcation procedures, including

physical review of stock held in safekeeping,

where practical.

4(c)(6) and (7) (Ownership of Shares in Any Nonbank Company of 5 Percent or Less) 3060.0

BHC Supervision Manual December 1992

Page 2

7. Determine that purchases and sales of stocks

are appropriately approved by directors or des-

ignated ofﬁcers.

8. Review minutes of the board of directors

meetings (where an investment company sub-

sidiary is involved).

3060.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

4(c)(6)

Applicability to shares

acquired D.P.C.

225.101 4–187

Aggregating shares owned

by subsidiaries

225.101 4–187

Five percent limit on ‘‘any

class of voting securities’’

225.137 4–189

Control with less than

5 percent

225.137 4–189

4(c)(7)

Indirect ownership of

shares of investment

company

225.102 4–188

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(6) and (7) (Ownership of Shares in Any Nonbank Company of 5 Percent or Less) 3060.0

BHC Supervision Manual December 1992

Page 3

Section 4(c)(8) of the BHC Act (Mortgage Banking)

Section 3070.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2014, this section was revised to

include a brief discussion of the December 13,

2013, “Interagency Statement on Supervisory

Approach for Qualiﬁed and Non-Qualiﬁed Mort-

gage Loans” that was issued to clarify the safety

and soundness expectations and Community Re-

investment Act (CRA) considerations for regu-

lated institutions engaged in residential mort-

gage lending. The section references the

Consumer Financial ProtectionBureau’s (CFPB)

Ability-to-Repay and Qualiﬁed Mortgage Stan-

dards Rule that was issued on January 10, 2013

(effective on January 10, 2014). Institutions may

issue qualiﬁed mortgages or non-qualiﬁed mort-

gages, based on their business strategies and

risk appetites. Refer to SR-13-20 and its attach-

ment.

A mortgage banker specializes in the origina-

tion, acquisition, and sale of residential real

estate loans to permanent investors (the second-

ary mortgage market). Most mortgage banking

ﬁrms that are afﬁliated with banks and bank

holding companies primarily originate residen-

tial real estate loans, although some ﬁrms may

engage in interim and other lending secured by

real estate. Unlike their nonbank competitors,

the vast majority of the loans mortgage banks

originate are sold to permanent investors in the

secondary mortgage market.

Mortgage banks can retain or sell their loans

and sell or retain the servicing of their mort-

gages. The mortgage banking industry currently

offers a wide variety of products, market mech-

anisms, ﬁnancing vehicles, and ﬁnancial strate-

gies due to competitive pressures within the

mortgage banking industry and rapid growth in

the demand for loans and related securities

within the secondary mortgage market. Mort-

gage bankers use these marketing and ﬁnancing

strategies to differentiate themselves from the

competition in terms of interest rates, maturities,

down-payment requirements, and product

offerings.

The earnings stream, cash ﬂow, and capital

needs of a mortgage banking company are all

highly inﬂuenced by management’s decision

whether to retain or sell the mortgage loans as

well as the related mortgage-servicing rights.

The majority of loans that are sold in the sec-

ondary market are originated under government-

sponsored programs. Such loans are either sold

directly or are converted into securities that are

collateralized by the underlying mortgages

(mortgage-backed securities). The pools of col-

lateralized mortgage loans backing mortgage-

backed securities provide a form of risk diversi-

ﬁcation for the investor.

Originations, secondary market sales, and

servicing constitute the primary functional busi-

ness lines within a typical mortgage company.

As an originator of mortgages, the company is

responsible for the initial phase of the mortgage,

from original contacts with the borrowers to the

closing of the loans. At closing, the company

disburses its funds and becomes the lender of

record. Mortgage loans can also be acquired

through a network of correspondent companies.

Most mortgage banking companies use a com-

bination of origination and acquisition strate-

gies. The decision about whether to originate

or purchase loans also varies over time due

to ﬂuctuations in demand and pricing

discrepancies.

The secondary marketing department is

responsible for selling loans in the secondary

market and managing the interest-rate risk asso-

ciated with loans during the interim period. In

most cases, the mortgage company retains the

loans until it can ﬁnd a permanent investor to

purchase the loans. The mortgage banker obtains

purchase commitments from permanent inves-

tors and submits completed loan documentation

packages to the investors for their approvals in

satisfaction of the commitments.

As part of the overall process, the mortgage

banker maintains a relationship with a variety of

other permanent investors to whom the origi-

nated mortgages are sold. These investors are

generally institutional investors such as securi-

ties dealers, commercial banks, life insurance

companies, pension funds, and other ﬁnancial

and nonﬁnancial institutions. Some of these

investors are restricted by state law, charter, or

bylaws as to the type of mortgages and the

locations of the property in which they can

invest. Accordingly, their purchase commit-

ments should incorporate these limits as well as

the price and/or required yield of the mortgage

loans or mortgage-backed securities. When these

commitments are ﬁlled and the mortgages sold

to the investors, the mortgage banker may retain

the servicing rights to the mortgages it sells to

permanent investors or sell the servicing rights

in the secondary market.

BHC Supervision Manual July 2014

Page 1

The servicing department manages the loans

that were retained in permanent loan portfolio

or those that were sold to another permanent

investor. Fees paid for services rendered in

administering the mortgage portfolios of inves-

tors are a principal source of revenue for most

mortgage bankers. In general, the company re-

ceives a fee that is usually based on a percent of

the unpaid balance of the administered mort-

gages. In return for the fee, the servicer is

responsible for collecting and remitting pay-

ments, managing the tax and insurance escrow

accounts,inspecting the propertieswhen required,

pursuing delinquent borrowers, foreclosing on

the mortgages when necessary, and providing

accounting support. Considering the services

rendered and the generally low fees involved,

the servicing portfolio must be sizable for the

company to be proﬁtable. The servicing port-

folio may represent very little credit risk to the

servicer and can be a valuable source of residual

income to the company.

The mortgage banking industry is experienc-

ing signiﬁcant consolidation. To be competitive,

participants must maximize economies of scale

and efﬁciencies. Emphasis has been placed on

using more efﬁcient systems and technologies

that enhance loan processing, underwriting, ser-

vicing, and the management of pipeline risk (the

interest-rate risk associated with the holding

period for the mortgages). Existing mortgage

banking ﬁrms are larger and operate more efﬁ-

ciently (faster, cheaper, and with higher quality)

than they did in the past. Operating efﬁciencies

are achieved through the use of sophisticated

information systems, such as electronic data

interchange, imaging, optical character recogni-

tion, expert systems, and other forms of artiﬁ-

cial intelligence.

Within a bank holding company, mortgage

banking subsidiaries generally focus on residen-

tial mortgage lending. As discussed initially,

these mortgage bankers may also engage in

other forms of lending. On an industry basis,

they extend loans to real estate brokers who buy

properties for resale, engage in second mortgage

and home improvement lending (usually through

dealer agreements), and extend interim loans.

Interim loans represent a means of funding a

project through one or more phases, with the

property and improvements as collateral for the

loan. The size of interim loans may range from

a single residence under construction to large

industrial, commercial, or residential projects.

Construction lending and other forms of lending

may be provided by other such real estate lend-

ing subsidiaries located elsewhere within the

bank holding company’s organizational structure.

The mortgage banker, as a lender, has the

ﬂexibility to fund any and all phases of a project

including land acquisition, development, and

construction. Land acquisition credit may be

extended for the acquisition of more than one

parcel of land, which may not necessarily be

identiﬁed with a speciﬁc project. More fre-

quently, acquisition credit is tied into a speciﬁc

project for which the lender expects to fund

more than one phase. In development-phase

lending, funds are advanced to ‘‘improve’’ the

property, bring utilities on-site, cut roadways,

and prepare the site for its intended use. Many

residential and industrial park projects are

funded through this phase, with the sale of indi-

vidual parcels providing the repayment of the

loan. Construction lending funds the project

from the foundation to completion. For those

loans that fund two or more phases, there may

be no clear distinction between the phases as

certain elements of each may be underway

concurrently.

On large projects funded through completion,

such as apartment and ofﬁce buildings where

the construction is to be repaid from a perma-

nent mortgage, the lender will usually require

the borrower to obtain a permanent mortgage

commitment from a third party. While this ‘‘take-

out’’ commitment may or may not be arranged

through the lender’s network of investors, this

commitment provides the lender with some

assurance of repayment. In some cases, particu-

larly in unsettled market environments, these

takeouts are not available, and the lender may

issue a ‘‘standby’’ commitment. On occasion,

no permanent ﬁnancing will be available upon

completion and the lender will extend a ‘‘bridge’’

loan for the interim period between project

completion and the placement of a permanent

mortgage. Making construction loans without

takeout commitments from responsible term

lenders could expose the construction lender to

adverse interest-rate movements as well as the

market acceptability of the project. The absence

of a takeout can represent a weakness in a loan.

The general lack of takeouts in a portfolio

should be a criticizable management practice

(unless mitigating circumstances prevail) and

should be discussed with management.

This section provides inspection guidance and

procedures for mortgage banking nonbank sub-

sidiaries of bank holding companies. Except for

the limited guidance that pertains only to bank

holding companies, they may also serve as exam-

ination guidance and procedures for mortgage

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2014

Page 2

banking subsidiaries of state member banks.

The way in which these procedures are used

should be determined on a case-by-case basis

depending on the size of a particular company

and its business activities. The information in

‘‘Board Oversight and Management,’’ ‘‘Finan-

cial Analysis,’’ and ‘‘Intercompany Transac-

tions’’ presented in this section is applicable to

all mortgage banking reviews. The subsection

‘‘Mortgage-Servicing Rights’’ is recommended

for use in companies that have signiﬁcant risk

exposure. The examiner should also target func-

tional areas such as production, marketing, and

servicing/loan administration.

3070.0.1 BOARD OVERSIGHT AND

MANAGEMENT

The examiner should assess the quality and

effectiveness of a mortgage banking company’s

board of directors (board) and executive man-

agement team, the appropriateness of its organi-

zational structure, the nature of its internal con-

trol environment, and the effectiveness of internal

control programs.

Such internal control pro-

grams may include internal and external audits,

loan review, quality control over mortgage loans

originated and/or serviced for investors, compli-

ance, fraud detection, and related employee

training programs.

The board and executive management team

must be evaluated within the context of the

particular circumstances surrounding each mort-

gage banking company. Since business com-

plexities and operating problems vary according

to the institution’s size, organizational structure,

and business orientation, directors and manag-

ers who are competent to effectively discharge

their responsibilities under one set of conditions

may be less competent as these conditions change.

Board oversight and management should

be rated satisfactory, fair, or unsatisfactory based

on both objective operating results and more

subjective criteria. Performance must be eval-

uated against virtually all the factors necessary

to operate the mortgage banking company’s

activities in a safe, sound, and prudent manner,

including the ability to anticipate and plan for

future events that may have a material impact

on the company’s ﬁnancial condition. Such a

rating should also be considered when assigning

a consolidated rating of risk management (see

sections 4070.1 (SR-95-51) and 4071.0

(SR-16-11)).

3070.0.1.1 Board Oversight

The mortgage banking company’s board pro-

vides oversight, governance, and guidance to

the executive management team. The board may

include executives of the mortgage banking

company, executives of the bank holding com-

pany and other afﬁliated companies, and outside

directors.

The examiner should determine whether a

separate board exists, as well as the identity and

qualiﬁcations of the members. Minutes of board

meetings should be reviewed to determine

whether directors are fulﬁlling their ﬁduciary

responsibilities. At a minimum, directors

should—

• select and retain a competent executive man-

agement team;

• establish, with management, the company’s

short- and long-term business objectives and

adopt operating policies to achieve those

objectives in a safe and sound manner;

• monitor operations to ensure they are con-

trolled adequately and are in compliance with

laws and policies;

• oversee the mortgage banking company’s busi-

ness performance; and

• ensure that the mortgage banking company

meets the community’s residential mortgage

credit needs.

The examiner should assess whether directors

exercise independent judgment in evaluating

management’s actions and competence, attend

board and committee meetings regularly, remain

well informed regarding the company’s activi-

ties and the mortgage banking industry overall,

and are knowledgeable regarding all applicable

state and federal laws and regulations. The

examiner should also review the quality of board

reporting. Board reports must provide accurate

and timely information to directors with respect

to operating results, asset-quality trends, liquid-

ity and capital needs, and relevant industry and

peer-group performance statistics for each

1. See section 1010.1 of the Commercial Bank Examina-

tion Manual and a report, ‘‘Internal Control—Integrated

Framework,’’ which was issued in September 1992 by the

Committee of Sponsoring Organizations of the Treadway

Commission, for a more detailed discussion of internal con-

trols. The Treadway Commission report broadly deﬁnes inter-

nal control as a process, effected by an entity’s board of

directors, management, and other personnel, designed to pro-

vide reasonable assurance regarding the effectiveness and

efﬁciency of operations, reliability of ﬁnancial reporting, and

compliance with applicable laws and regulations.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2014

Page 3

operational area. Directors should also receive

information regarding exceptions to established

policies and operating procedures, volume-

related processing backlogs, and the effective-

ness of the internal control programs. Informa-

tion on hedging products and strategies should

be routinely provided to the board and to hold-

ing company management. In connection with

this portion of the review, examiners should

also request and review information regarding

all loans to insiders and their related interests to

ensure that no preferential transactions have

been extended to these parties.

3070.0.1.2 Management

The executive management team generally con-

sists of a president and chief executive ofﬁcer

(CEO), chief operating ofﬁcer (COO), chief

ﬁnancial ofﬁcer (CFO), and senior executives in

charge of production, marketing, and servicing/

loan administration. Management formulates

operating policies and procedures and oversees

the day-to-day administration of mortgage bank-

ing activities. Management should be evaluated

in terms of its technical competence, leadership

skills, administrative capabilities, and knowl-

edge of relevant state and federal laws and

regulations. The management assessment should

evaluate management’s attitude toward risk, as

evidenced by the type of products that are

offered; the existence of effective hedging pro-

grams; and/or the degree of reliance that is

placed on the resources of afﬁliate banks, non-

banks, and other entities to support mortgage

banking company activities.

Prudent operating policies and procedures

that are consistent with the business needs and

risk-management practices of the parent bank

holding company should be in place for each

functional area. An effective risk-management

program should also be in place. Without ade-

quate management oversight, excessive errors

can occur, fraud or other violations of law may

go undetected, and ﬁnancial information may be

reported incorrectly. Any of these events can

damage the company’s image, impair its access

to external funding sources, and jeopardize its

ability to originate and sell mortgage loans in

the secondary market.

It is management’s responsibility to develop

and maintain management information systems

(MIS), which should be dedicated to obtaining,

formatting, manipulating, and presenting data to

managers when needed. Such systems should

generate accurate ﬁnancial statements; identify

the need for ﬁnancial, human, technological,

and physical resources; and produce timely and

useful management exception reports.

Management should also be evaluated on its

ability to plan effectively. Effective planning

entails the annual approval of an operating bud-

get and the development of a long-term strategic

plan that helps management anticipate changes

in the internal and external environment and

respond to changing circumstances. Because

losses on the origination of mortgage loans are

common in the mortgage banking industry, man-

agement should assess the servicing time neces-

sary to recapture costs and achieve required

returns. This information is critical to decisions

to purchase mortgage-servicing assets, and it

should be incorporated into hedging strategies.

The strategic plan should identify the com-

pany’s strengths and weaknesses, growth tar-

gets, and other strategic initiatives (including

management’s philosophy toward the business,

the extent of ﬁnancial risk-taking, commitments

to maintaining procedures and controls in man-

aging the business, and management’s commit-

ment to staff development) over a one- to three-

year time horizon. Planning efforts should also

address system deﬁciencies and technological

advancements within the industry. Without

appropriate planning, the company can only

react to external events and market forces.

Management should be results-oriented, but

not at the expense of sound risk-management

practices. Goals and objectives should be spe-

ciﬁc and measurable. Management should

develop a performance measurement system that

tracks progress toward achieving both ﬁnancial

and nonﬁnancial goals.

3070.0.1.3 Organizational Structure

The organizational structure should be reviewed

to determine, on a legal-entity basis, the rela-

tionship between the mortgage banking com-

pany, the bank holding company, and any other

bank or nonbank subsidiaries. The structure

should also be reviewed to determine whether

the lines of authority are clearly deﬁned, the

responsibilities are allocated logically, and man-

agement depth is sufﬁcient within each division,

department, or functional area.

The president and CEO usually reports directly

to the mortgage banking company’s board of

directors, as well as to an executive manage-

ment committee at the afﬁliate bank or the bank

holding company level. Other reporting lines

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2016

Page 4

may exist between functional area executives

and their counterparts at either a bank afﬁliate or

the holding company level.

3070.0.1.4 Control Environment

Management’s attitude toward risk is communi-

cated to employees through the company’s cor-

porate culture. In general, the CEO should

establish and communicate a corporate culture

that promotes safe, sound, and prudent business

practices. The corporate culture should provide

a positive control environment, set high stan-

dards, and reward ethical, desirable behavior.

Management’s failure to communicate

acceptable standards of behavior may encourage

impermissible or high-risk business practices.

For instance, compensation programs that are

incentive-based may generate poor-quality loans.

Below-market pricing strategies or overly

aggressive growth targets may further exacer-

bate asset-quality problems or generate loans in

excess of processing and servicing capabilities.

3070.0.1.5 Control Programs

Management controls in a mortgage banking

company consist of an internal audit, an exter-

nal audit, loan review, compliance, quality con-

trol over loans originated and/or serviced for

investors, fraud detection procedures and related

employee training programs, insurance cover-

age, and legal review. The examiner should

review recent reports conducted by internal loan

review, state and federal agencies, and private

investors to determine the scope of the review,

the nature of any problems noted, and the

adequacy of management’s response.

3070.0.1.5.1 Internal Audit

The internal audit function in a mortgage bank-

ing company is responsible for detecting irregu-

larities; determining compliance with applicable

laws and regulations; and appraising the sound-

ness and adequacy of accounting, operating, and

administrative control systems. Accounting,

operating, and administrative control systems

are designed to ensure the prompt and accurate

recording of transactions and a proper safe-

guarding of assets.

Internal audit activities may be conducted

through a separate department located on-site or

through the internal audit department of the

bank holding company. Very small ﬁnancial

institutions that do not maintain a separate audit

function may rely solely on their external audi-

tor to perform these functions.

Regardless of the organizational structure,

internal auditors must be independent of the line

areas being reviewed, have access to all com-

pany records, and maintain sufﬁcient status and

authority within the company. The internal audi-

tors’ ﬁndings should be reported directly to the

board or a designated committee thereof.

The scope, frequency, and coverage provided

through the internal audit program should reﬂect

the size and complexity of the institution. The

audit schedule should cover underwriting prac-

tices and other high-risk areas of mortgage

banking, including the most signiﬁcant balance-

sheet accounts, income statement accounts, and

internal control systems.

To yield meaningful results, the department

must be adequately staffed with individuals who

are experienced and knowledgeable about mort-

gage banking. Audit staff should receive ongo-

ing training and be encouraged to hold profes-

sional industry certiﬁcations.Internalauditreports

should be issued and responded to by line man-

agement in a timely fashion. Follow-up proce-

dures should be in place to ensure that correc-

tive measures are taken.

3070.0.1.5.2 External Audit

External auditors generally review and assess

the mortgage company’s ﬁnancial condition and

the adequacy of internal controls. The engage-

ment letter sets forth the external auditor’s

responsibilities, scope, and extent of reliance

that is placed on the internal audit department

with respect to the type of engagement. When

an external audit is to be performed, the audit is

an examination that is conducted to determine

that the present ﬁnancial condition of the com-

pany and the results of operations are fairly

stated and are in conformity with generally

accepted accounting principles.

Examiners should review the most recent

external audit report to determine whether the

opinion regarding the company’s ﬁnancial state-

ments and their disclosures was qualiﬁed in any

manner. If applicable, examiners should note

any signiﬁcant concerns or weaknesses in the

company’s internal control structure. Examiners

should also review management’s written

response to the audit to determine whether cor-

rective measures were appropriate, complete,

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2016

Page 5

and timely and whether the response reveals any

internal control weaknesses.

The reason behind any changes in external

audit ﬁrms used should be investigated. Unusual

items and areas of potential concern should be

discussed with management and/or the external

auditor. If questions arise during the safety-and-

soundness review, the examiner should deter-

mine whether the area of concern was consid-

ered to be a material item by external auditors,

the nature of audit work performed, and the

outcome of that review. If questions persist, the

examiner may want to request access to speciﬁc

external audit workpapers.

3070.0.1.5.3 Loan Review

Loan review activities may be conducted at the

mortgage banking company or in conjunction

with the loan review activities of either an afﬁli-

ate or the parent bank holding company. In any

event, loan review should determine whether

mortgage loans that are originated and/or pur-

chased meet underwriting standards as deﬁned

in the internal loan policy. Loan review may

also sample loans to determine whether they

meet underwriting criteria established by inves-

tors. The scope of the loan review program

should be evaluated. The examiner should also

review a copy of the most recent loan review to

determine whether problems are identiﬁed and

addressed in a timely manner.

3070.0.1.5.4 Quality Control

Mortgage banking companies that service loans

for investors must also maintain a separate qual-

ity control department to test the quality of

loans produced and serviced for investors.

Investors such as the Government National Mort-

gage Association (GNMA or Ginnie Mae), Fed-

eral Home Loan Mortgage Corporation (FHLMC

or Freddie Mac), and FannieMae issue very

speciﬁc guidelines that must be met with respect

to the scope and frequency of such reviews.

At a minimum, these investors require that

the mortgage banking company sample at least

10 percent of all closed loans each month and

conduct a quality control review to determine

the extent of accuracy, completeness, and adher-

ence to agency underwriting standards. Random

samples should include loans originated through

the company’s own production network, pur-

chased loans, loans for which work was per-

formed by a third party (outsourced), and loans

with various product characteristics, such as a

high loan-to-value or a convertible feature.

Quality control personnel reverify loan docu-

mentation, including the appraisal, down pay-

ment, employment, and income information.

After each review, the department should issue

a comprehensive report detailing speciﬁc qual-

ity control ﬁndings and recommendations. Qual-

ity control reviews must be completed within

90 days of closing. Exceptions to company pol-

icy or investor underwriting standards should be

documented and communicated to executive

management. Corrective measures should be

initiated promptly.

The quality control function should serve as

an early warning system that alerts management

to situations that may jeopardize the ﬁnancial

strength, image, or origination and sale capacity

of the company. To function as an effective

management control, the quality control depart-

ment should operate independently from the

production and servicing/loan administration

departments. Quality control should comple-

ment, not substitute, work performed by the

internal audit and loan review functions.

3070.0.1.5.5 Insurance Program

The insurance program should be reviewed to

determine whether coverage adequately protects

the mortgage banking company and its afﬁliates

against exposure to undue ﬁnancial risk. Insur-

ance policies should be reviewed and approved

by the board at least annually.

3070.0.1.5.6 Litigation

The legal department should be contacted to

determine whether existing or pending litigation

exposes the mortgage banking company or its

afﬁliates to undue ﬁnancial risk. Particular atten-

tion should be paid to the status of any actual or

pending class action lawsuits of a material nature.

Examiners should also determine whether

procedures exist to detect and investigate sus-

pected fraud, either internal or external. In many

instances, the legal department coordinates fraud

training and investigations, as well as the sub-

mission of criminal referral or suspicious activi-

ties reports and the initiation of legal action. If a

separate fraud division or unit does not exist,

examiners should determine whether procedures

governing the detection, investigation, and refer-

ral of potentially fraudulent situations exist

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2014

Page 6

and function effectively. Examiners should also

determine whether management reports ade-

quately detail and track potential exposure.

3070.0.1.5.7 Supervisory Approach for

Qualiﬁed and Non-Qualiﬁed Mortgage

Loans

An “Interagency Statement on Supervisory Ap-

proach for Qualiﬁed and Non-Qualiﬁed Mort-

gage Loans,” dated December 13, 2013, was

issued to clarify the safety-and-soundness ex-

pectations and Community Reinvestment Act

(CRA) considerations for regulated institutions

engaged in residential mortgage lending. The

Consumer Financial Protection Bureau’s (CFPB)

Ability-to-Repay and Qualiﬁed Mortgage Stan-

dards Rule

was issued on January 10, 2013

(effective on January 10, 2014). Institutions may

issue qualiﬁed mortgages or non-qualiﬁed mort-

gages, based on their business strategies and

risk appetites. Residential mortgage loans will

not be subject to safety-and-soundness criticism

based on their status as either qualiﬁed mort-

gages or non-qualiﬁed mortgages. As for safety-

and-soundness expectations, the agencies

con-

tinue to expect institutions to underwrite

residential mortgage loans in a prudent fashion

and to address key risk areas in their residential

mortgage lending, including loan terms, bor-

rower qualiﬁcation standards, loan-to-value lim-

its, documentation requirements, and appropri-

ate portfolio and risk-management practices.

Refer to SR-13-20 and its attachment.

3070.0.1.6 Inspection Objectives—Board

Management and Oversight

1. To assess the composition, qualiﬁcations,

and degree of oversight provided by the mort-

gage company’s board and executive manage-

ment team.

2. To determine whether the organizational

structure is appropriate given the nature and

scope of the mortgage banking company’s

operations.

3. To evaluate the reasonableness of the oper-

ating budget, long-term business planning, per-

formance measurement systems, and MIS and

related management and board reports.

4. To determine the nature of the company’s

internal control environment and the effective-

ness of its system of internal controls, including

internal and external audits, loan review, quality

control, suspicious activities and fraud detection

(including criminal referral and suspicious

activities reporting) and related employee train-

ing programs, insurance coverage, and pending

litigation.

3070.0.1.7 Inspection Procedures—Board

Management and Oversight

Board Oversight

1. Review biographies of the board of direc-

tors and minutes from board and committee

meetings to determine whether directors are

qualiﬁed and fulﬁlling their ﬁduciary

responsibilities.

2. Review the most recent package of infor-

mation that was provided to directors. Do they

receive sufﬁcient detail regarding the ﬁnancial

condition, internal controls, and risk-

management techniques employed within the

company?

Management

1. Review biographies of members of the

executive management team to determine their

level of experience, technical knowledge, lead-

ership skills, and administrative capabilities.

Discuss whether salaries are commensurate with

management’s experience level and expertise.

2. Evaluate the quality of operating policies

and procedures within each division or func-

tional area and the extent to which compliance

with such policies and procedures is monitored

and reported.

3. Evaluate the output from the planning pro-

cess, including the most recent operating bud-

get, business plan, and related performance mea-

surement system reports. Determine whether

objectives, goals, and growth targets are

reasonable.

1a. See the Ability-to-Repay and Qualiﬁed Mortgage Stan-

dards Rule (the Ability-to-Repay Rule)_ under the Truth in

Lending Act (Regulation Z), 78 Fed. Reg. 6408 (January 30,

2013), as amended. The Ability-to-Repay Rule requires insti-

tutions to make reasonable, good faith determinations that

consumers have the ability to repay mortgage loans before

extending such loans. In accordance with the rule, a “qualiﬁed

mortgage” may not have certain features, such as negative

amortization, interest-only payments, or certain balloon struc-

tures, and must meet limits on points and fees and other

underwriting requirements.

1b. The federal banking ﬁnancial institutions regulatory

agencies (the Federal Reserve, the Federal Deposit Insurance

Corporation, and the Ofﬁce of the Comptroller of the Cur-

rency).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual July 2014

Page 7

Organizational Structure

1. Review the organization chart to deter-

mine whether the organizational structure is

appropriate, as well as the appropriateness of

the division of functional responsibilities and

the degree of management depth within each

division or functional area.

Internal Control Environment

1. Evaluate the nature of the internal control

environment and how risk parameters are com-

municated to employees.

Internal Control Programs

1. Assess the effectiveness of internal con-

trols in identifying and controlling risks. Inter-

nal controls include internal and external audits,

quality control for mortgage loans, insurance

coverage, and fraud detection procedures and

related employee training programs.

Internal Audit

1. Determine whether a separate internal au-

dit function exists and, if so, its degree of

independence.

2. Review the qualiﬁcations of the internal

audit manager and his or her staff for mortgage

banking and accounting and auditing expertise.

Consider the size of the department and its

ongoing training programs, as well as the expe-

rience levels, educational backgrounds, and pro-

fessional certiﬁcations of the department’s staff.

3. Determine the scope and frequency of the

internal audit program to ensure that all high-

risk areas are reviewed regularly.

4. Review all internal audit reports, manage-

ment responses to them, and follow-up audit

reports for work conducted since the previous

inspection.

5. Select a signiﬁcant sample of internal audit

reports and respective workpapers and conduct

an intensive review of the internal audit pro-

gram. Determine that all issues and exceptions

were brought forward to the ﬁnal audit report,

the report was presented to the board or a com-

mittee thereof, and that any detected and dis-

closed problems or control weaknesses received

appropriate management attention.

6. Evaluate the internal audit department’s

system for following up on issues and excep-

tions. Determine whether prompt, satisfactory

resolution of issues was effected.

External Audit

1. Review the engagement letter for the most

recent external audit to determine the external

auditor’s scope, responsibilities, and extent of

reliance on the internal audit department.

2. Review the most recent external audit

report to determine whether the opinion regard-

ing the company’s ﬁnancial condition was quali-

ﬁed in any way and whether any internal control

weaknesses were noted. Review the notes to the

ﬁnancial statements for appropriate disclosures.

3. Discuss any unusual items and areas of

potential concern with management and/or the

external auditor. Determine whether any areas

of concern were considered to be material items

by the external auditors, based on the nature of

audit work performed, management’s represen-

tations in the management letter, and the out-

come of that review. If questions persist, con-

sider the need to request and review speciﬁc

external audit workpapers.

4. Discuss the reasons for any recent changes

in external auditors with management.

Compliance and Disaster Recovery

1. Review the methods used to ensure com-

pliance with state and federal laws and regula-

tions by—

a. interviewing the person who is respon-

sible for compliance to determine the nature of

outstanding problems and the adequacy of cor-

rective measures that have been taken, and

b. reviewing the system for logging,

tracking, and responding to customer complaints.

2. Determine whether the disaster recovery

plan is adequate.

Quality Control

1. Review the quality control department’s

policies and procedures to determine whether

the quality control program meets minimum

investor requirements.

2. Review a sample of reports issued by the

quality control unit to determine whether they

were issued in a timely manner and conclusions

were adequately documented.

3. Determine whether quality control results

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 8

are relayed to executive management and whether

follow-up procedures are adequate.

4. Determine whether the quality control unit

is sufﬁciently staffed and independent.

5. Determine whether quality control out-

sources work to outside parties. If so, are ade-

quate controls in place to ensure that such out-

sourcing meets the company’s own quality

standards?

Insurance

1. Review insurance policies maintained for

the mortgage banking company to determine

whether coverage is adequate and whether the

majority of insurable risks is included, giving

consideration to a cost versus beneﬁts analysis.

2. Review board minutes to ascertain the date

the board last reviewed and approved the insur-

ance program.

Litigation

1. Review all current and pending litigation

of a material nature and determine whether ade-

quate reserves are maintained to cover antici-

pated ﬁnancial exposure.

Fraud Detection and Training

1. Determine whether a separate fraud unit

exists and whether procedures are in place

regarding the detection and investigation of sus-

pected fraudulent activity and the issuance of

related management reports.

2. Evaluate the company’s early warning sys-

tem for detecting potential fraud. Is the level of

training adequate?

3. Review any criminal referral or suspicious

activities forms ﬁled since the prior inspection

and discuss their status with management.

3070.0.2 PRODUCTION ACTIVITIES

Loan production covers the process of originat-

ing or acquiring loans. Production begins with

the initial loan application and ends when a loan

has been underwritten and processed, closed,

and reviewed by post-closing.

3070.0.2.1 Types of Loans

Loans are categorized as either government or

conventional loans. Government loans generally

carry a below-market interest rate and are either

insured by the Federal Housing Administration

(FHA) or guaranteed by the Veterans Adminis-

tration (VA). Both agencies protect investors

holding such securities against losses in the

event of a borrower default, thereby slightly

reducing investors’ required yields. To be insured

or guaranteed, a loan must meet agency stan-

dards regarding the size, interest rate, and terms.

The lender can obtain a certiﬁcate of insurance

or guaranty to give support to a loan for securi-

tization. A certiﬁcate of insurance or guaranty

may not be needed for a loan to be securitized.

Loans that are not FHA-insured or VA-

guaranteed are referred to as conventional loans.

Conventional loans are generally originated for

larger loan amounts and made to stronger bor-

rowers. Conventional loans typically require

higher down payments and bear market interest

rates. Most lenders that offer programs with

smaller down-payment terms require that the

borrower purchase private mortgage insurance

for the top 5 to 20 percent of the loan principal

balance so that a proportionate share of the

credit risk is borne by a private mortgage insur-

ance (PMI) company.

The extent of credit risk associated with a

loan often depends on the marketing program

under which the loan is originated. Marketing

programs and participants are described brieﬂy

here; for a more detailed description, see ‘‘Mar-

keting Activities’’ later in this section.

The market for residential real estate loans is

dominated by three government-sponsored enti-

ties: the Government National Mortgage Asso-

ciation (GNMA), the Federal Home Loan Mort-

gage Corporation (FHLMC), and the Federal

National Mortgage Association (FannieMae).

GNMA is a government agency that guarantees

the timely payment of principal and interest on

pass-through securities that are backed by pools

of FHA-insured or VA-guaranteed mortgages.

These guaranties are backed by the full faith and

credit of the U.S. government. Although inves-

tors will get paid in full, servicers may retain

some risk of loss, particularly with respect to

VA loans (see subsection 3070.0.4.5 for addi-

2. See the appropriate agency seller/servicer guide for stan-

dards and requirements regarding certiﬁcates of insurance or

guaranty.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 9

tional information on ‘‘VA no-bids’’).

Pass-through securities provide for monthly

installments of interest at the stated certiﬁcate

rate plus scheduled principal amortization on

speciﬁc dates, despite the delinquency status of

the underlying loans, as well as any prepay-

ments and additional principal reduction. The

issuer collects the mortgage payments and, after

retaining servicing and any other speciﬁed fees,

remitsmonthlypayments to the certiﬁcate holders.

Although FHLMC and FannieMae are not

extensions of the U.S. government, the market

believes that there is an implicit guaranty that

their securities will be repaid. FHLMC and

FannieMae securitization involves the purchase

of conventional loans from lenders and the sell-

ing of mortgage-participation certiﬁcates, which

are similar to GNMA pass-through securities.

Participation certiﬁcates represent an ownership

interest in pools of conventional loans. FHLMC

and FannieMae guarantee the monthly pass-

through of interest, the scheduled amortization

of principal, and the ultimate repayment of prin-

cipal. Unlike GNMA pass-throughs, however,

participation certiﬁcates are not backed by the

full faith and credit of the U.S. government.

Conventional loans are classiﬁed as either

conforming or nonconforming. Conforming

loans must comply with FannieMae’s and/or

FHLMC’s underwriting and documentation

guidelines in order to be sold in the secondary

market. Conforming mortgages may be sold to

FannieMae or FHLMC on either a recourse or

nonrecourse basis.

Private pools of nonconforming loans that do

not meet FannieMae or FHLMC guidelines may

be sold in the secondary market under a private

label structure. Nonconforming loans are often

‘‘nontraditional’’ products such as loans with

teaser rates, limited documentation, and gradu-

ated payment schedules, as well as ‘‘jumbo’’

loans that exceed maximum agency size require-

ments. To improve salability, pools of noncon-

forming loans may be insured through third-

party credit enhancements (for example, letters

of credit) or various senior/subordinate struc-

tures. Since the underlying mortgages generally

already carry private mortgage insurance, such

pools are, in effect, doubly insured.

3070.0.2.2 Production Channels

Mortgage loan applications are generated through

either retail (internal) or wholesale (external)

production channels. Retail loans are originated

through the company’s own branch network. A

branch network is relatively costly, since origi-

nation costs often exceed the origination fees

received from the borrowers.

Wholesale production channels (where con-

tact with the borrower is made by another party)

take several forms. Whole loans can be pur-

chased either individually or by using bulk com-

mitments. Bulk commitments either require the

correspondent to deliver a set amount of loans

(mandatory) or deliver all registered loans that

close (best effort or optional).

Loans may be closed in the buyer’s own

name using its own funds, closed in the seller’s

name using the buyer’s own funds, or closed

and funded by the seller with delivery to the

buyer within a certain number of days. If the

seller closes in its own name, the mortgage and

note are generally assigned to the buyer simulta-

neously upon closing.

Three hybrid production channels are worth

mentioning here. Examiners should note that

terminology within the industry varies greatly.

Under the ﬁrst method, table funding, a mort-

gage banking company funds loans at closing

that have been originated by a correspondent or

broker according to the company’s own speciﬁ-

cations. Historically, the company’s ability to

record mortgage-servicing rights depended on

the degree of independence that was maintained

and the extent of risk borne by the originator.

See subsection 3070.0.6, on ‘‘Mortgage-

Servicing Assets and Liabilities.’’

The second hybrid method, assignment of

trade, involves the bulk purchase of loans and

investor commitments to sell the loans in the

secondary market. The purchaser bears virtually

no market risk under this production method.

The third hybrid method, co-issue, entails the

acquisition of servicing rights only, at the time a

security is issued.

Most mortgage originators operate on a non-

recourse basis. For purchasers of correspondent

production, credit risk increases to the extent

that the lender relies on other parties to correctly

process and underwrite the loan. Contracts with

correspondents should include representations

and warranties from the correspondent that loans

delivered meet the underwriting requirements of

the agency or investor program for which the

loan was originated. Approved correspondent

lenders should be continually monitored for the

quality of the product delivered and the ﬁnan-

cial ability to repurchase mortgages that do not

meet the standard representations and warran-

ties under which the mortgages are sold.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 10

3070.0.2.3 Production Strategies

A successful production strategy combines high

credit-quality standards with cost containment

and effective marketing. In contrast, an overly

aggressive or inappropriate strategy leads to

heightened production risk. High-risk produc-

tion strategies can be evidenced by relaxed

credit standards, low documentation require-

ments, an executive ofﬁcer’s compensation based

on volume, an emphasis on high-risk product

types or geographic areas, and/or dependence

on a limited number of production channels.

Examiners are responsible for recognizing and

reaching agreement with management to better

controlsuchhigh-riskproduction strategieswhere

appropriate.

3070.0.2.4 Production Process

There are ﬁve principal steps in the retail pro-

duction process: (1) pipeline entry, (2) process-

ing, (3) underwriting, (4) closing and funding,

and (5) post-closing. Each of these functions

should be independent from one another and

separately supervised to ensure the quality of

the loans produced. Each step is brieﬂy dis-

cussed below.

1. Pipeline entry. A loan has entered the

pipeline when a prospective borrower completes

a loan application. The applicant authorizes the

lender to verify his or her employment, credit

history, bank deposits, and other information

that evidences repayment capacity.

2. Processing. The application is then pro-

cessed to qualify the applicant and the property

for the loan. Processing personnel verify the

applicant’s employment history and credit infor-

mation and order an appraisal on the property.

Processing activities should be controlled through

standardized procedures, checklists, and systems.

3. Underwriting. The underwriting unit

approves or disapproves applications based on

underwriting criteria that are established by the

FHA, VA, FannieMae, and FHLMC and by

private mortgage insurers and institutional

investors. To ensure objectivity, the underwrit-

ing unit should not report to management of the

production function.

4. Closing and funding. After an application

has been approved, the lender generally issues a

commitment letter to the borrower, which states

the interest rate and terms of the loan. At clos-

ing, the lender or its agent obtains all the legal

and related documents executed by the parties

to the sale, disburses the proceeds of the loan,

and collects certain funds from the borrower.

5. Post-closing. After closing, a post-closing

review is performed to ensure that documents

were properly executed and underwriting in-

structionswere followed.The post-closingreview

also identiﬁes any trailing or missing documents

that must be tracked and obtained to meet inves-

tors’ pool certiﬁcation requirements. Speciﬁc

agency requirements are detailed in the agency

seller/servicer guides. Before the loan is trans-

ferred to the delivery or shipping department,

processing begins for the ﬁnal mortgage insur-

ance (from the private mortgage insurer or from

the FHA/VA guaranty certiﬁcate). Receipt of

the actual certiﬁcate may take 45 to 60 days or

longer. Pool custodians and investors will allow

the lender to complete the sale if ﬁnal documen-

tation, including the insurance certiﬁcate, is

expected to be received within a reasonable

timeframe.

3070.0.2.5 Production Risks

The production process can present risks of both

a short- and potentially long-term impact.

Operational inefﬁciencies can result in high

management and staff turnover, an inability to

meet investor documentation requirements, an

increasing number of pools that have not received

ﬁnal certiﬁcation, or an unusually high produc-

tion cost structure. Operations risk often increases

during peak volume periods. If additional

resources (which can include independent ser-

vice providers) are not allocated to the process-

ing, underwriting, closing, and post-closing areas,

delinquency levels may increase and workloads

may exceed existing capacity.

Management should be prepared to quickly

respond to interest-rate cycles and related vol-

ume increases or declines, since failure to act

promptly can affect earnings and capital. During

the pooling and securitization process, for exam-

ple, if the number of pools that lack ﬁnal certiﬁ-

cation exceed a certain limit, the company may

be required to seek ﬁnancial support in the form

of a letter of credit from an afﬁliate bank or

bank holding company to ensure that all required

loan documentation is secured in a timely man-

ner. Credit risk and operational inefﬁciencies

may also create liquidity problems and addi-

tional interest-rate risk if the company is unable

to sell its loans in the secondary market.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 11

To the extent a company retains servicing on

either its retail or correspondent production,

long-term credit risk issues may develop. These

include exposure to the pools being serviced

through recourse arrangements, potential non-

reimbursable foreclosure costs, or costs associ-

ated with VA ‘‘no-bid’’ options.

3070.0.2.6 Overages

In certain instances, originators and loan bro-

kers may have the ability to deviate from mort-

gage loan prices that are established by the

marketing department. An overage exists when

a lender permits an originator or broker to

impose a higher number of points (or a higher

interest rate) on a loan to certain borrowers

than is imposed for the same product offered to

other borrowers at a given point in time. (See

CA-94-6.)

Overages are often used as an incentive to

compensate originators or brokers. The amount

that is received over the expected price is often

shared by the mortgage banking company and

the originator or broker. The practice of permit-

ting overages may contribute to or result in

lending discrimination under the Equal Credit

Opportunity Act (ECOA) and the Fair Housing

Act (FHAct).

Examiners should review the mortgage bank-

ing company’s lending policy and determine

whether overages are permitted and whether the

practice has resulted in lending discrimination.

If a more detailed review of overages is deemed

necessary, such review should be performed in

conjunction with the appropriate Federal Reserve

System’s legal and consumer compliance staff.

3070.0.2.7 Inspection Objectives—

Production Activities

1. To determine the types of loans offered to

borrowers and any signiﬁcant changes in prod-

uct mix.

2. To determine whether mortgage loans are

securitized; if so, to determine whether mortgage-

backed securities are insured or otherwise guar-

anteed by government-sponsored agencies or

private entities.

3. To determine what channels are used to

originate loans.

4. To determine if production processes are

consistent with operational risk controls and

efforts to minimize risk.

5. To determine whether production pro-

cesses can handle cyclical changes in volume.

6. To determine whether overages are permit-

ted and to assess whether the practice has resulted

in lending discrimination.

3070.0.2.8 Inspection Procedures—-

Production Activities

General

1. Review organization charts to determine

the structure of the production function and its

status within the company. Verify that func-

tional units such as underwriting and quality

control are independently managed.

2. Determine the types of mortgage products

offered and the company’s target markets. Evalu-

ate portfolio trends for overreliance on one

product type and undue concentrations in one

geographic area.

3. Discuss the company’s credit culture, com-

pensation methods, and growth targets to deter-

mine whether income and loan volume are

emphasized over credit quality.

4. Determine whether the level of noncon-

forming or unsalable loans being originated

present undue risk and whether the quality and

delinquency trends for such loans are adequately

monitored.

Originations

1. Review policies and procedures for retail

branch originations. How are originators com-

pensated? Determine whether originators have

the authority to alter loan pricing parameters set

by the marketing unit.

2. Determine the size of the branch network

and its cost structure. Is the network growing or

shrinking? How does management plan for

anticipated changes in loan volume?

3. Determine if the mortgage banking com-

pany is involved in overage activities. If so—

a. determine whether management has

developed comprehensive policies and pro-

cedures, detailed documentation and tracking

reports, accurate ﬁnancial reporting systems and

controls, and comprehensive customer com-

plaint tracking systems to adequately monitor

and supervise overage activities;

b. review whether overages are an essen-

tial component of the mortgage banking com-

pany’s earnings and origination activities, and

review the percentage of mortgages originated

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 12

since the previous inspection that resulted in

overages and the average overage per loan;

c. determine if management reviews over-

age activity for disparate treatment and dispa-

rate impact; and

d. determine if overages are a major com-

ponentof loan ofﬁcer and/orbroker compensation.

4. Review policies and procedures for whole-

sale purchases. Which production channels are

used and how do they work? Channels may

include whole loan purchases (production ﬂow),

table funding, assignment of trade, or co-

issuances (bulk purchases of servicing rights

only). For each production channel, review how

brokers and correspondents are compensated.

5. Review the method for reviewing and

approving brokers and correspondents and spe-

ciﬁc programs under which wholesale loans are

purchased. Is there an approved list of corre-

spondents? How is it updated and how fre-

quently? Determine whether exceptions to this

list are made and by whom, and whether controls

are in place to prevent unauthorized purchases.

6. Evaluate the process for conducting ﬁnan-

cial reviews on correspondents. How often are

ﬁnancial statements obtained, and who analyzes

them?

7. Determine whether adequate controls are

in place to detect changes in the ﬁnancial condi-

tion of a correspondent, test and monitor the

quality of loans purchased, and evaluate the

correspondent’s ﬁnancial capacity to perform

under contractual repurchase obligations.

8. Select a sample of contracts for the largest

correspondents for additional review. Do con-

tracts clearly state pricing structures, maximum

dollar volumes, recourse arrangements, and

whether loans are purchased on a mandatory

delivery or a standby basis? Have any legal

issues arisen as a result of the contract lan-

guage? How frequently does management put

back loans to its largest correspondents?

9. Determine whether management informa-

tion systems adequately track approvals and

denials by loan type and production channel.

Are exceptions to policy adequately tracked and

monitored?

Processing

1. Determine whether processing is per-

formed in-house or by another party (a third-

party contractor or the originator). Review check-

lists and procedures for the processing unit and

determine whether loan tracking systems are

adequate.

2. Review steps that have been taken to ad-

dress any audit or quality control ﬁndings. Deter-

mine whether additional corrective actions are

necessary.

Underwriting

1. Determine whether underwriting is per-

formed in-house, by third-party underwriters, or

by the originator. Is management planning for

peak volume periods and are controls over the

underwriting process adequate?

2. Review policies and procedures to gain a

reasonable assurance that underwriting stan-

dards are prudent and comply with investor

guidelines. If individual underwriters perform

this function, determine whether management

has established approval limits, developed

exception procedures for loans that are rejected

or suspended, and receives reports that track

loan quality for each underwriter. If a committee

performs the underwriting function, review its

charter, composition, and minutes. If a scoring

system is used, review credit scoring methodol-

ogy. Can the system be overridden? If so, by

whom?

3. Review a representative sample (prefer-

ably a statistical sample) of current loans to test

the underwriting policies and procedures and

also determine the validity and adequacy of

documentation supporting loans held for sale or

investment.

4. If an unusual increase in unmarketable

loan inventory has been noted, select a small

sample of loans in current production for addi-

tional review. Does underwriting comply with

established guidelines? If a credit scoring sys-

tem is used, focus on loans that are of the lowest

acceptable grade. If deﬁciencies are noted, con-

sider expanding the review sample.

5. Review loans that were rejected and then

approved. Did the proper authority approve such

loans, and was management’s rationale ade-

quately documented?

Closing/Post-Closing

1. Evaluate procedures, checklists, and sys-

tems for closing loans. Are all required docu-

ments obtained from the borrower before funds

are disbursed? If not, evaluate the appropriate-

ness of suspense items.

2. Determine if a post-closing documentation

review process exists to differentiate, track, and

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 13

obtain both trailing and missing documents.

Assess its effectiveness.

3. Determine if wholesale loans are

re-underwritten at delivery. If not, how does

managementensure that loans are re-underwritten

in accordance with secondary marketing pro-

gram requirements?

4. Determine the number of pools that lack

ﬁnal pool certiﬁcation. Has this number exceeded

the maximum allowable limit since the previous

review? Why has this problem occurred, and

what steps are being taken to secure the neces-

sary documentation? Has a letter of credit been

posted? Does the situation pose undue ﬁnancial

risk for the company or any of its afﬁliates?

3070.0.3 MARKETING ACTIVITIES

The marketing department is typically respon-

sible for the development of mortgage products,

determination of products to be offered, and the

establishment of daily mortgage prices. The

marketing department, which is also referred to

as secondary marketing, is also responsible for

the sale of mortgage loans to investors. Given

these roles, the marketing department acts as an

intermediary between the borrower and the

investor. All of these activities require close

coordination to be effective and are appropri-

ately placed within one department.

3070.0.3.1 Oversight

Marketing activities are generally supervised by

a marketing committee, which may consist of

the chief executive ofﬁcer, chief operating ofﬁ-

cer, chief ﬁnancial ofﬁcer, and the executive

ofﬁcers responsible for marketing, production,

and servicing/loan administration. The market-

ing committee is responsible for the formulation

of marketing policies, departmental operating

procedures, pricing strategies, and parameters

governing the use of various mortgage-related

products and strategies used to hedge the interest-

rate risk associated with certain mortgage loans.

3070.0.3.2 Securitization

The marketing department’s primary tool in per-

forming its activities involves securitization out-

lets. Securitization activities are discussed in

SR-90-16, which transmitted the following docu-

ments: (1) the Examination Guidelines, (2) An

Introduction to Asset Securitization, and

(3) Accounting Issues Relating to Asset Securi-

tization. There is also a discussion of these

activities in the Commercial Bank Examination

Manual, section 4030.1. A review of the securi-

tization process can provide a clearer under-

standing as to the value the marketplace assigns

to a mortgage banker’s production. Mortgage

securities, however, are usually issued by an

entity other than the mortgage banking company

under inspection (such as government-

sponsored agencies, securities afﬁliates, or bro-

kerage ﬁrms).

Many approaches are used for securitization,

but the great majority of activity occurs with

conduits such as GNMA, FHLMC, and Fannie-

Mae. Conduits provide many programs that a

mortgage originator can use to deliver a mort-

gage or pools of mortgages in return for cash

or securities. To investigate current program

requirements and available options, the exam-

iner should consult the seller guidelines issued

by the agencies.

The securitization process presents the mar-

keting department with a complex set of options

to consider when deciding how to sell the com-

pany’s loan production for maximum proﬁt. If

the company’s own servicing valuation differs

from pricing offered by the agencies, for instance,

the marketing department can use some ﬂexibil-

ity in pool formation guidelines to retain or

divest servicing cash ﬂows. Recourse to the

originator or servicer can be negotiated to reduce

agency guaranty fees. Agencies also alter guar-

anty fees based on different methods of remit-

ting principal and interest payments. Sales to the

agencies can be on a best-efforts or mandatory

basis. A best-efforts basis is when loan delivery

is not required if the loan does not close. Better

prices are received for the lender’s acceptance

of the more rigid performance requirements of

mandatory commitments. Master commitment

contracts can be reviewed by the examiner to

determine negotiated terms.

Although most securitization activity occurs

within the programs already mentioned, private

security issues are also used. The private issues

are used primarily for loans that do not meet the

underwriting criteria of the agencies, commonly

due to larger than accepted loan amounts (jumbo

loans). Nonconforming loan production is usu-

ally sold to brokers or security afﬁliates who

have marketed the product to investors, some-

times using complex real estate mortgage invest-

ment conduits (REMICs).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 14

3070.0.3.3 Pooling Practices

As an intermediary between the borrower and

the investor, marketing personnel coordinate the

ﬂow of loan documents from the shipping

department to the pool custodian and the ulti-

mate holder. If servicing is retained, the loan

will be input into the company’s servicing sys-

tem soon after closing. Stafﬁng levels should be

adequate to ensure that processing backlogs are

managed and workloads remain reasonable. Tem-

porary help and/or outsourcing may be used

during peak volume periods.

Operating procedures governing the selection

of mortgage loans for pooling, packaging, and

sale should be evaluated to ensure that the ship-

ping and pooling processes are efﬁcient and that

loan ﬁles ultimately contain complete documen-

tation. Management reports should identify and

track the number of pools that lack ﬁnal agency

certiﬁcation and the status of missing (unavail-

able) and trailing (delayed) documentation.

If third-party guaranties are used during the

securitization process, procedures should also

establish methods for evaluating and monitoring

the ﬁnancial condition of all third-party entities

that provide credit enhancement. If loans or

securities are sold with recourse, management

reports shouldidentify and trackpotential recourse

obligations. Management should also analyze

historical recourse losses by investor and prod-

uct type and determine the appropriate level of

reserves to cover estimated recourse exposure.

3070.0.3.4 Marketing Risks and Risk

Management

3070.0.3.4.1 Techniques

The marketing department manages several risks,

which can be categorized as follows:

• unsalability

• pricing

• fallout

• counterparty performance

3070.0.3.4.2 Unsalability

Under most circumstances, a mortgage banking

company will originate mortgage products that

are acceptable to GNMA, FannieMae, FHLMC,

or other major investors. This minimizes the

risk that mortgage products originated will not be

marketable to investors and have to be retained

as a portfolio investment. However, the market-

ing department may also initiate certain prod-

ucts that are intended for the loan portfolio of

the mortgage company or portfolios of bank or

nonbank afﬁliates. In the case of production for

bank afﬁliates, underwriting and pricing

arrangements must be structured to ensure com-

pliance with the restrictions imposed by sec-

tions 23A and 23B of the Federal Reserve Act.

See the subsections on production activities

(3070.0.2) and intercompany transactions

(3070.0.7).

3070.0.3.4.3 Pricing Risk

The mortgage banking business is volume driven.

Because proﬁt margins are thin and ﬁxed costs

associated with loan production can be large

(especially in the case of a retail origination

network), it takes a signiﬁcant volume of mort-

gages to generate proﬁts. Mortgage pricing deci-

sions are critical because the price is a major

determinant in the volume of mortgages

originated.

Pricing strategies can be affected by divi-

sional proﬁt and loss allocations or external

industry practices. A neutral price structure sets

mortgageprices that are equivalentto the expected

price for which the mortgages will be sold to

investors, plus a normal servicing spread of

25 to 50 basis points depending on the type of

loan. Daily adjustments are usually made to

prices to reﬂect market changes for future settle-

ment of mortgage-backed securities (MBS).

Due to regional or local competition, mort-

gage banking companies often ﬁnd it necessary

to deviate from a purely neutral pricing strategy

to maintain volume in certain markets. How-

ever, large deviations from market price in either

a lower or even upward direction can have

adverse consequences. In addition to causing

marketing losses, price cutting could place

operational strains on the production and servic-

ing areas. Premium pricing can position the

company as a lender of last resort with adverse

credit quality implications.

The marketing department attempts to mini-

mize price risk by matching origination pricing

with the price it expects to receive from inves-

tors. However, estimating the price at which the

mortgages can be sold can be difﬁcult because it

is determined in large part by external factors

such as interest rates. The longer the elapsed

time between when the mortgage applicant

decides to lock in a loan rate and the time the

loan closes, the greater the risk that the prices

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 15

for which the mortgages can be sold will change.

Some companies encourage customers to ‘‘ﬂoat’’

their interest rate until closing approaches to

reduce the volume and costs of hedging.

3070.0.3.4.4 Fallout

A third type of risk that the marketing depart-

ment manages relates to pipeline ‘‘fallout.’’ This

is the risk that the proportion of loans in the

rate-committed pipeline that are expected to

close will change with a given change in interest

rates. As market interest rates decline, fewer

mortgages in the pipeline will close because

applicants will opt to make new applications at

the lower rates. As interest rates rise, the propor-

tion of pipeline loans that will close increases as

more applicants choose to lock in rates. Mis-

matches that occur in the long and short posi-

tions can result in ﬁnancial losses when the

institution needs to settle its trades.

3070.0.3.4.5 Hedging Strategies

The most common hedging strategy used to

protect the inventory of closed loans and the

rate-committed pipeline against adverse interest-

rate movements involves the use of mandatory

and optional forward sales of MBS. Under this

hedging strategy, the inventory and rate-

committed pipeline (the long position) are gen-

erally covered through short sales (mandatory

delivery contracts with settlements correspond-

ing to expected delivery volumes). Put and call

options on MBS are sometimes purchased to

manage heightened fallout risks during periods

of volatile interest-rate ﬂuctuations.

The typical practice is to hedge 100 percent

of the closed loan inventory that is marketable.

In addition, pipeline loans very near to closing

are generally also hedged at or close to 100 per-

cent. However, a signiﬁcant degree of uncer-

tainty exists as to the amount and timing of

30- and 60-day rate-committed pipeline closings

due to interest-rate ﬂuctuations, underwriting

delays, and cancellations. To control exposure

to rate movements, management must estimate

the percentage of the rate-committed pipeline

that is expected to close in the current economic

environment.

Although estimation techniques vary, data are

generally collected on a number of pipeline

characteristics such as product type, whether the

loan is a purchase or reﬁnance, and whether it is

retail- or wholesale-originated. Fallout behavior

can vary depending on these and other factors.

Based on this information, management then

derives an estimated closing percentage that

becomes management’s operating target for cov-

erage of the rate-protected pipeline.

Marketingpersonneloften use simulation mod-

eling to assess fallout percentages, assist in

balance-sheet valuations, and develop appropri-

ate hedging strategies. Such models may be

either purchased from outside vendors or devel-

oped in-house, and they vary greatly in their

degree of sophistication. In any event, the pri-

mary assumptions and inputs to the model should

be reasonable, well documented, and reviewed

periodically by both the marketing committee

and by an independent source such as an inter-

nal or external audit. Results from the market-

ing simulation model should be provided to

management through summary reports. Infor-

mation may also be provided to bank holding

company personnel for asset/liability manage-

ment purposes.

Other products may also be used to hedge

inventory loans and the rate-committed pipe-

line, particularly loans with an adjustable rate

feature or other specialized characteristics. The

marketing committee should review and approve

all specialized hedge products used, the degree

of correlation between the hedge product and

the underlying position being hedged, and the

degree of risk that each strategy or position

entails. The accounting department should also

determine whether such products qualify for

hedge accounting treatment, establish appropri-

ate management reports, and establish account-

ingpolicies.See subsection 3070.0.6, ‘‘Mortgage-

Servicing Rights.’’

3070.0.3.4.6 Position Reports

To limit risk, the marketing committee should

place prudent limits on the amount of exposure

that can be incurred through hedging operations.

Limits, which may be contained in the market-

ing policy, might establish a constraint on the

size of uncovered long positions, require that

coverage be maintained at the marketing com-

mittee’s current closure estimates, or establish

a constraint based on an earnings-at-risk

measurement.

Compliance with limits should be monitored

through regular position reports, which should

be provided to senior management (the market-

ing committee and perhaps the treasury function

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 16

of the parent company, if they participate in

decisions or policy enforcement) at least weekly.

Position reports should detail the company’s

long and short positions in relation to limits, as

well as unrealized and realized gains and losses

on loans and securities. Department managers

generally require daily position reports in order

to effectively monitor the position. Marketing

position reports may not reconcile directly with

reports prepared by the accounting department

for ﬁnancial reporting purposes. Signiﬁcant dif-

ferences should be investigated.

3070.0.3.4.7 Counterparty Performance

The marketing committee is also generally

responsible for managing investor/counterparty

performance risk. The marketing committee (or

the treasury department of the parent bank hold-

ing company) should approve all brokers and

dealers to which securities are sold before trad-

ing commences. Dealer limits should be estab-

lished to limit the maximum amount of trades

outstanding with each ﬁrm. Frequent position

reports should be prepared to monitor compli-

ance with established limits. The accounting

department may be responsible for the ongoing

monitoring of the ﬁnancial capacity of the bro-

kers and dealers.

3070.0.3.5 Inspection Objectives—

Marketing Activities

• To review the types of products developed.

• To determine the pricing strategies offered to

borrowers and investors.

• To review pipeline fallout estimation

techniques.

• To review hedging methods as they relate to

loan production.

• To determine whether information systems

are adequate for senior management to moni-

tor fallout behavior and hedge performance.

3070.0.3.6 Inspection Procedures—

Marketing Activities

Management Oversight

1. Review the composition of the marketing

committee and minutes from recent committee

meetings to determine the nature and scope of

its responsibilities, the frequency of meetings,

and the degree to which oversight over market-

ing activities is provided.

2. Review the marketing policy as it relates

to product offerings, pricing strategies, loan

sales, and hedging operations. Are all relevant

marketing risks identiﬁed? Note the date the

marketing policy was last reviewed and approved

by the board of directors.

3. Determine how management measures and

controls interest-rate risk associated with closed

loans in inventory and rate-locked loan applica-

tions in the pipeline. How are limits established

and quantiﬁed (i.e., earnings at risk, economic

value of equity at risk, percentage of capital,

etc.)? Are such limits reasonable? Evaluate man-

agement’s oversight of asset securitization ac-

tivities in accordance with SR-90-16, as

applicable.

4. Assess the adequacy of management infor-

mation systems and related management reports

that are designed to track compliance with

established policy. Determine the extent to which

operational practices adhere to policy. How are

exceptions handled?

Securitization and Pooling Practices

1. Determine the secondary marketing pro-

grams used to sell mortgages to investors and

the volume of sales under each program.

2. Discuss the strategies and procedures used

for the selection of mortgage loans for pooling,

packaging, and sale. Are there quality control

procedures in place to ensure that the ﬁles of

pooled loans contain complete documentation?

What impact does strategy have on departmen-

tal proﬁtability?

3. Evaluate the company’s securitization

practices:

• Determine how much risk the company

retains and in what form.

• Determine the source, conditions, and costs

of third-party guaranties. Verify that the

ﬁnancial condition of all third-party credit

enhancers is substantiated.

• Determine the procedures used to obtain

ﬁnal pool certiﬁcations from investors (coor-

dinate with the examiner(s) assigned to the

production function). Determine the num-

ber and volume of securities that lack ﬁnal

certiﬁcation. Is management doing every-

thing possible to obtain missing docu-

ments? Are problems volume-driven or due

to a lack of internal controls?

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1996

Page 17

4. Determine whether loans or securities are

sold with recourse. If so, are management infor-

mation systems in place to track recourse obli-

gations? Are analyses of recourse losses con-

ducted by investor and product type? Are reserves

held for recourse loans? What is the methodol-

ogy for determining the adequacy of reserves?

Review actual and potential losses. Are reserve

levels adequate to cover identiﬁed exposure? Is

compensation tied to trading proﬁt?

Unsalability

1. Review the marketing policy to determine

whether all mortgage products originated by the

mortgage company are intended to be salable in

the secondary market (for example, do they

conform to guidelines issued by GNMA, Fannie-

Mae, FHLMC, or other major investors?). How

is actual salability monitored?

2. Determine if mortgage loans that are not

salable are generated speciﬁcally for the perma-

nent investment portfolio of either the mortgage

bankingcompanyor its bankor nonbank afﬁliates.

3. Determine who is responsible for the review

of temporarily unsalable loans, the frequency of

such reviews, the actions taken to correct docu-

mentation and/or credit deﬁciencies, and if

internal controls are adequate. This information

is needed to ensure that hedge volumes are

accurate.

Pricing Strategies

1. Review the current list of mortgage prod-

uct offerings and the daily price sheet. Are

prices determined centrally and are they uni-

form? Discuss pricing strategies with manage-

ment to determine whether the company uses a

neutral, above-market, or below-market pricing

strategy.

2. Ascertain what procedures are in place to

ensure that deviations from the approved pricing

policies receive the proper degree of scrutiny

and approval by senior management. If such

discrepancies are common, why is this occur-

ring (competition, compensation schemes, or

departmental proﬁtability considerations)? What

impact have such deviations had on production

volumes and the company’s overall proﬁtabil-

ity?

3. Determine what policies are in effect

regarding customer rate-locks. If a rate-lock

expires, is it automatically renewed or is it rene-

gotiated at current interest rates? Are the num-

ber and dollar volume of loans with expired

rate-locks adequately monitored and tracked?

Fallout

1. Discuss the methodology used to predict

the volume of applications that are expected to

‘‘fall out’’ of the mortgage pipeline. Is fallout

methodology well documented?

ALCO/Simulation Modeling

1. Determine whether the expected fallout

ratio is based on intuition, historical data, or an

empirical model. Are assumptions reasonable?

Are volatility assumptions based on historical

performance or on implied volatility levels in

the market? Who is responsible for reviewing

model assumptions, and are these individuals

sufﬁciently independent from the process itself?

Does management also engage in sensitivity

analyses to determine the impact interest-rate

ﬂuctuations will have on expected fallout levels?

2. Determine to what extent management

uses output from these models in business plan-

ning, ﬁnancial management, and budgeting.

3. Assess the degree to which mortgage bank-

ing activities are incorporated into the parent

company’s asset/liability management reports

and program.

Hedging Practices

1. Discuss management’s philosophy and

strategy to determine the amount of interest-rate

risk they are willing to accept. How successful

has the company’s marketing strategy been over

the past few years and how is it changing? What

are management’s primary sources of market

information? Are sources sophisticated enough

given the size of the company and the scope of

its activities?

2. Review the marketing policy to determine

products and strategies used to hedge the interest-

rate risk associated with inventory loans and

rate-locked loan applications in the pipeline.

Review actual hedging practices to determine

whether they conform with established policy

limitations and guidelines. What percentage of

closed loans held in inventory and loan applica-

tions in the pipeline are matched against speciﬁc

investor commitments? How are coverage lev-

els determined and how have they changed over

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 18

time? Is the basis for this coverage ratio ade-

quately documented? Determine whether the

current coverage ratio exposes the company to

undue risk associated with potential marketing

losses.

3. Determine the adequacy of management’s

strategies for hedging loans that have special

risks (ARMs with interest-rate caps and ﬂoors).

4. Ascertain if basis risk exists for any hedg-

ing products, whether such risks are signiﬁcant,

and the impact on correlation. How is basis risk

identiﬁed, monitored, and controlled?

5. Determine whether call options are written

to enhance inventory yields. If so, verify that

they are written against covered positions. Deter-

mine whether management is speculating in any

way and whether this activity subjects the com-

pany to undue risk.

6. Obtain proﬁt/loss reports on hedging

activities. How frequently are they prepared,

how are they used, and to whom are they distrib-

uted? Evaluate the ﬁnancial results of the hedg-

ing program over the past three years. Is man-

agement taking on excessive risk to record proﬁts

in this area?

7. Review management reports relating to

pipeline and closed-loan hedging operations.

Determine whether such reports are complete,

accurate, and timely. Do such reports adequately

limit excesses, record exception approvals, and

detail risk exposures?

8. Review information provided to executive

management and the board to determine whether

hedging practices are adequately supervised.

Counterparty Risk

1. Review the marketing committee’s list of

approved brokers and dealers. Have appropriate

dealer limits been established and are such lim-

its adhered to? How are exceptions monitored,

reported, and controlled?

3070.0.4 SERVICING/LOAN

ADMINISTRATION

Mortgage banking companies that originate and

sell residential real estate loans in the secondary

market often retain the right to service those

loans for the investor for a fee. In return, the

servicer collects monthly payments from mort-

gagors, collects and maintains escrow accounts,

pays the mortgagors’ real estate taxes and insur-

ance premiums, and remits principal and inter-

est payments to the ultimate investors. The ser-

vicer also maintains records for the mortgagor,

collects late payments on delinquent accounts,

inspects property, initiates and conducts foreclo-

sures, and submits regular reports to investors.

Such functions and responsibilities should be

documented within a formal written servicing

agreement.

3070.0.4.1 Revenue Generation

The right to service mortgage loans provides a

stable source of earnings and the potential for

one-time gains. For this reason, servicing port-

folio growth has become a primary objective for

many mortgage banking companies.

Mortgage-servicing revenues are derived from

six sources. The primary source is the contrac-

tual servicing fee. Because this fee is usually

expressed as a ﬁxed percentage of each out-

standing mortgage loan’s principal balance,

servicing-fee revenues decline over time as the

loan balance declines.

The second source of servicing income arises

from the interest that can be earned by the

servicer from the escrow balance that the bor-

rower often maintains with the servicer for the

payment of taxes and insurance on the under-

lying property. This income may vary, however,

as some states require that interest payments on

escrow balances be paid to the borrower.

The third source of revenue is the ﬂoat earned

on the monthly loan payment. This opportunity

for ﬂoat arises because of the delay permitted

between the time the servicer receives the pay-

ment and the time that the payment must be

remitted to the investor.

The fourth source of revenue consists of

income late fees charged to the borrower if the

monthly payment is not made on time. A ﬁfth

source is income in the form of commissions

that many servicers receive from cross-selling

credit life and other insurance products to the

borrowers. The sixth and last source is when the

servicer might generate fee income by selling

mailing lists to third parties.

3070.0.4.2 Cost Containment

Long-term proﬁtability is achieved through cost

containment, technological improvements, and

economies of scale, which reduce the per-unit

cost of servicing. Servicing costs vary widely

across institutions depending on portfolio char-

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 19

acteristics such as product type, loan size and

age, delinquency status, and foreclosure statis-

tics. Nevertheless, two efﬁciency measures fre-

quently used within the industry to measure cost

containment are unit-servicing costs and the

number of loans serviced per employee. The

minimum size of a loan-servicing portfolio needed

to achieve economies of scale varies across

institutions and depends on portfolio character-

istics and the servicer’s expertise and techno-

logical capabilities.

Servicing data are available through the Mort-

gage Bankers Association’s publication, ‘‘Mort-

gage Banking Performance Report.’’ Based on

detailed ﬁnancial-statement information from a

sample of companies, the report presents a com-

pilation of performance data on all aspects of

the mortgage banking industry.

3070.0.4.3 Growth Strategies

Many companies have established aggressive

growth targets for their servicing portfolios. The

size of the portfolio may be increased through

originations, purchases of loans (individual or

bulk), or purchased servicing rights. Portfolio

size is reduced through normal runoff, prepay-

ments, and sales of either loans or servicing

rightsonly. Management’sgrowthstrategy should

be examined in light of its expertise and systems

capabilities.

3070.0.4.4 Servicing Agreements

The servicer generally operates under a written

contract with each investor. This contract, also

known as a servicing agreement, establishes

minimum conditions for the servicer such as its

ﬁduciary responsibilities, audit requirements,

and fees. Contracts may be standardized or tai-

lored to the individual investor.

Under most servicing agreements, the ser-

vicer warrants that full principal has been

advanced, the mortgage is in fact a ﬁrst mort-

gage on the property, and that the ﬁrst mortgage

position will be maintained by the servicer.

Additional warranties that are either unwritten

or implied may create signiﬁcant exposure for

the servicer.

A servicer may also enter into an agreement

with another company to subservice certain

loans or portfolios of loans. The company’s

method of evaluating and monitoring the ﬁnan-

cial condition of its subservicers should also be

reviewed. Servicing and subservicing agree-

ments should be evaluated in terms of the sub-

servicer’s responsibilities, reporting require-

ments, performance, and fees. They should also

be reviewed to determine that no additional

liabilities, real or contingent, are imposed upon

the company beyond its responsibilities as a

servicing agent.

3070.0.4.5 Recourse Obligations

A servicing agreement may contain speciﬁc

recourse obligations that go beyond the ser-

vicer’s customary ﬁduciary obligations. A mort-

gage banking company can choose to service

loans for investors either with or without recourse

back to the mortgage banking company. Servic-

ing agreements should be reviewed to determine

the extent of any recourse obligations. The risk

of recourse should also be discussed with man-

agement to assess whether the risk is being

identiﬁed and effectively managed.

The degree of recourse varies by investor.

FannieMae offers either ‘‘regular’’ or ‘‘special’’

servicing options. With FannieMae’s regular

option, the servicer retains all risk of loss from

mortgage default. With FannieMae’s special ser-

vicing option, the mortgage banking company

only retains exposure for normal representations

and warranties. FHLMC offers similar servicing

options. FannieMae and FHLMC generally limit

eligibility for the regular servicing option to

participants with the knowledge and ﬁnancial

wherewithal to make good on their recourse

obligations.

GNMA servicing carries no contractual

recourse. However, in the event of mortgage

default, the servicer may have exposure to

principal loss and other nonreimbursable

expenses, particularly with respect to VA-

guaranteed loans. If a borrower defaults on a

VA-guaranteed loan, the VA can exercise a ‘‘no-

bid’’ put option, which allows the VA to pay out

its guaranty and leave the property with the

servicer for disposition.

When a borrower defaults on a VA-

guaranteed loan, the VA makes a calculation

that will guide its decision to accept or reject

conveyance of the property. The VA’s decision

to exercise its no-bid option is based on the net

value of loan collateral and the VA’s guaranteed

percentage of the indebtedness. The mortgage

servicer, at its option, could pay down the out-

standing principal balance on the loan to a point

where the VA would not be expected to exercise

its no-bid option. Such ‘‘buydowns’’ result in

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 20

additional foreclosure losses for the servicer.

The risk-based capital guidelines require a

charge to capital when any risk of loss is retained

on such recourse obligations. The charge would

be at the bank holding company, the bank, or

both,

depending on ownership of the risk. For

this reason, the accuracy of reported recourse

obligations should be veriﬁed.

3070.0.4.6 Guaranty Fees

The amount of guaranty fee the mortgage bank-

ing company pays the government-sponsored

agencies (or private issuer) is negotiated. Guar-

anty fees vary based on the amount of recourse

assumed by the mortgage banking company (the

servicer) and the timing of the cash ﬂows. A

smaller guaranty fee is negotiated when the

guarantor assumes less risk or receives pay-

ments sooner in the remittance cycle. Remit-

tance cycles vary by investor.

The examiner should discuss with servicing

personnel the amount of risk that has been taken

on by the marketing department in exchange for

reduced guaranty fees. Excessive risk accepted

by the mortgage banking company should be

incorporated into the assessment of management.

3070.0.4.7 Internal Controls

The servicing process begins after the post-

closing review has been completed and the loan

has been set up on the mortgage banking com-

pany’s servicing computer system. Servicers are

responsible for adequately safekeeping loan

documents. Documents must be stored in a

secured and protected area such as a ﬁreproof

vault. Servicers must also maintain a tracking

system for following up on missing documents.

The control environment that sets the tone of

a servicing department’s operation should be

assessed. A servicing department’s management

faces a variety of risks that it should identify

and control. In addition to identifying and con-

trolling risks, management also needs to insti-

tute adequate and effective internal controls to

match a servicing portfolio’s growth and the

department’s technological changes. When

assessing the control environment, the examiner

needs to consider the extent to which manage-

ment uses internal and external audits, quality

control reports, and investor audits to ensure

that its policies and procedures are followed.

The servicer’s performance should be evalu-

ated, with any loss of servicing due to operating

inefﬁciencies or excessive risk-taking discussed

and noted. A discussion of the risks within each

operational area, as well as the management

reports and internal controls, follows.

• Loan accounting. Incoming payments may be

processed in-house, through a lockbox, or

through some combination of both. Payments

are deposited into a clearing account and then

transferred to the respective investor custodial

bank accounts the next day. Investor remit-

tances may be required daily, weekly, monthly,

or as funds are received. In certain cases,

servicing agreements may specify that pay-

ments be sent directly to security holders.

Numerous accounts through which incoming

and outgoing payments pass should be recon-

ciled daily to avoid costly processing errors.

The reconcilement process should be reviewed

with management to ensure that reconcile-

ments are performed on a timely basis and

without chronic discrepancies.

• Escrow administration. In addition to receiv-

ing and remitting payments, servicers are also

responsible for paying taxes and insurance on

the underlying property. Accurate information

must be maintained for each loan regarding a

legal description of the property; the appropri-

ate taxing authority, due dates, and amounts

for taxes owed; and the insurance provider

and due dates and amounts for insurance

owed. Failure to maintain such information

may result in missed tax and insurance pay-

ments on the property, which may lead to

penalties and/or lapsed insurance coverage.

The servicer’s record of tax penalties paid

over the past several years should be reviewed

to determine whether a problem exists in this

area.

Escrow account balances should be ade-

quate to meet expected tax and insurance

obligations. If the servicer advances its own

funds to cover an escrow overdraft, such pay-

ments may be capitalized and recorded as a

receivable only if the servicer is to be reim-

bursed by either the mortgagor or the inves-

tor. Escrow receivables should be aged, with

stale or otherwise uncollectible receivables

charged off.

Escrow accounts should be analyzed at

least annually, with a copy of the analysis

sent to the mortgagor. Shortages (overdrafts)

may be billed or spread out over 12 months.

3. If at the bank, then it is also consolidated at the bank

holding company level.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

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Page 21

Overages should be returned to the borrower

or handled in a manner consistent with fed-

eral and state laws and regulations. For loans

that were set up without an escrow account,

the examiner should verify that adequate

information has been obtained from the mort-

gagor to ensure that taxes and insurance are

current.

• Investor reporting. Investor remittance and

reporting requirements vary greatly. Remit-

tances are contractually arranged. In some

instances, the servicer may be required to

advance to investors funds that have not yet

been received from the mortgagor (for exam-

ple, cash advances to ensure timely payment

of principal and interest). In such cases, a

receivable is created on the balance sheet.

Receivables relating to investor remittances

should be aged in the same manner as escrow

receivables and periodically reviewed by a

supervisor. Stale or otherwise deemed uncol-

lectible receivables should be periodically

charged off in a timely manner.

Investor reports should include detailed

account reconciliations and information on

the mortgagor’s name, principal balance out-

standing, escrow balance, delinquency status

of the account, and any foreclosure activity or

transfer to the servicer’s other real estate

owned account. The quality and accuracy of

investor reporting should be periodically

reviewed by internal or external auditors.

• Collections, foreclosures, and other real estate

(ORE). Investor requirements also vary con-

cerning contact with delinquent borrowers,

forbearance policies, and reimbursement for

foreclosure expenses, ORE write-downs, and

related losses. Detailed policies concerning

collection efforts and foreclosures should be

in place and followed. The property should be

inspected regularly to ensure that its condition

is adequately monitored. Delinquency and

foreclosure statistics should be tracked by

product type and originator.

Foreclosures are generally initiated after

three full installments are due and unpaid.

The servicer notiﬁes the mortgagor of its

intent in writing and refers the case to an

attorney. Detailed records should be main-

tained for all expenses that are incurred. If the

loan is insured, claims may ultimately be ﬁled

against the FHA, VA, or private mortgage

insurance (PMI) company. However, it should

be noted that certain interest expenses and

collection or foreclosure costs are not reim-

bursable.

These expenses are a cost of doing

business that must be factored into the ser-

vicing fee charged for providing these services.

The timeframe for taking title on fore-

closed property varies widely and is deter-

mined by state law. Once title is taken, the

property should be classiﬁedas ORE. Although

all ORE is generally managed through a cen-

tralized unit, for accounting purposes, ORE

may fall into one of two distinct categories:

ORE that is owned by the mortgage banking

company, and ORE that is serviced on behalf

of the investor. ORE that is owned should

reconcile to the balance sheet, whereas ORE

that is serviced for others is an off-balance-

sheet item. ORE appraisal, valuation, and

ﬁnancing policies should be consistent with

regulatory policy. In-substance foreclosures

and any troubled debt restructurings should

be properly identiﬁed and accounted for.

• Payoffs. Loans are considered ‘‘paid off’’ when

the loan matures, the loan is reﬁnanced, or the

property is sold. Prior to payoff, the servicer is

responsible for sending payoff instructions to

the mortgagor. After a loan has been paid off,

the servicer makes a satisfaction remittance to

the investor or the pool; obtains documenta-

tion; cancels the note; and forwards the satis-

ﬁed mortgage documentation plus an escrow

refund check, if applicable, to the mortgagor.

A high level of reﬁnance activity may strain

payoff personnel’s ability to perform this obli-

gation accurately and promptly. Management

reports should monitor the level of payoff

activity and alert supervisors to operational

backlogs, the need to hire temporary person-

nel, or the need to outsource work to third

parties.

• Customer service. Poor service may damage

the mortgage banking company’s business

reputation (reputation risk) and ability to

originate, sell, and service loans within the

community. Because of name recognition,

problems in this area may also adversely

affect afﬁliate banks or the bank holding com-

pany and its nonbank companies.

For this reason, servicers should maintain

an adequate system for logging, tracking, and

responding to customer inquiries and com-

plaints. Management reports should track the

volume and disposition of such inquiries and

complaints. Inordinate volumes of complaints

may be an indication of operational backlogs,

inefﬁciencies, or mishandling of accounts. If

this occurs, corrective measures should be

4. For a detailed list of both reimbursable and nonreim-

bursable expenses, see the agency seller/servicer guides.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 22

initiated immediately.

3070.0.4.8 Data Security/Contingency

Planning

The servicing system should be of a complexity

and size necessary to accommodate both the

current and the projected volume of transac-

tions. Examiners should obtain information on

the servicing system in use and any limitations

it might pose in terms of future growth plans.

Procedures for maintaining physical security

in the workplace, data security, and ﬁle backup

also should be discussed with management. A

contingency plan should describe the use of

alternative backup sites, as well as procedures

that would be followed to reconstruct altered or

destroyed ﬁles. Contingency plans should be

reviewed and approved at least annually and

tested regularly.

3070.0.4.9 Inspection Objectives—

Servicing/Loan Administration

1. To assess the adequacy of management

oversight of risk through policies and proce-

dures, management information systems and

reports, and other internal and external audits,

with respect to the following:

• collecting monthly payments from

mortgagors

• reporting loan activity and remitting funds

to investors

• monitoring escrow account balances

• disbursing property insurance and real estate

tax payments

• monitoring delinquencies, initiating collec-

tion activities, and initiating foreclosure

proceedings in a timely manner

2. To evaluate the level of risk assumed by

the mortgage banking company through servic-

ing recourse arrangements.

3070.0.4.10 Inspection Procedures—

Servicing/Loan Administration

Management Assessment

1. Obtain an organization chart for the servic-

ing department and resumes for senior manage-

ment and key staff members. Evaluate manage-

ment’s qualiﬁcations and expertise.

2. Review servicing policies and procedures

manuals to determine whether reasonable

operating standards have been established for

each functional area. Also assess whether man-

agement reports adequately monitor compliance

with established policies and procedures. Deter-

mine how exceptions are identiﬁed and ad-

dressed.

3. Review internal and external audits, qual-

ity control reports, and investor audits to deter-

mine whether internal controls are functioning

effectively.

4. Evaluate safeguards in place for loan docu-

ments and determine if an adequate document

tracking system exists.

5. Verify that a disaster recovery plan is in

place that covers all in-house servicing func-

tions. Verify that backup systems exist should

primary systems fail. Determine if backup sys-

tems would provide information to substantiate

servicing portfolio asset values.

6. Obtain a list of subservicers and vendors,

if any, employed to perform servicing functions.

• Determine if a periodic review of services

provided by each subservicer is conducted.

In addition, the ﬁnancial condition of each

subservicer should be evaluated at least

annually.

• Determine whether a contingent operating

plan has been established should subser-

vicers and vendors be unable to perform

their contractual obligations.

Proﬁtability Analysis

1. Review business line proﬁtability for the

servicing department to identify signiﬁcant trends

and/or areas of potential weakness. Discuss and

review key efﬁciency measures such as unit cost

and cost per employee.

2. Analyze servicing income and expenses to

determine whether operations are proﬁtable and

economies of scale are being achieved in line

with industry norms:

• Determine whether all direct and indirect

costs are included.

• Compare servicing revenues with costs.

• Assess the impact of any bulk servicing

purchases or sales on departmental

proﬁtability.

• Analyze efﬁciency in light of manage-

ment’s growth projections.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 23

3. Review servicing portfolio trends and char-

acteristics, including the following:

• investors (GNMA, FannieMae, FHLMC,

private)

• recourse provisions

• loan types (30-year ﬁxed, 15-year ﬁxed,

ARM, balloon)

• average loan size

• interest rates (particularly those above

market)

• remaining contractual life

• projected life

• geographic distribution of mortgagors

• delinquency statistics

• foreclosure statistics

• number of subserviced loans and servicers

Loan Accounting

1. Review with management the procedures

for receiving payments from mortgagors and

depositing funds into segregated accounts. Deter-

mine that the segregation of duties and other

controls over custodian accounts are adequate.

2. Review any outstanding advances to

investors. Evaluate the collectibility of advances,

the timeliness of charge-offs, and the adequacy

of reserves.

3. Determine whether outstanding items

related to investor account reconciliations are

being resolved in a timely manner. Are recon-

ciliations routinely reviewed and approved by a

supervisor?

Escrow Administration

1. Review with management the system in

place for ensuring the timely payment of taxes,

insurance, and other obligations.

2. Review the servicer’s method for analyz-

ing the amount and adequacy of escrow account

balances, and evaluate its effectiveness. Assess

procedures relating to shortages and overages in

escrow accounts:

• Determine whether procedures comply with

12 U.S.C. 2609 (RESPA) and to the extent

possible with state laws.

• Determine whether the borrower is sent an

analysis statement showing the amount of

discrepancy, how it occurred, and an expla-

nation of how it is to be corrected.

3. Determine the volume of loans with no

escrow requirement and procedures for ensuring

that insurance payments and taxes are current.

4. Determine how escrow funds are invested,

assess the appropriateness of the investment

vehicles, and review management’s analysis of

yield on escrow funds.

5. Evaluate whether controls are in place to

prevent the use of escrow custodial accounts to

meet other obligations.

6. Review outstanding escrow advances, and

determine if claims for reimbursement are pro-

cessed in a timely manner. Evaluate the collect-

ibility of outstanding advances and verify that

uncollectible advances are charged off in a

timely manner.

Investor Reporting

1. Review the list of investors for which ser-

vicing is performed.

2. Review servicing contracts to verify that

signed, current contracts exist. Discuss with

management the nature of any recourse provi-

sions, forbearance requirements, and nonreim-

bursable collection and/or foreclosure expenses.

3. Review the most recent investor audit

reports on the servicing function. Discuss ﬁndings

with management and evaluate the adequacy of

any actions taken to correct deﬁciencies.

4. Determine whether any servicing contracts

have been terminated for cause or are likely to

be lost in the near future. Determine the reason

for any termination and the extent of any correc-

tive actions taken.

Collections and Foreclosures

1. Review and assess, on a statistical-sample

basis, the accuracy and adequacy of loan delin-

quency reports by product type and originator.

Ascertain the reasons for poor or declining asset

quality within the servicing portfolio.

2. Review policies and procedures for col-

lecting late payments.

• Determine when collection efforts start once

an account becomes delinquent.

• Verify that all attempts at collecting past-

due payments are documented, including

each date of communication with borrow-

ers, the nature of the communications, and

the customers’ replies.

3. Select a sample of ﬁles for borrowers who

are 120 days or more delinquent and determine

whether foreclosure proceedings are instituted

in a timely manner.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 24

• Determine if borrowers and investors are

appropriately notiﬁed of the initiation of

foreclosure action.

• Verify that contacts with borrowers are

documented.

• Determine whether property inspections are

conducted in accordance with policy.

• Verify that foreclosure practices comply

with FHA/VA/PMI requirements and

guidelines.

4. Determine the average foreclosure costs

for each product type. Foreclosure costs include

inspections, legal and administrative costs in

excess of those deﬁned as normal and custom-

ary, VA no-bid, and VA write-downs.

5. Obtain a list of loans in foreclosure in

which action has been delayed, and determine if

the justiﬁcations for delay are reasonable.

6. Determine the number and dollar volume

of delinquent loans that were purchased from

the servicing portfolio (buyouts or buybacks).

• Assess the impact of repurchases on proﬁt-

ability, the appropriateness of this practice,

and the accounting procedures for these

loans.

7. Discuss with management the effect that

negotiated guaranty fees may have on the level

of losses associated with foreclosures.

Payoffs

1. Review procedures for payoffs to deter-

mine whether—

• payoff instructions are sent to the mort-

gagor before payoff;

• satisfaction remittances are made to the

investor or to the pool, necessary documen-

tation is obtained, notes are canceled prop-

erly, and documentation plus any escrow

refund checks are sent to the mortgagor in a

timely manner; and

• internal controls are in place to ensure that

funds are not misappropriated and employee

fraud is detected and reported according to

policy.

Other Real Estate

1. Determine the number and dollar volume

of ORE by geographic location.

• Compare the volume of ORE with histori-

cal levels and the industry average for

similar-sized servicers.

• Evaluate the impact of ORE on proﬁtability.

• Review the policies and practices for ORE

accounting, property supervision, and

marketing. Verify that policies are consis-

tent with investor guidelines and regulatory

policies.

2. Determine whether ORE parcels are pur-

chased from the servicing unit by the bank

holding company or its afﬁliates.

• Evaluate the controls in place to limit or

prevent this practice and the accounting

treatment for such loans.

• Verify that information regarding ORE is

properly reported to the parent bank or

holding company for consolidation into

regulatory reports.

Customer Service

1. Review the system for logging, tracking,

and responding to customer complaints. Has the

volume of complaints grown? Are complaints

addressed promptly with any problems resolved

in a timely manner?

2. Review the servicer’s customer-complaint

ﬁle to gain more insight into the nature of the

complaints. Do complaints suggest that internal

policies and procedures are not being followed

or that stafﬁng levels are inadequate?

3070.0.5 FINANCIAL ANALYSIS

This section provides the examiner a framework

with which to analyze the ﬁnancial condition of

a mortgage banking company. The analysis be-

gins with a review of the mortgage company’s

balance sheet and income statement. The ﬁnan-

cial analysis should incorporate a review of

primary balance-sheet and income-statement

levels and trends, off-balance-sheet assets and

liabilities, asset quality, market share and earn-

ings performance, funding sources, liquidity

needs, and capital adequacy. Any problems or

conditions that expose the mortgage banking

company, afﬁliate banks and nonbanks, and/or

its parent bank holding company to undue ﬁnan-

cial risk should be brought to management’s

attention and documented in page one, Examin-

er’s Comments and Matters Requiring Special

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 25

Board Attention. The examiner should focus on

items that are either large relative to the com-

pany’s operations or that may pose undue ﬁnan-

cial risk. The examiner should also investigate

any trends that appear inconsistent with the

mortgage bankingcompany’sindustrypeergroup,

business orientation (such as wholesale versus

retail, originations versus servicing, etc.), and

future growth plans or with the current eco-

nomic and interest-rate environment.

Financial-statement presentation may vary

across mortgage banking companies. If ques-

tions arise, ﬁnancial-statement presentation and

accounting should be reviewed with the com-

pany’s internal and/or external accountants for

propriety. During the review of the ﬁnancial

statements,the examinershouldestablishwhether

regulatory reports are prepared accurately. Banks

must conform to the reporting requirements of

the Commercial Bank Reports of Condition and

Income (call report). Bank holding companies

and their direct subsidiaries must conform to

generally accepted accounting principles

(GAAP). Relevant GAAP statements of the

Financial Accounting Standards Board include

SFAS No. 65, ‘‘Accounting for Certain Mort-

gage Banking Activities,’’ as amended; SFAS

No. 91, ‘‘Accounting for Nonrefundable Fees

and Costs Associated with Originating or Ac-

quiring Loans and Initial Direct Costs of Leases’’;

SFAS No. 115, ‘‘Accounting for Certain Invest-

ments in Debt and Equity Securities’’; SFAS

No. 125, ‘‘Accounting for Transfers and Servic-

ing of Financial Assets and Extinguishments of

Liabilities;’’ and SFAS No. 80, ‘‘Accounting for

Futures Contracts.’’ Other relevant accounting

pronouncements are identiﬁed in appendix B,

Accounting Literature.

The ﬁnancial analysis should also include an

assessment of asset quality, earnings, liquidity

and funding, and capital. Any problems or con-

ditions that expose the mortgage banking com-

pany, afﬁliate banks and nonbanks, and/or the

parent bank holding company to undue ﬁnancial

risk should be brought to management’s atten-

tion and discussed in the Examiner’s Comments

and Matters Requiring Special Board Attention.

3070.0.5.1 Balance Sheet

3070.0.5.1.1 Assets

The asset side of the balance sheet may consist

of cash, reverse repurchase agreements, market-

able securities, receivables and advances, mort-

gage loans held for sale, mortgage loans held for

investment, mortgage-servicing assets (MSAs)

(including mortgage-servicing rights), reserves

for loan and other credit-related losses (contra

accounts), other real estate owned (OREO), and

other assets.

3070.0.5.1.1.1 Mortgage-Related Securities

The examiner should determine whether the

accounting treatment for mortgage-related secu-

rities reported on the balance sheet is consistent

with SFAS 115. SFAS 115 applies to equity

securities having readily determinable fair val-

ues and to all debt securities. It does not apply

to loans purchased.

Under SFAS 115, at acquisition and at each

subsequent reporting date, all debt and equity

securities that fall under the scope of the state-

ment should be classiﬁed into one of the follow-

ing categories:

• trading securities

• available-for-sale securities

• held-to-maturity securities

Both debt and equity securities can be assigned

to the above ﬁrst two categories. The third clas-

siﬁcation can only consist of debt securities.

Trading. Mortgage-backed securities that are

held for sale in conjunction with mortgage bank-

ing activities should be classiﬁed as trading

securities and reported at fair value. Debt securi-

ties not held to maturity and equity securities

that have readily determinable fair values should

be classiﬁed as trading securities when (1) they

are held for short periods of time and (2) they

have been acquired with the expectation of a

proﬁt from short-term price differences. Securi-

ties that are actively traded should be carried at

fair value on the balance sheet, with net unreal-

ized gains or losses included in income.

Available-for-sale. Debt and equity securities

having readily determinable fair values that are

not otherwise classiﬁed, as above, should be

categorized as available-for-sale and carried at

fair value on the balance sheet. Unrealized hold-

ing gains and losses should be reported in a

separate component of shareholders’ equity and

should not be included in income.

Held-to-maturity. For a security to qualify as

held-to-maturity under SFAS 115, the mortgage

banking company must demonstrate the positive

intent and ability to hold it until maturity.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 1998

Page 26

3070.0.5.1.1.2 High-Risk Securities

The examiner should also review any high-risk

mortgage securities that are on the balance sheet,

such as collateralized mortgage obligations

(CMOs), real estate mortgage investment con-

duits (REMICs), CMO and REMIC residuals,

and stripped mortgage-backedsecurities (stripped

MBSs). See sections 2126.1 and 2190.0.5.

3070.0.5.1.1.3 Mortgage Loans Held for Sale

The examiner should determine whether the

accounting treatment for mortgage loans held

for sale is consistent with SFAS 65, as amended.

Mortgage loans held for sale shall be reported at

the lower of cost or market value, determined as

of the balance-sheet date.

The amount by which

the cost exceeds market value shall be accounted

for as a valuation allowance. Changes in the

valuation allowance shall be included in net

income of the period in which the change occurs.

3070.0.5.1.1.4 Mortgage Loans Held for

Investment

Mortgage loans held for investment may include

loans that (1) do not meet secondary-market

guidelines and are therefore unsalable, (2) loans

that were repurchased from an investor due to

poor documentation and/or improper servicing,

(3) loans put back to the mortgage banking

company under recourse agreements,and (4) loans

intentionally originated for portfolio.

SFAS 65 states that a mortgage loan trans-

ferred to a long-term investment classiﬁcation

shall be transferred at the lower of cost or

market value as of the transfer date. The securi-

tization of a mortgage loan held for sale shall be

accounted for as the sale of the mortgage loan

and the purchase of an MBS classiﬁed as a

trading security at fair value. Any difference

between the carrying amount of the loan and its

principal balance shall be recognized as an

adjustment to yield by the interest method.

A mortgage loan shall not be classiﬁed as a

long-term investment unless the mortgage bank-

ing company has both the intent and the ability

to hold the loan for the foreseeable future or

until maturity. If the ultimate recovery of the

carrying amount of the loan is doubtful and the

impairment is considered to be other than tem-

porary, the carrying amount of the loan shall be

reduced to its expected collectible amount, which

becomes the new cost basis. The difference is

recognized as a loss. A recovery of the new cost

basis shall only be reported as a gain upon sale,

maturity, or disposition of the loan.

3070.0.5.1.2 Liabilities

The liability side of the balance sheet may

include repurchase agreements, commercial

paper, revolving warehouse lines of credit, long-

term debt instruments, intercompany payables,

and equity capital.

3070.0.5.1.2.1 Repurchase Agreements

A mortgage banking company may ﬁnance its

mortgage loans or MBSs held for sale by trans-

ferring mortgage loans or MBSs temporarily to

banks, nonbanks, or other ﬁnancial institutions

under formal repurchase agreements that indi-

cate that control over the future economic bene-

ﬁts relating to those assets and the risk of mar-

ket loss are retained by the mortgage banking

company.

Repurchase agreements can provide a cost-

effective method of holding mortgage-backed

securities before their sale to investors. Securi-

ties dealers repo the securities for a period of 30

to 180 days at a substantial cost advantage to

warehouse facilities. Repurchase agreements

involve delivery of the security to the dealer

with an agreement to repurchase it on a speci-

ﬁed date. Upon receipt, the dealer wires the

haircut proceeds to the mortgage company. The

mortgage company then reduces the amount of

its outstanding warehoused loans. If the repo is

being handled by the dealer that is arranging the

ultimate sale of the security, the amount of that

discount should approximate the discount on the

sale. If another dealer is involved in the ultimate

sale, the haircut may be greater because the

security must be repurchased and redelivered to

the second dealer. This may also require a

rehousing to provide funds to honor the repur-

chase commitment. Most warehouse lenders

allow traditional warehouse lines to be collater-

alized by individual mortgages and mortgage-

backed securities.

A mortgage banking company may use repur-

chase agreements in conjunction with sales of

5. According to SFAS 65, as amended, the capitalized

costs of acquiring rights to service mortgage loans, associated

with the purchase or origination of mortgage loans, shall be

excluded from the cost of mortgage loans for the purpose of

determining the lower of cost or market value.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 1998

Page 27

loan pools. The company may use repurchase

agreements to pledge mortgage loans and/or

MBSs as collateral for borrowings. In return, it

receives advanced funds against future deliver-

ies. The lenders are repaid through the sales of

MBSs. The amount outstandings bear interest

for the number of days the funds are outstanding.

Under repurchase agreements, the same loans

or MBSs are generally reacquired when they are

sold to permanent investors. Mortgages or MBSs

may also be transferred temporarily without a

repurchase agreement. However, some type of

informal agreement generally exists. Mortgage

loans and MBSs held for sale that are trans-

ferred under either formal or informal repur-

chase agreements shall be accounted for as col-

lateralized ﬁnancing arrangements and reported

as either mortgage loans held for sale or MBSs

classiﬁed as trading securities on the mortgage

banking company’s balance sheet.

3070.0.5.1.2.2 Commercial Paper

Another source of short-term funding is the

issuance of commercial paper. In general, com-

mercial paper represents unsecured notes with

maturities up to 270 days from the date of sale.

Because of its short maturity, proceeds should

be limited to current transactions with short-

term maturities. Commercial paper proceeds

should not be used to fund loans held for sale

for a period greater than one year.

Commercial paper can be less reliable than

warehouse lines of credit. If commercial paper

funding is used, examiners should review re-

lated commercial paper backup lines of credit

and ratings issued by credit rating agencies. The

reason for any rating changes during the prior

year should be investigated. Additional guid-

ance on this topic is set forth in sections 2080.05,

2080.1, and 5010.23.

3070.0.5.1.2.3 Revolving Warehouse Lines of

Credit

Short-term revolving warehouse credit lines are

often used to fund loans held for sale, which is

generally the largest asset on the company’s

balance sheet. Revolving credit lines may be

obtained from an afﬁliate bank, the parent bank

holding company, or an unrelated third party.

The extension of credit for a particular loan is

paid off when the mortgage lender sells the

mortgage loan to a government-sponsored agency

such as GNMA, FannieMae, or FHLMC or to a

private investor. Lenders who provide ware-

house lines of credit typically enter into a

warehouse credit agreement with the borrower.

Underthe agreement,the warehouse lender agrees

to extend credit to the mortgage banking com-

pany for the purpose of originating loans. The

mortgage banking company agrees to repay

each extension of credit within the terms of the

agreement. Each extension of credit is secured

by placing a lien on the originated mortgage

loan. The warehouse lender perfects its security

interest by taking possession of the original

promissory note executed by the borrower,

endorsed ‘‘in blank,’’ together with an assign-

ment of the mortgage securing the loan. To

further protect its security interest, the ware-

house lender usually takes the responsibility of

delivering the loan package to the secondary

market investor for purchase. The investor, in

turn, delivers the purchase price of the mortgage

directly to the warehouse borrower (mortgage

banking company). Each portion of the ware-

house line may be priced separately to reﬂect

various levels of risk and the documentation

requirements of each.

The details of all credit lines should be speci-

ﬁed in formal, written credit agreements. Re-

volving credit lines may be either unsecured or

secured by a lien on the underlying mortgages.

Under most secured lines, a formula is used to

calculate the borrowing base, which generally

consists of cash, cash equivalents, loans held for

sale, securities, and a percentage of the mortgage-

servicing portfolio less certain short-term

indebtedness. Some credit lines require the main-

tenance of compensating balances.

Internal credit arrangements (conducted either

by a mortgage banking subsidiary of a bank or

bank holding company) must comply with sec-

tions 23A and 23B of the Federal Reserve Act.

See sections 2020.1 and 3070.0.7 of this manual.

Examiners should evaluate the adequacy and

efﬁciency of warehouse funding operations. The

examiner should determine whether the ware-

house lender is of a sufﬁcient size and whether

it is well positioned ﬁnancially to provide ad-

equate lines of credit, as needed. Examiners

should ascertain whether funding must be regu-

larly derived from more than one warehouse

lender (including whether the warehouse line

has to be participated out to other lenders) and

whether the lender has proper internal controls

to safeguard collateral documents for pool certi-

ﬁcation. The examiner should also determine

what management’s contingency plans are for

the use of alternative ﬁnancing sources beyond

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 28

standard warehouse lines of credit for backup

ﬁnancing and lower-cost efﬁciency purposes.

Has management (1) explored variations in

existing lines of credit to reduce overall bor-

rowing costs and (2) determined what competi-

tor lenders are paying for similar ﬁnancing

facilities?

Procedures should be in place to monitor

compliance with all short-term debt covenants.

Covenants may limit servicing of loans with

recourse, limit total debt to speciﬁed levels,

and/or require minimum tangible net worth,

leverage, and current ratios. Most credit agree-

ments also limit the borrower’s ﬁnancial ﬂex-

ibility if the company’s long-term debt ratings

decline or the company becomes unrated or if

certain events occur related to securities.

3070.0.5.1.2.4 Long-Term Debt

Longer-termassets are more appropriatelyfunded

through the issuance of longer-term liabilities or

capital. Toward this end, mortgage banking com-

panies may issue medium- or long-term public

debt securities (including warrants to purchase

debt securities). Debt may be issued in the form

of ﬁxed-rate or ﬂoating-rate notes with various

repayment or redemption terms. Loan agree-

ments should specify all relevant terms and con-

ditions and may contain debt covenants similar

to those found in the warehouse funding

arrangements.

Long-term debt may incorporate restrictive

covenants which limit the company’s activities

in certain respects. These covenants may set

limits on the amount of senior debt outstanding

and the minimum amount of liquid net worth (as

deﬁned by the documents), and may limit the

proportions of speciﬁc categories of assets. Such

covenants should be reviewed to make certain

that they are not too restrictive and that they

permit ﬁnancial ﬂexibility.

3070.0.5.1.3 Equity Capital

Funding is also provided through equity capital,

which may be supplemented by capital contribu-

tions from the parent company or the direct

issuance of equity securities.

3070.0.5.2 Income Statement

Mortgage banking revenues generally consist of

the following: loan servicing/administration

revenue; loan-origination-fee revenue; interest

income; gains (losses) on the sale of mortgage

loans, mortgage securities, or mortgage-

servicing rights; and management and other fee

income. The examiner may ﬁnd that gross gain

(loss) on the sale of mortgage loans or securities

is reported on the income statement net of loan-

origination fees and direct loan-origination costs

such as personnel and ofﬁce expenses.

Expenses may include interest expense; sala-

ries, commissions, and other personnel costs;

interest losses on MBS pools; amortization of

mortgage-servicing assets and any other pur-

chased intangible assets; electronic data process-

ing and other selling, general, and administrative

costs; occupancy and equipment; depreciation;

provision for foreclosure and other loan losses;

and a provision for income taxes. Some compa-

nies net amortization of MSAs directly against

loan-servicing revenues.

3070.0.5.3 Unique Characteristics

The ﬁnancial analysis should reﬂect certain

operational characteristics that are unique to the

mortgage banking industry. Many of these char-

acteristics are cyclical based on interest rates

and economic conditions.

For example, the cost of funding loans in the

warehouse is relatively inexpensive during

periods of low interest rates, but may increase

signiﬁcantly as interest rates rise. Marketing

operations are also highly dependent on the

interest-rate cycle. During periods of falling

interest rates, the company may experience sub-

stantial gains on the sale of mortgage loans and

securities to permanent investors. Alternatively,

during periods of rising interest rates, the com-

pany will usually experience losses on the sale

of mortgages and securities. Interest-rate volatil-

ity can cause large ﬂuctuations in warehouse

funding costs and marketing gains and losses.

The examiner should also consider the impact

of current economic conditions on the size and

composition of the mortgage banking com-

pany’s balance sheet. Whentheeconomyexpands,

loan volume increases and the overall size of the

balance sheet tends to grow. During recessions,

the balance sheet should contract, reﬂecting the

lower demand for new loans. Management’s

planning efforts should incorporate this type of

economic trend analysis in their growth targets.

Steady annual growth may or may not be antici-

pated.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 29

Efﬁciency measures, such as activity ratios

(inventory turnover and efﬁciency ratios), should

be used to determine management’s ability to

originate and sell loans efﬁciently. The inven-

tory of loans held for sale is transitory, lasting

between 45 to 60 days. A buildup of loans on

the balance sheet may indicate processing de-

lays and/or asset-quality problems that may pre-

vent their ultimate sale to permanent investors.

Because of the transitory nature of the balance

sheet, traditional leverage ratios (asset-to-equity

capital) may not be meaningful and should be

used sparingly.

Another unique characteristic of a mortgage

banking company is the economic value of its

mortgage-servicing operations, which consti-

tutes an off-balance-sheet item. Failure to incor-

porate this economic value into the ﬁnancial

analysis may overstate the degree of ﬁnancial

leverage that is employed within the company.

3070.0.5.4 Asset Quality

The quality of assets that are on the balance

sheet is evidenced by the following: compliance

with original underwriting standards; the exis-

tence of effective loan review and quality con-

trol programs; borrower payment and agreement

performance; the fair value of MBSs held for

sale or investment; the collectibility, indepen-

dent valuation, nature, volume, and existence of

recorded assets; the application of GAAP in

accounting for the assets; and the degree of

protection afforded by real estate mortgage col-

lateral, including any private mortgage insur-

ance. The value afforded by real estate mortgage

collateral includes the extent of compliance

with the Federal Reserve Board’s real estate

appraisal regulations and guidelines. (See sec-

tion 2231.0.) Asset quality should be analyzed

in terms of regional and national economic fac-

tors as well as portfolio and managerial factors.

For any review of any loan portfolio, a sam-

pling of real estate appraisals should be included

to determine whether the appraisal results rea-

sonably support the amount loaned. If the prop-

erty appears to be overappraised or if there is a

problem with the appraisal (for example, the

appraisal is obsolete or the validity of the ap-

praisal is in question), the examiner should con-

sider recommending that a new appraisal be

performed.

It may be necessary for the examiner

to classify the loan (i.e., as a loss) and for the

parent holding company to increase its allow-

ance for loan and lease losses.

Bank holding companies and/or their non-

bank subsidiaries should be criticized if initial

appraised values appear to be inadequate and/or

not properly supported by proper documenta-

tion. If corrective action is not taken by manage-

ment, formal enforcement action should be con-

sidered. Such actions may require the bank

holding company to revamp its appraisal activi-

ties and/or collection procedures and, if war-

ranted, to retain the services of an independent

appraiser to conduct an evaluation of loan

collateral.

With respect to MBSs, the quality characteris-

tics of the underlying mortgage collateral should

be considered. If the securities are backed by

GNMA, FannieMae, or FHLMC, the rating agen-

cies consider such securities to be the highest

quality asset because of their linkage to the

federal government. If the collateral consists of

unsecuritized mortgages, the examiner should

consider the geographic dispersion, type of mort-

gage and property, underwriting standards, and

term to maturity of the underlying pool of mort-

gage loans. External factors can affect the value

of mortgage securities directly, such as the de-

fault or downgrading (by a credit rating agency)

of a private mortgage insurer.

To a large extent, insurance and guaranties

provided by government-sponsored agencies and

other third parties (for example, private mort-

gage, bankruptcy protection, fraud, and mort-

gage pool insurers, as well as performance bond

insurers and other guarantors) mitigate credit

risk for an originator; however, the originator

still remains responsible for the quality of loans

sold to investors for at least the ﬁrst 90 days,

as well as for any loans sold under recourse

arrangements. As a servicer, the company also

can be held liable if it does not initiate collec-

tion and foreclosure actions in strict accordance

with investor-servicing agreements. In addition,

certain interest losses and expenses relating to

collections, foreclosure, and ORE are not fully

reimbursable and should be anticipated.

The mortgage banking company must main-

tain adequate management reports to measure

and track the quality of originated, purchased,

and serviced assets. Proper administration over

loans and other assets held for sale or invest-

ment requires the use of aging and other track-

ing reports. For assets held for sale, the reports

should identify loans and other marketable assets,

6. For certain credits, the bank holding company should

develop criteria for obtaining reappraisals or revaluations as

part of a prudent portfolio review and monitoring program.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 30

other than marketable securities,

that have been

in this category longer than 60 days. In such

instances, a determination should be made as to

whether credit quality problems and/or docu-

mentation deﬁciencies exist that will prevent the

timely sale of the loan in the secondary market.

If problems are not correctable within a reason-

able timeframe, the loans and other related

assets should be revalued and transferred to the

held-for-investment category. Procedures gov-

erning the valuation and transfer of poor-quality

assetsshould be in writingand shouldbe followed.

The MIS should also generate for manage-

ment’s review reports on the delinquency status

of loans held for investment and loans serviced

for investors. Such reports provide an early

warning system and an analysis tool to evaluate

internal collection activities. If a loan becomes

delinquent (30 days or two payments past due),

the borrower should be contacted. Collection

efforts should be strengthened if the delinquency

continues. If the loan becomes severely delin-

quent, foreclosure proceedings should be initi-

ated consistent with the investor-servicing agree-

ment, and the value of the collateral supporting

the loans should be assessed. Anticipated short-

falls should be recognized as losses in a timely

manner.

MIS should also include an internal loan-

grading system, which tracks the borrower’s

ability to meet its monthly payment obligations.

Although MIS should be tailored to meet man-

agement’s needs, information should be consis-

tent with loan-grading systems that are used by

the controlling bank holding company and fed-

eral bank regulatory agencies. Reports should

also track collection and foreclosure actions ini-

tiated by the servicer and repurchase requests

initiated by a permanent investor or other third

party.

Examiners should also verify that appraisal

practices are consistent with the Board’s ap-

praisal regulations,

the interagency appraisal

and evaluation guidelines (see SR-94-50,

SR-94-55, SR-95-16, SR-95-27, and SR-99-26),

and any other state and federal laws and regu-

lations. Mortgage banking companies that are

subsidiaries of either state member banks or

bank holding companies are subject to the same

appraisal standards and requirements as their

parent companies.

3070.0.5.4.1 Classiﬁcation Procedures

The classiﬁcation process begins with an analy-

sis of delinquent loans. The examiner should

begin by obtaining an aged listing of all delin-

quent loans in the held-for-sale and the held-to-

maturity portfolios. Clear-cut shortfalls in prop-

erty values compared with loan or investment

values should usually be classiﬁed unless there

are mitigating circumstances. Usually loans or

investments with doubtful or loss elements have

other signiﬁcant weaknesses that will ordinarily

justify a classiﬁcation of substandard for the

remaining balance. Loans secured by collateral

such as real estate should be classiﬁed in accor-

dance with these guidelines and the applicable

classiﬁcation guidance found in sections 2060.1

and 2090.1 of the Commercial Bank Examina-

tion Manual and sections 2010.2, 2065.1, 2240.0,

and 5010.10 of this manual.

Portions of these loans may warrant a more

severe classiﬁcation if the value of the under-

lying collateral is insufﬁcient to fully repay the

loan. The identiﬁcation of potential or actual

loss exposure may warrant the use of either a

split (substandard and loss) or a doubtful rating.

The examiner should also review the ORE

portfolio, notes and accounts receivable, and

other investments on the company’s balance

sheet for potential classiﬁcations. ORE may usu-

ally warrant a substandard classiﬁcation due to

an investment’s nonearning status and an

increased probability of loss on disposal of the

underlying assets.

Assets that represent illegal or impermissible

holdings or those that are subject to some regu-

latory concern should not be classiﬁed, per se,

for these factors. Such holdings should be treated

separately within the report. In those instances

where a credit-quality issue is also present, the

classiﬁcation and the separate treatment should

be cross-referenced.

The examiner should also review any off-

balance-sheet exposure for which credit risk is

retained. Loans sold to investors on a recourse

basis have the potential of being put back to the

servicer. The portion of the recourse portfolio

that is severely delinquent should be classiﬁed

according to the guidelines provided previously,

since the exercise of this ‘‘put option’’ is highly

likely.

At the end of the classiﬁcation process, the

examiner should evaluate the level and trend of

classiﬁed assets to determine whether asset qual-

ity poses undue ﬁnancial risk to the mortgage

7. For mortgage-backed securities available-for-sale, simi-

lar account classiﬁcation procedures apply, but those are

accounted for in accordance with SFAS 115.

8. See Regulation Y, subpart G (12 C.F.R. 225.61–67), and

its incorporation by reference into Regulation H (12 C.F.R.

208.18).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 31

banking company or its parent bank holding

company. A list of total classiﬁcations should be

compiled and left with management.

As part of the analysis of asset quality, the

aggregate of loss classiﬁcations plus an amount

expected to ultimately be loss should be com-

pared with the existing allowance for loan and

lease losses. If the aggregate exceeds the exist-

ing contra asset balance(s) then additional loan-

loss provisions are needed. In such situations,

the parent company should be advised of the

deﬁciency and reminded of its responsibility to

ensure that an adequate allowance for loan and

lease losses, as well as other contra asset valua-

tion balances, is maintained by the subsidiary

for its asset portfolio.

Any discrepancies between the classiﬁcations

list and information contained on the company’s

MIS should also be discussed with manage-

ment. If asset quality presents undue or exces-

sive risk, appropriate comments should be docu-

mented and brought forward on Examiner’s

Comments and Matters Requiring Special Board

Attention, page one of the report.

3070.0.5.4.2 Presentation of

Classiﬁcations

As a minimum standard, brief write-ups stating

the reason for classiﬁcations should be provided

for any nonbank subsidiary’s asset whose doubt-

ful and/or loss classiﬁcation exceeds the lesser

of $100,000 or 5 percent of the subsidiary’s

total assets. In general, substandard assets should

be listed without a write-up, regardless of size.

However, a brief write-up is required for any

asset whose classiﬁcation is challenged by man-

agement. The examiner has the option to pro-

vide a write-up for any classiﬁed assets, regard-

less of size.

While the following presentation guidelines

may be useful in structuring the write-ups, the

examiner may include any other format appro-

priate to the situation:

• recapitulation of the status and purpose of the

loan, the lien position, type and appraised

value of the collateral, its delinquency and

accrual status, guarantors and other debit or

credit balances related to the loan

• the problems with the loan, borrower, or col-

lateral, presented in a concise, descriptive

narrative

• the examiner’s evaluation of the situation,

indicating estimated values, major assump-

tions, and mitigating or negative factors

• the classiﬁcation, which should represent a

logical combination of the relevant factors

presented in the ﬁrst three elements

Within the elements presented, the examiner

should stress accuracy, brevity, and clarity in the

presentation, as well as a logical pattern leading

to the classiﬁcation. Historical information and

ﬁnancial data that are not pertinent or that are

too stale to have a direct bearing on the present

situation should not be included.

Presentations for OREO properties need not

include the original loan date, history, and ﬁnan-

cial information, unless there is some relevance

to the current condition (for example, the prop-

erty has been foreclosed on for the second time

or some circumstance before foreclosure contin-

ues to have an impact). For those companies in

which numerous loans and OREO properties are

classiﬁed, a summary of classiﬁcations, seg-

mented by loans and real estate owned and

indexed to the pages containing the classiﬁca-

tions, presents clear beneﬁts to the users of

the report. This becomes more pertinent when

numerous assets below the write-up line are

included in total classiﬁcations. In addition, both

management and the subsequent examiners will

have an ofﬁcial listing of the classiﬁcations.

3070.0.5.4.3 Reserves

Management should establish and maintain

adequate contra asset allowances and other con-

tingency reserves to cover identiﬁed loss expo-

sure. Policies and procedures, and ﬁnancial state-

ment disclosures, should clearly state the purpose

of and intended accounting treatment for each

reserve. Management should evaluate the level

of each reserve account at least quarterly, docu-

ment this analysis, and replenish each reserve as

necessary.

The ﬁnancial presentation for reserves varies.

Reserves maintained for on-balance-sheet expo-

sure are generally reported as a contra asset.

Reserves maintained for contingent liabilities

relating to the sale of loans and servicing of

loans for investors may be shown as a liability

in practice.

Disclosures relating to valuation reserves

should be consistent with GAAP. Examiners

may wish to confer with the mortgage banking

company’s external auditors regarding the na-

ture or appropriateness of any reserve accounts

that are unusual.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual January 2007

Page 32

3070.0.5.5 Earnings Performance

Earnings performance should be assessed in

terms of the level, composition, quality, and

trend of net income. The earnings analysis should

consider internal factors such as the company’s

business orientation and management’s growth

plans, as well as relevant external factors such

as interest rates and economic trends.

Unusual aspects of origination and servicing-

fee income, marketing gains and losses, the net

interest margin, provisions for losses, salaries

and overhead items, or income taxes should be

discussed with management, as well as with

internal or external auditors. Large write-downs

or amortization adjustments relating to mortgage-

servicing rights should also be investigated. (See

section 3070.0.6.)

Current and historical ratio trend analysis,

compared with published industry results (for

example, see the Mortgage Bankers Associa-

tion’s annual statistics in the ‘‘Mortgage Bank-

ing Performance Report’’), should also be incor-

porated into the proﬁtability analysis, where

appropriate. This includes income structure, ex-

pense structure, and operating performanceratios.

However, ratios that compare earnings to aver-

age assets or equity may be of limited use unless

the examiner also considers the transitory nature

of the balance sheet and the impact of off-

balance-sheet servicing activities on the com-

pany’s use of ﬁnancial leverage. Finally, the

examiner should consider the company’s ability

to generate sustainable positive earnings consis-

tently over time, as well as the proportionate

share of consolidated earnings (or losses).

3070.0.5.6 Liquidity and Funding

Management’s ability to satisfy the company’s

liquidity needs and plan for contingencies with-

out placing undue strain on afﬁliate bank or

nonbank resources or reliance on the parent

bank holding company is crucial. Liquidity needs

depend on the size of the warehouse, the nature

and extent of longer-term assets, opportunities

to issue debt at a reasonable price, and manage-

ment’s ability to forecast and plan for contin-

gencies. Liquidity is often dependent on cash

generated through short-term liquid assets and

on short-term borrowings to fund operations.

Earnings performance, capital adequacy, the

degree of market contact with underwriters and

credit rating agencies, maintenance of debt cov-

enants, and contingent liquidity plans are all

signiﬁcant factors in the evaluation of liquidity.

Liquidity can quickly erode if investor percep-

tions of a company’s credit standing change.

Consequently, the ability to fund mortgage

operations under economic duress and access

to alternate liquidity sources become key

considerations.

Funding needs are driven by the need to

temporarily ﬁnance mortgage loans and MBSs

before their sale to a permanent investor. The

examiners should do a trend review of external

liquidity to assess how easy it is to sell mortgage-

backed securities by the ﬁrm in the secondary

market. The analysis should include the normal

trading volume in MBS securities, the volume

of loans held for sale and their market value,

and the size of the ‘‘ﬂoating’’ supply of mort-

gage securities or loans that are not closely held.

Liquidity needs must also take into consider-

ation longer-term assets such as ﬁxed assets,

mortgage-servicing rights, and permanent loan

and MBS portfolios. (See section 2080.05.)

3070.0.5.6.1 Financial Flexibility

The liquidity analysis should include a determi-

nation as to the company’s ﬁnancial ﬂexibility.

Financial ﬂexibility is the ability to obtain the

cash required to make payments as needed. Cash

can be obtained from (1) business operations;

(2) liquid assets already held by the company

either in the form of cash or marketable securi-

ties or by selling liquid assets such as receiv-

ables or inventories for cash; and (3) external

lines of credit, bank borrowings, or the issuance

of debt or equity securities in the capital markets.

3070.0.5.6.2 Cash-Flow Analysis

The liquidity analysis should also include a

review of the net current items on the cash-ﬂow

statement pertaining to cash ﬂow from opera-

tions, cash ﬂows from investing activities, and

cash ﬂows from ﬁnancing activities on a year-

by-year trend basis. The examiner’s analysis of

cash ﬂows may reveal transactional trends

between cash inﬂows and outﬂows. For exam-

ple, within the Cash Flows from Operating

Activities, cash ﬂow from the sale and principal

repayments on mortgage loans held for sale may

correlate with originations and purchases of

mortgage loans available for sale. With regard

to investing activities, attention should be given

to the differences between short-term purchases

of mortgage loans held for investment versus

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual January 2007

Page 33

principal repayments on mortgage loans held for

short-term investment. In addition, purchases of

real estate owned from the loan-servicing port-

folio may correlate with net sales of real estate

owned. A review of the ﬁnancing activities

should indicate if there is sufﬁcient cash ﬂow

provided from revolving warehouse lines of

credit, commercial paper, proceeds from the

issuance of any other short-term debt, and net

changes in advances payable to afﬁliates.

The summary analysis of the cash-ﬂow state-

ment should convey how the underlying transac-

tions collectively contribute to a positive cash

ﬂow and liquidity. When analyzing liquidity, the

examiner needs to consider the principles and

guidelines set forth in section 2080.05, ‘‘Fund-

ing (Bank Holding Company Funding and

Liquidity)’’ of this manual.

3070.0.5.6.3 Asset/Liability Management

In general, funding liability maturities should

closely approximate the maturities of under-

lying assets to mitigate the risk of a funding

mismatch. Otherwise, the company is exposed

to short-term interest-rate ﬂuctuations unless

appropriately hedged. Funding mismatches can

lead to signiﬁcant earnings volatility in the event

that interest rates change rapidly. Management’s

asset/liability management program should be

evaluated in terms of the degree of matching,

risk aversion, and the accuracy of information

that is provided to the holding company through

daily, weekly, or monthly management reports.

3070.0.5.7 Capital Adequacy

Capital must be adequate to absorb potential

operating losses, provide for liquidity needs and

expected growth, and meet minimum require-

ments set by third-party creditors and investors.

At a minimum, a mortgage banking company

must meet the nominal capital levels required

by investors such as FannieMae ($250,000) or

FHLMC ($1 million, based on ﬁnancial report-

ing under GAAP, or $500,000, adjusted for cer-

tain assets and any deferred-tax liability). Addi-

tional capital is required based on the outstanding

principal balance of loans serviced for investors.

If these requirements are not met, the company

may not be able to sell mortgages to and/or

service mortgages for these investors.

As noted above, these are minimum capital

requirements. Management should identify the

level of capital that is required to support cur-

rent operations and projected future growth,

given the risk tolerance preferences of manage-

ment and the board. Capital levels, dividend

payments, and capital planning should be ad-

dressed in a written capital plan that is reviewed

and approved by the board at least annually in

conjunction with the budgeting and strategic

planning activities.

There also may be a need to meet minimum

leverage ratios established by the parent bank

holding company or to meet debt covenants set

forth in either warehouse credit facilities or

long-term debt instruments. Companies that have

excessive off-balance-sheet risk or high growth

expectations may require additional capital. In

addition, risk-based capital guidelines impose

certain reporting requirements and limitations

regarding the amount of MSA mortgage bank-

ing companies may include in their regulatory

capital.

Capitallevels should be monitored and reported

to the company’s board of directors regularly to

mitigate the risk of inadequate or eroding capi-

tal. Management and the board are further encour-

aged to adopt a capital policy that speciﬁcally

addresses the particular needs of the company.

The examiner should evaluate capital ade-

quacy, the amount of dividends that are up-

streamed to the parent bank holding company,

and the extent to which the parent company can

be relied on to augment the ongoing capital

needs of its bank and nonbank subsidiaries. In

some instances, the parent company may oper-

ate on the premise that the mortgage banking

company requires little capital of its own as

long as the parent company remains adequately

capitalized.

Under the Federal Reserve’s source-

of-strength doctrine, the parent company must

be prepared to support its subsidiaries should

the ﬁnancial need arise. If the parent is not

prepared to inject capital and capital levels have

declined, the examiner should comment on the

mortgage banking company’s extended lever-

aged position on page one of the inspection

report. Under extreme circumstances, the exam-

iner should also recommend that its leverage be

reduced and its capital structure augmented to

ensure that mortgage operations are conducted

in a safe, sound, and prudent manner.

9. When MSAs are valued for inclusion in capital, the

risk-based capital guidelines for banks and BHCs require the

discount rate to be not less than the original discount rate

inherent in the intangible asset at the time of its acquisition,

based on the estimated future net cash ﬂows and price paid at

the time of purchase.

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3070.0.5.8 Overall Assessment

The overall ﬁnancial condition of the mortgage

banking company should reﬂect its ﬁnancial

statement presentation, asset quality, earnings,

liquidity and funding practices, and capital ade-

quacy. Report comments should be prepared to

the extent necessary.

3070.0.5.9 Inspection Objectives

1. To evaluate the ﬁnancial condition of the

mortgage banking company based on a review

of the following:

• primary balance-sheet and income-

statement levels and trends

• off-balance-sheet exposure such as the ser-

vicing portfolio

• asset quality

• earnings performance

• funding sources and liquidity needs

• capital adequacy

2. To determine the accuracy of regulatory

reporting (regulatory accounting practices (RAP)

and GAAP) and compliance with applicable

state and federal laws and regulations.

3. To evaluate the quality of the mortgage

banking company’s assets for collateral sufﬁ-

ciency, performance, credit quality, and

collectibility.

4. To assess earnings performance through

the analysis of the level, composition, and trend

of net income. If material, interest income,

impairment of mortgage-servicing assets, gains

and losses on asset sales, and personnel and

other expenses should be factored into the

analysis.

5. To assess the funding and liquidity needs

of the mortgage banking company through ratio

analysis and a review of the funding instruments

used.

6. To assess capital adequacy by ensuring

that investor minimum requirements are met

and by comparing capital levels with peer and

industry data. Consideration of the capital needs

of the individual mortgage banking company

should override any comparison with peers.

3070.0.5.10 Inspection Procedures

Financial Statement Level and Trends

1. Review the mortgage banking company’s

ﬁnancial statements and related notes over the

previous three-year period.

2. Discuss signiﬁcant balance-sheet and

income-statement categories with management,

as well as with internal and external auditors.

3. Determine whether ﬁnancial trends are

consistent with the economic environment,

interest-rate movements, the company’s busi-

ness orientation, and management’s intended

growth strategy.

4. Determine whether reports ﬁled with regu-

latory agencies are prepared accurately and sub-

mitted in a timely manner, with particular atten-

tion paid to the reporting for mortgage-servicing

assets and recourse obligations retained by the

mortgage banking company.

Asset Quality

1. Spread past-due and nonaccrual loans by

balance-sheet asset category (for example, mort-

gage loans held for sale, mortgage loans held

for investment), product type, and delinquency

status (for example, 31–90 days, 91–180 days,

and 181 days and over). Include any loans in the

process of foreclosure.

2. Obtain a trial balance and delinquency list-

ing for loans held for sale and loans held for

investment.

a. Reconcile balances of the real estate

held for sale and investment to the respective

general ledger accounts.

b. Classify severely delinquent loans as

required based on the ﬁnancial condition of the

borrower, his or her inability to make monthly

payments as required, and the protection afforded

by current collateral values.

c. Determine accounting policies and prac-

tices with respect to these loans. Review aging

reports for loans held for sale and for invest-

ment. Discuss the frequency of reviews for loans

held for sale, revaluation practices, and transfers

among accounts. Verify that accounting prac-

tices are consistent with GAAP and RAP.

3. Obtain a listing of loans in the process of

foreclosure and bankruptcy and discuss these

with management for potential classiﬁcation.

4. Reconcile all other real estate owned by

the mortgage banking company to the general

ledger and classify based on risks and any

income-producing characteristics of the proper-

ties. Compare current appraisals to carrying

value for potential write-downs.

5. Obtain a list of loans sold under recourse

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 35

arrangements and assess for potential classiﬁca-

tion.

6. Discuss the methodology used to establish

foreclosure reserves and related accounting pro-

cedures. Review analysis used to project future

foreclosures.

• Evaluatethe adequacyof foreclosure reserves

based on the volume of projected foreclo-

sure actions, average foreclosure costs, and

the past history of reinstated loans.

7. Review other reserve accounts and assess

for reasonableness.

Earnings Performance

1. Assess earnings performance in terms of

the level, composition, and trend of net income.

Consider internal factors, such as the company’s

business orientation and management’s growth

plans, and external factors, such as interest rates

and the economic environment, when evaluat-

ing earnings trends.

2. Discuss any unusual aspects of origination

and servicing-fee income, marketing gains and

losses, the net interest margin, reserves, write-

downs or adjustments in MSA amortization,

salaries and overhead items, or income taxes

with management, as well as with internal or

external auditors.

3. Incorporate ratio and industry compari-

sons into the earnings analysis, where appropri-

ate. Bear in mind that ratios that compare earn-

ings to total assets or equity are of limited use

unless the transitory nature of the balance sheet

and the impact of off-balance-sheet servicing

activities on the company’s use of ﬁnancial

leverage are taken into consideration.

Liquidity and Funding

1. Determine the mortgage banking com-

pany’s liquidity needs based on a review of the

size of its warehouse and the nature and extent

of other longer-term assets.

2. Determine whether sources of liquidity are

adequate, both under current conditions and eco-

nomic duress. Consider earnings performance,

capital adequacy, the degree of market contact

with underwriters and credit rating agencies,

maintenance of debt covenants, and contingent

liquidity-planning capabilities.

3. Evaluate ﬁnancial instruments used to fund

mortgage operations. Financial instruments may

include repurchase agreements, commercial

paper, revolving warehouse lines of credit, and/or

long-term debt. Review related credit agree-

ments and systems used to monitor compliance

with debt covenants.

4. Establish whether excessive borrowing

activities have led to a highly leveraged ﬁnan-

cial condition that exposes the company to money

market changes in the cost of funds. Evaluate

the impact a change in the company’s cost of

funds would have on its net interest margin and

earnings.

5. Determine the degree of ﬁnancial ﬂexibil-

ity the company maintains. Financial ﬂexibility

is the ability to obtain the cash required to make

payments as needed. Does the company possess

adequate ﬁnancial strength and have access to

lines of credit and/or assets that can be easily

collateralized?

6. Review the net current items on the cash-

ﬂow statement pertaining to cash ﬂow from

operations, cash ﬂows from investing activities,

and cash ﬂows from ﬁnancing activities on a

year-by-year trend basis. Determine whether

sufﬁcient positive cash ﬂow exists from the level

of current transactions. The summary analysis

of the cash-ﬂow statement should convey how

the underlying transactions collectively contrib-

ute to a positive cash ﬂow and liquidity.

7. Review asset/liability management prac-

tices to determine whether funding maturities

closely approximate the maturities of under-

lying assets or whether a funding mismatch

exists. Is the company exposed to short-term

interest-rate ﬂuctuations that may lead to signiﬁ-

cant earnings volatility in the event that interest

rates change rapidly?

Capital Adequacy

1. Determine whether capital levels are ade-

quate to absorb potential operating losses, pro-

vide for liquidity needs and expected growth,

and meet minimum requirements set by inves-

tors whose loans are serviced and other external

parties.

2. Review policies and procedures to deter-

mine whether management adequately monitors

and reports capital levels to the board of direc-

tors. Review the capital plan to determine whether

it adequately addresses the particular needs of

the company.

3. Evaluate the amount of dividends that are

upstreamed to the parent bank holding com-

pany, as well as the extent to which the parent

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 36

company can be relied on to augment the ongo-

ing capital needs of its bank and nonbank sub-

sidiaries. Is the parent company prepared to

support its subsidiaries should the ﬁnancial need

arise? Are cash dividends paid by the mortgage

banking subsidiary to the parent company rea-

sonable?

Accounting

1. Review accounting procedures for retail

loans. Determine whether loan fees in excess of

cost are deferred in accordance with SFAS 91.

Verify that income is recognized over the esti-

mated life of the asset and not in the current

period and that fees and costs are allowable

under SFAS 91. Are controls in place to ensure

proper recognition for net fee income when

loans are sold? (SFAS 91 applies to loans held

in portfolio, as well as to loans swapped for

securities when the securities are retained.)

2. Determine if the accounting for recogniz-

ing sales of loans and mortgage-backed securi-

ties (including participation agreements) is in

accordance with the three conditions for true

sales recognition speciﬁed in SFAS 77, ‘‘Re-

porting for Transfers of Receivables with

Recourse.’’

Also determine if the sales price

was adjusted for all probable adjustments (as

deﬁned in SFAS 5, ‘‘Accounting for Contingen-

cies’’). If the mortgage banking company is a

subsidiary of a bank, refer to the bank call

report, glossary entry on ‘‘sales of assets.’’

3. If servicing is retained, determine if a

‘‘normal servicing fee’’ is set and how it con-

forms to FannieMae/FHLMC fees and to FASB

Technical Bulletin 87-3, ‘‘Accounting for

Mortgage-Servicing Fees and Rights.’’

If the

mortgage banking subsidiary is a subsidiary of

a bank, see the reporting instructions for Sched-

ule F of the bank call report (Schedule RC-F

for Other Assets, Item 3—Excess residential

mortgage-servicing fees receivable).

Overall Financial Condition

1. Evaluate the overall ﬁnancial condition of

the mortgage banking company, considering its

asset quality, earnings, liquidity, and capital ade-

quacy. Update the ﬁnancial component of the

supervisory rating and prepare report comments

as necessary.

3070.0.6 MORTGAGE-SERVICING

ASSETS AND LIABILITIES

This subsection discusses mortgage-servicing

assets (MSAs) and liabilities and provides

guidance with respect to the measurement,

impairment testing, and ﬁnancial reporting

requirements of MSAs. The subsection con-

cludes with a discussion of MSA hedging prac-

tices and instruments.

SFAS No. 125 ‘‘Accounting for Transfers and

Servicing of Financial Assets and Extinguish-

ments of Liabilities,’’ was issued in June 1996

as an amendment to SFAS Nos. 65, 76, 77, and

115. The provisions of SFAS 125 supersede

SFAS 122 and are to be applied prospectively in

ﬁscal years beginning after December 31, 1996.

The statement requires that a liability be derec-

ognized when either (1) the debtor pays the

creditor and is relieved of its obligation for the

liability or (2) the debtor is legally released

from being the primary obligor under the liabil-

ity either judicially or by the creditor.

Under SFAS 125, a mortgage banking com-

pany is required to recognize as separate assets

or liabilities the right to service mortgage loans

for others, however those servicing rights are

acquired. Servicing of mortgage loans includes,

but is not limited to, collecting principal, inter-

est, and escrow payments from borrowers; pay-

ing taxes and insurance from escrowed funds;

monitoring delinquencies; executing foreclosure

10. A transfer is recognized as a sale if—

a. The transferor surrenders control of the future eco-

nomic beneﬁts of the receivables;

b. The transferor’s obligation, under the recourse provi-

sions of the sale agreement, can be reasonably estimated. The

transferor should have had past experience with the recourse

provisions so that a reasonable estimate can be made. The

current transferred receivables should possess characteristics

similar to previously transferred receivables evidencing the

transferor’s relevant prior experience.

c. The transferor cannot require the transferee to repur-

chase the receivables, except as stated in the agreement’s

recourse provisions.

11. According to FASB Technical Bulletin No. 87-3, the

servicing-fee rates set by GNMA, FHLMC, and FannieMae in

servicing agreements should be considered a normal servicing-

fee rate for transactions with those agencies. If the normal

service fees are expected to be less than the estimated servic-

ing costs, the expected loss should be recognized at the time

the loans are sold. If a seller/servicer sells mortgage loans

directly to private-sector investors and retains servicing on the

loans, the seller/servicer should consider the normal servicing-

fee rate that would have been speciﬁed in comparable servic-

ing agreements if the loans had been sold to or securitized by

one of the federally sponsored secondary market makers. As

of May 1995, normal servicing-fee rates established by GNMA,

FHLMC, and FannieMae were 44, 25, and 37.5 basis points,

respectively.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 37

if necessary; temporarily investing funds pend-

ing distribution; remitting fees to guarantors,

trustees, and others providing services; and

accounting for and remitting principal and inter-

est payments to the holders of beneﬁcial interest

in the mortgage loans. Servicing is inherent in

all mortgage loans; however, it becomes a dis-

tinct asset or liability only when contractually

separated from the underlying assets by sale

or securitization of the assets with servicing

retained or separate purchase or assumption of

the servicing.

3070.0.6.1 Measurement

A mortgage banking company initially acquires

MSAs either by (1) purchasing the right to

service mortgage loans separately or (2) pur-

chasing or originating mortgage loans and sell-

ing those loans with servicing rights retained.

When a mortgage banking company purchases

or originates mortgage loans, the cost of acquir-

ing those loans includes the cost of the related

MSAs.

With respect to SFAS 125, when an entity

incurs an obligation to service ﬁnancial assets, it

must record servicing assets or a servicing lia-

bility for each servicing contract, unless it secu-

ritizes the assets and retains all of the resulting

securities, classifying them as debt securities

that are to be held to maturity. When servicing

assets or liabilities are assumed, rather than

being acquired by a sale or undertaken in a

securitization of the ﬁnancial assets that are to

be serviced, they are measured initially at fair

value (that is, the price paid). A servicing asset

or liability is amortized in proportion to and

over the period of estimated net servicing income

(loss). Any impairment of a servicing asset or

liability is determined based on fair value.

When the mortgage banking company sells or

securitizes the loans and retains the MSAs, man-

agement shall allocate the total cost of the mort-

gage loans (the recorded investment in the mort-

gage loans including net deferred loan fees or

costs and any purchase premium or discount) to

the MSAs and the loans (without the MSAs)

based on their relative fair values if it is practi-

cable to estimate those fair values. If a mortgage

banking organization undertakes a servicing lia-

bility in a sale or securitization, the servicing

liability should initially be measured at fair

value.

The fair value of an asset is the amount at

which the 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 in active markets are the

best evidence of fair value and shall be used as

the basis for measurement, if available. If quoted

market prices are not available, the estimate of

fair value shall be based on the best information

that is available, including prices for similar

assets and the results of valuation techniques

used by management. Valuation techniques may

include the present value of estimated expected

future cash ﬂows using a discount rate commen-

surate with the risks involved; option-pricing

models; matrix pricing; option-adjusted spread

models; and fundamental analysis. Valuation

techniques for measuring MSAs should be con-

sistent with the objective of measuring fair value

and should incorporate assumptions that market

participants would use in their estimates of

future servicing income and expense, including

assumptionsabout prepayment, default, and inter-

est rates. If it is not practicable to estimate the

fair values of the MSAs and the mortgage loans

(without the MSAs), the entire cost of acquiring

the mortgage loans shall be allocated to the

mortgage loans (without the MSAs) and no cost

shall be allocated to the MSAs.

The amount capitalized as MSAs shall be

amortized in proportion to and over the period

of estimated net servicing income. Estimates of

future servicing revenue shall include expected

late charges and other ancillary revenue. Esti-

mates of expected future servicing costs shall

include direct costs associated with performing

the servicing function and appropriate alloca-

tions of other costs. Estimated future servicing

costs may be determined on an incremental-

cost basis.

MSAs are highly subject to interest-rate and

prepayment-rate risk since the amount of future

cash ﬂows that are provided to the holder is

derived from, and is thus dependent on, the

outstanding balances of the underlying mort-

gage loans.

Prepayments of underlying mort-

12. Several conventions exist for quantifying prepayment

speed. The most common convention is a measure developed

by the Public Securities Association (PSA). The PSA measure

was based on actual historical experience of FHA mortgages,

but it is not predictive. The PSA measure assumes that mort-

gages prepay at a rate of .2 percent per year in the ﬁrst month,

increase by .2 percent each subsequent month up to 30 months,

and remain at 6 percent per year thereafter until maturity. This

6 percent level is referred to as 100 percent PSA. Mortgages

that prepay at 200 percent PSA pay off twice as fast as a

mortgage that is performing at 100 percent PSA. Another

convention is known as the conditional prepayment rate

(CPR) measure. CPR assumes that a constant fraction of the

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 38

gage loans accelerate during periods of declin-

ing interest rates as borrowers take advantage

of the option they hold to reﬁnance their loans.

As interest rates decline, holders of MSAs are

exposed to a risk of prepayment of the under-

lying loans, and thus a diminished amount of

cash ﬂow from their investment. Holders of

interest-only stripped securities (I/O strips) are

exposed to similar interest-rate and prepayment

risks when interest rates decline.I/O strips possess

very similar prepayment risk characteristics.

A particular mortgage company’s exposure to

prepayment risk can also be inﬂuenced by port-

folio composition factors such as geographical

mix, loan-to-value ratios, and the proportion of

government (FHA/VA) and conventional loans

in the portfolio. Government loans that may be

assumable by the purchaser of a home are gener-

ally for smaller amounts and may be extended

to borrowers with limited ﬁnancial resources.

As a result, government loans tend to prepay

more slowly than conventional loans.

Unanticipated changes in interest rates, pre-

payment speed, or other valuation assumptions

may impair the carrying value of MSAs and

require accelerated amortization or a write-

down. Therefore, the recoverability of the

unamortized balance should be evaluated peri-

odically, and amortization and/or the value of

the asset should be adjusted accordingly. To the

extent that impairment is not recognized, MSA

values may be inﬂated. As a result, assets, earn-

ings, and capital may be overstated.

3070.0.6.2 Impairment Testing

SFAS 125 states that a mortgage banking com-

pany shall measure impairment of capitalized

MSAs

based on their fair value. For the pur-

pose of evaluating and measuring impairment of

capitalized MSAs, management should stratify

those assets based on one or more of the pre-

dominant risk characteristics of the underlying

loans.

Those characteristics may include loan

type, loan size, note rate, date of origination,

term, and geographic location.

Impairment shall be recognized through a

valuation allowance for an individual stratum.

The amount of impairment that is recognized

shall be the amount by which the capitalized

MSAs for a given stratum exceed their fair

value. The fair value of MSAs that have not

been capitalized shall not be used in the evalua-

tion of impairment.

Subsequent to the initial measurement of

impairment, management shall adjust the valua-

tion allowance to reﬂect changes in the measure-

ment of impairment. Fair value in excess of the

capitalized MSAs shall not be recognized. If the

fair value of a mortgage-servicing liability

increases above the book value, the increased

obligation shall be recognized as a loss in cur-

rent earnings. SFAS 125 does not address when

a mortgage banking company should record a

direct write-down of capitalized MSAs; there-

fore, examiner judgment in this area is required.

3070.0.6.3 Disclosures

SFAS 125 requires that the fair value of capital-

ized MSAs, and the methods and signiﬁcant

assumptions used to estimate that fair value, be

disclosed. If no cost is allocated to certain

MSAs, management shall describe those MSAs

and describe the reasons why it is not practi-

cable to estimate the fair values of the MSAs

and the mortgage loans (without the MSAs).

The

risk characteristics of the underlying loans

used to stratify capitalized MSAs for the pur-

poses of measuring impairment shall also be

disclosed. For each period for which results of

operations are presented, the activity in the

valuation allowances for capitalized MSAs,

including the aggregate balance of the allow-

ances at the beginning and end of each period,

aggregate additions charged and reductions cred-

ited to operations, and aggregate direct write-

downs charged against the allowances shall be

disclosed.

3070.0.6.4 Intercompany MSAs

Intercompany MSAs may arise when a mort-

gage banking company originates loans, sells

the loans to an afﬁliate bank, and the afﬁliate

bank records related MSAs. Intercompany MSAs

should be evaluated closely to determine whether

a valid business purpose exists, the loans are

actually sold, the entity holding the MSAs has

remaining principal is prepaid each period, ‘‘conditional’’ on

the previous period’s remaining balance. Typically, CPR is

computed over a one-month time period. The PSA model

simply represents a series of stable CPR assumptions.

13. The term “capitalized mortgage-servicing rights” refers

to the cost originally allocated to the MSAs less the amount

amortized.

14. SFAS 65, as amended, applies to impairment evalua-

tions of all capitalized MSAs. However, a mortgage banking

company may continue to apply its previous accounting poli-

cies for stratifying MSAs to MSAs that were capitalized

before the adoption of the amendments to SFAS 65.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 39

revalued the rights correctly, and such intercom-

pany MSAs are eliminated in consolidation. If

the purpose of the transaction is merely to

bolster capital levels at the bank, the practice

may constitute an unsafe and unsound banking

practice.

3070.0.6.5 Table Funding

One method of acquiring mortgage loans, and

recording related MSAs, is through so-called

‘‘table-funding arrangements.’’ In a table-

funding arrangement, the mortgage banking com-

pany provides the original funding when a mort-

gage broker or correspondent closes the mortgage

loan with the borrower. Concurrent with the

loan closing, the mortgage banking company

acquires the loan and the related MSAs.

Emerging Issues Task Force Issue No. 92-10

(EITF 92-10), ‘‘Loan Acquisitions Involving

Table Funding Arrangements,’’ clariﬁed under

what conditions these arrangements could be

characterized as loan purchases. According to

EITF 92-10, a mortgage banking company may

account for a loan acquired in a table-funding

arrangement as a purchase only if all of the

following conditions are met:

• The correspondent is registered and licensed

to originate and sell loans under the applica-

ble laws of the states or other jurisdictions in

which it conducts business.

• The correspondent originated, processed, and

closed the loan in its own name and is the ﬁrst

titled owner of the loan, with the mortgage

banking company becoming a holder in due

course.

• The correspondent is an independent third

party and not an afﬁliate of the mortgage

banking company as deﬁned in SFAS 65. As a

nonafﬁliate, the correspondent must bear all

of the costs of its place of business, including

the costs of its origination operations.

• The correspondent must sell loans to more

than one mortgage banking enterprise and

not have an exclusive relationship with the

purchaser.

• The correspondent is not directly or indirectly

indemniﬁed by the mortgage banking com-

pany for market or credit risks on loans origi-

nated by the correspondent. However, a com-

mitment by the mortgage banking company

for the purchase of loans from the correspon-

dent is not considered to be an indemniﬁca-

tion for purposes of this requirement.

If any one of the above criteria is not met,

the mortgage banking company must account

for the loan as an origination. MSAs that were

recorded before the adoption of the

SFAS 65 amendments should be reviewed to

ensure that they were originated and funded

consistent with the above requirements. MSAs

that are recorded under SFAS 125 may arise in

connection with either originated or purchased

mortgage loan transactions.

3070.0.6.6 Regulatory Reporting

The examiner should also determine whether

the method used to value MSAs is in accor-

dance with the instructions for the Bank Report

of Condition and Income (call report) and the

BHC reporting instructions (FR Y-9C). If capi-

talized MSAs are not appropriately valued, they

cannot be included in capital. Management should

review the carrying amount at least quarterly,

adequately document this review, and adjust the

book value as necessary.

3070.0.6.7 Risk-Based Capital

Readily marketable MSAs may be included in a

bank or bank holding company’s tier 1 capital

subject to certain limitations. Tier 1 capital for

bank holdingcompaniesincludescommonequity,

minority interest in the equity accounts of con-

solidated subsidiaries, qualifying noncumulative

perpetual preferred stock, and limited qualifying

cumulative perpetual preferred stock.

14a

Tier 1

capital excludes goodwill; amounts of mortgage-

servicing assets, nonmortgage-servicing assets,

and purchased credit-card relationships that, in

the aggregate, exceed 100 percent of tier 1 capi-

tal; amounts of nonmortgage-servicing assets

and purchased credit-card relationships that, in

the aggregate, exceed 25 percent of tier 1 capi-

tal;

all other identiﬁable intangible assets; and

deferred-tax assets that are dependent upon future

14a. Cumulative perpetual preferred stock is limited to

25 percent of tier 1 capital.

15. Amounts of MSAs, non-MSAs, and PCCRs in excess

of these limitations, as well as all other identiﬁable intangible

assets, including core deposit intangibles and favorable lease-

holds, are to be deducted from an organization’s core capital

requirements in determining tier 1 capital. Identiﬁable intan-

gible assets, however, exclusive of MSAs and PCCRs, acquired

on or before February 19, 1992, generally will not be deducted

from capital for supervisory purposes. They will, however,

continue to be deducted for applications purposes.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 1998

Page 40

taxable income, net of their valuation allow-

ance, in excess of certain limitations.

The amount of MSAs which may be included

in capital is also limited to the lesser of—

• the amount recorded on the balance sheet

under GAAP, or

• 90 percent of their fair market value. If both

the application of the limit on MSAs and

the adjustment of the balance-sheet amount

for MSAs would result in an amount being

deducted from capital, the bank holding com-

pany would deduct only the greater of the two

amounts from its core capital elements in

determining tier 1 capital.

3070.0.6.8 Previously Recognized Excess

Servicing-Fee Receivables

SFAS No. 125, ‘‘Accounting for the Transfers

and Servicing of Financial Assets and Extin-

guishments of Liabilities’’ (paragraph 20),

addresses the accounting treatment for excess

servicing-fee receivables based on contracts that

were in existence before January 1, 1997. Previ-

ously recognized servicing rights and excess

servicing-fee receivables are to be combined,

net of any previous servicing obligations under

the contract, as a servicing asset or a servicing

liability. Any previously recognized excess

servicing-fee receivables that exceed contractu-

ally speciﬁed servicing fees are to be reclassi-

ﬁed as interest-only strips receivables.

3070.0.6.9 MSA Hedging Practices and

Instruments

During the reﬁnancing waves of 1992 and 1993,

several mortgage banking companies experi-

enced large losses due to the impact of rising

prepayments on the value of servicing rights. As

a result, many companies have begun to hedge

MSAs. An effective hedge program should re-

ﬂect a solid understanding of the underlying

MSA risk characteristics.

3070.0.6.9.1 Hedging Practices

Interest-rate and prepayment-rate risk are often

reduced through the natural offset between the

production and servicing functions; however,

the degree of protection afforded by this rela-

tionship depends on the company’s business

orientation (originations versus purchases) and

can be very difﬁcult to measure.

Other ﬁnan-

cial instruments are also used to mitigate interest-

rate and prepayment-rate risks. The remainder

of this subsection discusses existing hedge

accounting guidance and rudimentary descrip-

tions of certain customized MSA hedge prod-

ucts. Examiners should also refer to the Federal

Reserve System’s Trading Activities Manual for

additional guidance on derivatives.

3070.0.6.9.2 Hedge Accounting

Existing accounting literature is vague with

respect to the accounting treatment for MSA

hedge products, particularly in the area of

derivatives. However, analogies exist that facili-

tate the application of existing accounting stan-

dards. SFAS No. 80, ‘‘Accounting for Futures

Transactions,’’ provides ﬁnancial reporting stan-

dards for exchange-traded futures contracts on

both interest-rate products and raw materials

(commodities). Several EITF issues releases

provide ﬁnancial reporting guidance for interest-

rate swap transactions. Finally, an issues paper

prepared by the American Institute of Certiﬁed

Public Accountants (AICPA), ‘‘Accounting for

Options,’’ provides informal but nonauthorita-

tive guidance relating to options contracts. The

AICPA issues paper addresses options on all

tangible goods, including both exchange-traded

options and nonexchange traded options on

interest-rate caps and ﬂoors.

To qualify for hedge-accounting treatment

under SFAS 80, a ﬁnancial instrument must

meet two criteria:

• The hedged item exposes the entity to price or

interest-rate risk.

• The ﬁnancial instrument used as a hedge

reduces that exposure and is designated as a

hedge.

SFAS 80 states that at the inception of the hedge

and throughout the hedge period, changes in the

market value of the ﬁnancial instrument used as

a hedge should correlate highly with changes in

16. When interest rates fall, increases in production vol-

umes and related revenues tend to offset runoff in the servic-

ing portfolio and reductions in servicing-fee income. Alterna-

tively, to the extent that the marketing department hedges less

than 100 percent of its estimated long position (closed loans

plus rate-locked loans that are expected to close) and interest

rates fall, the resulting marketing gains on the uncovered

position tend to offset a portion of any required write-downs

in the servicing portfolio.

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Page 41

the fair value of, or interest income or expense

associated with, the hedged item(s) so that the

results of the ﬁnancial instrument(s) used as a

hedge will substantially offset the effects of

price or interest-rate changes on the exposed

item(s). Although required correlation levels are

not speciﬁcally deﬁned, the accounting industry

has determined that 80 percent is a reasonable

benchmark.

Before claiming hedge-accounting treatment,

management must obtain an opinion from its

CPA or internal accountant conﬁrming that the

instrument that is proposed would qualify for

such treatment. If these criteria are not met, the

ﬁnancial instrument should be carried at its

market value (i.e., marked to market). Hedge

performance should be monitored daily and re-

ported to the responsible management or board

committee at least quarterly.

3070.0.6.9.3 Relevant MSA

Characteristics

To evaluate a mortgage banking company’s

hedge program for MSAs, one must ﬁrst under-

stand how MSAs perform. Duration, convexity,

and amortization are useful concepts that will be

reviewed as they relate to MSAs. Duration mea-

sures the change in the value of MSAs (or their

cash ﬂows) for a given change in interest rates.

Duration can be either positive or negative. An

asset with a positive duration, such as a ﬁxed-

income bond, tends to increase in value as inter-

est rates fall. Conversely, an asset with a nega-

tive duration, such as an MSA, tends to decrease

in value as interest rates fall.

Convexity measures the rate of change in an

instrument’s duration, or the nonlinearity of its

price/yield curve. Like duration, convexity can

be either positive or negative. An asset with a

positive convexity will rise more in value for a

given change in interest rates than it will fall if

interest rates move equally in the opposite direc-

tion. Conversely, an asset with a negative con-

vexity will decline more in value for a given

change in interest rates than it will increase in

value if interest rates move equally in the oppo-

site direction. Because of their prepayment char-

acteristics, MSAs and most other mortgage-

related assets are negatively convex within a

speciﬁed range of interest rates. Borrowers can

be expected to exercise their option to prepay a

loan at a time that is most disadvantageous to

the MSA holder.

MSAs are also an amortizing asset. When a

prepayment occurs, the loss of value is perma-

nent and cannot be recovered. The use of a

nonamortizing asset as a hedge would necessi-

tate an active hedge-management strategy to

adjust the position as the unamortized balance

of the MSAs declines. If the position is not

adjusted correctly, this strategy may expose

earnings and capital to additional risks that are

not within the scope of the company’s MSA

hedge program.

3070.0.6.9.4 Hedge Instruments

An effective MSA hedge instrument will pos-

sess characteristics that mitigate the interest-rate

and prepayment risks associated with MSAs

without assuming additional basis risk. Basis

risk measures how well changes in the value of

the hedge instrument correlate to changes in the

value of the MSA. An effective hedge should

also be reasonable in terms of transaction costs

and management’s time.

Several types of specialized derivative prod-

ucts have evolved to meet the needs of mort-

gage banking companies. Early MSA hedge

products were interest-rate-driven, utilizing zero-

coupon Treasury bonds or interest-rate swaps.

However, the basis risk of such hedges proved

to be excessive. Next came principal-only (PO)

and super-principal only (SPO) bonds, which

were prepayment-driven.

However, these prod-

ucts also proved ineffective due to geographic

basis risk, potential average-life mismatches,

additional capital requirements, and dissimilar

accounting treatment which led to accounting

losses.

MSA hedge products generally fall into three

categories: bond hedges, short-term option

hedges, and long-term option hedges. Bond

hedges use Treasury bonds, ‘‘plain vanilla’’

interest-rate swaps,interestamortizing rate swaps,

positive convexity swaps, POs, and SPOs. Bond

hedges may be either interest-rate-driven or

prepayment-rate-driven. Prepayment-rate-driven

products reduce more basis risk and are there-

fore more expensive. Although most bond hedges

are positively convex, they fail to provide enough

positive convexity to offset the negative convex-

ity in MSAs. In other words, when interest rates

decline, the value of the bond hedge will not

increase in an amount sufﬁcient to offset the

simultaneous decline in the MSAs. Another dis-

advantage to bond hedges is that the downside

17. A special class of REMIC securities backed by POs.

SPOs are a more leveraged type of PO.

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risk is generally unlimited.

Short-term option hedges consist of over-the-

counter (OTC) Treasury options, options on

futures contracts, and options on OTC mortgage

securities. Short-term option hedges generally

contain enough positive convexity to offset the

negative convexity of MSAs, and the downside

risk is limited to the option premium paid at

inception. However, option strategies using these

products require frequent rebalancing, are there-

fore expensive, and do not work well in a rap-

idly changing interest-rate environment because

they are not amortizing assets.

Long-term option hedges include prepayment

caps, interest amortizing rate (IAR) servicing

hedges, LIBOR ﬂoors, and swaptions. These

products may protect the servicer and/or seller

against changes in either interest rates or pre-

payments. As off-balance-sheet products, they

impose very few capital constraints on the MSA

holder.

A prepayment cap is an off-balance-sheet,

prepayment-driven option product that can be

used to hedge a mortgage-servicing portfolio. In

exchange for paying a fee, either up-front or

over the life of the hedge, the servicer and/or

seller receives a payment from the counterparty

every month that the option is ‘‘in the money.’’

The option is in the money if the difference

between the ‘‘strike balance’’ and the actual

balance of a ‘‘reference portfolio,’’ less the sum

of previous balance differences, is positive. Each

month the option is in the money, the counter-

party will pay the ‘‘strike price,’’ usually the

book cost of the servicing portfolio, multiplied

by this balance shortfall. The reference port-

folio, strike price, and strike balance can be

customized to match the servicer and/or seller’s

risk parameters and individual portfolio.

An IAR servicing hedge is an off-balance-

sheet, interest rate–driven option product that

can be used as either a revenue or a balance-

sheet hedge of a mortgage-servicing portfolio.

In exchange for paying a fee, either up-front or

over the life of the hedge, the servicer and/or

seller receives a series of payments from the

counterparty to the extent that amortization of a

‘‘reference balance’’ exceeds scheduled amorti-

zation of a ‘‘strike balance.’’ The main differ-

ence between an IAR and a prepayment cap is

that with an IAR, option payments are based on

the performance of a ‘‘reference portfolio’’ rather

than the seller and/or servicer’s actual portfolio.

For an IAR revenue hedge, the option payout is

based on the current balance shortfall between

the reference and strike balances. For an IAR

balance-sheet hedge, option payouts are based

on the cumulative excess amortization of the

reference balance over the strike balance. IAR

hedges are less expensive than comparable

prepayment-linked hedges because they contain

basis risk. If actual prepayments occur more

rapidly than predicted at the onset of the hedge,

the servicer and/or seller will be underhedged.

Numerous other types of customized hedge

products are available. The advantages and

disadvantages of each product should be well

understood before it is incorporated into a mort-

gage banking company’s interest-rate risk man-

agement strategies.

3070.0.6.10 Inspection Objectives

1. To determine whether MSAs pose a sig-

niﬁcant ﬁnancial risk to earnings and capital.

2. To evaluate management’s expertise and

the oversight provided by the board of directors.

3. To determine whether policies and proce-

dures used to initially record, amortize, and

reevaluate MSAs are in conformance with GAAP

and risk-based capital requirements, and whether

actual practice is consistent with stated policies

and procedures.

4. To verify that asset values are fairly stated.

5. To evaluate the methods used to hedge

interest-rate and prepayment risks associated

with MSAs, the degree of oversight provided by

management or the board of directors, the ade-

quacy of written policies and procedures, and

the effectiveness of the company’s hedge pro-

gram for MSAs.

6. To identify any excessive risk-taking which

is caused by the company’s business mix and/or

strategy.

3070.0.6.11 Inspection Procedures

1. Determine the extent of ﬁnancial risk asso-

ciated with MSAs through a review of the fol-

lowing:

a. Signiﬁcant changes in the size of the

servicing portfolio. Obtain a reconciliation for

the servicing portfolio for the prior ﬁscal year

and the most recent interim period. If signiﬁcant

growth has occurred, determine whether loans

were originated, purchased individually (on a

ﬂow basis), purchased in bulk transactions, or

acquired through whole company acquisitions.

If the portfolio size has declined, determine the

reason for such decline (sales of servicing rights,

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Page 43

prepayments) and the impact on the remaining

servicing portfolio.

b. The proportion of capitalized MSAs

relative to the outstanding principal balance of

mortgage loans in the servicing portfolio.

c. Other unusual characteristics of the ser-

vicing portfolio that may present undue risk,

such as the weighted average coupon rates,

weighted average maturities, delinquency char-

acteristics, or mix of government (FHA/VA)

loans versus conventional loans.

If the level of ﬁnancial risk is sufﬁcient to

place earnings and capital at risk, the examiner

should complete the remainder of the MSA

procedures.

2. Review the qualiﬁcations of the individu-

als who are responsible for initially recording,

amortizing and evaluating MSAs. Does manage-

ment possess the necessary accounting expertise

and experience with respect to valuation

methodologies?

3. Review the accounting systems used to

track MSAs. Is the necessary information being

maintained in an understandable and useable

form? Does the adoption of SFAS 65, as amended,

and 125 pose any system problems for the

company? Are such problems being addressed

in a timely manner? At a minimum, MSAs

should be tracked by product type and year

of origination. The following information should

be maintained for each pool of loans: the origi-

nal and current principal balance for each pool;

original and current book values of related MSAs;

prepayment speeds, normal servicing fees, and

the original discount rate used; and the actual

historical payment experience for each pool.

4. Review written policies and procedures

for initially recording, amortizing, and periodi-

cally revaluating MSAs. Determine the manage-

ment or board committees responsible for

approvalof such policies,the date of last approval,

and the frequency of their review.

5. Determine whether MSA policies and pro-

cedures are in conformance with GAAP and

risk-based capital requirements and whether

actual practice conforms with established poli-

cies and procedures. At a minimum, policies

and procedures should clearly address the fol-

lowing areas:

a. Initial valuation of MSAs and related

pricing policies. With respect to MSAs, policies

and procedures should describe the method for

allocating the total cost of originated and pur-

chased mortgage loans to the MSAs and the

related loans (without the MSAs) based on their

relative fair values at the date of origination or

purchase; procedures to be followed if a deﬁni-

tive plan for sale of the loans does not exist and

loans are sold at a later date; procedures to be

followed in the event that it is not practicable to

estimate the fair value of the MSAs and the

related loans (without MSAs); and MSAs

recorded under table funding relationships with

correspondents and/or brokers.

b. The method for amortizing MSAs over

the estimated lives of the assets, and instances

where amortization lives may be adjusted.

c. The method for measuring impairment

of capitalized MSAs based on their fair value.

Policies and procedures should address the basis

for stratiﬁcation of MSAs based on the risk

characteristics of the underlying loans; the types

of valuation allowances used to reﬂect changes

in the measurement of impairment; the method

used to arrive at the fair value of assets (quoted

market prices, estimated prices for similar assets,

and the results of valuation techniques); the

frequency of revaluation tests; the presentation

of valuation test results to senior management

and the board of directors; instances where

write-downs would be required; disclosures; and

the basis for assumptions used.

6. Verify that the valuation techniques for

measuring MSAs are consistent with the objec-

tive of measuring fair value. Review model

output and related manuals and/or marketing

materials. Evaluate the reasonableness of all key

parameters and assumptions, with an emphasis

on the source for prepayment speed estimates,

the number of interest-rate ‘‘paths’’ used (vec-

toring or binomial models being more desirable

than a single interest-rate projection path), the

basis for the interest rate used to discount cash

ﬂows, and the source of servicing revenue and

cost data.

7. Review the most recent quarterly valua-

tion process and the related output to determine

whether necessary write-downs or amortization

adjustments were made, management or board

oversight was adequate, and actual practice is

consistent with established policies and proce-

dures. Ensure that any signiﬁcant changes to the

model’s parameters and/or output are approved

by the appropriate management or board com-

mittee and that such changes are adequately

documented.

8. Verify that disclosures are accurate with

respect to the following:

• the fair value of capitalized MSAs

• the methods and signiﬁcant assumptions

used to estimate that fair value

• a description of MSAs for which no cost

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 44

has been allocated and the reasons why it is

not practicable to estimate the fair values of

those MSAs and the mortgage loans (with-

out the MSAs)

• the risk characteristics of the underlying

loans used to stratify capitalized MSAs for

the purposes of measuring impairment

• the activity in the valuation allowances for

capitalized MSAs, including the aggregate

balance of the allowances at the beginning

and end of each period; aggregate additions

charged and reductions credited to opera-

tions; and aggregate direct write-downs

charged against the allowances

9. Obtain a list of intercompany MSAs as of

the close of business for the most recent quarter-

end. Determine whether a valid business pur-

pose exists, the loans are actually sold, the en-

tity holding the MSAs has revalued the rights

correctly, and such intercompany MSAs are

eliminated in consolidation. If the purpose of

the transaction is merely to bolster capital levels

at the bank, the practice may constitute an

unsafe and unsound banking practice.

10. Review policies and practices regarding

the sale of MSAs and liabilities to investors.

11. If the company sells loans with recourse,

are recourse reserves established at the time of

sale? Are estimated losses factored into the

calculation of gain/loss on sale of loans?

12. Obtain an organizational chart to deter-

mine the individuals responsible for hedging

MSAs. Review biographies to ensure that staff

members responsible for this function are knowl-

edgeable regarding accounting guidance, hedge

products, and related strategies.

13. Review methods used to hedgethe interest-

rate and prepayment-rate risk associated with

MSAs. Verify the management or board com-

mittee responsible for approving hedge instru-

ments, the list of approved products, and the

frequency and date of last review.

14. Review management reports to deter-

mine the correlation between hedge instruments

and the underlying assets, the accounting treat-

ment for hedges, related gains and losses, and

the overall effectiveness of the company’s hedge

program. If hedge accounting treatment is being

used, management and/or the company’s exter-

nal accountants must perform the appropriate

level of due diligence and maintain adequate

supporting documentation. In determining the

effectiveness of the hedging program, the exam-

iner should compare the actual results of hedge

performance with the expected results.

15. Evaluate the quality of information that

is communicated to senior management, the

board of directors (if applicable), and the parent

company’s senior management and board of

directors to determine whether management and

directors are adequately informed regarding the

ﬁnancial risks associated with MSAs, amortiza-

tion methods and hedging techniques, and the

degree of risk inherent in the company’s strate-

gic focus and business mix with respect to the

projected volume of MSAs.

3070.0.7 INTERCOMPANY

TRANSACTIONS

A mortgage banking company that is organized

as a nonbank subsidiary of a bank holding com-

pany often sells assets to, receives funding from,

or services loans for its bank afﬁliates. Given

the trend toward managing mortgage banking

activities as a line function rather than by legal

entity, such intercompany transactions have

become an area of heightened supervisory

concern.

In general, sections 23A and 23B of the Fed-

eral Reserve Act are designed to prevent a bank

from being disadvantaged through the purchase

of low-quality assets from an afﬁliate, the pres-

sure to fund the majority of an afﬁliate’s working-

capital needs, and intercompany transactions

that either inadequately compensate the bank or

are not conducted on an arms-length basis.

3070.0.7.1 Section 23A of the Federal

Reserve Act

Section 23A was enacted as part of the Banking

Act of 1933 (the Glass-Steagall Act) for state

member banks and later extended to all feder-

ally insured banks.

Section 23A deﬁnes com-

panies that control or are under common control

with the bank as afﬁliates of the bank. For

example, the term ‘‘afﬁliates’’ includes bank

holding companies and their subsidiaries as well

as banks and nonbanking companies that are

under common individual control.

The two

18. As originally enacted, the Banking Act of 1933 cov-

ered only member banks. In 1966, Congress amended section

18(j) of the Federal Deposit Insurance Act, 12 U.S.C. 1828(j),

to extend the coverage of section 23A to include insured

nonmember banks. As a result, section 23A now applies to all

federally insured banks. (12 U.S.C. 371c)

19. Nonbank subsidiaries of banks, as opposed to nonbank

subsidiaries of bank holding companies, are not afﬁliates for

purposes of section 23A, unless the Board of Governors of the

Federal Reserve System determines otherwise. Banks that are

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BHC Supervision Manual June 1997

Page 45

primary aspects of section 23A—quantitative

restrictions and collateral requirements—are dis-

cussed next.

3070.0.7.1.1 Quantitative Restrictions

The quantitative restrictions imposed by sec-

tion 23A generally limit the aggregate amount

of so-called ‘‘covered transactions’’ to 10 per-

cent of the bank’s capital and surplus for trans-

actions with a given afﬁliate, and 20 percent of

the bank’s capital and surplus for transactions

with all of its afﬁliates.

Covered transactions

include—

• a loan or extension of credit by a bank to an

afﬁliate, such as a warehouse line of credit

provided to the afﬁliate;

• the purchase of or investment in securities

such as a privately issued MBS issued by an

afﬁliate;

• the purchase of assets from an afﬁliate, such

as a loan purchased either as an accommoda-

tion to a bank customer or for the bank’s

asset/liability management purposes;

• the acceptance by a bank of securities issued

by an afﬁliate as collateral for a loan or exten-

sion of credit by the bank to any person or

company (Securities might include either the

stock of a publicly held afﬁliate or the stock

from one of its ofﬁcer’s own business enter-

prises.); or

• the issuance by a bank of a guaranty, accep-

tance, or letter of credit, including an endorse-

ment or standby letter of credit, on behalf of

an afﬁliate (A letter of credit might be posted

by the bank to cover an excessive number of

GNMA pools that lack ﬁnal pool certiﬁca-

tion.).

The examiner should determine the bank’s

method for identifying covered transactions and

applying the quantitative limits for section 23A

purposes. If a covered transaction is found that

exceeds these quantitative limits, either on an

individual or an aggregate basis, an apparent

violation of section 23A has occurred. All such

apparent violations of law should be discussed

with management and cited in the report.

Particular attention should be paid to inter-

company asset transfers and funding arrange-

ments to determine whether they constitute cov-

ered transactions under section 23A. In

Interpretation 250.250 (12 C.F.R. 250.250)

the

Board determined that a member bank’s pur-

chase, without recourse, and at face value, of a

mortgage note, or a participation therein, from a

mortgage banking subsidiary of the parent bank

holding company, which had no ﬁnancial inter-

est in the underlying asset on which it had

granted credit through the note, did not involve

a ‘‘loan’’ or ‘‘extension of credit’’

from the

member bank to the seller of the mortgage note

within the meaning of section 23A if—

• the member bank’s commitment to purchase

the loan or participation therein was obtained

by the afﬁliate within the context of a pro-

posed transaction or series of proposed trans-

actions in anticipation of the afﬁliate’s com-

mitment to make such loan(s),

• the commitment to purchase the loan was

based on the bank’s independent credit evalu-

ation of the creditworthiness of the mortgag-

or(s),

and

• there could be no blanket advance commit-

ment by the member bank to purchase a stipu-

lated amount of loans that bore no reference

to speciﬁc proposed transactions. Accord-

ingly, the nonbank afﬁliate must have ade-

quate and independent working capital to fund

its operations.

The Board stated that if the bank followed

these procedures, then the bank would be taking

advantage of an individual investment oppor-

tunity and thus should be exempt from sec-

tion 23A. However, the Board was concerned

that the bank should not be allowed to set up a

business relationship with any afﬁliate which

could create the opportunity for the bank, at

some time in the future, to engage in unsafe

transactions because the bank felt impelled by

an improper incentive to alleviate the working-

capital needs of the afﬁliate. Accordingly, the

bank’s transactions with the afﬁliate should not

be of such a volume as to create pressure on the

bank to relax its sound credit judgment concern-

ing the individual loans involved and thereby

part of a chain banking organization are subject to the restric-

tions of section 23A.

20. For section 23A purposes, the deﬁnition for capital and

surplus includes the allowance for loan and lease losses.

21. See also Federal Reserve Regulatory Service, 3–1133.

22. Under section 23A, as amended by the Garn–St Germain

Act in 1982, a member bank’s purchase of a loan from its

nonbank afﬁliate that was made to an unafﬁliated party is now

considered a purchase of an asset from the afﬁliate unless it is

excepted under interpretation 250.250.

23. Dual employees may not be used to satisfy the indepen-

dent credit evaluation requirement.

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BHC Supervision Manual June 1997

Page 46

result in an inappropriate risk to the soundness

of the bank.

3070.0.7.1.2 Collateral Requirements

In addition to the quantitative restrictions, cer-

tain covered transactions between a bank and an

afﬁliate must also be secured at the time of the

transaction by collateral having a certain market

value. Unless otherwise exempted, covered trans-

actions that must be adequately secured include

loans or extensions of credit, guaranties, accep-

tances, and letters of credit issued on behalf of

the afﬁliate.

Collateralization requirements range from

100 percent to 130 percent depending on the

type of collateral used. Acceptable forms of

collateral include U.S. government or U.S.

government–guaranteed obligations, instru-

ments that are acceptable at the Federal Reserve’s

discount window, bank deposits that are segre-

gated into accounts speciﬁcally earmarked for

this purpose, other debt instruments, stock, leases,

or other real or personal property. According to

an August 31, 1987, Board interpretation (at

FRRS 3–1164.3), mortgage-servicing rights do

not constitute a permissible form of collateral

for purposes of section 23A because of (1) their

inherent volatility, making it difﬁcult to accu-

rately value the rights, and (2) the need to secure

permission to transfer servicing rights from the

legal owner of the underlying mortgage.

An example of a covered transaction that is

subject to both the quantitative restrictions and

the collateral requirements of section 23A would

be an overdraft in the mortgage company’s

checking account with an afﬁliate bank, which

is considered an extension of credit. A line of

credit by a bank to a nonbank afﬁliate also

constitutes a covered transaction. It is important

to remember that the full value of the line, not

just the portion drawn down, must satisfy the

quantitative and the collateral requirements of

section 23A at all times. The examiner should

review checking accounts and funding arrange-

ments to ensure that the appropriate level and

type of collateral is maintained. Collateral val-

ues should be monitored regularly so that depre-

ciated or matured collateral is replaced as needed.

3070.0.7.1.3 Prohibited Transactions

In addition to the quantitative and collateral

requirements, section 23A also prohibits certain

afﬁliate transactions altogether. Most impor-

tantly, a bank and its subsidiaries may not pur-

chase a low-quality asset (generally a classiﬁed

or past-due asset) from an afﬁliate or accept a

low-quality asset as collateral for a loan. Sec-

tion 23A also requires that all covered transac-

tions be conducted on terms that are consistent

with safe and sound banking practices.

3070.0.7.1.4 Exemptions from

Section 23A of the FRA

As mentioned previously, several types of inter-

company transactions are exempted from the

requirements of section 23A. For example, trans-

actions between banks in which 80 percent or

more of each bank’s stock is owned by the same

bank holding company (so-called ‘‘sister banks’’)

are exempt from most provisions of sec-

tion 23A.

Other transactions that are exempt

include the following:

• deposits received from the afﬁliate during the

ordinary course of business (checks in the

process of collection)

• immediate credit given to an afﬁliate for

uncollected items received in the ordinary

course of business

• loans, extensions of credit, guaranties, accep-

tances, or letters of credit issued on behalf of

the afﬁliate that are fully secured by obliga-

tions issued or guaranteed by the U.S. govern-

ment or a segregated earmarked account in

the bank

• the purchase of assets having a readily and

identiﬁable market price at the time of pur-

chase

• transactions that are deemed to be in the pub-

lic interest and consistent with the purposes of

the act

Internal controls should be in place to ensure

24. Item (2) refers to the bank’s ability to sell the mortgage-

servicing rights if the afﬁliate defaults on its loan.

25. Foreign banks do not qualify as sister banks for sec-

tion 23A purposes. These transactions are still subject to the

prohibition against the purchase of low-quality assets and to

the requirement that covered transactions be on terms and

conditions that are consistent with safe and sound banking

practices. It should also be noted that federal savings banks do

qualify for the sister-bank exemption if all banks in the

corporate chain have met their fully phased-in capital guide-

lines, as provided for in the Home Owner’s Loan Act.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 47

that all transactions are adequately reviewed.

Documentation should be maintained for inter-

company transactions that are exempted from

the requirements of section 23A.

3070.0.7.2 Section 23B of the Federal

Reserve Act

The Competitive Equality Banking Act of 1987

amended the Federal Reserve Act to add a new

provision, known as section 23B. In general,

section 23B provides that covered transactions

between a bank and its afﬁliates must be on

terms and under circumstances, including credit

standards, that are substantially the same or at

least as favorable to the bank as those prevailing

at the time for comparable transactions with or

involving nonafﬁliated companies. If no compa-

rable transactions exist, the transaction must be

on terms and under circumstances, including

credit standards, that in good faith would be

offered to or applied to nonafﬁliated companies.

A bank is also generally prohibited from pur-

chasing as a ﬁduciary securities or assets from

an afﬁliate except under speciﬁed circum-

stances. Finally, a bank and its afﬁliate may not

advertise or enter into an agreement that sug-

gests the bank is in any way responsible for the

obligations of the afﬁliate.

Section 23B applies to any covered transac-

tion with an afﬁliate, as that term is deﬁned in

section 23A. However, section 23B excludes

banks from the term ‘‘afﬁliate.’’ Therefore, trans-

actions between sister banks and banks that are

part of a chain banking organization are exempt

from section 23B.

3070.0.7.3 Management and Service Fees

The Federal Reserve System’s 1979 policy state-

ment on diversion of bank income practices is

intended to prevent excessive or unjustiﬁable

management or service fees, as well as any

other unwarranted payments or practices that,

by diverting bank resources to the parent com-

pany or a nonbank afﬁliate, may have an ad-

verse ﬁnancial impact on a subsidiary (paying)

bank (see section 2020.6). Diversion of income

practices with respect to a mortgage banking

company might potentially include, but are not

limited to—

• servicing fees, or other payments assessed by

the mortgage banking company and paid by

the bank that bear no reasonable relationship

to the fair market value, cost, volume, or

quality of services rendered by the nonbank

subsidiary in its role as servicer and/or seller;

• balances maintained by the bank primarily in

support of mortgage banking company bor-

rowings without appropriate compensation to

the bank;

• prepayment of fees to the mortgage banking

company for services not yet rendered;

• nonreimbursed origination fees, marketing

costs, or other expenses incurred by the bank

that primarily support the mortgage banking

company’s activities; and

• loan repurchase agreements between the bank

and the mortgage banking company while the

mortgage banking company is processing loans

in the mortgage pipeline.

Purchase and funding agreements should ade-

quately itemize and document the types of ser-

vices provided and the basis for fees. Billing

statements and other documentation should

clearly evidence that fees actually charged and

paid are reasonable and consistent with regula-

tory policy requirements as described.

3070.0.7.4 Tie-In Considerations of the

BHC Act

Section 106 of the BHC Act Amendments of

1970 contains ﬁve restrictions intended to pro-

hibit anticompetitive behavior by banks: two

prohibit tying arrangements; two prohibit reci-

procity arrangements; and one prohibits exclu-

sive dealing arrangements.

The tying restric-

tions, which have the greatest effect on industry

practices, prohibit a bank from restricting the

availability or varying the consideration for one

product or service (the tying product) on the

condition that a customer purchase another prod-

uct or service offered by the bank or by any of

its afﬁliates (the tied product).

Section 106 was adopted in 1970 when Con-

gress expanded the authority of the Board to

approve proposals by bank holding companies

to engage in nonbanking activities. The provi-

sions of section 106 were based on congressio-

nal concern that banks’ unique role in the econ-

omy, in particular their power to extend credit,

would allow them to create a competitive advan-

tage for their afﬁliates in the new, nonbanking

markets that they were being allowed to enter.

26. 12 U.S.C. 1972.

27. See S. Rep. No. 1084, 91st Cong., 2d Sess. (1970).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1998

Page 48

Congress therefore imposed special limitations

on tying by banks—restrictions beyond those

imposed by the antitrust laws. Section 106 is a

broader prohibition; unlike the antitrust laws, a

plaintiff in action under section 106 need not

show that (1) the seller has market power in the

market for the tying product, (2) the tying ar-

rangement has had an anticompetitive effect in

the market for the tied product, or (3) the tying

arrangement has had a substantial effect on in-

terstate commerce.

Section 106 applies only when a bank offers

the tying product.

The Board has authority to

grant exceptions to section 106, which it has

used to allow banking organizations to package

their products when doing so would beneﬁt the

organization and its customers without anticom-

petitive effects.

3070.0.7.4.1 Section 225.7(d) of

Regulation Y

The Board originally extended section 106, which

covers tying arrangements by banks only, to

cover nonbank afﬁliates and bank holding com-

panies. The Board rescinded this extension of

the statute effective April 21, 1997. Thus, unless

subject to another exemption, section 106

prohibits—

• a bank from telling a customer that it can only

receive a loan (or a discount thereon) if it

purchases another product from the bank; and

• a bank from telling a customer that it can only

receive a loan (or a discount thereon) if it

purchases another product from an afﬁliate of

the bank.

Section 106 and the Board’s regulation allow—

• a broker-dealer afﬁliate to tell a customer that

it can only receive placement services (or a

discount thereon) if it obtains a loan from an

afﬁliated bank; and

• a broker-dealer afﬁliate to tell a customer that

it can only receive placement services (or a

discount thereon) if it obtains a loan from a

nonbank afﬁliate.

These distinctions make sense if one keeps in

mind the concern of the statute: banks (not

nonbanks) have special power over credit and,

thus, are able to induce or coerce their custom-

ers into purchasing products that they would

otherwise prefer not to purchase or to purchase

from someone else.

3070.0.7.4.2 Interafﬁliate Tying

Arrangements Treated the Same as

Intrabank Arrangements

Section 106 contains an explicit exception (the

statutory traditional bank product exception)

that permits a bank to tie any product or service

to a loan, discount, deposit, or trust service

offered by that bank.

For example, a bank

could condition the use of its messenger service

on a customer’s maintaining a deposit account

at the bank. Although the statutory traditional

bank product exception appears to have been

effective in preserving traditional relationships

between a customer and bank, the exception is

limited in an important way—it does not extend

to transactions involving products offered by

afﬁliates.

The Board has adopted a regulatory tradi-

tional bank product exception that extends the

statutory exception to transactions involving

afﬁliates.

Although the Board has previously

limited the scope of this extension, interafﬁliate

arrangements are now exempt to the same extent

as intrabank arrangements.

3070.0.7.4.3 Foreign Transactions Under

Section 106

The Board has adopted a ‘‘safe harbor’’ from

the anti-tying rules for transactions with corpo-

rate customers that are incorporated or other-

wise organized and that have their principal

place of business outside the United States, or

with individuals who are citizens of a foreign

country and are not resident in the United States.

However, the safe harbor would not protect

tying arrangements in which the customer is a

U.S.-incorporated division of a foreign com-

pany. Furthermore, the safe harbor would not

28. See 1997 FRB 275.

29. The Board’s rule also includes a limited prohibition on

tying arrangements involving electronic beneﬁt transfer ser-

vices (12 C.F.R. 225.7(d)).

30. 12 U.S.C. 1972(1)(A).

31. See 12 C.F.R. 225.7(b)(1).

32. A similar action was taken for interafﬁliate reciprocity

arrangements, in which section 106 permits a bank to condi-

tion the availability of a product or service on the customer’s

providing to the bank some product or service ‘‘related to and

usually provided in connection with’’ a loan, discount, deposit,

or trust service (12 U.S.C. 1972(1)(C)).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1998

Page 49

shelter a transaction from other antitrust laws if

they were otherwise applicable.

3070.0.7.4.4 Technical Change

The Board also has adopted a deﬁnition of

‘‘bank’’ for purposes of the anti-tying rules. The

deﬁnition clariﬁes that any exemptions afforded

to banks generally also would be applicable to

credit card and other limited-purpose institu-

tions and to U.S. branches and agencies of for-

eign banks.

3070.0.7.5 Inspection Objective

1. To evaluate transactions between a mort-

gage banking company organized as a direct

subsidiary of a bank holding company and afﬁli-

ated banks for compliance with federal laws and

regulations, and related policy guidance.

3070.0.7.6 Inspection Procedures

1. Review management’s method for moni-

toring and identifying section 23A and 23B

covered transactions and applying the quantita-

tive limitations. Determine whether—

a. all covered transactions have been iden-

tiﬁed;

b. quantitative limits are calculated cor-

rectly;

c. covered transactions, including any

overdrafts and lines of credit, meet both the

quantitative limits and collateral requirements

of section 23A; and

d. adequate collateral values have been

maintained over the life of the covered transac-

tions (For example, collateral is maintained for

the full amount of any credit lines with the

bank, and any depreciated or matured collateral

has been replaced as required.).

2. Review purchase and funding contracts

between the mortgage banking company and the

bank, as well as the substance of actual transac-

tions, to determine that—

a. asset purchases by the bank are either

within the quantitative limits of section 23A or

meet the exemption requirements of C.F.R. sec-

tion 250.250,

b. all purchases are at fair market value

and consistent with market terms as required by

section 23B,

c. no low-quality assets were transferred

to the bank since the previous inspection,

d. the method of compensating the bank

for balances maintained and net interest income

earned on warehouse loans or lines is reason-

able and based on market terms.

3. Review servicing contracts between the

mortgage banking company and the bank, as

well as the substance of actual transactions, to

determine—

a. the capacity in which the afﬁliate is

acting (for example, is it acting as principal on

its own behalf or as an agent for the afﬁliate

bank?);

b. the nature of all services provided; and

c. billing arrangements, the frequency of

billing, the method of computation, and the

basis for such fees.

4. Review the bank holding company’s pol-

icy statement on the prohibition of tie-in

arrangements, the adequacy of training provided

to employees, and whether its respective subsid-

iaries are in full compliance with internal policy.

3070.0.8 REGULATION Y

COMPLIANCE

During the course of the on-site inspection, the

examiner is expected to conduct sufﬁcient tests

and inquiries to determine whether the company

is in compliance with Regulation Y and the act.

Such tests and inquiries would include a listing

of company ofﬁces which can be compared

with the approved ofﬁces, comparisons of credit-

related insurance policies and rate schedules

against stipulated public beneﬁts cited in Board

orders, and reviews of various activities for

technical compliance.

While not speciﬁcally detailed in this guid-

ance, the examiner may ﬁnd it necessary to

conduct a review of the company’s ledgers and

accounts that is sufﬁcient to disclose possible

impermissible activities and potential violations

of law. The audit function, both internal and

external, should not be solely relied on for this

disclosure because the auditor’s program may

emphasize other areas of concern. As a nonbank

subsidiary of a bank holding company, refer-

ence should be made to part 225 of the Code of

Federal Regulations (such as section 225.28(b)

of Regulation Y) and other relevant sections

thereof.

Concurrent with the review of assets for credit

quality, the examiner should undertake a review

33. See 12 C.F.R. 225.7(b)(3).

34. See 12 C.F.R. 225.7(e).

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 2000

Page 50

of asset-related activities for compliance with

the subsidiary’s approval orders. In mortgage

banking ﬁrms, it is possible that the company is

engaging unknowingly in certain impermissible

activities, such as those described by 12 C.F.R.

225.126 (i.e., real estate brokerage, land devel-

opment, real estate syndication, and property

management) and those deemed impermissible

by Board order (see sections 3000.0.4 and 3700.0

to 3700.12). The Board of Governors has ruled

(1972 FRB 429) that the purchase and develop-

ment of land for sale to third parties constitutes

land development by a nonbank subsidiary. How-

ever, the completion of a foreclosed property to

facilitate the recovery of funds advanced under

the loan appears to be permissible, provided that

the additional work brings the project underway

at foreclosure up to a saleable condition. The

Board has also ruled that property management

for third parties is impermissible (1972 FRB

652). However, property management as a ﬁdu-

ciary, for operating premises of afﬁliates, or for

properties acquired for debts previously con-

tracted (DPC) is permissible. In addition to the

other impermissible activities, engaging in real

estate joint ventures has also been ruled imper-

missible. If such impermissible activities are

found, they represent violations and should be

appropriately treated. The servicing agreements

should be reviewed to determine that no addi-

tional liabilities, real or contingent, are imposed

on the company beyond its responsibilities as a

servicing agent.

The usual source of growth in the servicing

portfolio is the company’s own origination

activity. However, it is not uncommon for a

company to supplement this growth with bulk

purchases of serviced mortgages from other

companies. Under certain circumstances, usu-

ally relating to the relative percentage of the

seller’s portfolio, these transactions may not

comply with 12 C.F.R. 225.132. Since these

transactions may represent the effective acquisi-

tion of a going concern subject to prior approval

by the Federal Reserve System, ‘‘servicing port-

folio’’ acquisitions should be reviewed for

compliance.

Section 225.22(d)(1) of Regulation Y pro-

vides an exemption from required Board ap-

proval for DPC property acquired in good faith

and divested within two years of acquisition.

The Board may permit additional extensions

that can result in the property being held by a

bank holding company for a total of 10 years, if

the property has value and marketability charac-

teristics similar to real estate. In conjunction

with the review of real estate owned, the exam-

iner should determine if any subsidiary holds

title to any property that should have been dis-

posed of within the time limits of Regulation Y,

the book value of which has been reduced to

zero and the property is not disclosed on the

balance sheet. See section 3030.0 ‘‘Acquisition

of DPC Shares or Assets,’’ for additional infor-

mation on DPC property acquired.

Legal counsel representing a BHC requested

an opinion as to whether certain proposed ﬂood

zone–determination activities, to be conducted

through a majority-owed (50 percent) joint ven-

ture company, would be within the scope of

activities related to extending credit as deﬁned

in section 225.28(b)(2) of Regulation Y. The

BHC proposes to engage in a variety of lending-

related activities, including providing real estate

appraisals and ﬂood zone determinations.

The Board has determined, in section

225.28(b)(2) of Regulation Y, that it is permis-

sible for bank holding companies to engage in

‘‘[a]ny activity usual in connection with mak-

ing, acquiring, brokering, or servicing loans or

other extensions of credit, as determined by the

Board.’’

(See 12 C.F.R. 225.28(b)(2).) The

Board also determined by regulation that per-

forming real estate appraisals is an activity that

is usual in connection with making, acquiring,

brokering, or servicing loans or other extensions

of credit. (See 12 C.F.R. 225.28(b)(2)(i).) The

Board had not speciﬁcally addressed whether

providing ﬂood zone determinations is an activ-

ity that is usual in connection with lending

activities.

The proposed ﬂood zone–determination ser-

vices are considered to be a necessary aspect of

mortgage lending in the United States. As noted,

federal law prohibits a federally regulated lender

from making, increasing, extending, or renew-

ing a loan that is secured by improved real

estate or a mobile home located in an area

35. The Gramm-Leach-Bliley Act (the GLB Act) amended

the Bank Holding Company Act to limit bank holding compa-

nies that are not ﬁnancial holding companies to engaging only

in ‘‘activities which had been determined by the Board by

regulation or order under this paragraph as of the day before

the date of the enactment of the Gramm-Leach-Bliley Act on

November 12, 1999, to be so closely related to banking as to

be a proper incident thereto (subject to such terms and condi-

tions contained in such regulation or order, unless modiﬁed by

the Board)’’ (12 U.S.C. 1843(c)(8)). Before November 12,

1999, the Board had determined that ‘‘[a]ny activity usual in

connection with making, acquiring, brokering, or servicing

loans or other extensions of credit, as determined by the

Board’’ was closely related to banking. Accordingly, the

Board retains authority after the GLB Act to deﬁne the scope

of this section 4(c)(8) activity and to modify the terms and

conditions that apply to the activity.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 2000

Page 51

designated by the Federal Emergency Manage-

ment Agency (FEMA) as a special ﬂood hazard

area unless the borrower obtains ﬂood insur-

ance.

(See 12 C.F.R. 208.25(c).) Further, fed-

eral law also provides that if a federally regu-

lated lender determines, at any time during the

life of a loan, that the improved real estate or

mobile home securing the loan is located in a

special ﬂood hazard area and is not covered by

ﬂood insurance, the lender must instruct the

borrower to obtain ﬂood insurance and must

purchase ﬂood insurance on the borrower’s behalf

if the borrower fails to promptly purchase the

required insurance. (See 12 C.F.R. 208.25(g).)

In addition, federal law requires the Federal

National MortgageAssociation, the FederalHome

Loan Mortgage Corporation, and the Govern-

ment National Mortgage Association (the

government-sponsored enterprises or GSEs) to

have procedures reasonably designed to ensure

that ﬂood insurance is in place where required at

the initiation of, and during the lives of, the

mortgage loans they purchase. (See 12 U.S.C.

4012a(b).) The GSEs meet this requirement by

requiring lenders that sell loans to them, and

companies that service loans for them, to moni-

tor on an ongoing basis the ﬂood zone status of

any loans sold to, or serviced for, the GSEs. To

comply with the requirements of federal law

and the GSEs, mortgage lenders must obtain an

initial ﬂood zone determination before the origi-

nation of each mortgage loan and must take

steps to monitor, throughout the life of the loan,

the ﬂood zone status of any improved real estate

or mobile home collateral securing the loan.

The joint venture company proposes to pro-

vide initial ﬂood zone determinations to mort-

gage lenders and to provide mortgage lenders

with ongoing ﬂood zone–tracking services with

respect to their mortgage loans. The company’s

activities would be limited to making determina-

tions as to whether particular parcels of real

estate are in designated ﬂood zones, preparing

the FEMA standard ﬂood zone–determination

form, and communicating ﬂood zone determina-

tions to customers. The company committed to

not be involved in placing, underwriting, or

issuing ﬂood insurance or in the collection of

ﬂood insurance premiums. The proposed ﬂood

zone determinations would be provided in con-

nection with providing real estate appraisals and

as a separate service. In addition, the joint ven-

ture company may assist customers who wish to

request that FEMA amend its ﬂood maps to

remove a property from a designated special

ﬂood hazard area.

The proposed ﬂood zone–determination ser-

vices were found to be an essential part of

mortgage lending, designed to assist mortgage

lenders in complying with the requirements of

federal law and the GSEs. The services gener-

ally would be provided to mortgage lenders,

thus usual in connection with making mortgage

loans. Board staff therefore issued the opinion

on July 9, 2002, concluding that the proposed

ﬂood zone–determination services are within the

scope of permissible activities related to extend-

ing credit under section 225.28(b)(2) of Regula-

tion Y (12 C.F.R. 225.28(b)(2)).

3070.0.9 ON-SITE INSPECTION OF

MORTGAGE BANKING

SUBSIDIARIES

Scheduling of on-site inspections of mortgage

banking nonbank subsidiaries of bank holding

companies should be done in accordance with

the Board policy for frequency and scope of

inspections. (See section 5000.0.2.) After review-

ing the material available at the parent company

level, including the audit review, a decision

whether or not to go on-site is in order. Some of

the determinants of this decision would include

relative size, current earnings performance, over-

all contribution to the corporation’s condition,

asset quality as indicated by nonaccrual and

delinquency reports, the level of risk exposure

to the organization (see section 4030.2), and the

condition of the company when last inspected.

From the information provided, it might be

determined that the company is operating prop-

erly and is in sound condition. In such a case, an

on-site inspection may not be warranted.

36. Statutory authority to issue ﬂood insurance policies

under the National Flood Insurance Program (NFIP) expired

on December 31, 2002, after Congress adjourned without

extending the FEMA authority. On January 13, 2003, the

National Flood Insurance Program Reauthorization Act was

approved, extending the authorization of the NFIP to Decem-

ber 31, 2003; this authorization was also made retroactive to

December 31, 2002.

37. Lenders are speciﬁcally permitted to charge a reason-

able fee to borrowers for ﬂood zone determinations and

life-of-the-loan tracking. For example, see 12 C.F.R. 208.25(h).

38. It was represented that the joint venture company

would only market its services to mortgage lenders and that it

would rarely provide services to nonlenders.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 2003

Page 52

Conversely, a deteriorating condition might be

detected that would require a visit, even though

a satisfactory condition had been determined

during the previous inspection. Mortgage sub-

sidiaries in unsatisfactory condition should be

inspected each time the parent company is

inspected. All signiﬁcant mortgage banking sub-

sidiaries should be fully inspected at least once

every three years.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 2003

Page 53

3070.0.10 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Loans to afﬁliates

section 23A of the FRA

371c

Restrictions on 371c

transactions with

afﬁliates

371c

Purchase of afﬁliate’s notes

from a third party

3–1131

Activities not closely

related to banking

225.126 4–184

Acquisition of assets 225.132 4–175.1

Purchase by member bank

of loans originated by a

mortgage banking ﬁrm

250.250 3–1133

Mortgage companies

acquired under sections

4(c)(1) or 4(c)(8) of the act

225.122 4–196

Activities closely related

to banking

225.131 4–176

Investments in community

welfare projects

225.127 4–178

Staff opinion on engaging in

certain proposed ﬂood

zone–determination activities

225.28(b)(2) 4–318.4

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 2003

Page 54

3070.0.11 APPENDIX A—FIRST DAY LETTER

June 15, 19x9

Mr. John Doe

President

XYZ Mortgage Bank Corporation

Boston, Massachusetts 02107

Dear Mr. Doe:

In conjunction with the inspection of the XYZ Bank Holding Company, we plan to begin an

inspection of XYZ Mortgage Bank Corporation on July 15, 19x9. To facilitate this inspection,

please provide a copy of or make available the following information relative to your organization’s

mortgage banking activities. Information should be as of xx/xx/xx and should be delivered to the

examiner-in-charge as soon as it is available. Whenever possible, standardized management reports

should be provided. Please include the name and telephone extension of the appropriate persons to

contact, by department, if additional information is necessary.

Board Oversight and Management

1. Provide a listing of the mortgage banking company’s board of directors that includes each

individual’s name, place of employment, title and position, age, management responsibilities (if

any), and the length of time he or she has served on the board.

2. List signiﬁcant management and board committees and have minutes from these meetings

available for examiner review. Provide a copy of standardized reports that are provided before

each meeting.

3. Provide an organizational chart that highlights individuals who are responsible for the follow-

ing functional areas: production, warehousing and funding, marketing, servicing, ﬁnance,

mortgage-servicing asset (MSA) valuations, internal audit, quality control, loan review, compli-

ance, and legal. Include biographies and salary information.

4. Describe any organizational changes that have taken place at the mortgage banking company

since xx/xx/xx, including any mergers, acquisitions, or consolidation of mortgage banking

activities. Describe any management changes at or above the senior vice president level and

provide details on management’s new responsibilities.

5. Provide a copy of standardized management reports that are used to monitor compliance with

established policies, operating procedures, and controls within each functional area.

6. Provide a copy of the mortgage banking company’s most recent operating budget and its

long-term strategic plan. Evaluate how interest-rate movements, competition, and other external

factors have affected product mix, stafﬁng levels, and the allocation of capital.

7. Describe the internal control environment and the internal control programs that are in place

within the mortgage banking company. Have available for examiner review the following

reports that were conducted since xx/xx/xx:

a. internal and external audits

b. loan reviews

FEDERAL RESERVE BANK

OF BOSTON

P. O. BOX 2076

BOSTON, MASSACHUSETTS 02106-2076

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 55

c. internal control and compliance audits completed by or on behalf of agencies such as HUD,

FHA, GNMA, FannieMae, FHLMC, state agencies, and private investors

Also have available management’s response to each report and the most recent copy of any

management reports that monitor the status of outstanding issues or problems.

8. Provide an organization chart for the internal audit department. Indicate the scope and

frequency of internal audits for the mortgage banking company, highlighting any weaknesses or

problem areas noted. Upon request, make internal audit workpapers available for examiner

review.

9. Provide an organization chart for the loan review department. Indicate the scope and frequency

of loan reviews for the mortgage banking company, highlighting any weaknesses or problem

areas noted. Upon request, make loan review workpapers available for examiner review.

10. Provide details on the nature and scope of the quality control program for loans originated

and/or serviced for investors. Include an organization chart for the unit(s) involved in such

activities, details on any outsourcing programs used since the previous inspection, copies of

quality control reports submitted to senior management, and management responses.

11. Describe the method for ensuring compliance with state and federal laws and regulations. Make

available for examiner review the procedures manual, work programs, and workpapers com-

piled by the person/department responsible for compliance.

12. Describe the insurance coverage in effect for the mortgage banking company and its ofﬁcers

and the date it was last reviewed by the board of directors.

13. Recap all mortgage banking–related legal claims/lawsuits in excess of $1 million. Indicate the

nature of any legal reserve that is maintained and the method used to assess reserve adequacy.

14. Describe the system for logging, tracking, and responding to customer complaints. The

customer complaint ﬁle should be made available for examiner review while on-site.

15. Provide a copy of the disaster recovery plan and describe safeguards in place to protect loan

documents and data processing input records.

Production and Correspondent Lending Data

16. Provide detailed organization charts for departments within the company which relate to the

production function (i.e., retail originations, wholesale purchases, processing, underwriting,

closing, shipping).

17. Provide information on the total number and dollar amount of loans generated by the following

sources during the two most recent ﬁscal years and the interim year-to-date period. For

purchased loans, please specify the method of purchase (i.e., bulk versus ﬂow), program name,

and amount subject to recourse back to either the seller or the investor):

a. originated by the mortgage banking company

b. purchased from afﬁliates

c. purchased from nonafﬁliated third parties

18. Provide written policies and procedures manuals that describe traditional and nontraditional

mortgage products, underwriting standards, closing and funding procedures, exception report-

ing practices, management and employee compensation methods, and training programs for

loan production personnel. State methods used to establish ongoing compliance with written

policies and procedures and provide copies of relevant management exception reports.

19. Describe the credit approval process used for in-house originations. Include information on rate

commitment options extended to the borrower, the average length of the commitment period,

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 56

controls that are in place to monitor fallout caused by processing backlogs, and procedures for

expired commitments.

20. Provide details on the correspondent lending program, including a list of approved institutions

and copies of the most recent loan-quality reports. Describe the credit review process before

purchase and any controls that are in place to protect the mortgage banking company against

future losses on loans purchased from afﬁliates and from correspondents.

21. Determine whether rate-locks are provided to correspondents on best effort production pro-

grams. What methods are used to verify reported loan fallout?

22. Provide information on the average income and cost per origination and compare with industry

standards. Describe the method of accounting used for origination fees and other related

noninterest income and expenses.

23. If the mortgage banking company is a subsidiary of a state member bank or sells loans to a bank

afﬁliate that is subject to Regulation O, furnish a list of extensions of credit to ‘‘an executive

ofﬁcer, director, or principal shareholder’’ (as deﬁned in section 215.2 of Regulation O) of—

a. the state member bank;

b. a bank holding company of which the state member bank is a subsidiary;

c. any other subsidiary of that bank holding company;

d. a company controlled by an insider, as deﬁned by Regulation O; and

e. a political or campaign committee that beneﬁts or is controlled by an insider as deﬁned by

Regulation O.

For all such extensions of credit, include the amount, date the loan(s) was originated or

renewed, interest rate, collateral requirements, total amount of loans outstanding to that

individual or company, and date of approval by the board of directors. Also include the

aggregate amount of loans outstanding to all such insiders as of the inspection date in relation to

the bank’s unimpaired capital and unimpaired surplus as deﬁned in Regulation O. (See

subsection 2050.0.3.2.)

Marketing and Hedging Data

24. Provide detailed organization charts for departments within the company that relate to the

marketing and hedging functions. Describe management’s roles and responsibilities with

respect to the sale of loans in the secondary market, asset securitization, funding, liquidity risk

management, interest-rate risk management, and interaction with the asset/liability management

function at the parent company.

25. Provide a copy of written policies and procedures used to hedge interest-rate risk associated

with the pipeline and closed-loan warehouse. Describe any parameters and limits that are in

place and provide a list of securities dealers with whom management is authorized to conduct

business.

26. Provide management reports on pipeline and closed-loan (warehouse) inventory volume, mix,

yield, age, and turnover as of the inspection date. Describe the method used to project fallout

and any models that are used to determine the sensitivity of the pipeline to interest-rate

ﬂuctuations.

27. Indicate the methods used to securitize loans for sale in the secondary market, including the use

of third-party guaranties and other forms of credit enhancement. Are securities generally sold or

retained on the balance sheet?

28. Provide information on the number and volume of securities that lacked ﬁnal pool certiﬁcation

as of the inspection date. State whether this volume is in compliance with investor guidelines. If

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 57

applicable, indicate whether the requirements for obtaining a letter of credit or other guaranty

have been satisﬁed.

Servicing Data

29. Provide a detailed organization chart for the servicing department.

30. List subservicers and vendors who are employed to perform servicing functions. Brieﬂy

describe the nature of the services provided.

31. Indicate whether any contracts with subservicers and/or vendors have been terminated for cause

since the prior inspection.

32. Provide the monthly servicing management reports since the prior inspection, including the

number of loans serviced, dollar volume, and composition of the servicing portfolio in terms of

product mix, average loan size, weighted average coupon rates, weighted average maturities,

geographic location, and delinquencies and foreclosures.

33. Provide a list of investors for whom servicing was performed as of the most recent quarter-end.

Identify any recourse or repurchase provisions and/or forbearance requirements.

34. State whether any investors have terminated servicing contracts with the mortgage company

and/or its afﬁliates for cause since the prior inspection, or if any are likely to be terminated in

the near future.

35. Provide a list of all major bulk purchases and sales of servicing since the prior inspection.

Identify the terms of each sale and any resulting gains or losses.

36. Provide a list and aging of all outstanding advances to investors as of the date of inspection.

37. Provide access to the servicing policies and procedures manual. Indicate the frequency with

which manuals are updated. How does management ensure that subservicers and vendors

comply with these same policies and procedures?

38. Provide a servicing-fee schedule (in basis points) for conventional, government, and nontradi-

tional loans serviced for third parties.

39. Provide copies of management reports used to track portfolio runoff.

40. Provide a loan delinquency report segmented into 30, 60, 90, 120, and 180 foreclosure

categories. Indicate the volume and number of loans in each segment by loan type. Also include

information on the number and dollar volume of delinquent loans that were purchased out of

investor pools.

41. Detail the number and dollar volume of other real estate (ORE) parcels segregated by

company-owned and investor-owned. Provide a list of loans in foreclosure for which action has

been delayed, if applicable.

42. Provide access to the customers’ complaint ﬁle so that examiners can review it while on-site.

Financial Data

43. Provide copies of the Report of Condition and Income and/or Y-series report that was ﬁled by

the mortgage banking company for the two previous ﬁscal years and the most recent interim

period.

44. Provide an internally prepared balance sheet and income statement that reconcile with the most

recent Report of Condition and Income and/or Federal Reserve Board Y-series report.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 58

45. Provide the latest published ﬁnancial statements, if applicable, including the annual report, SEC

10K, 10Qs, and any press releases.

46. Provide copies of the accounting policies pertaining to mortgage loans, securities, and other

assets held for sale and held for investment. Also provide copies of management reports that

monitor compliance with SFAS No. 115 (securities), the current SFAS No. 65 (loans), SFAS

No. 125 (mortgage-servicing assets), and internal policies as of the close of business of the

most recent quarter.

47. Provide details on all formal and informal funding mechanisms, including but not limited to

repurchase agreements, commercial paper programs, and debt issuance facilities. Indicate the

counterparties, where applicable; the amount uncommitted; and the amount outstanding under

each facility as of the close of the most recent quarter. Provide copies of all formal and informal

written agreements.

48. Provide copies of credit agreements for all funding lines from afﬁliated and nonafﬁliated

institutions. Describe methods used to monitor the credit quality of all funding sources. The

following information should be included:

a. lending bank (include copies of conﬁrmation letters)

b. total credit line

c. amount in use as of the inspection date

d. amount available for use and by whom

e. expiration date

f. compensating balance and/or fee arrangements

g. purpose

h. whether the credit lines are contractual obligations of the lenders

i. reciprocity arrangements, if any

j. collateral requirements

k. legal opinions evidencing compliance with sections 23A and 23B of the Federal Reserve

Act, as amended

49. Provide copies of any contingency planning documents that outline alternative courses of action

should the condition of traditional funding sources deteriorate.

50. Provide a copy of any standardized ﬁnancial presentations made to the executive management

team and to the board of directors.

51. Provide a copy of standardized management reports used to measure and track the quality of

originated, purchased, and serviced assets. Include an aging report that identiﬁes loans that are

past due 30, 60, 90, 120, and 180 or more days and indicate whether such loans are held for

sale, held for investment, or serviced for investors.

52. Provide a copy of internal policies that apply to loans held for investment. Indicate the date

each loan that was on the books as of the most recent quarter-end was transferred to this

account, its amortized cost, market value, and any write-downs or adjustments to yield at the

date of transfer. Indicate the person responsible for reviewing these loans for collectibility, the

frequency of such reviews, and any adjustments or write-downs taken over the past year.

53. Provide detail pertaining to the transfer or sale of assets between the nonbank mortgage banking

company and afﬁliated entities since the last inspection and that supports the FR Y-8 Reports.

Also provide related documentation evidencing methods for asset valuation and credit-quality

determination.

54. Provide detail on the allowance for loan and lease losses, contra asset valuation allowances, and

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 59

other reserve accounts as of xx/xx/xx (ﬁscal) and xx/xx/xx (interim). For each account in use,

provide a copy of the most recent analysis and a description of the applicable loan and other

losses provisions reserving methodology.

55. Provide a copy of the company’s policy with respect to real estate appraisals.

56. Provide a copy of management reports that are used for liquidity, funding, and asset/liability

management. If these activities are coordinated with afﬁliate bank or parent bank holding

company personnel, provide copies of the information that is routinely provided.

57. Indicate the method for assessing capital adequacy at the mortgage company level. Provide a

copy of the company’s capital and dividend policies, as well as a list of dividends paid to

shareholders during the two previous ﬁscal years and the most recent interim period. Are any

changes in the level of dividends planned or anticipated?

Mortgage-Servicing Assets

58. Provide an organization chart highlighting those areas and individuals responsible for the

recording, measurement, and impairment testing for originated and purchased mortgage-

servicing rights (MSAs).

59. Provide an inventory listing of all MSAs as of the close of business of the most recent quarter.

60. Discuss the various loan-origination and -purchase programs that give rise to MSAs; the

method for calculating and communicating the price paid to correspondents and brokers for

service release premiums; whether MSAs are recorded on table-funded loans; and the details on

any bulk purchases since the previous inspection, including the price paid and yield realized.

61. Discuss the various loan-sale programs that give rise to MSAs, the method for calculating and

recording the initial value of MSAs.

62. Provide a copy of detailed written policies and procedures regarding the initial recording,

amortization, and periodic revaluation and impairment testing for MSAs. Indicate the manage-

ment and/or board committee responsible for approving such policies and the date of last

approval.

63. Provide detailed information on any valuation models used for MSA revaluations and a copy of

the output as of the most recent quarter-end. Indicate whether such revaluations are performed

in-house or by an outside vendor and the frequency of such revaluations.

64. Reconcile fair market values of MSAs to their respective book values as of the most recent

quarter-end. Provide a copy of management reports and related journal entries used to record

amortization adjustments and/or write-downs.

65. Provide copies of worksheets used to calculate the amount of MSAs included in Tier 1 capital

for regulatory reporting purposes as of the most recent quarter-end.

66. Furnish copies of any management reports or presentations to the board of directors or a

committee thereof regarding the risk characteristics of MSAs, business risk analysis, and

methods used to hedge the interest-rate and prepayment-rate risks associated with capitalized

MSAs.

67. Provide an organization chart highlighting those areas and individuals responsible for hedging

the interest-rate and prepayment-rate risk associated with MSAs.

68. Provide information on any ﬁnancial instruments used to hedge interest-rate and prepayment-

risk associated with MSAs. Include a detailed prospectus on any customized hedge products

that are purchased from investment bankers and a statement from either internal or external

accountants on whether such instruments qualify for hedge accounting treatment under SFAS

No. 80.

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 60

69. Provide a copy of management reports that identify the number of contracts or instruments

used, their current market value, and the degree of correlation between the hedge instrument

and the underlying MSAs being hedged. Such reports should demonstrate the effectiveness of

the hedge under varying market conditions.

70. Provide information on the number and dollar volume of servicing rights sold during the most

recent ﬁscal year and interim period.

71. If mortgage-servicing assets are sold, provide information on the number and dollar volume

sold during the most recent ﬁscal year and interim period.

Intercompany Transactions

72. Provide an organizational chart on a legal-entity basis that includes the bank holding company

and all directly held bank and nonbank afﬁliates.

73. If the mortgage banking company is a direct nonbank subsidiary of the bank holding company,

describe the method for identifying transactions that constitute ‘‘covered transactions’’ under

sections 23A and 23B of the Federal Reserve Act, as well as the method for applying

quantitative limits for section 23A and 23B purposes.

74. Provide a current listing of collateral that is maintained for covered transactions. Indicate

whether collateral is maintained for the full amount of any credit lines with the bank and

whether any depreciated or matured collateral has been replaced since the previous review.

75. Provide copies of any purchase and funding contracts between the mortgage banking company

and afﬁliated bank(s). Please address whether any or all of the following conditions are met

and/or provide written support, where applicable:

a. asset purchases by the bank have been reviewed by management and are either within the

quantitative limits of section 23A or meet the exemption requirements of section 250.250

b. all purchases are at fair market value and consistent with market terms as required by sec-

tion 23B

c. no low-quality assets were transferred to a bank afﬁliate since the previous inspection

d. the method of compensating bank afﬁliates for balances maintained by the parent company

or its nonbank subsidiaries and the net interest income earned on warehouse loans or lines is

reasonable and based on market terms

76. Provide copies of any servicing contracts between the mortgage banking company and afﬁliate

bank(s). If not so stated, indicate the following information:

a. the capacity in which the afﬁliate is acting (for example, is it acting as principal on its own

behalf or as an agent for the afﬁliate bank?)

b. the nature of all services provided

c. billing arrangements, the frequency of billing, the method of computation and the basis for

such fees

d. the date of last review and approval by the mortgage banking company’s board of directors

77. Provide a copy of the bank holding company’s policy statement on the prohibition of tie-in

arrangements, a description of training that is provided to employees in this area, and an

attestation as to whether the nonbank subsidiary is in full compliance with internal policy.

78. If the mortgage banking company charges management or other fees, describe the nature of the

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 61

fees, the method of computation for such fees, and the settlement procedures. Include a listing

of fees charged for the prior two ﬁscal years and the most recent interim period.

79. Provide a copy of the bank holding company’s intercompany tax allocation policy. Indicate the

amount and timing of intercompany tax payments and credits received during the two previous

ﬁscal years and the most recent interim period. If credits are due, please indicate the amount

owed to the subsidiary and the date the intercompany receivable originated.

Sincerely yours,

Vice President,

Federal Reserve Bank of Boston

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual June 1997

Page 62

3070.0.12 APPENDIX B—ACCOUNTING LITERATURE

The following is a list of generally accepted

accounting principles (GAAP) governing the

mortgage banking industry that are in the form

of accounting standards and interpretations.

Accounting standards may change over time.

Current accounting literature should be reviewed

with management during each inspection.

Statements of Financial Accounting Standards (SFAS)

SFAS No. 5, ‘‘Accounting for Contingencies’’

SFAS No. 65, ‘‘Accounting for Certain Mortgage Banking Activities,’’ as amended

SFAS No. 77, ‘‘Reporting by Transferors for Transfers of Receivables with Recourse’’

SFAS No. 80, ‘‘Accounting for Futures Transactions’’

SFAS No. 91, ‘‘Accounting for Nonrefundable Fees and Costs Associated with Originating or

Acquiring Loans and Initial Direct Costs of Leases’’

SFAS No. 115, ‘‘Accounting for Certain Investments in Debt and Equity Securities’’

SFAS No. 125, ‘‘Accounting for Transfers and Servicing of Financial Assets and Extinguishments

of Liabilities’’

FASB Technical Bulletin

Technical Bulletin No. 87-3, ‘‘Accounting for Mortgage Servicing Fees and Rights’’

Emerging Issues Task Force (EITF)

Issue No. 85-13, ‘‘Sale of Mortgage Service Rights on Mortgages Owned by Others’’

Issue No. 85-26, ‘‘Measurement of Servicing Fee under FASB Statement No. 65—When a Loan Is

Sold with Servicing Retained’’

Issue No. 85-28, ‘‘Consolidation Issues Relating to Collateralized Mortgage Obligations’’

Issue No. 86-38, ‘‘Implications of Mortgage Prepayments on Amortization of Servicing Rights’’

Issue No. 86-39, ‘‘Gains from the Sale of Mortgage Loans with Servicing Rights Retained’’

Issue No. 87-25, ‘‘Sale of Convertible, Adjustable-Rate Mortgages with Contingent Repayment

Agreement’’

Issue No. 87-34, ‘‘Sale of Mortgage Servicing Rights with a Subservicing Agreement’’

Issue No. 88-11, ‘‘Allocation of Recorded Investment When a Loan or Part of a Loan Is Sold’’

Issue No. 89-4, ‘‘Accounting for a Purchased Investment in a Collateralized Mortgage Obligation

Instrument or in a Mortgage-Backed Interest-Only Certiﬁcate’’

Issue No. 89-5, ‘‘Sale of Mortgage Loan Servicing Rights’’

Issue No. 90-21, ‘‘Balance Sheet Treatment of a Sale of Mortgage Servicing Rights with a

Subservicing Agreement’’

Issue No. 92-10, ‘‘Loan Acquisitions Involving Table Funding Arrangements’’

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 2000

Page 63

3070.0.13 APPENDIX C—REGULATORY GUIDANCE

The following is a list of sections in this manual

that examiners may ﬁnd particularly useful in

the review of mortgage banking activities. Regu-

latory guidance also evolves over time. This list

is not all inclusive.

2010.0.1 Policy Statement on the Responsibility of Bank Holding Companies to Act as

Sources of Strength to Their Subsidiary Banks

2020.0–.7 Intercompany Transactions

2050.0 Extensions of Credit to BHC Ofﬁcials

2060.0–.6 Management Information Systems

2065.2 Determining an Adequate Level for the Allowance for Loan and Lease Losses

2080.05 Bank Holding Company Funding and Liquidity

2080.0–.3 BHC Funding Practices

2125.0 Trading Activities of Banking Organizations

2126.0 Nontrading Activities of Banking Organizations

2126.1 Investment Securities and End-User Derivatives Activities

2128.02 Asset Securitization

2130.0 Futures, Forward, and Option Contracts

2150.0 Repurchase Transactions

3070.0 Section 4(c)(8)—Mortgage Banking

3080.0 Section 4(c)(8)—Servicing Loans

4000 sections Financial Analysis

4030.0.2 Nonbanks (Analysis of Financial Condition and Risk Assessment)

4070.0 BHC Rating System

Section 4(c)(8) of the BHC Act (Mortgage Banking) 3070.0

BHC Supervision Manual December 2000

Page 64

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—

Associated Risks) Section 3070.3

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2015, this section is revised to

delete a footnote reference to SR letter 02-16,

“Interagency Questions and Answers on Capi-

tal Treatment of Recourse, Direct Credit Substi-

tutes, and Residual Interests in Asset Securitiza-

tions”

and its attachment, superseded by SR

letter 15-6 “Interagency Frequently Asked

Questions on the Regulatory Capital Rule.”

Refer to subsection 3070.3.2.5., “Second-

ary Market Activity.”

The Federal Reserve and the other federal bank-

ing and thrift regulatory agencies (the agen-

cies)

issued the Interagency Guidance on Non-

traditional Mortgage Product Risks on September

29, 2006. The guidance addresses both risk-

management and consumer disclosure practices

that institutions

should employ to effectively

manage the risks associated with closed-end

residential mortgage products that allow bor-

rowers to defer repayment of principal and,

sometimes, interest (referred to as nontradi-

tional mortgage loans). (See SR-06-15.)

Residential mortgage lending has tradition-

ally been a conservatively managed business

with low delinquencies and losses and reason-

ably stable underwriting standards. However,

during the past few years consumer demand has

been growing, particularly in high-priced real

estate markets, for nontraditional mortgage loans.

These mortgage products include such products

as “interest-only” mortgages, where a borrower

pays no loan principal for the ﬁrst few years of

the loan, and “payment-option” adjustable-rate

mortgages (ARMs), where a borrower has ﬂex-

ible payment options with the potential for nega-

tive amortization.

While some institutions have offered nontra-

ditional mortgages for many years with appro-

priate risk management and sound portfolio per-

formance, the market for these products and the

numberof institutions offering them has expanded

rapidly. Nontraditional mortgage loan products

are now offered by more lenders to a wider

spectrum of borrowers; these borrowers may not

otherwise qualify for more traditional mortgage

loans and may not fully understand the risks

associated with nontraditional mortgage loans.

Many of these nontraditional mortgage loans

are underwritten with less stringent income and

asset veriﬁcation requirements (reduced docu-

mentation) and are increasingly combined with

simultaneous second-lien loans.

Such risk lay-

ering, combined with the broader marketing of

nontraditional mortgage loans, exposes ﬁnancial

institutions to increased risk relative to tradi-

tional mortgage loans.

Given the potential for heightened risk levels,

management should carefully consider and

appropriately mitigate exposures created by these

loans. To manage the risks associated with non-

traditionalmortgageloans,managementshould—

• ensure that loan terms and underwriting stan-

dards are consistent with prudent lending prac-

tices, including consideration of a borrower’s

repayment capacity;

• ensure that consumers have sufﬁcient infor-

mation to clearly understand loan terms and

associated; and

• recognize that many nontraditional mortgage

loans, particularly when they have risk-

layering features, are untested in a stressed

environment. As evidenced by experienced

institutions, these products warrant strong risk-

management standards, capital levels com-

mensurate with the risk, and an allowance for

loan and lease losses (ALLL) that reﬂects the

collectibility of the portfolio.

The Federal Reserve expects institutions to

effectively assess and manage the risks associ-

ated with nontraditional mortgage loan products.

Institutions should use the guidance to ensure

that risk-management practices adequately

1. The Board of Governors of the Federal Reserve System,

the Ofﬁce of the Comptroller of the Currency, the Federal

Deposit Insurance Corporation, the Ofﬁce of Thrift Supervi-

sion, and the National Credit Union Administration.

2. The term institution(s), as used in this interagency guid-

ance, applies to Federal Reserve-supervised state member

banks and their subsidiaries, bank holding companies, and the

nonbank subsidiaries of bank holding companies. It also refers

to all other federally supervised banks and their subsidiaries,

savings associations and their subsidiaries, savings and loan

holding companies and their subsidiaries, and credit unions.

3. Interest-only and payment-option ARMs are variations

of conventional ARMs, hybrid ARMs, and ﬁxed-rate prod-

ucts. Refer to the appendix at 3060.3.4 for additional informa-

tion on interest-only and payment-option ARM loans. This

guidance does not apply to reverse mortgages; home equity

lines of credit (HELOCs), other than as discussed in the

Simultaneous Second-Lien Loans section; or fully amortizing

residential mortgage loan products.

4. Refer to the appendix for additional information on

reduced documentation and simultaneous second-lien loans.

5. Refer to the Interagency Guidelines Establishing Stan-

dards for Safety and Soundness in 12 C.F.R. 208, appendix

D-1.

BHC Supervision Manual July 2015

Page 1

address these risks. Risk-management pro-

cesses, policies, and procedures in this area will

be carefully scrutinized. Institutions that do not

adequately manage these risks will be asked to

take remedial action.

This guidance focuses on the higher risk ele-

ments of certain nontraditional mortgage prod-

ucts, not the product type itself. Institutions with

sound underwriting, adequate risk management,

and acceptable portfolio performance will not

be subject to criticism merely for offering such

products.

3070.3.1 NONTRADITIONAL LOAN

TERMS AND UNDERWRITING

STANDARDS

When an institution offers nontraditional mort-

gageloanproducts, underwritingstandardsshould

address theeffectof a substantialpayment increase

on the borrower’s capacity to repay when loan

amortization begins. Underwriting standards

should also comply with the Federal Reserve’s

real estate lending standards and appraisal regu-

lations and associated guidelines.

Central to prudent lending is the internal dis-

cipline to maintain sound loan terms and under-

writing standards despite competitive pressures.

Institutions are strongly cautioned against ced-

ing underwriting standards to third parties that

have different business objectives, risk toler-

ances, and core competencies. Loan terms should

be based on a disciplined analysis of potential

exposures and compensating factors to ensure

that risk levels remain manageable.

3070.3.1.1 Qualifying Borrowers for

Nontraditional Loans

Payments on nontraditional loans can increase

signiﬁcantly when the loans begin to amortize.

Commonly referred to as payment shock, this

increase is of particular concern for payment-

option ARMs where the borrower makes mini-

mum payments that may result in negative

amortization. Some institutions manage the

potential for excessive negative amortization

and payment shock by structuring the initial

terms to limit the spread between the introduc-

tory interest rate and the fully indexed rate.

Nevertheless, an institution’s qualifying stan-

dards should recognize the potential impact of

payment shock, especially for borrowers with

high loan-to-value (LTV) ratios, high debt-to-

income (DTI) ratios, and low credit scores. Rec-

ognizing that an institution’s underwriting crite-

ria are based on multiple factors, an institution

should consider these factors jointly in the quali-

ﬁcation process and potentially develop a range

of reasonable tolerances for each factor. How-

ever, the criteria should be based upon prudent

and appropriate underwriting standards, consid-

ering both the borrower’s characteristics and the

product’s attributes.

For all nontraditional mortgage loan prod-

ucts, an institution’s analysis of a borrower’s

repayment capacity should include an evalua-

tion of the borrower’s ability to repay the debt

by ﬁnal maturity at the fully indexed rate,

assuming a fully amortizing repayment sched-

ule.

In addition, for products that permit nega-

tive amortization, the repayment analysis should

be based upon the initial loan amount plus any

balance increase that may accrue from the nega-

tive amortization provision.

6. Refer to 12 C.F.R. 208.51 subpart E and appendix C and

12 C.F.R. 225 subpart G.

7. The fully indexed rate equals the index rate prevailing at

origination plus the margin that will apply after the expiration

of an introductory interest rate. The index rate is a published

interest rate to which the interest rate on an ARM is tied.

Some commonly used indices include the 1-Year Constant

Maturity Treasury Rate (CMT), the 6-Month London Inter-

bank Offered Rate (LIBOR), the 11

District Cost of Funds

(COFI), and the Moving Treasury Average (MTA), a 12-

month moving average of the monthly average yields of U.S.

Treasury securities adjusted to a constant maturity of one

year. The margin is the number of percentage points a lender

adds to the index value to calculate the ARM interest rate at

each adjustment period. In different interest-rate scenarios, the

fully indexed rate for an ARM loan based on a lagging index

(for example, the MTA rate) may be signiﬁcantly different

from the rate on a comparable 30-year ﬁxed-rate product. In

these cases, a credible market rate should be used to qualify

the borrower and determine repayment capacity.

8. The fully amortizing payment schedule should be based

on the term of the loan. For example, the amortizing payment

for a loan with a 5-year interest-only period and a 30-year

term would be calculated based on a 30-year amortization

schedule. For balloon mortgages that contain a borrower

option for an extended amortization period, the fully amortiz-

ing payment schedule can be based on the full term the

borrower may choose.

9. The balance that may accrue from the negative amortiza-

tion provision does not necessarily equate to the full negative

amortization cap for a particular loan. The spread between the

introductory or ‘‘teaser’’ rate and the accrual rate will deter-

mine whether a loan balance has the potential to reach the

negative amortization cap before the end of the initial payment-

option period (usually ﬁve years). For example, a loan with a

115 percent negative amortization cap but only a small spread

between the introductory rate and the accrual rate may reach a

moderate 109 percent maximum loan balance before the end

of the initial payment-option period, even if only minimum

payments are made. The borrower could be qualiﬁed based on

this lower maximum loan balance.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual July 2015

Page 2

Furthermore, the analysis of repayment

capacity should avoid overreliance on credit

scores as a substitute for income veriﬁcation in

the underwriting process. The higher a loan’s

credit risk, either from loan features or borrower

characteristics, the more important it is to verify

the borrower’s income, assets, and outstanding

liabilities.

3070.3.1.2 Collateral-Dependent Loans

Institutions should avoid the use of loan terms

and underwriting practices that may heighten

the need for a borrower to rely on the sale or

reﬁnancing of the property once amortization

begins. Loans to individuals who do not

demonstrate the capacity to repay, as structured,

from sources other than the collateral pledged

are generally considered unsafe and unsound.

Institutions that originate collateral-dependent

mortgage loans may be subject to criticism, cor-

rective action, and higher capital requirements.

3070.3.1.3 Risk Layering

Institutions that originate or purchase mortgage

loans that combine nontraditional features, such

as interest-only loans with reduced documenta-

tion or a simultaneous second-lien loan, face

increased risk. When features are layered, an

institution should demonstrate that mitigating

factors support the underwriting decision and

the borrower’s repayment capacity. Mitigating

factors could include higher credit scores, lower

LTV and DTI ratios, signiﬁcant liquid assets,

mortgage insurance, and other credit enhance-

ments. While higher pricing is often used to

address elevated risk levels, it does not replace

the need for sound underwriting.

3070.3.1.4 Reduced Documentation

Institutions increasingly rely on reduced docu-

mentation, particularly unveriﬁed income, to

qualify borrowers for nontraditional mortgage

loans. Because these practices essentially substi-

tute assumptions and unveriﬁed information for

analysis of a borrower’s repayment capacity and

general creditworthiness, they should be used

with caution. As the level of credit risk increases,

the Federal Reserve expects an institution to

more diligently verify and document a bo-

rrower’s income and debt-reduction capacity.

Clear policies should govern the use of reduced

documentation. For example, stated income

should be accepted only if there are mitigating

factors that clearly minimize the need for direct

veriﬁcation of repayment capacity. For many

borrowers, institutions generally should be able

to readily document income using recent W-2

statements, pay stubs, or tax returns.

3070.3.1.5 Simultaneous Second-Lien

Loans

Simultaneous second-lien loans reduce owner

equity and increase credit risk. Historically, as

combined loan-to-value ratios rise, so do defaults.

A delinquent borrower with minimal or no equity

in a property may have little incentive to work

with a lender to bring the loan current and avoid

foreclosure. In addition, second-lien HELOCs

typically increase borrower exposure to increas-

ing interest rates and monthly payment burdens.

Loans with minimal or no owner equity gener-

ally should not have a payment structure that

allows for delayed or negative amortization

without other signiﬁcant risk-mitigating factors.

3070.3.1.6 Introductory Interest Rates

As a marketing tool for payment-option ARM

products, many institutions offer introductory

interest rates set well below the fully indexed

rate. When developing nontraditional mortgage

product terms, an institution should consider the

spread between the introductory rate and the

fully indexed rate. Since initial and subsequent

monthly payments are based on these low intro-

ductory rates, a wide initial spread means that

borrowers are more likely to experience nega-

tive amortization, severe payment shock, and an

earlier-than-scheduled recasting of monthly pay-

ments. Institutions should minimize the likeli-

hood of disruptive early recastings and extraor-

dinary payment shock when setting introductory

rates.

3070.3.1.7 Lending to Subprime

Borrowers

Mortgage programs that target subprime bor-

rowers through tailored marketing, underwriting

standards, and risk selection should follow the

10. A loan will not be determined to be ‘‘collateral-

dependent’’ solely through the use of reduced documentation.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual July 2015

Page 3

applicable interagency guidance on subprime

lending.

Among other things, the subprime

guidance discusses circumstances under which

subprime lending can become predatory or abu-

sive. Institutions designing nontraditional mort-

gage loans for subprime borrowers should pay

particular attention to this guidance. They should

also recognize that risk-layering features in loans

to subprime borrowers may signiﬁcantly increase

risks for the institution and the borrower.

3070.3.1.8 Non-Owner-Occupied Investor

Loans

Borrowers ﬁnancing non-owner-occupied invest-

ment properties should qualify for loans based

on their ability to service the debt over the life

of the loan. Loan terms should reﬂect an appro-

priate combined LTV ratio that considers the

potential for negative amortization and main-

tains sufﬁcient borrower equity over the life of

the loan. Further, underwriting standards should

require evidence that the borrower has sufﬁcient

cash reserves to service the loan, considering

the possibility of extended periods of property

vacancy and the variability of debt service

requirementsassociated with nontraditional mort-

gage loan products.

3070.3.2 PORTFOLIO AND

RISK-MANAGEMENT PRACTICES

Institutions should ensure that risk-management

practices keep pace with the growth and chang-

ing risk proﬁle of their nontraditional mortgage

loan portfolios and changes in the market. Active

portfolio management is especially important

for institutions that project or have already expe-

rienced signiﬁcant growth or concentration lev-

els. Institutions that originate or invest in nontra-

ditional mortgage loans should adopt more robust

risk-management practices and manage these

exposures in a thoughtful, systematic manner.

To meet these expectations, institutions should—

• develop written policies that specify accept-

able product attributes, production and port-

folio limits, sales and securitization practices,

and risk-management expectations;

• design enhanced performance measures and

management reporting that provide early warn-

ing for increasing risk;

• establish appropriate ALLL levels that con-

sider the credit quality of the portfolio and

conditions that affect collectibility; and

• maintain capital at levels that reﬂect portfolio

characteristics and the effect of stressed eco-

nomic conditions on collectibility. Institutions

should hold capital commensurate with the

risk characteristics of their nontraditional mort-

gage loan portfolios.

3070.3.2.1 Policies

An institution’s policies for nontraditional mort-

gage lending activity should set acceptable lev-

els of risk through its operatingpractices,account-

ing procedures, and policy exception tolerances.

Policies should reﬂect appropriate limits on risk

layering and should include risk-management

tools for risk-mitigation purposes. Further, an

institution should set growth and volume limits

by loan type, with special attention for products

and product combinations in need of heightened

attention due to easing terms or rapid growth.

3070.3.2.2 Concentrations

Institutions with concentrations in nontraditional

mortgage products should have well-developed

monitoring systems and risk-management prac-

tices. Monitoring systems should keep track of

concentrations in key portfolio segments such as

loan types, third-party originations, geographic

area, and property occupancy status. Concentra-

tions also should be monitored by key portfolio

characteristics such as non-owner-occupied

investor loans and loans with (1) high combined

LTV ratios, (2) high DTI ratios, (3) the potential

for negative amortization, (4) credit scores of

borrowers that are below established thresholds,

and (5) risk-layered features. Further, institu-

tions should consider the effect of employee

incentive programs that could produce higher

concentrations of nontraditional mortgage loans.

Concentrations that are not effectively managed

will be subject to elevated supervisory attention

and potential examiner criticism to ensure timely

remedial action.

11. See SR-99-6, Subprime Lending and its attachment,

Interagency Guidance on Subprime Lending, March 1, 1999,

and SR-01-4, Subprime Lending and its attachment, inter-

agency Expanded Guidance for Subprime Lending Programs,

January 31, 2001.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual July 2015

Page 4

3070.3.2.3 Controls

An institution’s quality control, compliance, and

audit procedures should focus on mortgage lend-

ing activities posing high risk. Controls to moni-

tor compliance with underwriting standards and

exceptions to those standards are especially im-

portant for nontraditional loan products. The

quality control function should regularly review

a sample of nontraditional mortgage loans from

all origination channels and a representative

sample of underwriters to conﬁrm that policies

are being followed. When control systems or

operating practices are found deﬁcient, business-

line managers should be held accountable for

correcting deﬁciencies in a timely manner.

Since many nontraditional mortgage loans

permit a borrower to defer principal and, in

some cases, interest payments for extended

periods, institutions should have strong controls

over accruals, customer service, and collections.

Policy exceptions made by servicing and collec-

tions personnel should be carefully monitored to

conﬁrm that practices such as re-aging, payment

deferrals, and loan modiﬁcations are not inad-

vertently increasing risk. Customer service and

collections personnel should receive product-

speciﬁc training on the features and potential

customer issues with these products.

3070.3.2.4 Third-Party Originations

Institutions often use third parties, such as mort-

gage brokers or correspondents, to originate

nontraditional mortgage loans. Institutions should

have strong systems and controls in place for

establishing and maintaining relationships with

third parties, including procedures for perform-

ing due diligence. Oversight of third parties

should involve monitoring the quality of origi-

nations so that they reﬂect the institution’s lend-

ing standards and compliance with applicable

laws and regulations.

Monitoring procedures should track the qual-

ity of loans by both origination source and key

borrower characteristics. This will help institu-

tions identify problems such as early payment

defaults, incomplete documentation, and fraud.

If problems involving appraisals, loan documen-

tation, credit problems, or consumer complaints

are discovered, the institution should take imme-

diate action. Remedial action could include more

thorough application reviews, more frequent

re-underwriting, and even termination of the

third-party relationship.

3070.3.2.5 Secondary-Market Activity

The sophistication of an institution’s secondary-

market risk-management practices should be

commensurate with the nature and volume of

activity. Institutions with signiﬁcant secondary-

market activities should have comprehensive,

formal strategies for managing risks. Contin-

gency planning should include how the institu-

tion will respond to reduced demand in the

secondary market.

While third-party loan sales can transfer a

portion of the credit risk, an institution remains

exposed to reputation risk when credit losses on

sold mortgage loans or securitization transac-

tions exceed expectations. As a result, an institu-

tion may determine that it is necessary to repur-

chase defaulted mortgages to protect its reputation

and maintain access to the markets.

3070.3.2.6 Management Information and

Reporting

Reporting systems should allow management to

detect changes in the risk proﬁle of its nontradi-

tional mortgage loan portfolio. The structure

and content should allow the isolation of key

loan products, risk-layering loan features, and

borrower characteristics. Reporting should also

allow management to recognize deteriorating

performance in any of these areas before it has

progressed too far. At a minimum, information

should be available by (1) loan type (for exam-

ple, interest-only mortgage loans and payment-

option ARMs); (2) risk-layering features (for

example, payment-option ARMs with stated

income and interest-only mortgage loans with

simultaneous second-lien mortgages); (3) under-

writing characteristics (for example, LTV, DTI,

and credit score); and (4) borrower performance

(for example, payment patterns, delinquencies,

interest accruals, and negative amortization).

Portfolio volume and performance should be

tracked against expectations, internal lending

standards, and policy limits. Volume and perfor-

mance expectations should be established at the

subportfolio and aggregate portfolio levels. Vari-

ance analyses should be performed regularly to

identify exceptions to policies and prescribed

thresholds. Qualitative analysis should occur

when actual performance deviates from estab-

12. Reserved footnote.

13. Reserved footnote.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual July 2015

Page 5

lished policies and thresholds. Variance analysis

is critical to the monitoring of a portfolio’s risk

characteristics and should be an integral part of

establishing and adjusting risk-tolerance levels.

3070.3.2.7 Stress Testing

Based on the size and complexity of their lend-

ing operations, institutions should perform sen-

sitivity analysis on key portfolio segments to

identify and quantify events that may increase

risks in a segment or the entire portfolio. The

scope of the analysis should generally include

stress tests on key performance drivers such as

interest rates, employment levels, economic

growth, housing value ﬂuctuations, and other

factors beyond the institution’s immediate con-

trol. Stress tests typically assume rapid deterio-

ration in one or more factors and attempt to

estimate the potential inﬂuence on default rates

and loss severity. Stress testing should aid an

institution in identifying, monitoring, and man-

aging risk, as well as developing appropriate

and cost-effective loss-mitigation strategies. The

stress testing results should provide direct feed-

backin determiningunderwritingstandards, prod-

uct terms, portfolio concentration limits, and

capital levels.

3070.3.2.8 Capital and Allowance for

Loan and Lease Losses

Institutions should establish an appropriate ALLL

for the estimated credit losses inherent in their

nontraditional mortgage loan portfolios. They

should also consider the higher risk of loss

posed by layered risks when establishing their

ALLL.

Moreover, institutions should recognize that

their limited performance history with these

products, particularly in a stressed environment,

increases performance uncertainty. Capital lev-

els should be commensurate with the risk char-

acteristics of the nontraditional mortgage loan

portfolios. Lax underwriting standards or poor

portfolio performance may warrant higher capi-

tal levels.

When establishing an appropriate ALLL and

considering the adequacy of capital, institutions

should segment their nontraditional mortgage

loan portfolios into pools with similar credit-

risk characteristics. The basic segments typi-

cally include collateral and loan characteristics,

geographic concentrations, and borrower quali-

fying attributes. Segments could also differenti-

ate loans by payment and portfolio characteris-

tics, such as loans on which borrowers usually

make only minimum payments, mortgages with

existing balances above original balances, and

mortgages subject to sizable payment shock.

The objective is to identify credit quality indica-

tors that affect collectibility for ALLL measure-

ment purposes. In addition, understanding char-

acteristics that inﬂuence expected performance

alsoprovidesmeaningful information aboutfuture

loss exposure that would aid in determining

adequate capital levels.

Institutions with material mortgage banking

activities and mortgage servicing assets should

apply sound practices in valuing the mortgage

servicing rights for nontraditional mortgages.

The valuation process should follow generally

accepted accounting principles and use reason-

able and supportable assumptions.

3070.3.3 CONSUMER PROTECTION

ISSUES

While nontraditional mortgage loans provide

ﬂexibility for consumers, the Federal Reserve is

concerned that consumers may enter into these

transactionswithoutfully understanding the prod-

uct terms. Nontraditional mortgage products

have been advertised and promoted based on

their affordability in the near term; that is, their

lower initial monthly payments compared with

traditional types of mortgages. In addition to

apprising consumers of the beneﬁts of nontradi-

tional mortgage products, institutions should

take appropriate steps to alert consumers to the

risks of these products, including the likelihood

of increased future payment obligations. This

information should be provided in a timely

manner—before disclosures may be required

under the Truth in Lending Act or other laws—to

assist the consumer in the product selection

process.

3070.3.3.1 Concerns and Objectives

More than traditional ARMs, mortgage products

such as payment-option ARMs and interest-only

mortgages can carry a signiﬁcant risk of pay-

ment shock and negative amortization, neither

of which may be fully understood by consum-

ers. For example, consumer payment obliga-

14. See SR-03-4, dated February 25, 2003, Interagency

Advisory on Mortgage Banking and its attachment, which has

the same title.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual July 2015

Page 6

tions may increase substantially at the end of an

interest-only period or upon the ‘‘recast’’ of a

payment-option ARM. The magnitude of these

payment increases may be affected by factors

such as the expiration of promotional interest

rates, increases in the interest-rate index, and

negative amortization. Negative amortization

also results in lower levels of home equity as

compared with a traditional amortizing mort-

gage product. When borrowers go to sell or

reﬁnance the property, they may ﬁnd that nega-

tive amortization has substantially reduced or

eliminated their equity in the property—even

when the property has appreciated. The concern

that consumers may not fully understand these

products is exacerbated by marketing and pro-

motional practices that emphasize potential bene-

ﬁts without also providing clear and balanced

information about material risks.

In light of these considerations, communica-

tions with consumers, including advertisements,

oral statements, promotional materials, and

monthly statements, should provide clear and

balanced information about the relative beneﬁts

and risks of these products, including the risks

of payment shock and of negative amortization.

Clear, balanced, and timely communication to

consumers of the risks of these products will

provide consumers with useful information at

crucial decision-making points, such as when

they are shopping for loans or deciding which

monthly payment amount to make. Such com-

munication should help minimize potential con-

sumer confusion and complaints, foster good

customer relations, and reduce legal and other

risks to the institution.

3070.3.3.2 Legal Risks

Institutions that offer nontraditional mortgage

products must ensure that they do so in a man-

ner that complies with all applicable laws and

regulations. With respect to the disclosures and

other information provided to consumers, appli-

cable laws and regulations include the following:

• Truth in Lending Act (TILA) and its imple-

menting regulation, Regulation Z

• Section 5 of the Federal Trade Commission

Act (FTC Act)

TILA and Regulation Z contain rules governing

disclosures that institutions must provide for

closed-end mortgages (1) in advertisements,

(2) with an application,

(3) before loan con-

summation, and (4) when interest rates change.

Section 5 of the FTC Act prohibits unfair or

deceptive acts or practices.

Other federal laws, including the fair-lending

laws and the Real Estate Settlement Procedures

Act (RESPA), also apply to these transactions.

Moreover, the Federal Reserve notes that the

sale or securitization of a loan may not affect an

institution’s potential liability for violations of

TILA, RESPA, the FTC Act, or other laws in

connection with its origination of the loan. State

laws, including laws regarding unfair or decep-

tive acts or practices, also may apply.

3070.3.3.3 Recommended Practices

Recommended practices for addressing the risks

raised by nontraditional mortgage products

include the following:

3070.3.3.4 Communications with

Consumers

When promoting or describing nontraditional

mortgage products, institutions should provide

consumers with information that is designed to

help them make informed decisions when

selecting and using these products. Meeting this

objective requires appropriate attention to the

timing, content, and clarity of information pre-

sented to consumers. Thus, institutions should

provide consumers with information at a time

that will help consumers select products and

choose among payment options. For example,

institutions should offer clear and balanced prod-

uct descriptions when (1) a consumer is shop-

ping for a mortgage (such as when the consumer

makes an inquiry to the institution about a mort-

gage product and receives information about

nontraditional mortgage products) or (2) market-

15. These program disclosures apply to ARM products and

must be provided at the time an application is provided or

before the consumer pays a nonrefundable fee, whichever is

earlier.

16. The Board of Governors enforces this provision under

the FTC Act and section 8 of the Federal Deposit Insurance

Act. See the joint Board and FDIC guidance titled Unfair or

Deceptive Acts or Practices by State-Chartered Banks, March

11, 2004.

17. Institutions should review the recommendations relat-

ing to mortgage lending practices set forth in other supervi-

sory guidance from their respective primary regulators, as

applicable, including guidance on abusive lending practices.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 7

ing relating to nontraditional mortgage products

is provided by the institution to the consumer.

Clear and balanced information should not be

offered by the institution only upon the submis-

sion of an application or at consummation.

The provision of such information would serve

as an important supplement to the disclosures

currently required under TILA and Regulation

Z, as well as other laws.

3070.3.3.4.1 Promotional Materials and

Product Descriptions

To assist consumers in their product selection

decisions, promotional materials and other prod-

uct descriptions should provide information about

the costs, terms, features, and risks of nontradi-

tional mortgages (including information about

the matters discussed below).

Payment Shock. Institutions should apprise con-

sumers of potential increases in payment obliga-

tions for these products, including circum-

stances in which interest rates or negative

amortization reach a contractual limit. For exam-

ple, product descriptions could state the maxi-

mum monthly payment a consumer would be

required to pay under a hypothetical loan exam-

ple once amortizing payments are required and

the interest rate and negative amortization caps

have been reached.

Such information also

could describe when structural payment changes

will occur (for example, when introductory rates

expire or when amortizing payments are re-

quired) and what the new payment amount

would be or how it would be calculated. As

applicable, these descriptions could indicate that

a higher payment may be required at other

points in time due to factors such as negative

amortization or increases in the interest-rate

index.

Negative Amortization. When negative amorti-

zation is possible under the terms of a nontradi-

tional mortgage product, consumers should be

apprised of the potential for increasing principal

balances and decreasing home equity, as well as

other potential adverse consequences of nega-

tive amortization. For example, product descrip-

tions should disclose the effect of negative am-

ortization on loan balances and home equity,

and could describe the potential consequences

to the consumer of making minimum payments

that cause the loan to negatively amortize. (One

possible consequence is that it could be more

difﬁcult to reﬁnance the loan or to obtain cash

upon a sale of the home.)

Prepayment Penalties. If the institution may

impose a penalty in the event that the consumer

prepays the mortgage, consumers should be

alerted to this fact and to the need to ask the

lender about the amount of any such penalty.

Cost of Reduced Documentation Loans. If an

institution offers both reduced and full docu-

mentation loan programs and there is a pricing

premium attached to the reduced documentation

program, consumers should be alerted to this

fact.

3070.3.3.4.2 Monthly Statements on

Payment-Option ARMs

Monthly statements that are provided to con-

sumers on payment-option ARMs should pro-

vide information that enables consumers to make

informed payment choices, including an expla-

nation of each payment option available and the

impact of that choice on loan balances. For

example, the monthly payment statement should

contain an explanation, as applicable, next to

the minimum payment amount that making this

payment would result in an increase to the con-

sumer’s outstanding loan balance. Payment state-

ments also could provide the consumer’s current

loan balance, what portion of the consumer’s

previous payment was allocated to principal and

to interest, and, if applicable, the amount by

which the principal balance increased. Institu-

tions should avoid leading payment-option ARM

borrowers to select a non-amortizing or nega-

tively amortizing payment (for example, through

the format or content of monthly statements).

18. Institutions also should strive to (1) focus on informa-

tion important to consumer decision making; (2) highlight key

information to make it more prominent; (3) employ a user-

friendly and readily navigable format for presenting the infor-

mation; and (4) use plain language, with concrete and realistic

examples. Comparative tables and information describing key

features of available loan products, including reduced docu-

mentation programs, also may be useful for consumers who

are considering the nontraditional mortgage products and

other loan features described in this guidance.

19. Institutions may not be able to incorporate all of the

practices recommended in this guidance when advertising

nontraditional mortgages through certain forms of media,

such as radio, television, or billboards. Nevertheless, institu-

tions should provide clear and balanced information about the

risks of these products in all forms of advertising.

20. Consumers also should be apprised of other material

changes in payment obligations, such as balloon payments.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 8

3070.3.3.4.3 Practices to Avoid

Institutions also should avoid practices that

obscure signiﬁcant risks to the consumer. For

example, if an institution advertises or promotes

a nontraditional mortgage by emphasizing the

comparatively lower initial payments permitted

for these loans, the institution also should pro-

vide clear and comparably prominent informa-

tion alerting the consumer to the risks. Such

information should explain, as relevant, that

these payment amounts will increase, that a

balloon payment may be due, and that the loan

balance will not decrease and may even increase

due to the deferral of interest or principal pay-

ments. Similarly, institutions should avoid pro-

moting payment patterns that are structurally

unlikely to occur.

Such practices could raise

legal and other risks for institutions, as described

more fully above.

Institutions also should avoid such practices

as (1) giving consumers unwarranted assurances

or predictions about the future direction of inter-

est rates (and, consequently, the borrower’s future

obligations); (2) making one-sided representa-

tions about the cash savings or expanded buying

power to be realized from nontraditional mort-

gage products in comparison with amortizing

mortgages; (3) suggesting that initial minimum

payments in a payment-option ARM will cover

accrued interest(orprincipal andinterest) charges;

and (4) making misleading claims that interest

rates or payment obligations for these products

are ‘‘ﬁxed.’’

3070.3.3.5 Control Systems

Institutions should develop and use strong con-

trol systems to monitor whether actual practices

are consistent with their policies and procedures

relating to nontraditional mortgage products.

Institutions should design control systems to

address compliance and consumer information

concerns as well as the safety and soundness

considerations discussed in this guidance. Lend-

ing personnel should be trained so that they are

able to convey information to consumers about

product terms and risks in a timely, accurate,

and balanced manner. As products evolve and

new products are introduced, lending personnel

should receive additional training, as necessary.

Lending personnel should be monitored to deter-

mine whether they are following these policies

and procedures. Institutions should review con-

sumer complaints to identify potential compli-

ance, reputation, and other risks. Attention should

be paid to appropriate legal review and to using

compensation programs that do not improperly

encourage lending personnel to direct consum-

ers to particular products.

With respect to nontraditional mortgage loans

that an institution makes, purchases, or services

using a third party, such as a mortgage broker,

correspondent, or other intermediary, the institu-

tion should take appropriate steps to mitigate

risks relating to compliance and consumer infor-

mation concerns discussed in this guidance.

These steps would ordinarily include, among

other things, (1) conducting due diligence and

establishing other criteria for entering into and

maintaining relationships with such third par-

ties, (2) establishing criteria for third-party com-

pensation designed to avoid providing incen-

tives for originations inconsistent with this

guidance, (3) setting requirements for agree-

ments with such third parties, (4) establishing

procedures and systems to monitor compliance

with applicable agreements, bank policies, and

laws, and (5) implementing appropriate correc-

tive actions in the event that the third party fails

to comply with applicable agreements, bank

policies, or laws.

3070.3.4 APPENDIX (TERMS USED IN

THIS DOCUMENT)

Interest-Only Mortgage Loan. An interest-only

mortgage loan refers to a nontraditional mort-

gage in which, for a speciﬁed number of years

(for example, three or ﬁve years), the borrower

is required to pay only the interest due on the

loan, during which time the rate may ﬂuctuate

or may be ﬁxed. After the interest-only period,

the rate may be ﬁxed or it may ﬂuctuate based

on the prescribed index and payments, including

both principal and interest.

Payment-Option ARM. A payment-option ARM

is a nontraditional adjustable-rate mortgage that

allows the borrower to choose from a number of

different payment options. For example, each

month, the borrower may choose a minimum

payment option based on a ‘‘start’’ or introduc-

tory interest rate, an interest-only payment option

21. For example, marketing materials for payment-option

ARMs may promote low predictable payments until the recast

date. Such marketing should be avoided in circumstances in

which the minimum payments are so low that negative amor-

tization caps would be reached and higher payment obliga-

tions would be triggered before the scheduled recast, even if

interest rates remain constant.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 9

based on the fully indexed interest rate, or a

fully amortizing principal and interest payment

option based on a 15- or 30-year loan term, plus

any required escrow payments. The minimum

payment option can be less than the interest

accruing on the loan, resulting in negative amor-

tization. The interest-only option avoids nega-

tive amortization but does not provide for prin-

cipal amortization. After a speciﬁed number of

years, or if the loan reaches a certain negative

amortization cap, the required monthly payment

amount is recast to require payments that will

fully amortize the outstanding balance over the

remaining loan term.

Reduced Documentation. Reduced documenta-

tion is a loan feature that is commonly referred

to as ‘‘low doc/no doc,’’ ‘‘no income/no asset,’’

‘‘stated income,’’ or ‘‘stated assets.’’ For mort-

gage loans with this feature, an institution sets

reduced or minimal documentation standards to

substantiate the borrower’s income and assets.

Simultaneous Second-Lien Loan. A simulta-

neous second-lien loan is a lending arrangement

where either a closed-end second lien or a home

equity line of credit (HELOC) is originated

simultaneously with the ﬁrst-lien mortgage loan,

typically in lieu of a higher down payment.

3070.3.5

3070.3.5 INSPECTION OBJECTIVES

1. To ascertain if the banking organization

has adequate risk-management processes,

policies, and procedures to address the risk

associated with its nontraditional mortgage

loans.

2. To evaluate whether the banking organiza-

tion’s nontraditional mortgage loan terms

are supported by a disciplined analysis of

its potential exposures versus the mitigating

factors that ensure that risk levels are ad-

equately managed.

3. To determine if the underwriting standards

for nontraditional mortgage loans comply

with the Federal Reserve’s real estate lend-

ing standards and appraisal regulations and

associated guidelines.

4. To evaluate whether the banking organiza-

tion’s management carefully considers and

appropriately assesses and mitigates the risk

exposures created by the nontraditional mort-

gage loans by ensuring that—

a. its loan terms and underwriting stan-

dards are consistent with prudent lending

practices, including consideration of a

borrower’s repayment capacity;

b. its nontraditional mortgage loan prod-

ucts have strong risk-management stan-

dards, capital levels commensurate with

the risk, and an allowance for loan and

lease losses that reﬂects the collectibility

of the portfolio; and

c. its consumers have sufﬁcient informa-

tion to clearly understand the loan terms

and associated risks prior to making a

nontraditional mortgage loan product

choice.

5. To determine if the banking organization

has borrower qualiﬁcation criteria that

include an evaluation of a borrower’s repay-

ment capacity and ability to repay the debt—

the full amount of the credit extended, includ-

ing any balance increase that may accrue

from negative amortization—by the ﬁnal

maturity date at the fully indexed rate.

3070.3.6 INSPECTION PROCEDURES

Risk Mitigation

1. Assess the banking organization’s manage-

ment procedures to mitigate the risk created

by nontraditional mortgage products. Deter-

mine that—

a. underwriting standards and terms are

consistent with prudent lending prac-

tices, including consideration of each

borrower’s repayment capacity;

b. products are supported by strong risk-

management standards, capital levels that

are commensurate with their risk, and an

allowance for loan and lease losses that

reﬂects the collectiblity of the portfolio;

and

c. borrowers have sufﬁcient information to

clearly understand the terms of their loans

and their associated risks.

Underwriting Standards

1. Determine if the banking organization’s

underwriting standards—

a. address the effect of a substantial pay-

22. Going forward in this section (for bank holding com-

pany inspection purposes) ‘‘banking organization’’ refers to

the bank holding company and its nonbank subsidiaries that

are supervised by the Federal Reserve System.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 10

ment increase in the borrower’s capacity

to repay when loan amortization begins,

b. comply with the Federal Reserve’s real

estate lending standards and appraisal

regulations and associated guidelines, and

c. require that loan terms are based on a

disciplined analysis of potential expo-

sures and mitigating factors, which will

ensure that risk levels remain manageable.

2. Verify that the banking organization’s non-

traditional mortgage loan qualiﬁcation stan-

dards recognize the potential impact of pay-

ment shock (particularly for borrowers with

high loan-to-value ratios, high debt-to-

income ratios, and low credit scores).

3. Ascertain that the analysis of a borrower’s

repayment capacity include—

a. an evaluation of the borrower’s ability to

repay the debt by ﬁnal maturity at the

fully indexed rate, assuming a fully amor-

tizing repayment schedule;

b. a repayment schedule that is based on

the initial loan amount plus any balance

increase that may accrue from a negative

amortization provision; and

c. avoiding an overreliance on credit scores

as a substitute for income veriﬁcation or

reliance on the sale or reﬁnancing of the

property (pledged as collateral) when

amortization begins.

4. Determine whether originated or purchased

mortgage loans that combine nontraditional

features (such as interest-only loans with

reduced documentation and second-lien

loans) have mitigating factors (that is, higher

credit scores, lower LTVs and DTI repay-

ment ratios, signiﬁcant liquid assets, mort-

gage insurance, or other credit enhance-

ments) that support the underwriting

decisions and the borrower’s repayment

capacities.

5. Verify that the banking organization has

clear loan underwriting policies governing

the use of—

a. reduced documentation of the borrow-

er’s ﬁnancial capacity (for example, non-

veriﬁcation of reported income when the

borrower’s income can be documented

based on recent W-2 statements, pay

stubs, or tax returns),

b. minimal or no owner’s equity for second-

lien home equity lines of credit (such

loans generally should not have a pay-

ment structure allowing for delayed or

negative amortization without other sig-

niﬁcant risk-mitigating factors),

c. introductory interest rates (banking orga-

nizations should minimize the likelihood

of disruptive early recastings and extraor-

dinary payment shock when setting

introductory rates),

d. subprime lending (adherence to the inter-

agency guidance on subprime lending),

and

e. non-owner-occupiedinvestorloans (quali-

ﬁcations should be based on the borrow-

er’s ability to service the debt over the

life of the loan, which would include a

combined LTV ratio that considers nega-

tive amortization and sufﬁcient borrower

equity, and continuing cash reserves).

Portfolio and Risk-Management Practices

1. If the banking organization originates or

invests in nontraditional mortgage loans,

determine if more robust risk-management

practices have been adopted to manage the

exposures.

a. Verify that there are appropriate written

lending policies that have been adopted

and are being used and monitored, speci-

fying acceptable product attributes, pro-

duction and portfolio limits (growth and

volume limits by loan type), sales and

securitization practices, and risk-

management expectations(acceptable lev-

els of risk).

b. Determine if enhanced performance mea-

sures have been designed and if there is

management reporting that provides an

early warning for increasing risk.

c. Find out if the appropriate ALLL levels

have been established that consider the

credit quality of the portfolio and the

conditions that affect collectibility.

d. Evaluatewhetheradequatecapitalis main-

tained at levels that reﬂect portfolio char-

acteristics and the effect of stressed eco-

nomic conditions on collectibility.

e. Determine if capital is held commensu-

rate with the risk characteristics of the

banking organization’s nontraditional

mortgage loan portfolios.

2. If the banking organization has concentra-

tions in nontraditional mortgage products,

determine if there are—

a. well-developed monitoring systems and

risk-management practices, which moni-

tor and keep track of concentrations in

23. See SR-01-4 and SR-99-6.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 11

key portfolio segments, such as by loan

type, third-party originations, geographic

area, and property occupancy status, and

b. systems that also monitor key portfolio

characteristics: non-owner-occupied

investor loan and loans with (1) high

combined LTV ratios, (2) high DTI

ratios, (3) the potential for negative am-

ortization, (4) credit scores of borrowers

that are below established thresholds,

and (5) risk-layered features.

3. Determine if the banking organization has

adequate quality controls and compliance

and audit procedures that focus on mort-

gage lending activities posing high risk.

a. Determine if the banking organization

has strong internal controls over accruals,

customer service, and collections.

b. Verify that policy exceptions made by

servicing and collections personnel are

carefully monitored and that practices

such as re-aging, payment deferrals, and

loan modiﬁcations are not inadvertently

increasing risk.

c. Find out if the quality control function

regularly reviews (1) a sample of nontra-

ditional mortgage loans from all origina-

tion channels and (2) a representative

sample of underwriters conﬁrming that

underwriting policies are followed.

4. Bank oversight of third-party originators—

a. determine if the banking organization

has strong systems and controls in place

for establishing and maintaining relation-

ships with third-party nontraditional mort-

gage loan originators, including proce-

dures for due diligence, and

b. ﬁnd out if the oversight of third-party

mortgage loan origination lending prac-

tices includes monitoring the quality of

originations (that is, the quality of origi-

nation sources, key borrower characteris-

tics, appraisals, loan documentations, and

credit repayment histories) so that they

are reﬂective of the banking organiza-

tion’s lending standards and in compli-

ance with applicable laws and regulations.

5. Determine if the banking organization’s

risk-management practices are commensu-

rate with the nature, volume, and risk of its

secondary-market activities.

a. Find out if there are comprehensive for-

mal strategies for managing the risks

arising from signiﬁcant secondary-

market activities.

b. Ascertain if contingency planning includes

howthe bankingorganization will respond

to a decline in loan demand in the sec-

ondary market.

c. Determine if there were any repurchases

of defaulted mortgages and if the bank-

ing organization complies with its risk-

based capital guidelines.

6. Evaluate the appropriateness of manage-

ment information and reporting systems for

the level and nature of the banking organi-

zation’s mortgage lending activity.

a. Verify that the reporting allows manage-

ment to detect changes in the risk proﬁle,

or deteriorating performance, of its non-

traditional mortgage loan portfolio.

b. Determine if management information is

reported and available by loan type, risk-

layering features, underwriting charac-

teristics, and borrower performance.

c. Find out if—

1) portfolio volume and performance are

tracked against expectations, internal

lending standards, and policy limits;

2) volume and performance expecta-

tions are established at the subportfo-

lio and aggregate portfolio levels;

3) variance analyses are regularly per-

formed to identify exceptions to poli-

cies and prescribed thresholds; and

4) qualitative analyses are performed

when actual performance deviates

from established policies and

thresholds.

7. Determine if the banking organization, based

on the size and complexity of its lending

operations, performs sensitivity analysis on

its key portfolio segments to identify and

quantify events that may increase its risks

in a segment or the entire portfolio.

8. Verify that the scope of the sensitivity analy-

sis includes stress tests on key performance

drivers such as interest rates, employment

levels, economic growth, housing value ﬂuc-

tuations, and other factors beyond the bank-

ing organization’s immediate control.

9. Find out if the stress testing results provide

direct feedback for determining underwrit-

ing standards, product terms, portfolio con-

centration limits, and capital levels.

10. Determine if the banking organization has

established an appropriate ALLL for the

estimated credit losses and commensurate

capital levels for the risk inherent in its

nontraditional mortgage loan portfolios (con-

sidering the higher risk of loss posed by the

layered risks).

11. If the banking organization has material

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 12

mortgage banking activities and mortgage

servicing assets—

a. evaluate whether sound practices were

applied in valuing the mortgage servic-

ing rights for its nontraditional mort-

gages and

b. ascertain if the valuation process fol-

lowed the nontraditional mortgage and

other interagency guidance and gener-

ally accepted accounting principles, and

whether reasonable and supportable

assumptions were used.

Section 4(c)(8) of the BHC Act (Nontraditional Mortgages—Associated Risks) 3070.3

BHC Supervision Manual January 2007

Page 13

Section 4(c)(8) of the BHC Act (Mortgage Banking—Derivative

Commitments to Originate and Sell Mortgage Loans) Section 3071.0

3071.0.1 INTERAGENCY ADVISORY

ON ACCOUNTING AND REPORTING

FOR COMMITMENTS TO ORIGINATE

AND SELL MORTGAGE LOANS

On May 3, 2005, the Federal Reserve and the

other federal ﬁnancial institution regulatory agen-

cies

(the agencies) issued an Interagency

Advisory on Accounting and Reporting for Com-

mitments to Originate and Sell Mortgage

Loans.

(See SR-05-10.)

The advisory provides guidance on the appro-

priate accounting and reporting for commit-

ments to—

• originate mortgage loans that will be held for

resale, and

• sell mortgage loans under mandatory-delivery

and best-efforts contracts.

Commitments to originate mortgage loans

that will be held for resale are derivatives and

must be accounted for at fair value on the bal-

ance sheet by the issuer. All loan-sales agree-

ments, including both mandatory-delivery and

best-efforts contracts, must be evaluated to deter-

mine whether the agreements meet the deﬁni-

tion of a derivative under Statement of Financial

Accounting Standards No. 133, ‘‘Accounting for

Derivative Instruments and Hedging Activities,’’

as amended by Statement of Financial Account-

ing Standards No. 149, ‘‘Amendment of State-

ment 133 on Derivative Instruments and Hedg-

ing Activities’’ (collectively, FAS 133). A

ﬁnancial institution should also account for loan-

sales agreements that meet the deﬁnition of a

derivative at fair value on the balance sheet.

The advisory discusses the characteristics that

should be considered in determining whether

mandatory-delivery and best-efforts contracts

are derivatives and the accounting and regula-

tory reporting treatment for both commitments

to originate mortgage loans that will be held for

resale and those loan-sales agreements that meet

the deﬁnition of a derivative. The advisory also

addresses the guidance that should be consid-

ered in determining the fair value of derivatives.

The advisory provides additional guidance on

the application of FAS 133. Financial institu-

tions, including those that are not required to ﬁle

reports with the Securities and Exchange Com-

mission (SEC), are expected to follow the guid-

ance in SEC Staff Accounting Bulletin No. 105,

‘‘Application of Accounting Principles to Loan

Commitments’’ (SAB 105).

A ﬁnancial institution is expected to account

for and report derivative loan commitments and

forward loan-sales commitments as derivatives

in accordance with generally accepted account-

ing principles (GAAP), which include the use of

valuation techniques that are reasonable and

supportable in the determination of fair value.

An institution’s failure to account for and report

derivative loan commitments and forward loan-

sales commitments in regulatory reports in

accordance with GAAP may be an unsafe and

unsound practice.

3071.0.1.1 Accounting and Reporting

3071.0.1.1.1 Accounting Policies

Well-managed ﬁnancial institutions have writ-

ten and consistently applied accounting policies

for commitments to originate mortgage loans

that will be held for resale and to sell mortgage

loans under mandatory-delivery and best-efforts

contracts, including approved valuation method-

ologies and procedures to formally approve

changes to those methodologies. The method-

ologies should be reasonable, objectively sup-

ported, and fully documented. Procedural disci-

pline and consistency are key concepts in any

valuation-measurement technique. Institutions

should ensure that internal controls, including

effective independent review or audit, are in

place to provide integrity to the valuation pro-

cess. Institutions’ practices should, therefore,

reﬂect these concepts to ensure the reliability of

their valuations of derivative loan commitments

and forward loan-sales commitments.

3071.0.1.1.2 Derivative Loan

Commitments

A ﬁnancial institution should account for deriva-

1. The agencies are the Board of Governors of the Federal

Reserve System, the Federal Deposit Insurance Corporation,

the National Credit Union Administration, the Ofﬁce of the

Comptroller of the Currency, and the Ofﬁce of Thrift Supervi-

sion.

2. The guidance in the interagency advisory is also in-

tended to apply to ﬁnancial-statement reporting by bank hold-

ing companies.

3. Staff accounting bulletins (SABs) summarize the views

of the SEC’s staff regarding the application of generally

accepted accounting principles.

BHC Supervision Manual January 2006

Page 1

tive loan commitments at fair value on the bal-

ance sheet, regardless of the manner in which

the intended sale of the mortgage loans will be

executed (e.g., under a best-efforts contract, a

mandatory-delivery contract, or the institution’s

own securitization). An institution should report

each ﬁxed, adjustable, and ﬂoating derivative

loan commitment as an ‘‘other asset’’ or an

‘‘other liability’’ in their regulatory reports based

upon whether the individual commitment has a

positive (asset) or negative (liability) fair value.

With respect to ﬂoating derivative loan com-

mitments, because the interest rate on such a

commitment ‘‘ﬂoats’’ on a daily basis with mar-

ket interest rates, the fair value of a ﬂoating

derivative loan commitment approximates zero

as long as the creditworthiness of the borrower

has not changed. However, as with other deriva-

tive loan commitments, an institution must report

the entire gross notional amount of ﬂoating

derivative loan commitments in its regulatory

reports.

Commitments to originate mortgage loans

that will be held for investment purposes and

commitments to originate other types of loans

are not within the scope of FAS 133 and, there-

fore, are not accounted for as derivatives.

institution should report the unused portion of

these types of commitments, which are not con-

sidered derivatives, as ‘‘unused commitments’’

in its regulatory reports.

3071.0.1.1.3 Forward Loan-Sales

Commitments

A ﬁnancial institution should account for for-

ward loan-sales commitments for mortgage loans

as derivatives at fair value on the balance sheet.

Each forward loan-sales commitment should be

reported as an ‘‘other asset’’ or an ‘‘other liabil-

ity’’ based upon whether the individual commit-

ment has a positive (asset) or negative (liability)

fair value.

3071.0.1.1.4 Netting of Contracts

For balance-sheet-presentation purposes, FAS

133 does not provide speciﬁc guidance on

ﬁnancial-statement presentation.

A ﬁnancial

institution may not offset derivatives with nega-

tive fair values (liabilities) against those with

positive fair values (assets), unless the criteria

for ‘‘netting’’ under GAAP have been satis-

ﬁed.

In addition, an institution may not offset

the fair value of forward loan-sales commit-

ments against the fair value of derivative loan

commitments (the pipeline) or mortgage loans

held for sale (warehouse loans). Rather, forward

loan-sales commitments must be accounted for

separately at fair value, and warehouse loans

must be accounted for at the lower of cost or fair

value (commonly referred to as ‘‘LOCOM’’)

with certain adjustments to the cost basis of the

loans if hedge accounting is applied.

3071.0.1.1.5 Hedge Accounting

A ﬁnancial institution should follow the guid-

ance in FAS 133 when applying hedge account-

ing to its mortgage banking activities. If the

FAS 133 qualifying criteria are met, an institu-

tion may apply—

• fair-value hedge accounting in a hedging

relationship between forward loan-sales com-

mitments (the hedging instrument) and ﬁxed-

rate warehouse loans (the hedged item), or

• cash-ﬂow hedge accounting in a hedging

relationship between forward loan-sales com-

4. When preparing Reports of Condition and Income (Call

Reports) and the Consolidated Financial Statements for Bank

Holding Companies (BHC reports), ﬁxed, adjustable, and

ﬂoating derivative loan commitments should not be reported

as unused commitments in Schedule RC-L, Derivatives and

Off-Balance Sheet Items (Schedule HC-1 for bank holding

companies), because such commitments are to be reported as

derivatives in this schedule.

5. See FAS 133, paragraph 10(i).

6. Regardless of whether the underlying mortgage loans

will be held for investment or for resale, commitments to

purchase mortgage loans from third parties under either

mandatory-delivery contracts or best-efforts contracts are

derivatives if, upon evaluation, the contracts meet the deﬁni-

tion of a derivative under FAS 133. An institution should

report its loan-purchase commitments that meet the deﬁnition

of a derivative at fair value on the balance sheet.

7. That is, FAS 133 does not provide speciﬁc guidance

where, in the ﬁnancial statements, the fair value of derivatives

or the changes in the fair value of derivatives should be

classiﬁed and presented on the ﬁnancial statement.

8. When an institution has two (or more) derivatives with

the same counterparty, contracts with positive fair values and

negative fair values may be netted if the conditions set forth in

FASB Interpretation No. 39, ‘‘Offsetting of Amounts Related

to Certain Contracts’’ (FIN 39), are met. Those conditions are

as follows: (1) each of the parties owes the other determinable

amounts; (2) the reporting party has the right to set off the

amount owed with the amount owed by the other party;

(3) the reporting party intends to set off; and (4) the right of

setoff is enforceable at law. In addition, without regard to the

third condition, fair-value amounts recognized for derivative

contracts executed with the same counterparty under a master

netting arrangement may be offset.

9. See Statement of Financial Accounting Standards No.

65, ‘‘Accounting for Certain Mortgage Banking Activities’’

(FAS 65), paragraph 4.

Mortgage Banking—Derivative Commitments to Originate and Sell Mortgage Loans 3071.0

BHC Supervision Manual January 2006

Page 2

mitments (the hedging instrument) and the

forecasted sale of the warehouse loans and/or

the loans to be originated under derivative

loan commitments (the forecasted

transaction).

If a ﬁnancial institution does not apply hedge

accounting, either because the FAS 133 hedge

criteria are not met or the institution chooses not

to apply hedge accounting, forward loan-sales

commitments should be treated as nonhedging

derivatives. If hedge accounting is not applied,

an institution will account for its warehouse

loans at the lower of cost or fair value. Because

nonhedging forward loan-sales commitments

are accounted for at fair value through earnings,

such an approach causes volatility in reported

earnings if the fair value of the warehouse loans

increases above their cost basis. In this situa-

tion, the volatility is a result of recognizing the

full amount of any decline in the fair value of

the forward loan-sales commitments in earnings

while not adjusting the carrying amount of the

warehouse loans above their cost basis.

3071.0.1.1.6 Income-Statement Effect

Unless cash-ﬂow hedge accounting is applied, a

ﬁnancial institution should include the periodic

changes in the fair value of derivative loan

commitments and forward loan-sales commit-

ments in current-period earnings. An institution

should report these changes in fair value in

either ‘‘other non-interest income’’ or ‘‘other

non-interest expense,’’ but not as trading rev-

enue, in their regulatory reports. However, an

institution’s decision as to whether to report the

changes in fair value in its regulatory reports in

an income or expense line item should be con-

sistent with its presentation of these changes in

its general-purpose external ﬁnancial statements

(including audited ﬁnancial statements)

and

should be consistent from period to period.

3071.0.1.2 Valuation

3071.0.1.2.1 Fair Value

FAS 133 indicates that the guidance in State-

ment of Financial Accounting Standards No.

107, ‘‘Disclosures About Fair Value of Finan-

cial Instruments’’ (FAS 107), should be fol-

lowed in determining the fair value of deriva-

tives.

Thatguidanceprovides that quoted market

prices are the best evidence of the fair value of

ﬁnancial instruments. However, when quoted

market prices are not available, which is typi-

cally the case for derivative loan commitments

and forward loan-sales commitments, estimates

of fair value should be based on the best infor-

mation available in the circumstances (e.g., valu-

ation techniques based on estimated expected

future cash ﬂows). When expected future cash

ﬂows are used, they should be the institution’s

best estimate based on reasonable and support-

able assumptions and projections.

Estimates of fair value should consider prices

for similar assets or similar liabilities and the

results of valuation techniques to the extent

available in the circumstances. In the absence of

(1) quoted market prices in an active market,

(2) observable prices of other current market

transactions, or (3) other observable data sup-

porting a valuation technique, the transaction

price represents the best information available

with which to estimate fair value at the incep-

tion of an arrangement.

A ﬁnancial institution should not recognize

an unrealized gain or loss at inception of a

derivative instrument unless the fair value of

that instrument is obtained from a quoted mar-

ket price in an active market or is otherwise

evidenced by comparison to other observable

current market transactions or based on a valua-

tion technique incorporating observable market

data.

Based on this guidance, derivative loan

commitments generally would have a zero fair

value at inception.

However, subsequent

changes in the fair value of a derivative loan

commitment must be recognized in ﬁnancial

statements and regulatory reports (e.g., changes

in fair value attributable to changes in market

interest rates).

When estimating the fair value of derivative

loan commitments and those best-efforts con-

tracts that meet the deﬁnition of a derivative, a

10. See FAS 133, paragraphs 20–21, and related FAS 133

guidance for hedging instruments, hedged items, and fore-

casted transactions that qualify for fair-value and cash-ﬂow

hedge accounting.

11. See footnote 7.

12. See FAS 133, paragraph 17.

13. See footnote 3 in Emerging Issues Task Force Issue

No. 02-3 (EITF 02-3), ‘‘Issues Involved in Accounting for

Derivative Contracts Held for Trading Purposes and Contracts

Involved in Energy Trading and Risk Management Activi-

ties.’’

14. If a potential borrower pays the lender a fee upon

entering into a derivative loan commitment (e.g., a rate-lock

fee), there is a transaction price, and the lender should recog-

nize the derivative loan commitment as a liability at inception

using an amount equal to the fee charged to the potential

borrower.

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ﬁnancial institution should consider predicted

‘‘pull-through’’ (or, conversely, ‘‘fallout’’) rates.

A pull-through rate is the probability that a

derivative loan commitment will ultimately result

in an originated loan. Some factors that may be

considered in arriving at appropriate pull-

through rates include (but are not limited to) the

origination channel (which may be either inter-

nal [retail] or external [wholesale or correspon-

dent, to the extent the institution rather than the

correspondent closes the loan]),

current mort-

gage interest rates in the market versus the

interest rate incorporated in the derivative loan

commitment, the purpose of the mortgage (pur-

chase versus reﬁnancing), the stage of comple-

tion of the underlying application and under-

writing process, and the time remaining until the

expiration of the derivative loan commitment.

Estimates of pull-through rates should be based

on historical information for each type of loan

product adjusted for potential changes in market

interest rates that may affect the percentage of

loans that will close. An institution should not

consider the pull-through rate when reporting

the notional amount of derivative loan commit-

ments in regulatory reports but, rather, must

report the entire gross notional amount.

3071.0.1.2.2 SAB 105

In March 2004, the SEC issued SAB 105 to

provide guidance on the proper accounting and

disclosures for derivative loan commitments.

SAB 105 is effective for derivative loan com-

mitments entered into after March 31, 2004.

SAB 105 indicates that the expected future cash

ﬂows related to the associated servicing of loans

should not be considered in recognizing deriva-

tive loan commitments. Incorporating expected

future cash ﬂows related to the associated ser-

vicing of the loan essentially results in the

immediate recognition of a servicing asset. Ser-

vicing assets should only be recognized when

the servicing asset has been contractually sepa-

rated from the underlying loan by sale or securi-

tization of the loan with servicing retained.

Further, no other internally developed intangible

assets (such as customer-relationship intangible

assets) should be recognized as part of deriva-

tive loan commitments. Recognition of such

assets would only be appropriate in a third-party

transaction (for example, the purchase of a

derivative loan commitment either individually,

in a portfolio, or in a business combination).

3071.0.1.3 Standard-Setter Activities

Financial institutions should be aware that the

SEC or the Financial Accounting Standards

Board (FASB) may issue additional fair-value,

measurement, or recognition guidance in the

future (e.g., a fair-value measurement state-

ment). To the extent that additional guidance is

issued, institutions must also consider the guid-

ance in developing fair-value-estimate method-

ologies for derivative loan commitments and

forward loan-sales commitments as well as mea-

suring and recognizing such derivatives.

3071.0.1.4 Changes in Accounting for

Derivative Loan Commitments and

Loan-Sales Agreements

Financial institutions should follow Accounting

Principles Board Opinion No. 20 (APB 20),

‘‘Accounting Changes,’’

if a change in their

accounting for derivative loan commitments,

best-efforts contracts, or mandatory-delivery con-

tracts is necessary. APB 20 deﬁnes various types

of accounting changes and addresses the report-

ing of corrections of errors in previously issued

ﬁnancial statements. APB 20 states, ‘‘Errors in

ﬁnancial statements result from mathematical

mistakes, mistakes in the application of account-

ing principles, or oversight or misuse of facts

that existed at the time the ﬁnancial statements

were prepared.’’

For regulatory reporting purposes, a ﬁnancial

institution must determine whether the reason

for a change in its accounting meets the APB 20

deﬁnition of an accounting error. If the reason

for the change meets this deﬁnition, the error

should be reported as a prior-period adjustment

if the amount is material. Otherwise, the effect

of the correction of the error should be reported

in current earnings.

If the effect of the correction of the error is

15. If an institution commits to purchase a loan that will be

closed by a correspondent in the correspondent’s name, the

institution would have a loan-purchase commitment rather

than a derivative loan commitment. See footnote 6.

16. See Statement of Financial Accounting Standards No.

140 (FAS 140), ‘‘Accounting for Transfers and Servicing of

Financial Assets and Extinguishments of Liabilities,’’ para-

graph 61.

17. Effective December 15, 2005, APB 20 will be replaced

by FASB Statement No. 154, ‘‘Accounting Changes and Error

Corrections—A Replacement of APB Opinion No. 20 and

FASB Statement No. 3.’’

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Page 4

material, a ﬁnancial institution should also con-

sult with its primary federal regulatory agency

to determine whether any of its prior regulatory

reports should be amended. If amended regula-

tory reports are not required, the institution

should report the effect of the correction of the

error on prior years’ earnings, net of applicable

taxes, as an adjustment to the previously reported

beginning balance of equity capital. For the Call

Report, the institution should report the amount

of the adjustment in Schedule RI-A, item 2,

‘‘Restatements due to corrections of material

accounting errors and changes in accounting

principles,’’ with an explanation in Schedule

RI-E, item 4.

The effect of the correction of the error on

income and expenses since the beginning of the

year in which the error is corrected should be

reﬂected in each affected income and expense

account on a year-to-date basis beginning in the

next quarterly income statement (Call Report) to

be ﬁled and not as a direct adjustment to retained

earnings.

3071.0.1.5 Deﬁnitions of Terms Used in

the Advisory

3071.0.1.5.1 Derivative Loan

Commitment

The term derivative loan commitment refers to a

lender’s commitment to originate a mortgage

loan that will be held for resale. Notwithstand-

ing the characteristics of a derivative set forth in

FAS 133, these commitments to originate mort-

gage loans must be accounted for as derivatives

by the issuer under FAS 133 and include, but

are not limited to, those commonly referred to

as interest-rate-lock commitments.

In a derivative loan commitment, the lender

agrees to extend credit to a borrower under

certain speciﬁed terms and conditions in which

the interest rate and the maximum amount of the

loan

are set prior to or at funding. Under the

agreement, the lender commits to lend funds to

a potential borrower (subject to the lender’s

approval of the loan) on a ﬁxed- or adjustable-

rate basis, regardless of whether interest rates

change in the market, or on a ﬂoating-rate basis.

In a typical derivative loan commitment, the

borrower can choose to—

• ‘‘lock in’’ the current market rate for a ﬁxed-

rate loan (i.e., a ﬁxed derivative loan

commitment),

• ‘‘lock in’’ the current market rate for an

adjustable-rate loan that has a speciﬁed for-

mula for determining when and how the inter-

est rate will adjust (i.e., an adjustable deriva-

tive loan commitment), or

• wait until a future date to set the interest rate

and allow the interest rate to ‘‘ﬂoat’’ with

market interest rates until the rate is set (i.e., a

ﬂoating derivative loan commitment).

Derivative loan commitments vary in term and

expire after a speciﬁed time period (e.g., 60

days after the commitment date). Additionally,

derivative loan commitments generally do not

bind the potential borrower to obtain the loan,

nor do they guarantee that the lender will approve

the loan once the creditworthiness of the poten-

tial borrower has been determined.

3071.0.1.5.2 Forward Loan-Sales

Commitment

The term forward loan-sales commitment refers

to either (1) a mandatory-delivery contract or

(2) a best-efforts contract that, upon evaluation

under FAS 133, meets the deﬁnition of a

derivative.

3071.0.1.5.3 Mandatory-Delivery

Contract

A mandatory-delivery contract is a loan-sales

agreement in which a ﬁnancial institution com-

mits to deliver a certain principal amount of

mortgage loans to an investor at a speciﬁed

price on or before a speciﬁed date. If the institu-

tion fails to deliver the amount of mortgages

necessary to fulﬁll the commitment by the speci-

ﬁed date, it is obligated to pay a ‘‘pair-off’’ fee,

based on then-current market prices, to the

investor to compensate the investor for the short-

fall. Variance from the originally committed

principal amount is usually permitted, but typi-

cally may not exceed 10 percent of the commit-

ted amount.

All loan-sales agreements must be evaluated

to determine whether they meet the deﬁnition of

a derivative under FAS 133.

A mandatory-

18. In accordance with the ‘‘Background Information and

Basis for Conclusions’’ in Statement of Financial Accounting

Standards No. 149 (FAS 149), the notional amount of a

derivative loan commitment is the maximum amount of the

borrowing. See FAS 149, paragraph A27.

19. See FAS 133, paragraph 6, for the characteristics of a

ﬁnancial instrument or other contract that meets the deﬁnition

of a derivative.

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BHC Supervision Manual January 2006

Page 5

delivery contract has a speciﬁed underlying (the

contractually speciﬁed price for the loans) and

notional amount (the committed loan-principal

amount), and requires little or no initial net

investment. Additionally, a mandatory-delivery

contract requires or permits net settlement or the

equivalent thereof as the institution is obligated

under the contract to either deliver mortgage

loans or pay a pair-off fee (based on the then-

current market prices) on any shortfall on the

delivery of the committed loan-principal amount.

Since the option to pay a pair-off fee accom-

plishes net settlement, it is irrelevant as to

whether the mortgage loans to be delivered are

considered readily convertible to cash.

Based

on these characteristics, a mandatory-delivery

contract meets the deﬁnition of a derivative at

the time an institution enters into the commitment.

3071.0.1.5.4 Best-Efforts Contract

The term best-efforts contract refers to a loan-

sales agreement in which a ﬁnancial institution

commits to deliver an individual mortgage loan

of a speciﬁed principal amount and quality to an

investor if the loan to the underlying borrower

closes. Generally, the price the investor will pay

the seller for an individual loan is speciﬁed prior

to the loan being funded (e.g., on the same day

the lender commits to lend funds to a potential

borrower). A best-efforts contract that has all of

the following characteristics would meet the

deﬁnition of a derivative:

• an underlying (e.g., the price the investor will

pay the seller for an individual loan is speci-

ﬁed in the contract)

• a notional amount (e.g., the contract speciﬁes

the principal amount of the loan as an exact

dollar amount or as a principal range with a

determinable maximum amount)

• requires little or no initial net investment (e.g.,

no fees are exchanged between the seller and

investor upon entering into the agreement, or

a fee that is similar to a premium on other

option-type contracts is exchanged)

• requires or permits net settlement or the equiva-

lent thereof (for example, the seller is contrac-

tually obligated to either (1) deliver the loan

to the investor if the loan closes or (2) pay a

pair-off fee, based on then-current market

prices, to the investor to compensate the in-

vestor if the loan closes and is not delivered.

Since the option to pay a pair-off fee accom-

plishes net settlement, it is irrelevant as to

whether the loan to be delivered is considered

readily convertible to cash.).

3071.0.1.5.5 Master Agreement

A ﬁnancial institution may enter into one of

several types of arrangements with an investor

to govern the relationship between the institu-

tion and the investor and set the parameters

under which the institution will deliver indi-

vidual mortgage loans through separate best-

efforts contracts. Such an arrangement might

include, for example, a master agreement or an

umbrella contract. These arrangements may

specify an overall maximum principal amount

of mortgage loans that the institution may deliver

to the investor during a speciﬁed time period,

but generally they do not specify the price the

investor will pay for individual loans. Further,

while these arrangements may include pair-off-

fee provisions for loans to be sold under indi-

vidual best-efforts contracts covered by the

arrangements, the seller is neither contractually

obligated to deliver the amount of mortgages

necessary to fulﬁll the maximum principalamount

speciﬁed in the arrangement nor required to pay

a pair-off fee on any shortfall. Because these

arrangements generally either do not have a

speciﬁed underlying or determinable notional

amount or do not require or permit net settle-

ment or the equivalent thereof, the arrangements

typically do not meet the deﬁnition of a deriva-

tive. As discussed above, an individual best-

efforts contract governed by one of these

arrangements may, however, meet the deﬁnition

of a derivative.

As the terms of individual best-efforts con-

tracts and master agreements or umbrella con-

tracts vary, a ﬁnancial institution must carefully

evaluate such contracts to determine whether

the contracts meet the deﬁnition of a derivative

in FAS 133.

20. See FAS 133, paragraph 57(c)(1), for a description of

contracts that have terms that implicitly or explicitly require

or permit net settlement.

21. The use of a maximum amount as the notional amount

of a best-efforts contract is consistent with the loan-

commitment discussion in the ‘‘Background Information and

Basis for Conclusions’’ in FAS 149. See FAS 149, paragraph

A27.

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3071.0.1.6 Example of the Accounting

for Commitments to Originate and Sell

Mortgage Loans

3071.0.1.6.1 ABC Mortgage Financial

Institution (Best-Efforts Contracts and No

Application of Fair-Value Hedge

Accounting)

The following simpliﬁed example was devel-

oped to provide a ﬁnancial institution that has a

limited number of derivative loan commitments

general guidance on one approach that may be

used to value such commitments.

This exam-

ple also illustrates the regulatory reporting

requirements for derivative loan commitments

and forward loan-sales commitments.

The guidance in this example is for illustra-

tive purposes only, as there are several ways that

a ﬁnancial institution might estimate the fair

value of its derivative loan commitments. A

second approach to valuing derivative loan com-

mitments is described in Derivative Loan Com-

mitments Task Force Illustrative Disclosures on

Derivative Loan Commitments, a practice aid

developed by staff of the American Institute of

Certiﬁed Public Accountants (AICPA) and a

task force comprising representatives from the

ﬁnancial services, mortgage banking, and public

accounting communities.

As indicated in the

body of the interagency advisory, a ﬁnancial

institution must consider the guidance in FAS

133, FAS 107, EITF 02-3, and SAB 105 in

measuring and recognizing derivative loan com-

mitments and forward loan-sales commitments.

In addition, an institution should be aware that

the SEC or FASB may issue additional guidance

in the future that may alter certain aspects of

this example.

3071.0.1.6.1.1 Background

ABC Mortgage Financial Institution (ABC) en-

ters into ﬁxed, adjustable, and ﬂoating deriva-

tive loan commitments to originate mortgage

loans that it intends to sell. The institution

accounts for the commitments as derivative

ﬁnancial instruments as required under FAS

133.

ABC enters into best-efforts contracts with a

mortgage investor under which it commits to

deliver certain loans that it expects to originate

under derivative loan commitments (i.e., the

pipeline) and loans that it has already originated

and currently holds for sale (i.e., warehouse

loans). ABC and the mortgage investor agree on

the price that the investor will pay ABC for an

individual loan with a speciﬁed principal amount

prior to the loan being funded. Once the price

that the mortgage investor will pay ABC for an

individual loan and the notional amount of the

loan are speciﬁed, and ABC is obligated to

deliver the loan to the investor if the loan closes,

the contract represents a forward loan-sales com-

mitment. Under FAS 133, ABC accounts for

these forward loan-sales commitments as

derivative ﬁnancial instruments.

On December 31 of a given year, the notional

amounts of ABC’s mortgage banking derivative

loan commitments and forward loan-sales com-

mitments are as follows:

Table 1—Notional Amounts of Derivative

Loan Commitments and Forward

Loan-Sales Commitments

Notional

amount

Derivative loan

commitments

Fixed-rate

commitments

$ 8,500,000

Adjustable-rate

commitments 1,500,000

Floating-rate

commitments

2,000,000

Total derivative loan

commitments $12,000,000

[A]

22. This example uses the deﬁnitions and concepts pre-

sented in the body of the Interagency Advisory on Accounting

and Reporting for Commitments to Originate and Sell Mort-

gage Loans (the interagency advisory). Refer to the inter-

agency advisory for clariﬁcation of the terms and concepts

used in this example.

23. Estimating fair values when quoted market prices are

unavailable requires considerable judgment. Valuation tech-

niques using simpliﬁed assumptions may sometimes be used

(with appropriate disclosure in the ﬁnancial statements) to

provide a reliable estimate of fair value at a reasonable cost.

See FAS 107, paragraphs 60–61.

24. The practice aid is available at www.aicpa.org/download/

members/div/acctstd/Illustrative_Disclosure_on_Derivative_

Loan_Commitments.pdf.

25. Alpha references in table 1 and the text of this example

refer to the ‘‘Reference’’ column in table 3.

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Table 1—continued

Notional

amount

Forward loan-sales

commitments

Pipeline loan

commitments

$12,000,000

Warehouse loan

commitments 8,000,000

Total forward loan-

sales commitments $20,000,000

[B]

Market interest rates have changed through-

out the time period that ABC’s derivative loan

commitments and forward loan-sales commit-

ments have been outstanding. Some of the ﬁxed-

rate commitments are at rates above current

market rates while others are at rates at or below

current market rates. All of ABC’s adjustable-

rate commitments are at rates below current

market rates.

Based on its past experience, ABC estimates

a pull-through rate of 70 percent on its ﬁxed-

rate commitments for which the locked-in rate

is above current market rates (i.e., 70 percent of

the commitments will actually result in loan

originations) and a pull-through rate of 85 per-

cent for its ﬁxed-rate commitments for which

the locked-in rate is at or below current market

rates. ABC also estimates a pull-through rate of

85 percent for all of its adjustable-rate commit-

ments that are below market rates.

The pull-through-rate assumptions in this

example have been simpliﬁed for illustrative

purposes. In determining appropriate pull-

through rates, a ﬁnancial institution must con-

sider all factors that affect the probability that

derivative loan commitments will ultimately

result in originated loans. Therefore, an institu-

tion is expected to have more granularity (i.e.,

stratiﬁcation) in its application of pull-through-

rate assumptions to its derivative loan

commitments.

3071.0.1.6.1.2 Discussion of ABC’s Approach

to Valuing Derivative Loan Commitments and

Forward Loan-Sales Commitments

ABC estimates the fair value of its derivative

loan commitments using the best information

available in the circumstances because quoted

market prices are not available. In this case,

ABC uses valuation techniques that take into

account current secondary-market loan pricing

information.

ABC had noted the appropriate

reference price for the underlying loans on the

day that each derivative loan commitment was

given to a borrower, and assigned an initial fair

value of zero to each loan commitment consis-

tent with the guidance in SAB 105 and EITF

02-3. At the end of the month, ABC compares

the current reference price of each underlying

loan with its initial reference price and calcu-

lates the price difference. ABC then calculates

the fair value of these derivatives by multiply-

ing the price difference by the estimated pull-

through rate. This approach is illustrated in

table 2.

As illustrated in table 2, ABC excludes time

value from its fair-value-estimate methodology

due to the short-term nature of the derivative

loan commitments. As the exclusion of time

value is not appropriate for all fair-value esti-

mates, an institution must consider the terms of

its speciﬁc agreements in determining an appro-

priate estimation methodology.

In the example in table 2, ABC estimated the

initial reference price of the underlying loan to

be originated under the commitment, excluding

the value of the associated servicing rights, to be

$100,000. That is, at the date it entered into the

ﬁxed derivative loan commitment with the bor-

rower, ABC estimated it would receive $100,000,

excluding the value of the associated servicing

rights, if the underlying loan was funded and

sold in the secondary market on that day. Because

this amount is equal to the notional amount of

the loan, ABC would not experience a gain or

loss on the sale of the underlying loan (before

considering the effect of the loan-origination

fees and costs associated with the loan). As

such, the fair value of this derivative loan com-

mitment would be zero, and there would not be

any unrealized gain or loss at the inception of

the derivative loan commitment. This may not

be true for all derivative loan commitments.

ABC defers all unrealized gains and losses at

the inception of its derivative loan commitments

until the underlying loans are sold. ABC’s pol-

icy is based on the short-term nature of its

26. In general, source data for secondary-market loan-

pricing information may include, for example, quotations

from rate sheets; brokers; or electronic systems such as those

provided by third-party vendors, market makers, or mortgage

loan investors. When secondary-market loan-pricing informa-

tion that includes the value of servicing rights is used, the fair

value of the derivative loan commitments ultimately must

exclude any value attributable to servicing rights.

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Table 2—ABC’s Calculation of the Fair Value of Derivative Loan Commitments: An

Example of a Fixed Derivative Loan Commitment for Which the Locked-In Rate Is

Above the Current Market Rate*

Notional

amount

loan

Initial reference

price of loan

to be

originated under

commitment—

excluding

servicing

rights

Current reference

price of loan

to be

originated under

commitment—

excluding

servicing

rights

Price

difference

Pull-

through

rate

Fair value of

derivative

loan

commitment

(1) (2) (3) [(3) - (2)] (4) [(3) - (2)] × (4)

$100,000 $100,000 $100,500 $500 70% $350

* The example in this table presents the fair-value calculation for one derivative loan commitment. The fair value of this

derivative, which is positive, would be added to all the other derivative loan commitments with positive fair values. Netting

derivatives with positive fair values (assets) against derivatives with negative fair values (liabilities) is not permitted unless the

conditions stipulated in FIN 39 are met. Refer to footnote 8.

derivative loan commitments and was adopted

in order to not accelerate the timing of gain

recognition. As this practice may not be appro-

priate for all derivative loan commitments or

other derivatives initially accounted for under

EITF 02-3, and due to the lack of authoritative

guidance in this area, an institution should con-

sult with its accounting advisers concerning the

appropriateaccountingforitsspeciﬁcagreements.

After applying the methodology described

above to individual derivative loan commit-

ments, ABC aggregates the fair values of the

derivative loan commitments by type (i.e., ﬁxed,

adjustable, and ﬂoating) and by whether the

commitments have above-, at-, or below-market

rates. The fair values of the ﬁxed derivative loan

commitments with above-market rates, adjusted

for the appropriatepull-through rate,total$21,000

[C], which represents an asset. The aggregate

fair value of the ﬁxed derivative loan commit-

mentsthat have at- or below-marketrates,adjusted

for the appropriate pull-through rate, sums to

($31,000) [D], which represents a liability. For

the adjustable derivative loan commitments, the

aggregate fair value, adjusted for the pull-

through rate, is approximately ($2,000) [E],

which is also a liability. The fair value of the

ﬂoating derivative loan commitments

approximates zero.

ABC also estimates the fair value of its for-

ward loan-sales commitments outstanding at the

end of the month using a similar methodology

as that described above. Based upon this infor-

mation, ABC determines that the estimated fair

value of the forward loan-sales commitments

related to its derivative loan commitments and

warehouse loans with above-market rates is

approximately ($45,000) [F], which represents a

liability, because current market interest rates

for comparable mortgage loans are lower than

the rates in effect when the derivative loan com-

mitments were initiated. (Consequently, current

offered delivery prices for similar commitments

are greater than the delivery prices of ABC’s

existing forward loan-sales commitments. There-

fore, the change in the fair value of ABC’s

forward loan-sales commitments since they were

entered into represents a loss.) The fair value of

ABC’s forward loan-sales commitments related

to its derivative loan commitments and ware-

house loans with at- or below-market rates is

estimated to be $50,000, which is an asset.

3071.0.1.6.1.3 Regulatory Reporting

The following table illustrates the regulatory

reporting requirements for the derivative-related

dollar amounts cited in the example.

As illustrated in table 3, depending upon par-

ticular market circumstances, individual deriva-

tive loan commitments and forward loan-sales

27. The absolute value of the fair value of the forward

loan-sales commitments is greater than the absolute value of

the fair value of the related derivative loan commitments

because the forward loan-sales commitments also apply to,

and act as an economic hedge of, ABC’s warehouse loans.

ABC accounts for its warehouse loans at the lower of cost or

fair value in accordance with FAS 65. In this example, ABC

does not apply hedge accounting to its warehouse loans.

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Page 9

Table 3—Regulatory Reporting Implications for Derivative Loan Commitments and

Forward Loan-Sales Commitments

Amount Reference

Derivative loan commitments

Notional amount of ‘‘over-the-counter written options’’

$12,000,000 [A]

Derivatives with a positive fair value held for purposes

other than trading (asset) $21,000 [C]

Derivatives with a negative fair value held for purposes

other than trading (liability) $33,000 [D + E]

Forward loan-sales commitments

Notional amount of ‘‘forward contracts’’ $20,000,000 [B]

Derivatives with a positive fair value held for purposes

other than trading (asset) $50,000 [G]

Derivatives with a negative fair value held for purposes

other than trading (liability) $45,000 [F]

Derivative loan commitments and forward loan-sales

commitments

Total notional amount of derivative contracts held for

purposes other than trading $32,000,000 [A + B]

commitments may have either positive or nega-

tive fair values, which ABC properly reports

gross as assets or liabilities on its balance sheet.

In addition, for regulatory reporting purposes,

ABC consistently reports the periodic changes

in the fair value of its derivative contracts in

‘‘other non-interest expense’’ in its income state-

ment. Alternatively, ABC could have chosen to

consistently report these fair-value changes in

‘‘other non-interest income’’ in its regulatory

reports.

3071.0.2 INSPECTION OBJECTIVE

1. To ﬁnd out if the bank holding company

accounted for and reported the following

transactions at their fair value: (1) its com-

mitments to originate mortgage loans that

were held for resale (derivatives) and (2) its

loan-sales agreements that are derivatives. If

so, ascertain if these transactions were

accounted for and reported—

a. in accordance with the instructions for the

BHC reports (for example, the FR Y-9C);

GAAP; and SR-05-10 and its attached

May 3, 2005, Interagency Advisory on

Accounting and Reporting for Commit-

ments to Originate and Sell Mortgage

Loans and

b. based on reasonable and supportable valu-

ation techniques as prescribed by the May

3, 2005, interagency advisory.

3071.0.3 INSPECTION PROCEDURES

1. Determine whether the bank holding com-

pany has written and consistently applied

accounting policies to its commitments to

(1) originate mortgage loans that were held

for resale and (2) sell mortgage loans under

mandatory-delivery and best-efforts contracts.

2. Find out if the bank holding company has

developed and uses approved valuation meth-

odologies and procedures to obtain formal

approval for changes to those methodologies.

a. Ascertain whether the valuation method-

ologies are reasonable, objectively sup-

ported, and fully documented.

28. Because derivative loan commitments are in certain

respects similar to options, they are reported with ‘‘over-the-

counter written options’’ for regulatory reporting purposes.

Mortgage Banking—Derivative Commitments to Originate and Sell Mortgage Loans 3071.0

BHC Supervision Manual January 2006

Page 10

b. Determine if the bank holding company

has internal controls, including an effec-

tive independent review or audit, in place

that give integrity to the valuation process.

3. If the bank holding company issues ﬁxed-,

adjustable-, and ﬂoating-rate derivative loan

commitments or forward loan-sales commit-

ments, review an adequate sample that evi-

dences the full coverage of these types of

transactions.

a. Ascertain if these transactions were prop-

erly reported on the balance sheet as an

‘‘other asset’’ or an ‘‘other liability,’’ based

on whether the individual commitment

has a positive (asset) or negative (liabil-

ity) fair value in accordance with the

instructions for the BHC reports.

b. Determine if the ﬂoating-rate derivative

loan commitments and other derivative

loan commitments were reported at their

entire gross notional amount in the BHC’s

reports (such as the FR Y-9C).

c. Find out if the balance sheet correctly

presents accounts for all such transac-

tions, including the netting of contracts,

the application of hedge accounting to

mortgage banking activities, the valuation

of derivatives, and any material or other

accounting changes for derivative loan

commitments and loan-sales agreements.

Also determine if the bank holding com-

pany complies with the May 3, 2005,

Interagency Advisory on Accounting and

Reporting for Commitments to Originate

and Sell Mortgage Loans and with GAAP.

d. Ascertain if periodic changes in the fair

value of derivative loan commitments and

forward loan-sales commitments are

reportedin current-periodearnings as either

‘‘other non-interest income or ‘‘non-

interest expense, as appropriate.

4. Report to the central point of contact or

examiner-in-charge any failure by the bank

holding company’s management to follow

(1) the bank holding company’s accounting

and valuation policies for its commitments to

originate mortgage loans that are held for

resale and its commitments to sell mortgage

loans, (2) the instructions for the Consoli-

dated Financial Statement for Bank Holding

Companies, (3) the May 3, 2005, interagency

advisory, or (4) GAAP.

5. When additional inspection scrutiny is

needed—based on the examination’s ﬁnd-

ings; the supervisory concerns discussed in

section 3071.0; the February 23, 2003, Inter-

agency Advisory on Mortgage Banking (see

SR-03-4 and its attachment); and the May 3,

2005, Interagency Advisory on Accounting

and Reporting for Commitments to Originate

and Sell Mortgage Loans (see SR-05-10 and

its attachment)—consider using the compre-

hensive mortgage banking examination pro-

cedures in the appendix section A.2040.3 of

the Commercial Bank Examination Manual.

Mortgage Banking—Derivative Commitments to Originate and Sell Mortgage Loans 3071.0

BHC Supervision Manual January 2006

Page 11

Section 4(c)(8) of the BHC Act (Activities Related to Extending

Credit) Section 3072.0

In 1997, the Board amended Regulation Y to

include ‘‘activities related to extending credit’’

in section 225.28(b)(2), which includes the fol-

lowing permissible nonbanking activities:

Section No.

1. real estate and personal property

appraising 3270.0

2. arranging commercial real estate

equity ﬁnancing 3220.0

3. check-guaranty services 3320.0

4. collection agency services 3330.0

5. credit bureau services 3340.0

6. asset-management, servicing, and

collection activities 3084.0

7. acquiring debt in default 3104.0

8. real estate settlement services

3072.8

1. Real estate settlement services do not include providing

title insurance as principal, agent, or broker.

BHC Supervision Manual July 2006

Page 1

Section 4(c)(8) of the BHC Act Real Estate Settlement Services

Section 3072.8

In 1997, the Board incorporated real estate ser-

vicing into section 225.28(b)(2) as one of the

activities related to extending credit. (See 12

C.F.R. 225.28(b)(2)(viii).) Real estate settle-

ment services do not include providing title

insurance as principal, agent, or broker. Previ-

ously, the Board had approved the activity by

Board order. In the order, the Board found that

real estate settlement services consist of—

1. reviewing the status of the title in the title

commitment, resolving any exceptions to the

title, and reviewing the purchase agreement

to identify any requirements that need to be

complied with;

2. verifying payoffs on existing loans secured

by the real estate and verifying the amount of

and then calculating the prorating of special

assessments and taxes on the property;

3. obtaining an updated title insurance commit-

ment to the date of closing; preparing the

required checks, deeds, and afﬁdavits; and

obtaining any authorization letters needed;

4. establishing a time and place for the closing,

conducting the closing, and ensuring that all

parties properly execute all appropriate docu-

ments and meet all commitments;

5. collecting and disbursing funds for the par-

ties, holding funds in escrow pending satis-

faction of certain commitments, and prepar-

ing the HUD settlement statement, the deed

of trust, mortgage notes, the Truth-in-

Lending statement, and purchaser’s afﬁda-

vits; and

6. recording all of the documents required under

law. (See 1990 FRB 1058.)

3072.8.1 REAL PROPERTY

EXCHANGE TRANSACTIONS UNDER

SECTION 1031 OF THE INTERNAL

REVENUE CODE

A request submitted to the Board on behalf of a

bank holding company (BHC) requested an

advisory opinion pursuant to section 225.27 of

Regulation Y (12 C.F.R. 225.27). The BHC was

proposing the acquisition of a subsidiary (the

1031 exchange subsidiary) that provided ser-

vices to customers seeking to make exchanges

of real property pursuant to section 1031 of the

Internal Revenue Code (1031 exchange

transactions).

Section 1031 of the Internal Revenue Code

provides a U.S. taxpayer with deferral of gain

when the taxpayer exchanges his or her property

for another property of a ‘‘like kind.’’ In a

‘‘forward’’ 1031 exchange transaction, the tax-

payer ﬁrst sells his or her existing property and

later purchases a replacement property.

In order

to complete a forward 1031 exchange transac-

tion successfully, a taxpayer must satisfy certain

conditions in section 1031 of the Internal Rev-

enue Code and the U.S. Treasury regulations

that implement section 1031. For example, in a

forward 1031 exchange transaction, at the clos-

ing of the sale of the initial property, the pro-

ceeds of the sale must be held by an individual

or entity otherwise unrelated to the transaction

(the qualiﬁed intermediary). In addition, the tax-

payer engaging in the forward 1031 exchange

transaction may not receive the sale proceeds

during the period in which a replacement prop-

erty is identiﬁed (up to 45 days) and acquired

(up to 180 days). In this request, the BHC was

proposing to acquire a subsidiary that would act

as a qualiﬁed intermediary in forward 1031

exchange transactions involving real property.

The 1031 exchange subsidiary would engage

in several activities in order to facilitate forward

1031 exchange transactions. First, the subsidi-

ary would provide its customer with documents

relatedto the exchange to ensure that the exchange

qualiﬁed as a valid forward 1031 exchange

transaction. Speciﬁcally, the subsidiary would

provide an exchange agreement, an assignment

agreement, and a notice. The exchange agree-

ment is a contract between the customer and the

subsidiary that, among other features, notes the

requirements for the successful completion of

the transaction. The assignment agreement trans-

fers from the customer to the subsidiary certain

responsibilities for the sale of the initial prop-

erty and the receipt of sales proceeds in order to

ensure that the customer does not ‘‘construc-

tively receive’’ the proceeds of the initial prop-

erty sale for tax purposes. These responsibilities

may include taking the transitory title to the

initial property and replacement property as they

are transferred from seller to buyer. The notice

informs the purchaser of the initial property that

the transaction is part of a forward 1031 exchange

transaction; it helps establish that the mecha-

1. In a ‘‘reverse’’ 1031 exchange transaction, the taxpayer

ﬁrst purchases a replacement property and later sells his or her

property. The proposal did not include the provision of ser-

vices to customers seeking to make reverse 1031 exchange

transactions.

BHC Supervision Manual July 2006

Page 1

nism for the forward 1031 exchange transaction

is in place at the time of the sale.

Second, the 1031 exchange subsidiary would

invest the proceeds of the sale of the initial

property on behalf of the customer until the

customer acquired the replacement property.

The proceeds would be invested at the discre-

tion of the subsidiary but would typically be

deposited into deposit accounts at the BHC’s

subsidiary state-chartered commercial bank.

The

subsidiary would also transfer the necessary

funds to the appropriate party to effect the cus-

tomer’s purchase of the replacement property. If

the customer does not identify a replacement

property or purchase the replacement property

within the required time periods set forth in

section 1031 of the Internal Revenue Code or

U.S. Treasury regulations implementing section

1031, the proceeds of the sale of the initial

property would be transferred to the customer. It

was represented that the subsidiary would act in

a ﬁduciary capacity in holding, investing, and

disbursing the customer’s funds and that a state-

chartered nondepository trust company would

be allowed to engage in the activities of the

subsidiary.

The 1031 exchange subsidiary (1) would not

participate in negotiating the terms of the real

property sale and purchase transactions that con-

stitute the forward 1031 exchange transaction

and (2) would not assist the customer in locating

a buyer of the initial property or a seller of the

replacement property. The requestor also asserted

that the proposed services are permissible non-

banking activities for BHCs under section

225.28(b) of Regulation Y (12 C.F.R. 225.28(b)).

In view of all the facts of the record, Board

staff opined that the proposed activities of the

1031 exchange subsidiary would be permissible

real estate settlement services under section

225.28(b)(2)(viii) of Regulation Y (12 C.F.R.

225.28(b)(2)(viii)); would be trust company func-

tions under section 225.28(b)(5) of Regulation

Y (12 C.F.R. 225.28(b)(5)); and would be ﬁnan-

cial advisory services, including tax-planning

and tax-preparation services, under section

225.28(b)(6) of Regulation Y (12 C.F.R.

225.28(b)(6)).

The opinion is limited to the activities relat-

ing to the 1031 exchange transaction described

in the opinion and in the correspondence

exchanged between the requestor and Board

staff. See the Board staff’s February 9, 2006,

legal interpretation.

2. The BHC’s commercial bank subsidiary also may be a

lender with respect to real properties involved in the 1031

exchange transaction. Any lending relationship between the

bank and the customer would depend on the ability of the

customer and the loan transaction to meet the bank’s standard

underwriting terms and conditions.

3. The Ofﬁce of the Comptroller of the Currency (OCC)

authorized national banks to provide a wide range of services

to facilitate their customers’ 1031 exchange transactions. See

OCC Interpretive Letter No. 880 (December 16, 1999) and

OCC Corporate Decision No. 2001–30 (October 10, 2001).

Section 4(c)(8) of the BHC Act Real Estate Settlement Services 3072.8

BHC Supervision Manual July 2006

Page 2

Section 4(c)(8) of the BHC Act

(Education-Financing Activities) Section 3073.0

3073.0.1 EXPANDED STUDENT-

LOAN-SERVICING ACTIVITIES

A bank holding company applied for the Board’s

approval under section 4(c)(8) of the Bank Hold-

ing Company Act (BHC Act) and section 225.23

of Regulation Y to expand the student-loan-

servicing activities of its nonbank subsidiary.

The activities would consist of—

1. providing student-loan authorities (the author-

ity) with regular reports that include informa-

tion in the aggregate and by individual lend-

ers concerning the volume of loans being

serviced for the authority and the volume of

loans outstanding;

2. preparing projections for approval by the

authority of student loans to be purchased

and commitments to be issued in the future,

based on the volume of loans being serviced

and commitments outstanding, consistent with

the amount of funds available to the author-

ity as the result of its sale of bonds;

3. advising eligible lenders, borrowers, and other

interested parties of the authority’s student-

loan-purchase program, including the criteria

used by the authority in purchasing student

loans and the extent to which the authority

will be purchasing loans in the future based

on the availability of funds; and

4. meeting regularly with the authority to advise

it of the nonbank subsidiary’s efforts in con-

nection with the student-loan activities.

Under no circumstances would the nonbank

subsidiary be authorized to bind the authority or

its bank trustee to commit to purchase or actu-

ally to purchase student loans from eligible

lenders.

The proposed activities were regarded as being

equivalent to the activities of a mortgage bank-

ing subsidiary of a bank holding company,

authorized under section 225.28(b)(1) of Regu-

lation Y, with respect to acquiring and servicing

mortgage loans for institutional investors or in

connection with the secondary-mortgage mar-

ket. The activities proposed and currently con-

ducted by the applicant, to the extent that they

were different from the services performed by

any institution that services loans for others,

were perceived as being different only in that

they related to servicing student loans for a

governmental authority. Banks and their non-

bank subsidiaries generally provide comprehen-

sive loan-acquisition and -servicing ‘‘packages’’

for investors in mortgage and other loans. The

bank holding company’s nonbank subsidiary

was the nation’s largest servicer of student

loans, and was thus particularly well equipped

to perform the proposed expanded services.

In addition to determining that the proposed

activities were closely related to banking to

approve the application, the Board had to con-

clude that the proposed activities would produce

beneﬁts to the public that would outweigh any

possible adverse effects, such as unsound bank-

ing practices, unfair competition, conﬂicts of

interests, or undue concentration of resources.

The Board made that conclusion in addition to

determining that the balance of public interest

factors that it is required to consider under sec-

tion 4(c)(8) of the BHC Act was favorable.

Accordingly, the application was approved on

July 1, 1985 (1985 FRB 725).

BHC Supervision Manual December 1998

Page 1

Section 4(c)(8) of the BHC Act

(Servicing Loans) Section 3080.0

A bank holding company or its subsidiary may

engage in the activity of servicing loans or other

extensions of credit for either afﬁliated compa-

nies or for persons or institutions not afﬁliated

with the holding company. The service will

often be carried on as an additional activity of a

credit-extending subsidiary, such as a mortgage

company, where the loan serviced was origi-

nated by the subsidiary and subsequently sold to

an investor. A servicing company provides the

collection vehicle through receipt and disburse-

ment of funds for investors who may not pos-

sess the resources to accomplish the activity.

The purpose of servicing is to keep a sound loan

in good standing for a passive investor. The

servicing company’s remuneration is usually

based upon a percentage of the outstanding bal-

ance of the loan.

The traditional servicing arrangement arises

from the normal business of a mortgage com-

pany. The company grants extensions of credit

to qualiﬁed borrowers and subsequently pack-

ages and sells these loans, normally without

recourse, to individuals or institutional investors

who contract the collection of the credit to the

mortgage company. The company may also pur-

chase mortgages or other extensions of credit in

the open market with the intention of reselling

the credit and retaining the servicing or can

simply purchase servicing portfolios (12 C.F.R.

225.132). The collection itself is basically a

bookkeeping function.

Servicing loans for others is relatively risk-

free to the company when the credits are sold

without recourse to investors. A credit which

has been sold with recourse represents an unusual

circumstance and should, therefore, be reviewed

in detail. The serviced loans will generally be

high quality mortgages which are in turn pur-

chased from the company by passive investors

desiring a ﬁxed rate of return on their funds.

The risk to a servicing company lies in its

portfolio of unsold loans, or its ‘‘warehouse.’’

The risk is two-fold: (1) the loan may not be of

high enough quality to attract an investor so that

the servicing company will have to continue to

carry the credit for its own account, and (2) the

loan was made at an interest rate which is below

current market rates. In the latter case, the ser-

vicing company must either sell the loan at a

discount or continue to hold the credit for its

own account. In either case, the loan is treated

as an asset of the company and involves credit

risk.

The inspection of a servicing company, or a

servicing department of a credit-extending sub-

sidiary, should focus on adequacy of documen-

tation and controls, and on the quality and mar-

ketability of the warehoused loans. The examiner

should obtain a past due report for the portfolio

and note in the inspection report signiﬁcant

credits which are past due together with the

period of delinquency, the type of loan, and the

asset classiﬁcation, if any. The nature of the

servicing business is such that the number of

past dues should be small because loans are

only warehoused for a short period of time until

they can be sold to an investor. As a rule, a past

due loan or a current loan which has been ware-

housed for more than several months is indica-

tive of some problem with the credit. Each loan

should be evaluated to determine the reason it

has not been sold.

During periods of rising long-term interest

rates, the warehouse portfolio becomes subject

to the risk that a loan may not be marketable,

except at a discount, because of its relatively

low yield. This affects both the servicer’s income

and liquidity.

In the case of the parent company acting as a

servicer, the inspection should also determine

whether the activity is being carried on under

the proper exemption. A bank holding company

may act as a servicer under section 4(c)(8) of

the Act or under the provisions of sections

4(a)(2) and/or 4(c)(1) of the Act. If carried on

under Section 4(a)(2) of the BHC Act, the hold-

ing company is limited to servicing loans only

for its own account or its banking and nonbank-

ing subsidiaries. If carried under Section

4(c)(1)(C) of the BHC Act, the bank holding

company is limited to servicing loans only for

its own account or its banking subsidiaries.

Finally, the income of the company should be

subject to scrutiny. A servicing company should

be a proﬁtable business. The servicer receives a

fee based upon a percentage of the outstanding

balance of the loan. In the early years of the

payback period, the fee should signiﬁcantly

exceed the cost of the service, and because

much of the portfolio will be reﬁnanced either

prior to its maturity or prepaid, the fee income

should be sufﬁcient to cover the servicer’s cost

plus proﬁt. The reason for poor earnings in this

activity is generally either inefﬁciency in the

collection area, failure to attain the breakeven

point of servicing volume, or the inability to

turnover the warehouse portfolio often enough

to maintain new fee generation. In the event that

BHC Supervision Manual December 1992

Page 1

the servicer is unproﬁtable, the examiner should

determine the reasons and clearly set them forth

in the inspection report.

The servicing arrangement is of a ﬁduciary

nature and as such it gives rise to certain contin-

gent liabilities. In the situation where the ser-

vicer is not fully and properly discharging its

servicing responsibilities in accordance with the

servicing agreement, the holder of the serviced

notes might bring legal claims against the ser-

vicer. The inspection process should direct

attention to this area including a review of the

servicing agreement and veriﬁcation that the

servicer is fulﬁlling its obligations. Manage-

ment should be reminded of the signiﬁcant loss

exposure which can result from improper atten-

tion to its ﬁduciary responsibilities.

3080.0.1 INSPECTION OBJECTIVES

1. To determine that internal controls are

adequate to administer effectively the servicing

of the loan portfolio.

2. To determine the level of exposure to

credit risk of loans held for the ﬁrm’s own

account.

3. To determine if the ﬁrm’s earnings are

sufﬁcient so as not to be a burden on the parent

or subsidiary bank.

3080.0.2 INSPECTION PROCEDURES

1. Review the balance sheet to determine the

volume of credits held for the ﬁrm’s own account

and evaluate their asset quality.

2. Review internal controls and evaluate their

adequacy.

3. Review earnings and appraise the impact

on the parent and bank subsidiaries.

4. Review servicing agreements and evaluate

the potential or contingent risks to which the

ﬁrm is exposed in the event of failure by a

borrower to service its loan properly.

5. Determine whether mortgage servicing

rights are recorded as an asset and whether they

are being amortized over the average life of the

loans being serviced.

Section 4(c)(8) of the BHC Act (Servicing Loans) 3080.0

BHC Supervision Manual December 1992

Page 2

Section 4(c)(8) of the BHC Act (Asset-Management,

Asset-Servicing, and Collection Activities) Section 3084.0

A bank holding company may engage under

contract with a third party in the management,

servicing, and collection

of the types of assets

that an insured depository institution may origi-

nate and own. The company cannot engage in

real property management or real estate broker-

age services as part of these services. See Regu-

lationY, section225.28(b)(2)(vi). Provided below

are some initial historical examples of Board

orders that involve asset-management services

related to this nonbanking activity. The commit-

ments and conditions provided for within the

Board orders should not be considered to be

currently applicable.

3084.0.1 ASSET-MANAGEMENT

SERVICES TO CERTAIN

GOVERNMENTAL AGENCIES AND

UNAFFILIATED FINANCIAL

INSTITUTIONS WITH TROUBLED

ASSETS

Three bank holding companies (the applicants)

applied for the Board’s approval under section

4(c)(8) of the BHC Act to engage de novo in

providingasset-managementservices to theReso-

lution Trust Corporation and the Federal Deposit

Insurance Corporation, and generally to unafﬁli-

ated ﬁnancial institutions with troubled assets.

The applicants committed to conduct these

activities under the same terms and conditions

as set out in 1988 FRB 771.

The commitments and conditions of this order

required that (1) the asset-management activi-

ties would be provided to the banks and savings

associations, (2) the applicant would obtain the

Board’s approval before providing asset-

management services for pools of assets that

were not originated or held by ﬁnancial institu-

tions and their afﬁliates, (3) the applicant would

cause its asset-management subsidiary to estab-

lish procedures to preserve the conﬁdentiality of

information obtained in the course of providing

asset-management services, and (4) neither the

applicant nor its management subsidiary would

take title to the assets managed by the asset-

management subsidiary.

The applications of these holding companies

were approved by a Board order on Decem-

ber 24, 1990 (1991 FRB 124). Two additional

orders about providing asset-management ser-

vices were approved on March 25, 1991 (1991

FRB 331 and 334).

3084.0.2 ASSET-MANAGEMENT

SERVICES FOR ASSETS

ORIGINATED BY NONFINANCIAL

INSTITUTIONS

Two bank holding companies (the applicants)

applied jointly for the Board’s approval under

section 4(c)(8) of the BHC Act to engage de

novo in collection-agency activities pursuant to

Regulation Y through a joint venture. The Board

concluded that the collection activities were

permissible.

The bank holding companies also applied for

the Board’s approval to engage in asset-

management, asset-servicing, and collection

activities through a nonbank of the joint venture

located in New Jersey. The subsidiary would

provide asset-management services to the Reso-

lution Trust Corporation (RTC) and the Federal

Deposit Insurance Corporation (FDIC). It would

also provide these services to unafﬁliated third-

party investors that purchase pools of assets

assembled by the RTC or the FDIC. Under the

proposal, neither the applicants nor this non-

bank subsidiary would acquire an ownership

interest in the assets that they manage or in the

institutions for which they provide the asset-

management services. The applicants further

committed that they would not provide real

property management or real estate brokerage

services as part of the proposed activities.

The Board previously determined that, within

certain parameters, providing asset-management

services for assets originated by ﬁnancial institu-

tions (banks, savings associations, and credit

unions) and their bank holding company afﬁli-

ates is an activity closely related to banking (see

1991 FRB 331, 334 and section 3600.15.3). The

applicants proposed to conduct all asset-

management activities subject to the same con-

ditions as in the Board orders previously cited.

The applicants proposed to engage in asset-

management activities for assets originated by

nonﬁnancial institutions as well as by ﬁnancial

institutions. These assets include real estate,

consumer, and other loans; equipment leases;

and extensions of credit. Assets of nonﬁnancial

institutions include pension funds, leasing com-

1. Asset-management services include acting as agent in

the liquidation or sale of loans and collateral for loans, includ-

ing real estate and other assets acquired through foreclosure

or in satisfaction of debts previously contracted.

BHC Supervision Manual June 1999

Page 1

panies, ﬁnance companies, and investment com-

panies formed to engage in asset-management

activities. The managed assets would be limited

to the types of assets that ﬁnancial institutions

have the authority to originate. The Board con-

cluded that the applicants would have the exper-

tise to engage in managing these types of assets,

regardless of the originating entity. The Board

also determined that the proposal was consistent

with the asset-management proposals approved

in its prior orders. The Board concluded that the

applicants’ proposed activities are closely related

to banking and approved the order on December

21, 1992. (1993 FRB 131)

Section 4(c)(8)—(Asset-Management, Asset-Servicing, and Collection Activities) 3084.0

BHC Supervision Manual June 1999

Page 2

Section 4(c)(8) of the BHC Act

(Receivables) Section 3090.0

Two nonbanking activities authorized under

section 4(c)(8) of the BHC Act, per Regulation

Y in section 225.28(b)(1), are the discount pur-

chasing of a client’s accounts receivables (fac-

toring) and the establishment of a revolving

credit facility secured by an assignment of

accounts receivable (accounts receivable ﬁnanc-

ing). These activities date back to Board orders

issued in 1951. See sections 3090.1 and 3090.2.

BHC Supervision Manual December 1997

Page 1

Section 4(c)(8) of the BHC Act

(Factoring) Section 3090.1

3090.1.1 INTRODUCTION

Factoring is the discount purchasing of the cli-

ent’s accounts receivable invoices for goods that

have been manufactured and shipped. Factoring

differs from accounts receivable ﬁnancing in

that the factor assumes the credit risk of collect-

ing payment from the recipient of the goods.

The principal advantage of factoring is that the

client is assured of the collection of the pro-

ceeds of its sales, regardless of whether the

factor is paid.

A factor generally offers four basic services:

(1) credit investigation and approval; (2) buying

the client’s accounts receivable at a discount

(generally between .75 and 1.5 percent) after

shipment of the goods to which there is no

subsequent claim, just a claim against the

invoices; (3) bookkeeping in the form of posting

accounts; and (4) advancing funds in the form

of an ‘‘open account’’ when there could be

30 days between shipment and payment. The

later allows the client to replenish inventory

loans for working capital or expansion.

Maturity factoring and advance factoring are

the basic techniques of the industry. In maturity

factoring, an average maturity due date is com-

puted for the receivables purchased during a

period and the client receives payment on that

date. Advance factoring uses the same computa-

tions, however, the client has the option of tak-

ing advance payments equal to a percentage of

the balance due at any time prior to the com-

puted average maturity due date. The unad-

vanced balance, sometimes called the ‘‘client’s

equity,’’ is payable on demand at the due date.

The factor’s balance sheet reﬂects the pur-

chases as ‘‘factored receivables’’ and the liabili-

ties as ‘‘due to clients.’’ Usually the due to

clients balance will be signiﬁcantly less than the

factored receivables balance because of pay-

ments and advances to the clients. The income

statement will show factoring commissions,

which represent the discount on the receivables

purchased. Interest income for advances on the

due to client balances may or may not be a

separate line item.

The factor is a pivoting point between the

buyer and the seller. The buyer must pay or all

parties lose. Also the seller must have a reputa-

tion for delivering quality merchandise. The fac-

tor must know the business well enough to

account for sudden increases in returns for out-

of-speciﬁcation merchandise or for merchandise

of low quality. If the seller does not perform

adequately, payment for the goods may not be

forthcoming, and if bankruptcy threatens the

seller, buyers may hold back their future

purchases.

3090.1.2 FUNDING

Since factors traditionally provide ﬁnancing to

industries with seasonal borrowing require-

ments, such as textiles, shoes, clothing, and

other consumer goods, their own funding pro-

grams will usually reﬂect this volatility. It may

be expected that factors generally will have

greater access to short-term unsecured credit

facilities than would be expected for other non-

bank activities. This would hold true for factors

funded solely from internal sources as well as

external sources.

Because of a factor’s inherent funding volatil-

ity, a major portion of a factor’s liabilities will

be short-term debt. For the internally funded

company, this source will be predominantly

commercial paper proceeds from the parent

company, with perhaps some bank line proceeds

intermixed. The externally funded company will

probably rely on bank lines for its short-term

needs, usually with the parent company’s guar-

anty of the debt.

Longer term funding may be provided through

bank term loans and subordinated debt, although

the volume of this type of debt appears to be

low relative to other ﬁnancing industries. The

terms and covenants of long-term debt appear to

allow for relatively more ﬂexibility in opera-

tions and more highly leveraged positions than

similar debt for other ﬁnancing industries in

recognition of the volatility of factoring opera-

tions and the liquidity of factoring assets.

The principal suppliers of senior and subordi-

nated funds to factors and accounts receivable

ﬁnancers appear to be limited to a few insurance

companies that specialize in this ﬁeld, although

a few banks also provide senior term funding.

These lenders have incorporated their percep-

tions of acceptable balance sheet ratios and

earnings performance into their debt agreements

as restrictive covenants. Since comparative

industry data is limited, these restrictive cove-

nants may be the examiner’s primary means of

evaluating leverage, loss reserves, and capital

adequacy. The ‘‘due to clients’’ account is another

signiﬁcant measure of a factor’s liabilities. As

noted before, the account represents the

BHC Supervision Manual December 1992

Page 1

accumulation of the amounts payable to the

clients upon the maturity of their factored

receivables. This liability is, to a large extent,

self-liquidating through the collection of those

receivables.

An analysis of the changes in the relative

proportions of the ‘‘due to clients’’ account

should provide valuable input into the analysis

of a factor’s earnings. Since factoring is a highly

competitive industry, price cutting has reduced

factoring commissions to a point where they

provide minimal support to earnings; therefore,

the interest margins on factoring advances have

a signiﬁcant impact on net income. The implica-

tion of the analysis of proportional changes is

that as more clients take advances (reducing

‘‘due to clients’’), proﬁt margins should widen,

and conversely, as the ‘‘due to clients’’ propor-

tion of total liabilities rises, proﬁt margins may

be expected to narrow.

3090.1.3 INSPECTION OBJECTIVES

1. To determine whether the company is op-

erating within the scope of its approved activi-

ties and within the provisions of the Act and

Regulation Y.

2. To determine whether transactions with

afﬁliates, including banks, are in accordance

with applicable statutes and regulations.

3. To determine the quality of the asset port-

folios, and whether lending, monitoring and col-

lection policies are adequate to maintain sound

asset conditions.

4. To determine the adequacy of the reserve

for loan losses and whether the asset charge-off

policy is appropriate.

5. To determine the viability of the company

as a going-concern, and whether its afﬁliate

status represents a potential or actual adverse

inﬂuence upon the condition of the consolidated

corporation.

3090.1.4 INSPECTION PROCEDURES

The inspection procedures for a factor have

been divided into two phases, preliminary and

on-site, when considered necessary.

The preliminary phase entails the gathering

and analysis of information at the parent com-

pany in order to determine the scope of the ﬁeld

work to be performed on-site. The on-site seg-

ment of the procedures expresses some of the

typical practices and considerations in this form

of ﬁnancing.

During the preliminary phase, the following

information should be reviewed:

1. System approvals for ofﬁces and activities,

including stipulated public beneﬁts;

2. Financial statements, both interim and ﬁs-

cal, for a sufﬁcient period to determine trends

and operating patterns;

3. All management reports which should

indicate problem loans, loan volume, new

accounts and other reports regarding loan port-

folio and company status;

4. External debt instruments to determine

material restrictive covenants;

5. Internal audit reports and workpapers;

6. Minutes of the board of directors, execu-

tive committee and loan committee, if available

at the parent company;

7. The resultsof a parentcompanyloanreview,

if any.

8. To be requested:

a. Schedules of past due loans, intercom-

pany participations, and large loans;

b. Schedules of problem accounts, liqui-

dating accounts, and repossessed assets;

c. General ledger trial balance;

d. Loan trial balance, including over-

advances;

e. Statements of company lending, accrual,

and other policies;

f. Reconcilement of the loan loss reserve

for the period between inspections;

g. Listing of common borrowers between

afﬁliates.

3090.1.4.1 On-Site Procedures

After reviewing the material available at the

parent company, including the audit review, a

decision whether to go on-site is in order. Some

of the determinants of this decision are relative

size, current earnings performance, overall con-

tribution to the corporation’s condition, asset

quality as indicated by internal loan review

reports and problem loan reports, and the condi-

tion of the company when last inspected. From

the information provided, it might be deter-

mined that the company is operating properly

and is in apparently sound condition. In such a

case, an on-site inspection may not be war-

ranted. Conversely, a deteriorating condition

might be detected which would require a visit,

even though a satisfactory condition had been

determined during the previous inspection. Sub-

sidiaries in unsatisfactory condition should be

Section 4(c)(8) of the BHC Act (Factoring) 3090.1

BHC Supervision Manual December 1992

Page 2

inspected each time the parent company is

inspected.

The following comments provide a general

outline of the factor’s basic operation. This out-

line will provide a background for the com-

ments in the inspection procedures.

While the typical factoring agreement stipu-

lates that all accounts receivable of a client are

assigned to the factor, not all are purchased

without recourse. The agreement between the

factor and the client will usually state that

receivables subject to shipping disputes and

errors, returns, and adjustments are chargeable

to the client because they do not represent bona

ﬁde sales. In addition, sales made without the

factor’s approval are considered client risk

receivables, with full recourse to the client if the

customer fails to pay.

The usual approval process requires the client

to contact the factor’s credit department before

ﬁlling a sales order on credit terms. The credit

department will research its ﬁles, determine the

credit worthiness of the customer, and approve

or reject the sale. As stated before, if the credit

department rejects the sale, the client may com-

plete the sale, but at its own risk. The most

common reasons for rejection are sales to afﬁli-

ates, sales to known bad risks, sales to custom-

ers whose credit cannot be veriﬁed, and sales to

customers whose outstanding payables exceed

the factor’s credit line.

Once a sale has been made and the receivable

assigned to the factor, approved or not, the

client’s account will be credited for the net

invoice amount of the sale. That is, any trade or

volume discounts, early payment terms, and

other adjustments are deducted from the invoice

amount. The receivable then becomes part of

the client’s ‘‘availability’’ to be paid in advance

or at the computed due date, depending upon the

basis of the factoring arrangement.

Each month the client will receive an ‘‘ac-

counts current’’ statement from the factor which

details the transactions on a daily basis. This

statement will reﬂect the daily assignments of

receivables, remittances made, deductions for

term loans, and interest charges and factoring

commissions. Credit memos, client risk, charge

backs, and other adjustments will also be shown.

Client risk charge backs are the amounts deducted

from the balance due to the client upon the

failure of customers to pay receivables factored

at client risk.

The accounts current statement and the avail-

ability sheets will be necessary for the asset

analysis process. Considering the volume of

transactions, the accounting system that devel-

ops this data will probably be automated, which

may allow the factor to obtain comparison and

monitoring data on the client. If a monitoring

system is in place, the data provided will be

valuable in the asset analysis process.

The evaluation of a factor includes a review

of its systems and controls as well as an analysis

of the quality of its assets, both of which may be

accomplished by a two segment analytical

approach. A major portion of a factor’s assets

will be factored receivables, for which the credit

department has the responsibility for credit qual-

ity and collection. The other major portion of

the assets will be the client loans and credit

accommodations, for which the account ofﬁcers

are responsible. The procedures for each area

will be dealt with separately.

3090.1.4.2 Credit Department

Because of its integral function in the credit and

collection process, the credit department is the

heart of a factor. The department maintains

credit ﬁles, which are continually updated as

purchases are made and paid for by the custom-

ers. These ﬁles will include ﬁnancial statements,

credit bureau reports, and details of purchasing

volume and paying habits. Usually, each cus-

tomer will have an assigned credit line, which is

the credit department’s estimate of the custom-

er’s credit capacity.

The evaluation of this department should take

the form of a review of a sample of the customer

ﬁles. The sample may be drawn from lists of

large volume customers and closely monitored

customers, or it may be a random sample. The

examiner should have either a copy of depart-

mental policies and procedures or a verbal

understanding of them prior to the review. It

should be kept in mind that the objective of the

review is to critique the credit and collection

process and to verify departmental effective-

ness, and not to obtain classiﬁcations.

3090.1.4.3 Asset Evaluation

Prior to the review of asset quality, the examiner

should receive the lists of problem clients, client

over-advances, term loans, and credit accommo-

dations; as well as the aging schedule of fac-

tored receivables including client risk receiv-

ables. These will be used as the basis for selecting

the clients to be reviewed. It is recommended

that the selection be made from the list of clients

with term loans, largest ﬁrst, in addition to the

Section 4(c)(8) of the BHC Act (Factoring) 3090.1

BHC Supervision Manual December 1992

Page 3

acknowledged problems. Clients with high dilu-

tion rates and those with client risk receivables

equal to 20 percent or more of factored volume

may also be included.

It should be noted that a factor usually col-

lects principal and interest payments directly

from the client’s availability, which means that

the expected delinquency rate is minimal. Past

due factored volume is not an effective measure

of client quality.

A maturity client’s availability is the sum of

all factored receivables, less trade and other

discounts, factoring commissions, credit memos,

and client risk charge-backs. There may also be

other deductions for letters of credit and other

credit accommodations. An advance client’s

availability would be further reduced by ad-

vances on the factored receivables, interest

charges, and the reciprocal of the contractually

agreed upon ‘‘advance’’ percentage. This recip-

rocal, 20 percent in the case of an 80 percent

advance client, is sometimes referred to as the

client’s ‘‘equity’’ in the factored receivables.

Availability may be increased by liens on addi-

tional collateral such as inventory, machinery

and equipment, real estate, and other marketable

assets.

The review and analysis of asset quality will

be procedurally similar to that used in accounts

receivable ﬁnancing. However, certain aspects

of the ﬁnancial statements may need elabora-

tion. The client’s balance sheet will have a ‘‘due

from factor’’ account instead of accounts receiv-

able. The account balance may be somewhat

lower than a normal receivables balance, which

would affect turnover ratios and other short-

term ratios. The difference relates to the client’s

ability to convert sales to cash faster with a

factor than if the receivables were to be col-

lected normally. In addition, the analysis of the

statements should incorporate an assessment of

the client’s ability to absorb normal dilution and

the potential losses associated with client risk

receivables, particularly when these factors are

higher than usual for the portfolio.

As a factor’s systems and controls for client

loans are somewhat similar to those for accounts

receivable ﬁnancing, the evaluation of asset

quality must consider these factors before the

classiﬁcation of a client is made. While the

typical client may have less than satisfactory

ﬁnancial statements, the factor’s working knowl-

edge of the client’s operations and industry

tends to mitigate the risk factors present.

For classiﬁcation purposes, ‘‘client risk

receivables’’ is the only portion of factored vol-

ume that is appropriate for use in the amount

classiﬁed. Because of the recourse aspect the

balance is considered as an indirect obligation

rather than a direct obligation.

As a further step in the evaluation of the

lending area and its controls, the evaluation of

the steps taken and the results of at least one

recent client liquidation should be made. By

reviewing the chronology of events along with

the loan and collateral balances, the effective-

ness of systems and controls under extended

circumstances may be assessed. The type of

liquidation will have a bearing on the losses

taken. Losses tend to be higher when client

fraud is involved.

In the process of evaluating a factor’s condi-

tion, the adequacy of systems and controls and

the capability of management are considered

signiﬁcant measures. Asset quality, as measured

by classiﬁcations, may be inﬂuenced by sea-

sonal aspects and should be carefully analyzed

to allow for such inﬂuences. Because of a lack

of regular and consistent comparative data for

the industry, earnings and capital adequacy

are evaluated in terms of the company’s own

performance.

The review of the company’s internal systems

and controls should be continuous during the

inspection. Considering the large volume of

daily transactions that ﬂows through a factor,

any internal control that can be easily negated

represents a potential problem and should be

brought to management’s attention. In the broad

context, this review would include the credit

controls for both clients and customers. Since

credit problems can develop rapidly in factor-

ing, credit controls and systems must be respon-

sive to the identiﬁcation of these problems.

Deﬁciencies noted should be discussed with

management and, if signiﬁcant, cited in the

report. The company’s earnings trends may be

evaluated by using a comparative yield on assets

approach. By analyzing yields on asset cate-

gories from period to period the examiner will

be able to make a judgment as to the efﬁciency

of the systems. Factors are subject to the same

price competition in the commercial ﬁnance

market as accounts receivable ﬁnancers. Declin-

ing portfolio yields may reﬂect the inroads made

by competition and may indicate a decline in

future proﬁtability.

The subject of capital adequacy is inﬂuenced

by the aforementioned seasonal characteristics.

Over the period of a year, the comparisons of

equity to assets and equity to liabilities will vary

signiﬁcantly. It is suggested that an average

balance sheet be used to stabilize the variations.

Section 4(c)(8) of the BHC Act (Factoring) 3090.1

BHC Supervision Manual December 1992

Page 4

In addition to balance-sheet ratio analysis, the

effects of dividends and fees paid to the parent

company on the capital accounts may be ana-

lyzed to determine the rate of internal capital

generation. If the company is in a growth pro-

ﬁle, or attempting to gain market share, the

comparisons between ﬁscal periods may reﬂect

a declining trend. Such a trend should be dis-

cussed with parent company management.

The report comments should summarize these

considerations in a clear, concise presentation.

3090.1.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Loans to afﬁliates 23A FRA

371c

Purchase of afﬁliate’s notes from

a third party

23A FRA

371c

3–1131 1951 FRB 960

Activities not closely related

to banking

4(c)(8) BHC Act

1843(c)(8)

225.126 4–184

Acquisition of assets 4(c)(8) BHC Act

1843(c)(8)

225.132 4–175.1 1974 FRB 725

1984 FRB 370

Real estate mortgages as eligible

collateral under section 23A

23A FRA

371c

1933 FRB 566

Indebtedness of afﬁliate on assets

acquired from member bank

23A FRA

371c

3–1125 1936 FRB 324

Marketability of collateral under

section 23A

23A FRA

371c

3–1121 1935 FRB 395

Activities closely related

to banking

4(c)(8) BHC Act

1843(c)(8)

225.123

225.28(b)(1)

4–176 1971 FRB 514

1975 FRB 245

1984 FRB 50

1984 FRB 370

1984 FRB 376

1984 FRB 452

1984 FRB 736

1986 FRB 143

1988 FRB 177

1988 FRB 330

1989 FRB 79

1992 FRB 74

Community development

activities

4(c)(8) BHC Act

1843(c)(8)

225.127

225.28(b)(12)

4–178 1972 FRB 572

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Factoring) 3090.1

BHC Supervision Manual December 1997

Page 5

Section 4(c)(8) of the BHC Act

(Accounts Receivable Financing) Section 3090.2

3090.2.1 INTRODUCTION

Accounts receivable ﬁnancing is a revolving

credit facility secured by an assignment of

accounts receivable. As a ﬁnancing technique, it

allows the client (the ﬁnanced company) to

obtain working capital without waiting for cus-

tomer payments. This form of ﬁnancing is fre-

quently used by companies with working-capital

shortages, companies in seasonal industries, and

companies with weak ﬁnancial conditions. Typi-

cally, the funding requirements of these compa-

nies are in excess of any amounts that would be

available through unsecured bank ﬁnancing.

The ﬁnancing process begins with a bona ﬁde

credit sale by the client and the assignment of

the resulting receivable to the ﬁnancer. Upon

assignment, the ﬁnancer advances a speciﬁc per-

centage of the receivable to the client. The loan

is repaid by customers’ direct payments or, in

the case of a lockbox, by the remittance of the

customer’s payment to the ﬁnancer, who returns

the amount in excess of the loan to the client.

While a simple concept for a single transac-

tion, the operations of an accounts receivable

ﬁnancer become a complex process when many

clients and perhaps thousands of receivables are

involved.

Companies engaged in accounts receivable

ﬁnancing usually incorporate the full range of

commercial ﬁnancing activities into their opera-

tion. These activities would include inventory

ﬁnancing, loans secured by machinery and equip-

ment, some forms of real estate loans, and loans

secured by other assets. As a general statement,

these companies will provide working-capital

ﬁnancing using almost any form of viable collat-

eral to secure the loans. These additional activi-

ties are facilitated by the ﬁnancer’s in-depth

knowledge of the borrowers’ ﬁnancial condi-

tions and cash ﬂows. This knowledge comes

from the controls placed on the borrowers, such

as periodic ﬁeld audits, the ﬂow of the borrow-

er’s cash through the company, and an internal

staff that specializes in the ﬁnanced industries.

3090.2.2 FUNDING

Accounts receivable ﬁnancing companies, like

factors, traditionally provide working-capital

ﬁnancing to seasonal industries. Consequently,

the funding programs of these ﬁnancing com-

panies will reﬂect these variations in their

increased use of short-term funds relative to

other nonbanking activities.

Since many accounts receivable clients have

seasonal businesses, a large portion of the

ﬁnancer’s liabilities will be short-term debt. For

internally funded ﬁnancers, this debt will be

predominantly commercial paper proceeds from

the parent company, with perhaps some bank

lines intermixed. The externally funded com-

pany will probably rely on bank lines for its

short-term needs, usually with the parent com-

pany’s guaranty of the debt.

Longer term funding may be provided through

bank term loans and subordinated debt, although

the volume of this type of debt appears to be

low relative to other ﬁnancing industries, another

parallel to factoring. The terms and covenants of

long-term debt appear to allow for more ﬂexibil-

ity in operations and somewhat more highly

leveraged positions than similar debt for other

ﬁnancing industries. This practice is apparently

in recognition of the volatility of this form of

ﬁnancing and the liquidity of the assets support-

ing the ﬁnancer’s loans.

The principal suppliers of senior and subordi-

nated funds to collateral lenders (factors and

accounts receivable ﬁnancers) appear to be lim-

ited to a few insurance companies that special-

ize in this ﬁeld, although a few banks also

provide senior term funding. These lenders have

incorporated their perceptions of acceptable

balance-sheet ratios and earnings performance

into their debt agreements as restrictive cov-

enants. Since comparative industry data are

limited, these restrictive covenants may be the

examiner’s primary means of evaluating lever-

age, loss reserves, and capital adequacy.

3090.2.3 INSPECTION OBJECTIVES

1. To determine whether the company is op-

erating within the scope of its approved activi-

ties and within the provisions of the act and

Regulation Y.

2. To determine whether transactions with

afﬁliates, including banks, are in accordance

with applicable statutes and regulations.

3. To determine the quality of the asset port-

folios and whether lending, monitoring, and col-

lection policies are adequate to maintain sound

asset conditions.

4. To determine the adequacy of the reserve

for loan losses and whether the asset charge-off

policy is appropriate.

5. To determine the viability of the company

as a going concern, and whether its afﬁliate

BHC Supervision Manual June 1996

Page 1

status represents a potential or actual adverse

inﬂuence upon the condition of the consolidated

corporation.

3090.2.4 INSPECTION PROCEDURES

The inspection procedures for an accounts

receivable company have been divided into two

phases, preliminary and on-site.

The preliminary phase entails the gathering

and analysis of information at the parent com-

pany in order to determine the scope of the ﬁeld

work to be performed on-site, if required. The

on-site segment of the procedures expresses

some of the typical practices and considerations

in this form of ﬁnancing.

During the preliminary phase, the following

information should be reviewed:

1. system approvals for ofﬁces and activities,

including stipulated public beneﬁts

2. ﬁnancial statements, both interim and ﬁs-

cal, for a sufﬁcient period to determine trends

and operating patterns

3. all management reports which should

indicate problem loans, loan volume, new

accounts and other reports regarding loan port-

folio and company status

4. external debtinstruments to determinemate-

rial restrictive covenants

5. internal audit reports and workpapers—

a. internal control exception report to

determine weaknesses and corrective actions,

b. ﬂow charts in the workpapers which

will enable the examiner to become familiar

with company systems, and

c. additional internal reports may be iden-

tiﬁed which may assist the inspection on-site

6. minutes of the board of directors, execu-

tive committee and loan committee, if available

at the parent company

7. the results of a parent company loan review,

if completed

8. To be requested:

a. schedules of past-due loans, inter-

company participations, and large loans

b. schedules of problem accounts, liquidat-

ing accounts, and repossessed assets

c. general ledger trial balance

d. loan trial balance

e. statements of company lending, accrual,

and other policies

f. reconcilement of the loan-loss reserve

for the period between inspections

g. listing of common borrowers between

afﬁliates

3090.2.4.1 On-Site Procedures

After reviewing the material available at the

parent company level, including the audit review,

a decision whether to go on-site is in order.

Some of the determinants of this decision would

include relative size, current earnings perfor-

mance, overall contribution to the corporation’s

condition, asset quality as indicated by internal

loan review reports and problem loan reports,

and the condition of the company when last

inspected. From the information provided, it

might be determined that the company is operat-

ing properly and is in apparently sound condi-

tion. In such a case, an on-site inspection may

not be warranted. Conversely, a deteriorating

condition might be detected which would re-

quire a visit, even though a satisfactory condi-

tion had been determined during the previous

inspection. Subsidiaries in unsatisfactory condi-

tion should be inspected each time the parent

company is inspected.

The on-site inspection procedure will be simi-

lar to that used in a commercial department of a

bank. Selection and evaluation of the assets,

review of internal controls, identiﬁcation of

lending policies, and credit review procedures

are all familiar areas to the examiner and do not

need further explanation. However, the account-

ing and reporting systems are somewhat differ-

ent and will require the examiner to become

familiar with systems and policies before pro-

ceeding with the asset evaluation process.

3090.2.4.2 Accounting and Controls

There are two basic systems within the account-

ing and control environment of an accounts

receivable company. The ﬁrst system provides

accounting and control for client loans and col-

lateral balances and is frequently automated to

handle the large ﬂows of data generated in the

operation. It is also common to ﬁnd lockbox

arrangements with banks that tie into the client

system for the receipt of customer remittances.

Such lockbox arrangements provide a greater

degree of control over remittances.

The mechanics of the client system will be

detailed in the internal audit ﬁle, which should

also indicate the adequacy and efﬁciency of the

system’s controls. The audit ﬁle may also indi-

cate the accounting techniques used and the

client-monitoring reports that are generated by

the system, such as dilution rates and trends,

and year-to-year volume and operating compari-

sons. The client system provides the basic data

for the company’s accounting and control sys-

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2

BHC Supervision Manual June 1996

Page 2

tem. While the basic accounting considerations

are outlined in the AICPA Industry Audit Guide:

Audits of Finance Companies, there are certain

accounting aspects which deserve additional

treatment. In some cases where a group of

related companies are clients, the ﬁnancing

arrangements may include cross-guarantees and

cross-collateralizationagreements. In these cases,

the ﬁnancer might utilize excess availability for

some of the related entities to offset the over-

advance of another entity. Another treatment

that may be applied is the use of a ‘‘reserve for

liquidating accounts,’’ which in some instances

is a speciﬁc reserve for a problem account that

reverses at least current period earnings for the

account. This reserve is in addition to the allow-

ance for bad debts and may not be an explicit

balance sheet account, but an offset to gross

loans outstanding.

3090.2.4.3 Deﬁnitions

While many of the following comments deﬁne

certain routine accounting and control consider-

ations for accounts receivable ﬁnancing, certain

of the concepts are necessary for proper evalua-

tion of client quality (i.e., availability, dilution,

over-advances, and advances on other collat-

eral). These deﬁnitions are general in nature as

is the terminology, however, the processes will

be similar in almost every company.

Loans to the client are based upon a contrac-

tual percentage of the client’s eligible receiv-

ables against which the ﬁnancer has agreed to

advance funds. Eligible receivables include all

assigned receivables, less trade discounts, early

payment discounts, contra-accounts (reciprocal

sales between the client and customers), receiv-

ables past due beyond the eligibility period

speciﬁed in the contract, and other adjustments.

The advance percentage is determined by a

number of factors which include the expected

average dilution rate (disputed invoices, mis-

shipped goods, returns and allowances, etc.) and

the client’s expected gross proﬁt margin. As a

general rule, lenders in this ﬁeld try to ﬁnance

only the cost of sales and not the client’s proﬁts.

Because this form of ﬁnancing involves rap-

idly changing collateral balances, a high volume

of customer payments, and frequent loan re-

quests, the ﬁnancer has to determine the client’s

‘‘availability’’ (loanable funds) before advanc-

ing the loan. Availability is the total of eligible

receivables times the advance percentage less

credit memos and the current loan balance.

Credit memos are adjustments to the customer’s

account for errors in the client’s shipments (i.e.,

the quantity shipped was less than that ordered).

It is the client’s responsibility to provide this

information to the ﬁnancer on a daily basis. If

there is sufﬁcient availability, the requested

amount is usually advanced. On occasion, the

availability computation will show the client to

be ‘‘over-advanced,’’ that is the loan balance

exceeds the agreed percentage advance against

collateral. This situation may have occurred be-

cause some receivables have become past due,

or the ﬁnancer may have authorized additional

funds to meet some valid client requirement. As

a rule, over- advance positions are usually sub-

ject to a quick paydown to reduce the loan

balance to the original contractual terms.

At times, the availability computation will

reﬂect additional collateral value in the form of

inventories, machinery and equipment, and other

assets, shown net of an advance percentage.

These categories usually indicate term loans,

secured by liens against the respective assets,

which expand the collateral base and provide

additional support to the client’s working capital

requirements. These term loans should not be

confused with loans for the acquisition of such

assets which might appear only in the client’s

monthly statement.

The accounts receivable ﬁnancer charges in-

terest on the daily cash borrowings of the client

and accumulates these charges on the client’s

monthly statement. The total interest charge for

advances on receivables and other loans is

deducted directly from remittances received by

the ﬁnancer. Accordingly, the expected delin-

quency rate for an accounts receivable operation

is low except for the rare loan which is paid

directly by the client and other assets which

formerly belonged to a defunct client.

3090.2.4.4 Over-Advances and Other

Loans

It was indicated earlier that an over-advance

represented funds advanced in excess of avail-

able loanable funds and that there are two basic

causes for over-advances. Some over-advances

occur because a portion of eligible receivables

becomes past due and ineligible for advances.

This condition is usually corrected by the

assignment of additional receivables or receipt

of customer payments, and therefore may exist

only for a few days.

The other basic over-advance occurs when a

client requires additional funds for valid busi-

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2

BHC Supervision Manual December 1995

Page 3

ness purposes, such as an inventory buildup at

the beginning of a season. In such cases, the

over-advance is set up as a very short-term loan

and paid down rapidly out of the client’s avail-

ability. While the policy for over-advances varies

between ﬁnancers, when they are permitted they

are usually carefully analyzed by the internal

credit committee and closely monitored until

paid off.

If a client is involved only in receivables

ﬁnancing and has made an over-advance request,

the ﬁnancer generally will prefer to take a lien

against inventory rather than make an unsecured

over-advance. Regardless of the purpose of the

inventory loan, the ﬁnancer will advance only a

small percentage of the inventory value (40 to

50 percent) to allow for shrinkage, spoilage and

obsolescence of the collateral. While inventory

liens are in effect, the ﬁeld audit staff will par-

tially verify the inventory during each audit.

While machinery and equipment may be

pledged as additional collateral to support work-

ing capital loans during the business period,

most client companies will also ﬁnance equip-

ment purchases on a secured basis. In either

case, the ﬁnancer usually advances a percentage

of the quick sale or auction value of the equip-

ment as determined by an appraisal. During

ﬁeld audits, the presence of the equipment and

appropriate lien tagging are veriﬁed by the ﬁeld

auditors.

On occasion, a lien on real estate is part of the

pledged collateral. The real estate may be oper-

ating premises, land, or the property of the

principal of the client. Such liens may occur

when the client is acquiring new, or expand-

ing old, operating facilities and is using the

ﬁnancing relationship to fund the project. How-

ever, in many cases the lien was taken to pro-

vide additional collateral for working capital

loans. In either case, appropriate documentation

and appraisals should be on ﬁle.

It should be noted that loans on real estate

collateral are limited to those providing support

to the primary business of the client. Loans to

ﬁnance speculative real estate acquisitions, and

unrelated commercial property are not consid-

ered to be the usual practice of this industry, and

would be considered as not complying with the

general activities of a commercial ﬁnance com-

pany, unless speciﬁcally approved.

3090.2.4.5 Asset Evaluation

In selecting the loans to be reviewed, the ﬁrst

group to be considered is the acknowledged

problem accounts. The next sample should be

drawn from accounts with high dilution rates,

those with frequent or large over-advances, and

those which constantly take down all of their

availability. Participations, purchased or sold,

between afﬁliates should also be included in the

examiner’s sample. While this approach may

exclude some of the larger accounts, it is intended

to include those accounts which are potential

problems in the primary review group. Should

the company have a monitoring system for

potential problem accounts, the system should

be used for drawing the review sample.

The principal tools for the review process

should include: the credit ﬁle, the ﬁeld audit ﬁle,

the monthly statement for the inspection date,

the availability sheet for the inspection date, and

updated information for the interim period end-

ing with the on-site inspection date. Within the

credit ﬁle, the copies of the ﬁnancing agree-

ments will indicate the speciﬁc terms of the

borrowing relationship: the pledged collateral;

advance percentage; interest rate; guarantees;

appraisals; and the required communications,

such as monthly receivables agings, inventory

and machinery and equipment certiﬁcation,

etc. The usual ﬁle information will also in-

clude management’s analysis of the client’s

operations.

The ﬁeld audit ﬁle will contain the audit

reports originated by the ﬁnancer’s ﬁeld audit

staff. These reports are usually quite comprehen-

sive, with a primary focus upon critical ﬁnancial

areas. As a minimum, the auditors will analyze

trade payables, State and federal taxes, cash

ﬂows, inventories, and receivables. Particular

attention is paid to the client’s sales and ship-

ping procedures in order to ascertain that valid

invoices are being assigned to the ﬁnancer. The

client’s accounting procedures are also analyzed

to determine their effectiveness and accuracy.

These reports represent a primary source of

information regarding the general ﬁnancial con-

dition of the client.

The client’s monthly statement and availabil-

ity sheets represent spot information on the cli-

ent’s activity. Many clients operate in seasonal

industries such as clothing and textiles. In such

industries, a client will tend to use all of its

availability, as well as seasonal over-advances,

during its inventory buildup period, and will pay

off the over-advances and may have excess

availability during the sales and collection period.

The examiner will have to analyze the client’s

current position with regard to its particular

operating cycle. Over-advances granted to a cli-

ent for valid reasons do not necessarily repre-

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2

BHC Supervision Manual December 1995

Page 4

sent undue exposure or a substandard asset for

the ﬁnancer.

The ﬁnancial statements of a client quite fre-

quently reﬂect a ‘‘relatively unsatisfactory or

weak’’ ﬁnancial condition, with minimal work-

ing capital, high leverage, and uncertain earn-

ings as prime ingredients. There have been cases

where both deﬁcit working capital and deﬁcit

net worth were in evidence, however, the ﬁnanc-

ing relationship has continued to function prop-

erly. The ﬁnancer can continue these relation-

ships if the short-term factors (sales volume,

receivables and inventory turnover, and current

liabilities) are appropriate and the character of

the principals warrants the exposure. Analysis

of a ﬁnanced client should emphasize the short-

term analytical factors and the related trends in

the evaluation of asset quality.

Such factors as the success of the selling

season, availability of materials, and fad mer-

chandising will have direct impact on the cli-

ent’s ﬁnancial condition. While the loan may be

adequately protected by pledged collateral, the

ability of the client to continue operations may

be affected by these short-term factors.

For classiﬁcation purposes, the ﬁnancer’s con-

trols will have to be considered in addition to

weighing the degree and quality of collateral

protection, short-term factors, and the client’s

ability to withstand any ﬁnancial reverses that

are evident. Clients with deﬁcit net worth, past-

due trade obligations, and delinquent taxes should

be considered to be problems and appropriately

classiﬁed. The ability of the ﬁnancer to control

the risk exposure in the portfolio will be an

important consideration in determining whether

to classify a speciﬁc loan.

3090.2.4.6 DPC Assets

In some companies, assets acquired from de-

funct clients remain in the loan account instead

of being reclassiﬁed to another balance-sheet

category. Usually, these assets are uncollected

accounts receivable, inventory, and machinery

and equipment which have not been liquidated.

However, these assets may include securities, as

well as business and personal real estate, which

had been pledged as collateral. By retaining

these assets in the loan category, effective liqui-

dation of the respective assets may be delayed

because they usually represent small dollar

amounts. Apart from this consideration, classiﬁ-

cation as loans may disguise the fact that certain

of the assets may be subject to provisions of

Regulation Y and the act, such as control and

retention considerations. Separate control of

these assets is recommended.

It is common practice in the accounts receiv-

able and factoring industry for the lender to

require a pledge of client company stock by the

principals, particularly in overextended situa-

tions. Additional pledges of securities owned by

the principals may also provide added collateral.

While such pledges are not precluded by Regu-

lation Y and the act, once they become com-

pany assets they should be reviewed for control

and retention purposes.

3090.2.4.7 Financial Condition

Secured lending relies upon the four C’s of

credit: the traditional Capital, Character, Capac-

ity, and Collateral. Pragmatically, these lenders

practice a ﬁfth C, Control. In this context, con-

trol implies the continuous monitoring of the

client’s ﬁnancial condition, continued evalua-

tion of the collateral, constant contact with the

client, and the adjusting of the credit accommo-

dation to conform to the client’s current situa-

tion. This control is the reason that the secured

lender can maintain a proper and mutually prof-

itable ﬁnancing arrangement with the client.

It is to be expected that the typical portfolio

may include clients with less than satisfactory

ﬁnancial conditions. Considering the controls

imposed upon the borrowing relationships, the

secured lender has compensated for some of the

additional risk in the loans. The combination of

ﬁeld audits, collateral controls, and account

ofﬁcer contact can be expected to reduce the

exposure to unsatisfactory clients to a mini-

mum. However, clients do fail and losses may

be taken in liquidating the account. The inci-

dence rate of liquidations and the extent of

losses taken may be an indicator of the effective-

ness of company controls.

The earnings of an accounts receivable com-

pany are based upon loans carrying interest rates

above prime, which means that loan volume is a

major determinant of revenues. Because this

industry is very competitive, loan pricing is

frequently used to obtain new clients from other

lenders in order to promote growth in loan vol-

ume. Increases in loan volume combined with

declining interest margins may be an indicator

of price competition that is yielding negative

results. Analysis of client turnover may verify

this possibility.

In summary, management’s ability to control

risk and achieve proﬁtability is essential to the

soundness of an accounts receivable operation.

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2

BHC Supervision Manual December 1997

Page 5

The effectiveness of company policies, the

expertise of the lending staff and ﬁeld audit

staff, and the adequacy of systems and controls

are the expressions of this ability to control risk.

Company proﬁtability is a measure of man-

agement’s ability to obtain satisfactory client

quality and terms in a price-competitive envi-

ronment. The examiner will have to balance

these factors in assessing the condition of the

company.

3090.2.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Loans to afﬁliates 23A FR Act

371c

Purchase of afﬁliate’s notes

from a third party 3–1131 1951 FRB 960

Acquisition of assets 225.132 4–175.1 1974 FRB 725

1984 FRB 370

Activities closely related

to banking

225.123 4–176 1971 FRB 514

1975 FRB 245

Investments in community

welfare projects

225.127 4–178 1972 FRB 572

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Accounts Receivable Financing) 3090.2

BHC Supervision Manual December 1997

Page 6

Section 4(c)(8) of the BHC Act

(Consumer Finance) Section 3100.0

3100.0.1 INTRODUCTION

The basic activity of a consumer ﬁnance com-

pany is making installment loans to individuals

andispermissiblepursuanttosection 225.28(b)(1)

of Regulation Y and section 4(c)(8) of the BHC

Act (the act). In most areas, a company may

make these loans under one or more of the

following licenses: consumer discount, small

loan, sales ﬁnance, or second mortgage. Most of

a company’s activity will probably be direct

cash lending, in which the borrower and the

lender come into direct contact with one another

in the credit-extension process. However, a sig-

niﬁcant volume of lending is done through third-

party contact. This is sales ﬁnance lending in

which the company purchases, or discounts, the

loans originated by a durable goods dealer in

daily retail sales activity. Second mortgage lend-

ing may be originated from either direct contact

or through home-improvement contractors.

Most consumer ﬁnance companies offer credit-

related insurance as part of their services, and

may have a captive insurance subsidiary if they

are large enough. Inspection considerations and

procedures for reviewing credit-related insur-

ance activities are covered in section 3170.0.

3100.0.2 FUNDING

In some holding companies, management has

elected to use a conventional industry funding

pattern to support its consumer ﬁnance com-

pany operations. This pattern makes use of long-

term subordinated debt in a speciﬁc proportion

to equity capital. The further addition of senior

long-term and short-term debt is then limited by

restrictive covenants incorporated into the sub-

ordinated debt agreements. These covenants also

provide operating limits for management in such

areas as the proportions of speciﬁc classes of

assets, minimum levels of net worth to be main-

tained, and the maximum dividend payout

allowable. Since the wording and limits of

these covenants are negotiated between the bor-

rower and the subordinated debt holder, gener-

alizations regarding the usual terms are not

practicable.

It appears that certain life insurance compa-

nies supply most of this subordinated debt to the

consumer ﬁnance industry. Along with their

general knowledge of the industry, these insur-

ance companies police their loans by requiring

periodic reports from the borrower and by send-

ing teams of their people to review the borrow-

er’s operations. In a sense, this approach to

funding represents regulation and control by

market forces rather than by governmental

intervention.

In other holding companies, management has

elected to support these operations using hold-

ing company funding sources such as commer-

cial paper and lines of credit. In using this

approach, operating management is generally

free from market restrictions on operations.

It is likely that most afﬁliated consumer ﬁnance

companies will have a funding plan that falls

somewhere between these two extremes. Since

commercial paper generally carries a lower total

cost than bank lines of credit, the examiner may

ﬁnd that the senior short-term debt component

is almost completely supplied by the parent

company. On the other hand, long-term debt

may have been obtained directly, or with the

parent company’s guaranty, or it may have been

borrowed from the parent company’s sources—

that is, the parent borrows from a third party and

re-lends the proceeds to the subsidiary.

Since a large volume of consumer installment

paper carries maturities of three years or more,

the use of commercial paper proceeds with

maximum maturities of 270 days warrants some

comment. Securities Act Release No. 401 spe-

ciﬁcally recognizes this use of commercial paper

as appropriate. Further information may be found

in the Code of Federal Regulations, 17 C.F.R.

231.4412. Also see sections 2080.1 and 5010.16

for information on commercial paper.

3100.0.3 INSPECTION OBJECTIVES

1. To determinewhether thecompanyis operating

within the scope of its approved activities

and within the provisions of the act and

Regulation Y.

2. To determine whether transactions with

afﬁliates, including banks, are in accordance

with applicable statutes and regulations.

3. To determine the quality of the asset port-

folio, and whether lending, monitoring, and

collection policies are adequate to maintain

sound asset conditions.

4. To determine the adequacy of the reserve for

loan losses and whether the asset charge-off

policy is appropriate.

5. To determine the viability of the company as

a going concern, and whether its afﬁliate

BHC Supervision Manual December 1997

Page 1

status represents a potential or actual adverse

inﬂuence on the condition of the consoli-

dated corporation or the subsidiary bank(s).

3100.0.4 INSPECTION PROCEDURES

After reviewing the material available at the

parent company level, including the audit review,

a decision whether or not to go on-site is in

order. Some of the determinants of this decision

would include relative size, current earnings

performance, overall contribution to the corpo-

ration’s condition, asset quality as indicated by

delinquency reports and industry comparisons

(detailed later in this section), and the condition

of the company when last inspected. From the

information provided, it might be determined

that the company is operating properly and is in

apparently sound condition. In such a case, an

on-site inspection may not be warranted, provid-

ing that a fairly recent on-site inspection had

been conducted. Conversely, a deteriorating con-

dition might be detected which would require a

visit, even though a satisfactory condition had

been determined during the previous inspection.

Subsidiaries in unsatisfactory condition should

be inspected each time the parent company is

inspected.

The inspection procedures for a consumer

ﬁnance company have been divided into two

phases: preliminary and on-site. The prelimi-

nary phase entails the gathering and analysis of

information at the parent company to determine

the scope of the ﬁeld work to be performed

on-site. The on-site phase establishes a mini-

mum scope of the inspection at the main ofﬁce,

and includes considerations to be incorporated

into a visit to ﬁeld ofﬁces if the inspection scope

is expanded to that degree.

During the preliminary phase, the following

information should be reviewed:

1. system approvals for ofﬁces and activities,

including stipulated public beneﬁts

2. ﬁnancial statements, both interim and ﬁscal,

for a sufﬁcient period to determine trends

and operating patterns

3. all management reports which should indicate

problem loans, loan volume, delinquencies,

and other reports regarding loan portfolio

and company status including the Robert

MorrisAssociates’ Direct Cash LendingQues-

tionnaire and similar reports

4. external debt instruments to determine mate-

rial restrictive covenants

5. internal audit reports and workpapers:

a. internal control exception reports to

determine weaknesses and corrective

actions

b. ﬂow charts in the workpapers to become

familiar with company systems

c. additional internal reports may be identi-

ﬁed which may assist the inspection on-site

6. examination reports of any state regulatory

agencies having jurisdiction over the compa-

ny’s ofﬁces

7. minutes of the board of directors, executive

committee, and any other such committee, if

available at the parent company

8. the results of a parent company loan review

or operations review, if conducted and

available

9. the following items to be requested from

management:

a. detailed past-due schedules and inter-

company participations

b. schedule of problem accounts, liquidating

accounts, and repossessed assets

c. general-ledger trial balance

d. loan trial balance

e. policy statements on lending, accrual, and

charge-offs

f. reconcilement of the loan-loss reserve for

the period between inspections

g. organization chart

h. listing of company ofﬁces with addresses

and operating licenses

3100.0.4.1 On-Site Phase

The procedures of the on-site inspection are

intended to evaluate management and its super-

visory efforts, to determine the soundness and

compliance with the company’s operating poli-

cies, and to analyze the impact of these policies

on the company’s ﬁnancial condition using ratio

analysis. A thorough understanding of the poli-

cies and systems of the company is necessary

for the examiner to accurately determine the

company’s condition.

During the initial period on-site, the examiner

may obtain an overview of the company’s sys-

tems by interviewing the key staff ofﬁcers. These

individuals can provide the examiner with the

detailed reports, policy manuals, and other infor-

mation necessary for the inspection.

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 2

3100.0.4.2 Policy Evaluation

Because of its large volume of transactions and

the number of ofﬁces involved, the typical con-

sumer company will maintain an extensive set

of policy and procedure manuals which are

intended to guide company personnel in their

daily activities. During the review of these manu-

als, the examiner should bear in mind that lib-

eral policies and procedures may allow the com-

pany to mask portfolio problems and reﬂect

other than an accurate condition in its ﬁnancial

statements.

The principal policies to be considered cover

such areas as:

1. extensions of credit;

2. treatment of delinquent accounts and partial

payments;

3. loan renewals;

4. loan charge-offs;

5. provisions for loan losses;

6. bulk purchases of loans, for both credit and

account purposes; and

7. treatment of deferred income.

After assessing the soundness of company poli-

cies, the next step is to test their implementation

through a review of the company’s supervisory

structure.

3100.0.4.3 Evaluation of the Supervisory

Structure

The effectiveness of the supervisory structure is

a key element in the condition of a consumer

ﬁnance operation. This system serves two func-

tions: it communicates the policies to the ﬁeld

personnel, and it enforces those policies. Assum-

ing that management’s policies are valid, the

effectiveness of this system will be partially

reﬂected in the ratio analysis of the company.

However, it may take close analysis to deter-

mine whether any poor ratios are due to inad-

equate policies or ineffective enforcement.

In order to evaluate the supervisory effort, the

examiner may review a sample of the various

supervisor’s reports which are prepared after

visits to the loan ofﬁces. The sample should

represent a cross-section of the ofﬁces and super-

visors in order to obtain a balanced view of the

company.

A further evaluative step may be undertaken

if there are sufﬁcient resources available to the

examiner. The on-site visits to selected loan

ofﬁces may provide considerable input to the

examiner in assessing supervisory effort. In

selecting the ofﬁces to be visited, well-

performing as well as poor-performing ofﬁces

should be selected. Concentration on poor ofﬁces

will result in a biased assessment of the supervi-

sory effort and may result in an invalid evalua-

tion of company policies. The selection of the

ofﬁces may be made by using the number of

policy exceptions cited, poor performance

records, or local economic conditions as criteria.

3100.0.4.4 Detailed Procedures for an

Ofﬁce Visit

The following steps outline a general procedure

for determining ﬁeld compliance with company

policies and assessing the effectiveness of the

supervisory effort. The examiner may modify,

eliminate, or expand any of these steps or may

devise any procedure deemed appropriate under

the circumstances present.

The review of loans on-site should be ori-

ented toward conﬁrming the implementation of

company policies for delinquency, balance

renewals, charge-offs, extensions, partial pay-

ments, collection, and loan approvals.This review

is intended to be a test of compliance and not

a review of speciﬁc assets for classiﬁcation

purposes.

1. Review the detailed delinquency report for

the selected ofﬁce for a short period before

the inspection date, generally two or three

months. Trace the well overdue loans through

to resolution, pay-off, charge-off, or rein-

statement. Check these loans against the loan

been granted to these customers and if so,

determine if they are in accordance with

company policy.

2. Review the controls for charging off loans

and determine the effectiveness of the collec-

tion and recovery effort.

3. Review the loans to present borrowers. While

renewals are usually granted to the better

customers, the examiner will ﬁnd a volume

of renewals (‘‘under 10 percent new money

advanced’’ loans). In some companies, these

‘‘under 10 percent new money’’ loans repre-

sent efforts to rehabilitate borrowers with

poor payment records due to ill health, unem-

ployment, etc. However, the examiner may

ﬁnd that management is using this approach

to adjust and control delinquency and loss

rates. There should be sufﬁcient internal con-

trols present to prevent the continuous renewal

of such loans to poor borrowers.

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 3

The examiner may ﬁnd that some ofﬁce

personnel are circumventing these controls,

for example, by advancing 11 percent new

money to the borrower. If found, such cir-

cumvention raises serious questions regard-

ing portfolio quality, the adequacy of internal

controls, and the effectiveness of the supervi-

sory effort. A high volume of ‘‘under 10 per-

cent’’ loans or evidence of circumvention of

controls may warrant separate treatment in

the report.

4. Review partial-payment, interest-only, and

extension accounts. Signiﬁcant numbers of

these accounts may indicate potential prob-

lems for the loan portfolio and the ofﬁce.

5. Review credit-extension and loan documen-

tation procedures, especially if the ofﬁce’s

portfolio has a high level of losses or fre-

quent litigation. Proper credit controls and

documentation are essential for sound opera-

tions. If the ofﬁce extends second mortgage

ﬁnancing, appraisals and lien searches should

be included with the documentation.

6. Test the ofﬁce’s delinquency reporting. There

are two methods for computing delinquen-

cies, a contractual basis and the recency

basis. On a contractual basis, principal reduc-

tions are applied to the most overdue pay-

ment under the contract and the loan is con-

sidered past due from the date of the oldest

unsatisﬁed payment. On a recency basis,

delinquency is computed from the date of

last payment regardless of contract terms.

As an example, assume a loan was granted

with payments beginning the ﬁrst of March.

The borrower makes the ﬁrst payment on

time and the second payment on the ﬁrst of

June. On the ﬁrst of April, the loan is a

30-day recency account and current contrac-

tually. On the ﬁrst of May, the loan is a

60-day recency account and a 30-day con-

tractual account. Upon receipt of payment in

June, the loan is current on a recency basis

and a 60-day (two-payment) contractual

account. Notice the difference in computa-

tions between the banking industry and the

consumer ﬁnance industry.

The consumer ﬁnance industry has begun

to institute contractual delinquency reporting

standards. As these standards are developed

and reﬁned, changes in the computation of

delinquent accounts may be expected.

7. Review the collection effort. The past-due

accounts will be under the control of the

collection manager, whose objective is to

return these accounts to current status. The

manager’s collection efforts must begin early

in the delinquency pattern if the loans are to

be salvaged from charge-off. Consistent, per-

sistent, frequent effort is expected.

The foregoing steps should provide the examiner

opportunity to evaluate the company’s policies,

procedures, and supervisory systems.

3100.0.4.5 Additional Procedures

While ﬁeld visits are a desirable aspect of the

inspection procedure, the examiner may have to

rely on other procedures to be satisﬁed with

certain aspects of company operations, particu-

larly when the company reports past-due receiv-

ables on a recency rather than a contractual

basis. The additional procedures may be neces-

sary when the examiner has other reasons to

question portfolio quality or the adequacy of

internal controls.

The examiner may perform an extensivereview

of the most recent audit of the company, includ-

ing the workpapers and programs of the internal

and independent auditors, when available. In

this review, the examiner should be able to

determine whether internal controls are adequate,

and portfoliocharacteristicsare properlyreported.

3100.0.4.6 Compliance

Certain aspects of the company are subject to

review for compliance with the requirements of

the act and Regulation Y. These include public

beneﬁts, ofﬁce activities and locations, and bulk

purchases of assets.

1. Public beneﬁts stipulated in approval orders

frequently require continuing reduced inter-

est rates or insurance charges as part of the

approval to operate. It is expected that these

relative public beneﬁts continue in effect

despite changes in state-mandated rates.

2. Ofﬁce locations and activities are subject to

approval by the Board before opening for

business. The operating licenses and activi-

ties of the ofﬁces should also be reviewed for

compliance with the respective approvals.

3. On occasion, a consumer ﬁnance company

may make a bulk purchase of loans or other

assets of another ﬁnance company. Under

certain circumstances, these purchases require

the prior approval of the Board (12 C.F.R.

225.132). These bulk purchases should not

be confused with the bulk purchase of sales

ﬁnance contracts from a retailer recently

signed to a dealer agreement.

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 4

4. While most consumer ﬁnance activity relates

to consumer installment loans, some compa-

nies also extend credit under the ‘‘large loan’’

provisions of the consumer lending statutes

of certain states. While the limitations vary

from state to state, these provisions allow

loans of many times the size of normal con-

sumer loans. A review of these large loans

may indicate that there are extensions of

credit to local businesses which may consti-

tute commercial installment lending. Unless

speciﬁcally approved by the System, this

activity may not be permissible for the com-

pany being inspected. Review for compli-

ance with various consumer regulations is

the responsibility of the Federal Trade Com-

mission.

3100.0.4.7 Asset Classiﬁcation Policy

As previously discussed, companies use one of

two different methods of delinquency computa-

tion. In general, classiﬁcations should be based

on the contractual reporting basis whenever

possible. Since much of the industry utilizes

recency reporting, which tends to reduce classi-

ﬁcations comparatively, the classiﬁcation

approach enumerated above may unduly penal-

ize an afﬁliated company using the contractual

basis. This is particularly true when such impor-

tant measures of portfolio quality as the liquida-

tion ratios are in line with industry averages.

Therefore, formula classiﬁcation may result in

more severe classiﬁcations for companies using

the contractual method than those reporting on a

recency basis. Examiners should indicate the

reporting method used when calculating

classiﬁcations.

Classiﬁcation information is used to evaluate

the adequacy of the loss reserve. In assessing

the adequacy of the loss reserves, the examiner

should take into consideration the charge-off

frequency, the period of delinquency which

would require charge-off under company policy,

and the controls regarding renewal of severely

past-due accounts. A shorter charge-off cycle

prevents the accumulation of poor-quality assets;

in this respect, monthly charge-offs are prefer-

able to annual charge-offs. An unlimited ‘‘when

deemed uncollectible’’ charge-off policy is con-

sidered lax and inadequate. The delinquency

period to required charge-offs refers to the period

of time a loan is past due before it is charged to

the reserve; a six-month period is understand-

ably preferred to a nine-month or one-year

period. Management should have sufﬁcient con-

trols in place to prevent the continued

renewal of loans to avoid charge-off. Adequate

controls might include special coding of such

loans, with supervisory review of the renewals.

Inadequate controls over these assets represent

poor management practices deserving special

comment.

Most subordinated debt agreements provide

for an adjustment (reduction) to net worth when

calculating compliance with leverage limits for

any loans past due 60 days on a recency basis

that exceed loss reserves. As there are some

seasonal characteristics to the loan portfolio, it

may be of beneﬁt to compare the delinquency

statistics on inspection date to the company’s

seasonal pattern as revealed in both the subordi-

nated debt calculations and monthly past-due

reports. It is possible that a currently adverse

portfolio condition may be due to local eco-

nomic conditions which correct themselves over

a period of time. Such conditions may relate to a

tourist economy, an agricultural community, or

a strike at a major local employer’s plant. Con-

sumer ﬁnance companies are very sensitive to

these local factors; therefore, these factors may

temper the examiner’s evaluation of the loss

reserves.

3100.0.4.8 Ratio Analysis

In order to assess the condition of a company

using ratio analysis, the examiner will have to

be familiar with the company’s accounting poli-

cies and systems. It will become obvious from

the data used in the ratios that, under certain

accounting treatments, the data can be misinter-

preted. The following analysis has been struc-

tured around the Direct Cash Lending Question-

naire, published by the Robert Morris Associ-

ates and endorsed by the National Consumer

Finance Association, in an effort to provide both

a format for developing the information and a

means of minimizing the possibility of misinter-

pretation. While some consumer companies do

not prepare the questionnaire, much of the infor-

mation is required for management purposes

and should be available from company systems.

The analytical factors presented have been

derived from two principal sources: A Lender’s

Approach to a Realistic Analysis of Consumer

Finance Companies by Richard E. Edwards

(Philadelphia: The Philadelphia National Bank,

1970) and the Industry Audit Guide: Audits of

Finance Companies by the Committee on Finance

Companies (New York: American Institute of

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 5

Certiﬁed Public Accountants, 1988). These

sources provide basic information on certain

accounting and management policies and are

recommended as references for the examiner.

While the Federal Reserve System stipulates no

speciﬁc accounting policies, the examiner may

choose to criticize those policies which result in

a misleading presentation of the company’s

ﬁnancial condition.

Each year the Annual Statement Studies, pub-

lished by Robert Morris Associates, includes

sets of consumer ﬁnance company operating

ratios. This information will provide a back-

ground against which the performance of the

company under inspection can be measured.

Such compiled ratios should be used only as

background as they represent the ‘‘average com-

pany’’ in the respective sample. Attention should

be directed toward the company’s trends as they

compare to the industry’s trends and the changes

in the company that are indicated by those

trends.

3100.0.4.9 Delinquency

As shown in the Annual Statement Studies, the

delinquency rates are on a recency-of-payment

basis. While past-due statistics based on con-

tractual payments are preferred, companies con-

tinue to report on a recency basis. It is important

to have full knowledge of the company’s report-

ing, lending, and renewal policies in order to

fully understand the implications of this data.

The trends for ‘‘interest-only’’ accounts and

‘‘partial-payment’’ accounts will provide some

measure of the adherence of the operating per-

sonnel to company policy regarding these loan

categories.

3100.0.4.10 Liquidation

Liquidation ratios provide two types of informa-

tion. First, they indicate the amount of principal

cash ﬂowing back to the company for liquidity

purposes. Secondly, they indicate the amount

required to pay senior debt and the period of

time required to do so. Several ratios follow:

1. Average monthly cash principal collection to

average net monthly outstanding.

The higher this percentage, the more liq-

uid the portfolio. A company following con-

servative policies such as requiring full pay-

ments and a contractual aging of receivables

will tend to show a higher principal collec-

tion percentage and, accordingly, a higher

liquidity. This ratio can be used to estimate

near term collections as compared to current

outstandings.

Monthly cash collections should not include

loan renewals or rebates during the period.

On an industry-wide basis, there appears to

be a pattern of increased loan renewals dur-

ing November and December, which would

be reﬂected in a seasonal decrease in princi-

pal cash collections. Lower than expected

collections may be indications of changes in

local economic patterns or of increased mar-

ket effort by a competitor which has resulted

in loan payoff. In any event, adverse change

in the collection pattern should be reviewed

for the underlying causes.

2. The ratio of unsubordinated liabilities less

cash and near cash to estimated monthly

principal collections results in the number of

months it would take to pay senior debt.

3. The ratio of senior debt to gross receivables

reﬂects the proportion of gross receivables

which would have to be liquidated to repay

senior debt. The higher the percentage, the

more senior lenders are relying on the assets

for protection.

3100.0.4.11 Loss Reserves

Analysis of the loss reserve for a speciﬁc entity

has to include company policy regarding loan

charge-offs, delinquencies, payments,and charge-

off frequency. In addition, if charge-offs are

made gross of deferred income, the reserve

account may be slightly larger than if charge-

offs were net of deferred income. Ratios used to

evaluate loss reserves include—

1. Reserve for loan losses to total receivables,

net of deferred income,

2. Loans charged off less recoveries to average

outstandings (net or gross of deferred income,

depending on policy).

Unless the company’s charge-off and

delinquency policies are realistic, this ratio

will not depict true losses over the periods,

and

3. Recoveries to loans charged off tends to be

higher in companies with conservative charge-

off policies than those with liberal policies.

This ratio is indicative of the effectiveness of

a company’s collection and follow-up policy.

3100.0.4.12 Volume

Analyzing aspects of a company’s loan volume

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 6

can provide the examiner with some informa-

tion regarding the company’s renewal and credit

policies.

Lengthening of loan maturities during the

current period will be reﬂected in the future

average monthly principal collections and in the

company’s liquidity. While loans of longer

maturity are not necessarily indicative of an

adverse trend, the reasons behind a longer matu-

rity portfolio should be analyzed. Ratios used to

evaluate loan volume include:

1. New money advanced to present borrowers

to total loan volume.

This ratio is somewhat indicative of whether

the company’s renewal policy is conserva-

tive or liberal. A high percentage may indi-

cate that a volume of new money is being

advanced along with the renewal of the pre-

vious balance.

2. Loans to present borrowers with less than 10

percent new money advanced to loan volume.

A high ratio can indicate the possibility of

disguised delinquencies and potential charge-

offs. The examiner may take a random sample

of loans in the new money advanced to

present borrowers category and review them

to determine whether or not the company’s

‘‘balance renewal’’ policy is being followed.

The preceding ratios were presented because

they represent a means of measuring the effect

of certain company policies. The analysis of

company operations may be expanded to include

other ratios such as return on equity, return on

assets, interest margins, and other conventional

measurements. The particular format utilized

will, of course, vary to some degree between

companies, however, the analysis should be

broad enough in scope to determine the compa-

ny’s trends and the causes of those trends.

3100.0.4.13 Evaluation of the Company’s

Condition

Ratio analysis of a consumer ﬁnance company

is a feasible technique for evaluating its condi-

tion because of the ‘‘portfolio effect’’ of its

assets. However, the examiner must look beyond

the ratios and analyze the effects of company

policies on the elements of the ratios. As an

example, if a company only charges off loans

once a year, the losses determined by a formula

classiﬁcation would be less just after the charge-

off date than just before.

In comparing classiﬁcations from one inspec-

tion to another, there might be a difference in

the loss classiﬁcations which may be interpreted

as an apparent improvement or decline in asset

quality should the inspections bracket the charge-

off date. Similar misinterpretations can occur

from a change in charge-off frequency, a change

to an automatic charge-off policy, or a shorten-

ing in the past-due period required for charge-

off.

Certain accounting and reporting techniques

may also be misleading in ratio analysis. For

example, an artiﬁcial improvement in earnings

would be reported when a company changes

from a collection basis to an accrual basis of

income recognition, if the collection and

follow-up policy had been poor or deteriorating.

Only a thorough review of the accounting poli-

cies and an understanding of their interplay with

operating policies will prevent this type of mis-

interpretation. In some cases, the company’s

accounting system may yield results that inad-

vertently distort the ratios. A company recogniz-

ing income on a straight-line basis would, dur-

ing a period of low loan volume, reﬂect improving

gross interest income as a percentage of loans

outstanding. While the importance of realistic

accounting policies cannot be overstated, nei-

ther can the proper interpretation of reported

results be overstressed.

One of the key elements in the evaluation of

the company’s performance is reﬂected in the

ratios, but not quantiﬁed by the analysis. The

company’s internal controls and management

information systems are the primary means of

controlling asset quality and communicating

management’s policies. The supervisory effort

is not only reﬂected by the ratios, but also in

such areas as personnel turnover, citations in

state supervisory reports, audit exceptions, and

litigation. The systems relied on by manage-

ment should be responsive not only to the chang-

ing needs of the company, but also to the chang-

ing climate of consumer regulations.

In the inspection report commentary, the

examiner should maintain an objective view of

the company under inspection. Management’s

corrective actions for exceptions and plans to

reverse adverse trends are a necessary ingredi-

ent in the commentary. Report comments should

give the reader an accurate picture of the condi-

tion of the company and its relationship with,

and impact on, the ﬁnancial condition of the

consolidated corporation and the subsidiary

bank(s).

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 7

3100.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Activities not closely

related to banking

225.126 4–184

Marketability of collateral

under section 23A

3–1121 1935 FRB 395

Activities closely related to

banking

225.123 4–176 1971 FRB 514

1975 FRB 245

Expansion of activities

of a trust company, or

acquisition of a de novo

bank, to include consumer

lending

225.28(b)(1) 1984 FRB 371

1985 FRB 51

1985 FRB 55

1985 FRB 61

1985 FRB 253

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Consumer Finance) 3100.0

BHC Supervision Manual December 1997

Page 8

Section 4 (c)(8) of the BHC Act

(Acquiring Debt in Default) Section 3104.0

The Board amended Regulation Y, effective

April 21, 1997, to include the acquiring of debt

in default as an authorized nonbanking activity

for bank holding companies (see Regulation Y,

section 225.28(b)(2)(vii)). A bank holding may

acquire debt that is in default at the time of

acquisition if the company—

1. divests shares or assets securing debt in

default that are not permissible investments

for bank holding companies, within the time

period required for divestiture of property

acquired in satisfaction of a debt previously

contracted under section 225.12(b) of Regu-

lation Y;

2. stands only in the position of a creditor and

does not purchase equity of obligors of debt

in default (other than equity that may be

collateral for such debt); and

3. does not acquire debt in default secured by

shares of a bank or bank holding company.

The Board held that these restrictions were

necessary to deﬁne the scope of the activity and

to ensure that the activity remains the acquisi-

tion of debt instead of an impermissible non-

banking activity involving the acquisition of

securities or other assets. As for calculating the

time period for disposing of the underlying

shares or assets, the time period is the same as

that applied under the BHC Act to disposing of

shares or assets acquired in satisfaction of a debt

previously contracted. During this period, a

bank holding company can divest the property

or, in the case of any debt that has been previ-

ously contracted, restructure the debt.

The initial Board order that was issued to

permit the acquisition of defaulted debt is sum-

marized here as a historical example of the

nonbanking activity. Provisions or commitments

made in the Board order should not be relied

upon. The current requirements are found in

section 225.28(b)(2)(vii) of Regulation Y.

3104.0.1 ACQUISITION OF

DEFAULTED DEBT—BOARD ORDER

A bank holding company (the applicant) within

the meaning of the BHC Act gave notice under

section 4(c)(8) of the BHC Act (12 U.S.C.

1843(c)(8)) and the Board’s Regulation Y that it

proposed to acquire a company (the company)

and engage nationwide in asset-based commer-

cial lending and management of assets.

The applicant proposed to engage through the

company in managing certain assets as the cor-

porate general partner in two limited partner-

ships (the partnerships).

The applicant commit-

ted to conduct the activities, which the Board

previously determined to be permissible, through

the partnerships, subject to the limitations previ-

ously established by the Board.

One nonbanking activity proposed by the

partnerships, acquisition of defaulted debt, was

an activity that the Board had not previously

approved. The partnerships are engaged primar-

ily in making, servicing, and investing in dis-

counted bank loans and other debt securities.

The partnerships acquire debt that has been or is

in the process of being restructured, including

secured and unsecured debt in the form of bank

loans, privately placed and publicly traded debt

instruments, bonds, notes, debentures, and dis-

counted receivables.

The applicant stated that

the partnerships will take an active role in the

restructuring of the defaulted debt they acquire,

including participating on creditors’ commit-

tees. The applicant indicates that such dis-

counted debt would be acquired for the purpose

of restructuring the debt to achieve a higher

yield and greater collateral protection.

Some of the debt the partnerships would

acquire may be in default at the time of acquisi-

tion and may be secured by voting shares or

1. The ﬁrst partnership group (in which the company

owned more than a 50 percent interest) was to terminate by

December 31, 1995. The company owned less than 50 percent

of the second partnership group, which would terminate by

December 31, 1999.

2. See 1994 FRB 736. The partnerships, together with the

applicant and its afﬁliates, would hold not more than 5 percent

of any class of voting securities of any issuer and not more

than 25 percent of the total equity, including subordinated

debt, of any issuer. In addition, the applicant committed that

no directors, ofﬁcers, or employees of the applicant or its

afﬁliates will serve as directors, ofﬁcers, or employees of any

issuer of which the applicant and its afﬁliates hold more than

10 percent of the total equity. The applicant also committed

that future limited partnerships would be structured in the

same manner as the current partnerships.

3. The partnerships are not leveraged, and the applicant

stated that the partnerships will not be leveraged. The appli-

cant has committed that neither the applicant nor any of

its subsidiaries would be permitted to make loans to the

partnerships.

4. The debt investments may include investments in com-

panies that may be contemplating, be involved in, or recently

have completed a negotiated restructuring of their outstanding

debt or a reorganization under chapter 11 of the Federal

Bankruptcy Code.

BHC Supervision Manual June 1999

Page 1

other assets that would be impermissible for a

bank holding company to hold without Board

approval.

Because the partnerships would have

the right in some cases to take title immediately

to shares or assets securing defaulted debt that

they acquire, the applicant committed that the

partnerships would treat this collateral, as well

as any other assets acquired in renegotiating this

debt, as assets acquired in satisfaction of a debt

previously contracted (DPC). Under the BHC

Act, a bank holding company must divest any

shares or assets acquired as DPC within two

years from the date the asset is acquired. For

this purpose, the applicant has committed that it

will consider shares or assets acquired in satis-

faction of defaulted debt to have been acquired

on the date the defaulted debt is acquired.

The Board stated that the acquisition of

defaulted debt under the circumstances and con-

ditions proposed by the applicant is an activity

that is closely related to banking. The applicant

stated that it will only purchase debt, not equity,

and will stand in the position of a creditor.

Based on all the facts of record, the Board

concluded that the proposed activities are closely

related to banking. The Board approved the

notice on October 17, 1995 (see 1995 FRB

1128). Approval was speciﬁcally conditioned

on the applicant’s compliance with the commit-

ments made in connection with the notice.

5. The applicant has committed that the partnerships will

not acquire debt in default that is secured by shares of banks

or bank holding companies.

6. The applicant could apply for up to a three-year exten-

sion. See 12 C.F.R. 225.22(d)(1). The Board notes that the

divestiture requirement would be satisﬁed if, during the dives-

titure period, the partnerships renegotiate the debt into a

performing obligation and release the collateral to the bor-

rower as part of the renegotiation. To the extent that defaulted

debt acquired by the partnerships is secured by assets or

shares that would be permissible investments for a bank

holding company, this divestiture commitment would not

apply.

Section 4(c)(8) of the BHC Act (Acquiring Debt in Default) 3104.0

BHC Supervision Manual June 1999

Page 2

Section 4(c)(8) of the BHC Act (Credit Card Authorization

and Lost/Stolen Credit Card Reporting Services)

Section 3105.0

A bank holding company applied for the Board’s

approval, pursuant to section 4(c)(8) of the BHC

Act, to engage de novo, through its existing

nonbank subsidiary, in credit card authorization

services and lost/stolen credit card reporting

services. The credit card authorization activity

would consist of providing, for a fee, a service

to issuers of credit cards that would enable

merchants to determine the validity and credit

limits of cards tendered to them. In addition, the

applicant was to provide, for a fee, a reporting

service to credit card holders, that would enable

them to report the loss or theft of any of their

credit cards via a single toll-free telephone call

to the nonbank subsidiary.

A number of banks indirectly offer the ser-

vice of reporting lost cards that are issued by

other institutions by arranging with independent

companies to provide the service under a trade

name associated with the bank. With respect to

credit card authorization services, banks have a

ﬁnancial interest in the security of the credit

cards and the availability of credit. Based on the

foregoing, the Board believed that banks gener-

ally have, in fact, provided the services pro-

posed by the applicant and are particularly well

suited to provide the proposed services. On that

basis, the Board concluded that the proposed

services were closely related to banking.

Since the proposed credit card reporting ser-

vice would create more competition and provide

greater conveniences by allowing an individual

who loses more than one card to report all lost

cards at once to one source rather than having to

make separate notiﬁcations to each card issuer,

and there was no evidence of adverse effects as

a result of the proposal, the application was

approved by the Board on January 5, 1985

(1985 FRB 648). See Regulation Y, sec-

tion 225.28(b)(2).

BHC Supervision Manual December 1998

Page 1

Section 4(c)(8) of the BHC Act

(Stand-Alone Inventory-Inspection Services) Section 3107.0

A domestic bank holding company (the appli-

cant) applied for the Board’s permission under

section 4(c)(8) of the BHC Act and section

225.23(a)(3) of the Board’s Regulation Y to

engage de novo, through a wholly owned sub-

sidiary, in the following services to customers

who make loans secured by inventory:

1. identifying inventory and deciding its gen-

eral condition, level of protection, and amount

of use, as appropriate

2. identifying inventory subject to a purchase-

money security interest under the Uniform

Commercial Code

3. identifying missing inventory and any credit

exposure that could result

4. supporting the proper allocation of loan pay-

ments that are related to the aging or sale of

inventory

The applicant would provide the above

inventory-inspection services only in connec-

tion with an extension of credit either by the

BHC (applicant) or a third pary. The service

would be provided throughout the United States,

but only in connection with inventory pledged

as collateral for a loan.

Bank holding companies currently inspect

and survey collateral for loans made or services

provided by them. Banks inspect collateral for

loans originated in direct lending activities. The

applicant suggested that its proposed collateral-

inspection services to third-party lenders are

identical to the collateral-inspection services

performed for its own extensions of credit.

In accordance with section 225.28(b)(1) of

Regulation Y, the Board authorized bank hold-

ing companies to make, acquire, and service

loans for the company’s own account or for the

account of others. The Board believes that these

activities include collateral-inspection services

provided to third parties in connection with

third-party extensions of credit. The Board also

believes that bank holding companies have the

necessary expertise to provide this service for

other lenders (on a stand-alone basis).

The Board found that public beneﬁts would

result from a potential increase in the availabil-

ity of inventory ﬁnancing. It noted that there

was no evidence suggesting that the proposal

would result in signiﬁcant adverse effects. The

ﬁnancial and managerial resources of the appli-

cant were believed to be consistent with previ-

ous approvals. The Board, based on the facts of

record, and the commitments and conditions

made by the applicant, approved the request on

September 13, 1993 (1993 FRB 1053).

1. For example, a loan may be secured by a pool of

inventory collateral, but there may be an agreement to apply

loan proceeds to speciﬁc items of collateral in a speciﬁed

order. Equipment used beyond a stated number of hours might

be of limited value, and the lender might agree to release its

security interest in such items. The inspection of inventory

collateral would verify the equipment’s proceeds to pay off

the oldest (or the youngest) items of collateral ﬁrst (or last),

rather than applying the proceeds pro rata to all items.

BHC Supervision Manual December 1998

Page 1

Section 4(c)(8) of the BHC Act

(Industrial Banking) Section 3110.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2015, this section was revised

to amend the beginning discussion and to include

statutory and regulatory citations and a current

Board order reference within section 3110.0.4.

A bank holding company may acquire or retain

an industrial bank to the extent authorized by

state law, under section 225.28(b)(4) of Regula-

tion Y only if the industrial bank acquired by

the holding company is not a ‘‘bank’’ within the

meaning of the Bank Holding Company Act.

Industrial loan companies, industrial banks, and

Morris Plan banks are state-chartered ﬁnancial

institutions that engage primarily in the business

of furnishing consumer loans and small- busi-

ness loans. The distinction between these insti-

tution and consumer ﬁnance companies lies in

the ability of the industrial loan company to

generate funds through the acceptance of depos-

its or issuance of certiﬁcates of indebtedness

(thrift notes). Although some of these institu-

tions have the same charters as banks (in some

states), they traditionally have not been consid-

ered to be banks for purposes of the Bank Hold-

ing Company Act as they cannot both make

commercial loans and accept demand deposits,

although in some states they have been empow-

ered to offer NOW accounts. Under a decision

of the Supreme Court, NOW accounts are not

demand deposits for the purposes of deﬁning

what a bank is. Thus, industrial loan companies

and similar institutions may offer NOW accounts

and make commercial loans without being treated

as banks for purposes of the Bank Holding

Company Act. These institutions may be in-

sured by the Federal Deposit Insurance Corpora-

tion and are eligible for membership in the

Federal Reserve System.

3110.0.1 NONBANKING

ACQUISITIONS NOT REQUIRING

PRIOR BOARD APPROVAL

In accordance with 12 C.F.R. 225.22(d)(8) of

Regulation Y, the Board’s prior approval is not

required for certain asset acquisitions by a lend-

ing company or industrial bank. This refers to

the assets of an ofﬁce(s) of a company of which

all, or substantially all, the assets relate to mak-

ing, acquiring, or servicing loans for personal,

family, or household purposes, if—

• the acquiring company has previously received

Board approval to engage in lending or indus-

trial banking activities under Regulation Y;

• the assets acquired during any 12-month period

do not represent more than 50 percent of the

risk-weighted assets (on a consolidated basis)

of the acquiring lending company or indus-

trial bank, or more than $100 million, which-

ever amount is less;

• the assets acquired do not represent more than

50 percent of the selling company’s consoli-

datedassetsthat are devotedto lending activities

or industrial banking business;

• the acquiring company notiﬁes the Reserve

Bank of the acquisition within 30 days after

the acquisition; and

• the acquiring company, after giving effect to

the transaction, meets the Board’s capital

adequacy guidelines and the Board has not

previously notiﬁed the acquiring company

that it may not acquire the assets under the

exemption.

3110.0.2 INSPECTION OBJECTIVES

1. To determine the quality of the loan portfolio

and the overall condition of the company.

2. To determine what exposure the subsidiary

presents to the holding company and subsidi-

ary bank(s).

3. To determine compliance with applicable

laws and regulations.

3110.0.3 INSPECTION PROCEDURES

1. Contactthe applicable stateregulatoryagency

to determine the legal parameters within

which the company operates and to assess

the degree to which the company is super-

vised. Each of the institutional structures

under this exemption is state chartered, and

the laws and regulations vary widely from

state to state. The company may be directly

supervised by its state department of bank-

ing or may be subject to virtually no super-

vision or regulation. If the company is

insured by the Federal Deposit Insurance

Corporation or is a member of the Federal

Reserve System, the company is primarily

subject to the primary supervision and regu-

lation of that agency. In cases in which the

BHC Supervision Manual January 2015

Page 1

company is supervised by a banking agency,

that agency’s report of examination will

generally sufﬁce. However, when the com-

pany is not supervised or examined, or

when the Reserve Bank ﬁnds the supervis-

ing agency’s report inadequate, an on-site

inspection is necessary.

2. Focus on an evaluation of the loan portfolio

and securities account, a determination of

the volatility of the deposits, an appraisal of

the adequacy of the audit program, and a

review of the company’s internal policies.

3. Review the receivables representing lend-

ing activities. The company should provide

a schedule of the aging of the consumer

receivables. It is preferable that the aging

be done on a contractual method. Classiﬁ-

cation of the consumer paper may be done

on a formula basis. The larger credits must

be given a complete evaluation.

4. Review the adequacy of the allowance for

loan and lease losses in conjunction with

the asset evaluation.

5. Price the securities portfolio, with particular

emphasis placed upon determining its

liquidity. Since the deposits of these institu-

tions are not always insured, they are more

susceptible to a deposit run off; therefore,

the requirement of adequate liquidity is of

paramount importance.

The deposits may be insured by a guar-

anty corporation up to a certain limit in

some states. These guaranty corporations

have provided some stability to the indus-

try. The guaranty corporations are indepen-

dent of any government agency or munici-

pality and therefore are limited in the amount

of protection which can be offered depositors.

6. Review back-up lines of credit available to

ensure secondary liquidity to the company.

7. Review the deposit accounts of the com-

pany. The deposits are evidenced by certiﬁ-

cates of indebtedness, or thrift notes. Infor-

mation regarding the number of deposits,

the size of accounts, and maturity distribu-

tion should be obtained to assess the stabil-

ity of the funding base.

8. Determine that the institution makes proper

disclosure to the public as to the type of

instrument the certiﬁcate represents. Some

states require that a disclosure statement, or

a prospectus, be ﬁled with the public yearly,

which sets forth the uses to which the funds

are being put and states that the funds are

not insured. This prospectus should be

reviewedfor proper disclosureof the required

information to ensure against possible suits.

9. Check the company’s policy concerning

withdrawals, giving recognition to state law

requirements, to ascertain whether funds are

generally not allowed to be withdrawn with-

out prior notice.

10. Review the scope of the internal or external

audits.

Section 4(c)(8) of the BHC Act (Industrial Banking) 3110.0

BHC Supervision Manual January 2015

Page 2

3110.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Reference for authorized

nonbanking activity—

activity closely related to

banking

4(c)(8)

4j(2)(A)

225.28(b)(4) 1982 FRB 253

1983 FRB 921

1984 FRB 231

1984 FRB 234

1984 FRB 371

1984 FRB 469

1984 FRB 741

1985 FRB 476

BHC indirect acquisition

of an industrial bank

4(c)(8)

4j(2)(A)

225.24

225.28(b)(1)

and (3)

2014 FRB 59, Q2

Nonbanking acquisition not

requiring Board approval

(conditions speciﬁed)

225.22 (d)(8)

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Industrial Banking) 3110.0

BHC Supervision Manual January 2015

Page 3

Section 4(c)(8) of the BHC Act

(Acquisition of Savings Associations) Section 3111.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2016, this section was revised

to include in subsection 3111.03 additional Board

orders that have authorized the acquisition of

savings and loan holding companies.

3111.0.1 ACQUISITION OF A

SAVINGS ASSOCIATION

Prior to 1989, the Board had determined that

the operation of a savings association was closely

related to banking but concluded, as a general

rule, that the operation of a savings and loan

association was not a proper incident to banking

because the potential adverse effects, of allow-

ing the afﬁliations of banks and thrift institu-

tions outweighed the potential public beneﬁts

(1977 FRB 280). Upon consideration of some

individual cases, the Board found that the adverse

effects of the afﬁliation would be outweighed by

the public beneﬁts of preserving the failing thrift

institution as a competitor in its market and of

ensuring public conﬁdence. (See 1985 FRB

462.) The 1982 Garn–St Germain Act recog-

nized the Board’s authority under section 4(c)(8)

of the BHC Act to approve such acquisitions

by authorizing the Board to dispense with the

necessary notice and hearing requirements of

this section under appropriate emergency

circumstances.

The Financial Institutions Reform, Recovery,

and Enforcement Act of 1989 (FIRREA)

amended section 4 of the Bank Holding Com-

pany Act (BHC Act) to authorize, effective

August 9, 1989, bank holding companies (BHCs)

to acquire any savings association. The legisla-

tion lifted the previously existing ‘‘tandem

operations’’ restrictions as they applied to sav-

ings associations owned by BHCs. (See 1989

FRB 716, appendix I.) These restrictions (1) pro-

vided that savings associations acquired by a

BHC could not be operated in tandem with any

other subsidiary of the BHC and (2) required

approval by the appropriate Federal Reserve

Bank before the savings association engaged in

any transactions with the BHC or its other sub-

sidiaries. The Board may not impose these re-

strictions on such transactions in the future,

except for those restrictions required by sections

23A and 23B of the Federal Reserve Act.

With respect to previous Board approvals of

the acquisition of problem thrifts by BHCs,

FIRREA required the Board to modify those

approvals by limiting any restrictions on trans-

actions between the savings association and

its holding company afﬁliates to those required

under sections 23A and 23B of the Federal

Reserve Act. In 1989, the Board removed the

tandem restrictions imposed on the operations

of savings association subsidiaries of a BHC.

(See 1989 FRB 71b.)

The Board amended Regulation Y pursuant

to FIRREA, effective October 10, 1989 (12

C.F.R. 225.28(b)(4)(ii)). The regulation allows

BHCs to acquire healthy and failed or failing

savings and loan associations in accordance

with FIRREA. The regulation permits BHCs to

acquire savings and loan associations in any

state, regardless of whether the holding com-

pany may operate a bank in that state. It does

not impose any operational or branching condi-

tions on the operation of savings and loan asso-

ciations. The regulation authorizes, as a permis-

sible activity under section 4(c)(8) of the BHC

Act, the owning, controlling, or operating of a

savings association if the savings association

engages only in deposit taking, lending, and

other activities that are permissible for BHCs.

The Board has permitted a short divestiture

period for impermissible investments and other

activities. (See 1992 FRB 707.)

The Board requires that when a BHC acquires

a savings association, the BHC must conform

the acquired institution’s direct and indirect ac-

tivities to those permissible for BHCs under

section 4 of the BHC Act.

In 2002, a foreign banking organization sub-

ject to the provisions of the BHC Act, and its

wholly owned subsidiary, requested the Board’s

approval under section 4(c)(8) and section 4(j)

of the BHC Act to acquire a savings association

and thereby engage in operating a savings asso-

ciation, and to conduct certain nonbanking ac-

tivities as a result of that acquisition. The for-

eign banking organization committed that it

would conform all the activities of the acquired

savings association to those permissible under

1. Section 225.2(m) of Regulation Y deﬁnes a savings

association as (1) any federal savings association or federal

savings bank; (2) any building and loan association, savings

and loan association, homestead association, or cooperative

bank if such association or cooperative bank is a member of

the Savings Association Insurance Fund; and (3) any savings

bank or cooperative deemed by the director of the Ofﬁce of

Thrift Supervision to be a savings association under section

10(l) of the Home Owners’ Loan Act.

BHC Supervision Manual January 2016

Page 1

section 4(c)(8) of the BHC Act and Regulation

Y. (See section 225.28(b)(4)(ii). See also 2002

FRB 385, 2002 FRB 485, 2003 FRB 439, 2004

FRB 503, and 2005 FRB 91.) The foreign bank-

ing organization was also treated as a ﬁnancial

holding company. Any other activities of the

acquired savings association were, therefore, re-

quired to conform to those permissible for a

ﬁnancial holding company under section 4(k) of

the BHC Act.

3111.0.2 APPROVAL TO BECOME A

BHC BY ACQUIRING ANOTHER BHC

A savings and loan holding company (SLHC)

requested the Board’s approval, under section 3

of the BHC Act, to become a bank holding

company (BHC), by merging with HN Corpo-

ration (a bank holding company) and thereby

acquire HNB, a national bank. The SLHC re-

quested the Board’s approval to continue to op-

erate SB, a subsidiary federal savings bank, un-

til its conversion to a national bank. After the

merger, SLHC would convert SB to a national

bank and merge its subsidiary commercial bank

(SCB) and HNB into SB, the survivor being

SB.

SLHC also requested the Board’s approval

under section 3 of the BHC Act to acquire HN’s

minority interest in another BHC, BBI and its

subsidiary bank, B Bank.

3111.0.2.1 Financial, Managerial, and

Other Supervisory Considerations

Sections 3 and 4 of the BHC Act require the

Board to consider the ﬁnancial and managerial

resources and future prospects of the compa-

nies, banks, and savings associations involved

in a proposal and certain other supervisory fac-

tors.

These factors include supervisory and

examination information received from the rel-

evant federal and state supervisors of the organi-

zations involved in the proposal, and other avail-

able ﬁnancial information, including information

provided by the SLHC. The Board is required to

consider the managerial resources of the organi-

zations involved and the proposed combined

organization.

3111.0.2.2 Nonbanking Activities

The SLHC ﬁled a notice pursuant to sections

4(c)(8) and 4(j) of the BHC Act to (1) retain its

ownership interest in SB and thereby operate a

savings association and (2) engage in activities

that are permissible for BHCs through its non-

banking subsidiaries, including lending, loans

servicing and related activities, leasing, and sell-

ing credit-related insurance. The Board previ-

ously has determined by regulation that the

operating of a savings association by a BHC and

the other nonbanking activities for which SLHC

has requested approval, are closely related to

banking for the purposes of section 4(c)(8) of

the BHC Act.

With respect to the public interest factors

under section 4(j) of the act, the Board must

determine whether the operation of SB as a

savings association by a BHC can reasonably be

expected to produce beneﬁts to the public, such

as greater convenience, increased competition,

or gains in efﬁciency, that outweigh possible

adverse effects,such as concentrationof resources,

decreased or unfair competition, conﬂicts of in-

terests, or unsound banking practices. The re-

cord indicated that consummation of the pro-

posal would create a stronger and more diversiﬁed

ﬁnancial services organization and would pro-

vide current and future customers of HNB with

expanded ﬁnancial products and services.

2. 12 U.S.C. 1842(c)(2) and (3).

3. A comment received from the public expressed concern

that SLHC acquired control over HN before obtaining the

Board’s approval of the application as the result of an exten-

sion of credit the SLHC made to HN. The extension of credit

was made after the SLHC had ﬁled its application with the

Board to acquire HN. The SLHC loaned HN $50 million,

secured by the shares of HNB. HN invested the loan proceeds

in HNB to increase the bank’s capital.

The Board noted its concern about a banking organization

seeking to acquire another banking organization and making a

loan to the acquiree in advance of the Board’s approval of the

acquisition. Such types of loans raise concern that the transac-

tions would be, in substance, the acquisition of a controlling

interest or would provide the acquirer with the ability to

exercise a controlling inﬂuence over the management and

policies of the BHC before receiving approval. The Board

carefully reviewed the loan transaction, its supporting docu-

mentation, and the relationships of the organizations after the

loan transaction. Based on all the facts of record, the Board

concluded that the loan did not result in SLHC acquiring

voting securities of, or a controlling equity interest in, HN, or

in SLHC exercising, or having the ability to exercise, a

controlling inﬂuence over HN. The Board noted that it contin-

ues to believe that when a loan is made by an acquirer to a

target organization before it receives agency approval of its

acquisition proposal, it raises important issues, and that it will

review these arrangements critically and carefully.

4. See 12 C.F.R. 225.28(b)(1), (2), (3), (4), (8), and (11).

Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0

BHC Supervision Manual January 2016

Page 2

3111.0.2.3 Noncontrolling Investment

The SLHC proposed to acquire 17.5 percent of

BBI’s voting shares that HN currently owned

and to increase up to 19.9 percent its total

ownership of BBI’s voting shares. The Board

previously had approved HN’s investment in

BBI as a passive investment, and HN complied

with certain commitments that were previously

relied on by the Board in determining that an

investing BHC would not exercise a controlling

inﬂuence over another BHC or bank for the

purposes of the BHC Act (‘‘Passivity Commit-

ments’’).

The SLHC indicated that it did not

propose to control or exercise a controlling

inﬂuence over BBI and that its indirect invest-

ment in B Bank also would be a passive invest-

ment. The SLHC provided the passivity com-

mitments to the Board (see appendix A). Based

on those commitments, the Board concluded

that the SLHC would not acquire control of, or

have the ability to exercise a controlling inﬂu-

ence over, BBI or B Bank through the proposed

acquisition of BBI’s voting shares.

3111.0.2.4 Appendix A

Passivity Commitments

The SLHC will not, without the prior approval

of the Federal Reserve Board or its staff, di-

rectly or indirectly:

1. Exercise or attempt to exercise a controlling

inﬂuence over the management or policies

of BBI or any of its subsidiaries;

2. Have or seek to have a representative of

SLHC serve on the board of directors of

BBI or any of its subsidiaries;

3. Have or seek to have any employee or

representative of SLHC serve as an ofﬁcer,

agent, or employee of BBI or any of its

subsidiaries;

4. Take any action that would cause BBI or

any of its subsidiaries to become a subsidi-

ary of SLHC;

5. Acquire or retain shares that would cause

the combined interests of SLHC and its

ofﬁcers, directors, and afﬁliates to equal or

exceed 19.9 percent of the outstanding vot-

ing shares of BBI or any of its subsidiaries;

6. Propose a director or slate of directors in

opposition to a nominee or slate of nomi-

nees proposed by the management or board

of directors of BBI or any of its subsidiaries;

7. Solicit or participate in soliciting proxies

with respect to any matter presented to the

shareholders of BBI or any of its subsidiaries;

8. Attempt to inﬂuence the dividend policies;

loan, credit, or investment decisions or poli-

cies; pricing of services; personnel deci-

sions; operations activities, including the

location of any ofﬁces or branches or their

hours of operation, etc.; or any similar ac-

tivities or decisions of BBI or any of its

subsidiaries;

9. Dispose or threaten to dispose (explicitly or

implicitly) of shares of BBI in any manner

as a condition or inducement of speciﬁc

action or non-action by BBI or any of its

subsidiaries;

10. Enter into any other banking or nonbanking

transactions with BBI or any of its subsidi-

aries, except that SLHC may establish and

maintain deposit accounts with BBI, pro-

vided that the aggregate balance of all such

deposit accounts does not exceed $500,000

and that the accounts are maintained on

substantially the same terms as those pre-

vailing for comparable accounts of persons

unafﬁliated with BBI.

11. Acquire or seek to acquire any nonpublic

ﬁnancial information of BBI or any of its

subsidiaries, beyond the information already

available to it as a shareholder of BBI.

SLHC also conﬁrms that there are no legal,

contractual, orstatutory provisions thatwould

allow it or its subsidiaries to have any

access to ﬁnancial information of BBI or its

subsidiaries beyond the information avail-

able to shareholders.

3111.0.2.5 Interstate Acquisition

Under the Dodd-Frank Act, the Board of Gover-

nors of the Federal Reserve System may not

approve the acquisition of an insured depository

institution (including a savings association) if

the home state of the insured depository institu-

tion is a state other than the home state of the

5. The Board previously determined that the acquisition of

less than a controlling interest in a bank or BHC is not a

normal acquisition for a BHC. The requirement in section

3(a)(3) of the BHC Act that the Board’s approval be obtained

before a BHC acquires more than 5 percent of the voting

shares of a bank seems to suggest, however, that Congress

contemplated the acquisition by BHCs of between 5 and

25 percent of the voting shares of banks. See 12 U.S.C.

1843(a)(3). On this basis, the Board has previously approved

the acquisition of a BHC of less than a controlling interest in a

bank or BHC. See 2006 FRB C37 (acquisition of up to

24.89 percent of the voting shares of a BHC); 2005 FRB 74

(acquisition of 24.9 percent of the shares of a BHC); and 2000

FRB 52 (acquisition of up to 9.9 percent of the voting shares

of a BHC).

Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0

BHC Supervision Manual January 2016

Page 3

bank holding company and the applicant con-

trols, upon consummation, more than 10 percent

of the total amount of insured deposits in the

United States. (For the Dodd-Frank cite, see 12

USC 1843(c)(8). Pub. L. 111-203 124 stat 1547,

1634)

3111.0.3 LAWS, REGULATIONS, INTERPRETATIONS, ORDERS

Subject Laws

Regulations

Interpretations

Orders

Activity approval 1843(4)(i) 225.28(b)(4)(ii) 1997 FRB 275

Determination that the

operation of a thrift

institution is closely related

to banking and a proper

incident thereto

225.28(b)(1),

(2), (3), (4), (8),

and (11)

2010 FRB B7

1989 FRB 86

1986 FRB 724

1986 FRB 342

1985 FRB 340

1983 FRB 812

1982 FRB 660

1982 FRB 316

1977 FRB 280

1974 FRB 868

Bank holding companies

acquiring savings associations

must conform their direct and

indirect nonbank activities to

those permissible for bank

holding companies

225.28(b)(4)(ii) 2014 FRB 13, Q3

(FRB Order

No. 2014-16)

2010 FRB B7

2005 FRB 91

2004 FRB 503

2003 FRB 439

2002 FRB 485

2002 FRB 385

Acquisition of stock savings

and loan associations

1985 FRB 462

Removal of tandem restric-

tions

1989 FRB 716

Establishing branches on an

interstate basis after

acquisition

1993 FRB 890

BHC’s joint acquisition of a

savings association, merged

subsequently into a subsidiary

bank

225.28(b)(4)(ii) 2014 FRB 23, Q4

(FRB Order

No. 2014-22)

Minority investment (interest)

in a savings bank

1995 FRB 509

Acquisition of a BHC of less

than a controlling interest in a

bank or BHC

2006 FRB C37

2005 FRB 74

2000 FRB 52

Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0

BHC Supervision Manual January 2016

Page 4

Subject Laws

Regulations

Interpretations

Orders

Acquisition of a savings and

loan holding company

1843(c)(8)

and (j)

225.28(b)(4)(ii) 2015 FRB 61

(Board Order

No. 2015-27

2015 FRB 37

(Board Order

No. 2015-34

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Acquisition of Savings Associations) 3111.0

BHC Supervision Manual January 2016

Page 5

Section 4(c)(8) of the BHC Act

(Trust Services) Section 3120.0

The performance of trust services by a trust

company subsidiary that is neither a ‘‘bank’’ nor

a nonbank bank encompasses virtually any kind

of ﬁduciary, agency, or custodial service com-

monly performed by a trust company so long as

the subsidiary does not accept demand deposits

or make loans, except as expressly permitted by

section 225.28(b)(5) of Regulation Y. Generally,

under Regulation Y, a trust company may only

accept deposits arising out of trust funds not

currently invested; perform escrow services,

such as receiving, holding, and disbursing down-

payments and other funds deposited by purchas-

ers in real estate transactions; and act as an

agent for an issuer of, or broker or dealer in,

securities in a capacity of a paying agent,

dividend-disbursing agent, or securities clearing

agent, so long as the funds are not used by the

customer as a general-purpose checking account

and do not bear interest. The subsidiary’s lend-

ing activities are restricted to making call loans

to securities dealers and to purchasing money

market instruments; however, such loans may

not be used to provide funding for nonbank

subsidiaries of the holding company.

Trust companies may be either state chartered

or nationally chartered. Some nationally char-

tered trust companies have national bank char-

ters but have agreed through limitations in their

bylaws to engage only in those activities permit-

ted for trust departments of national banks. To

prevent the use of a trust company as a vehicle

for evasion of section 3(d) of the Bank Holding

Company Act, the Board has conditioned its

approval of certain interstate acquisitions by

requiring that (1) the trust company’s demand

deposit–taking activities not be operated in tan-

dem with any other subsidiary, (2) demand

deposit and commercial lending services of

afﬁliates will not be linked in any way, and

(3) the trust company will not engage in any

transactions with afﬁliates, other than the pay-

ment of dividends or the infusion of capital,

without the Board’s approval (for example, see

U.S. Trust Corporation, 1984 FRB 371). The

scope of these conditions may be reviewed by

the Board in connection with nonbank bank

applications.

As part of normal administration of its trust

accounts, a trust company will from time to time

engage in an activity, such as property manage-

ment or land development, that has been

determined to be not closely related to banking

by the Board. Any such service may only be

performed incidentally to ﬁduciary-account

administration and may not be offered or mar-

keted as a separate service.

The board of directors and senior manage-

ment of ﬁnancial holding companies (FHCs)

and bank holding companies (BHCs) are

responsible for overseeing the operations of

their ﬁduciary activities in a safe and sound

manner. Such oversight (particularly for those

BHCs and FHCs engaged in a broad range of

ﬁnancial activities) at the consolidated level is

important because the risks associated with ﬁnan-

cial activities as well as ﬁduciary activities can

cut across legal entities and business lines. Fed-

eral Reserve examiners review and assess the

internal policies, reports, and procedures and

effectiveness of the BHC/FHC consolidated risk-

management process.

The appropriate regulator of trust activities

(including activities of a ﬁduciary, agency, or

custodial nature) has the primary responsibility

for evaluating risks, hedging, and risk manage-

ment at the legal-entity level for any subsidiary

or subsidiaries that the regulator supervises.

Federal Reserve examiners should seek to use

the examination ﬁndings of the appropriate regu-

lators. (See SR-00-13.)

To determine the complete scope of ﬁduciary

assets within an FHC/BHC, examiners should

reference the Uniform Bank Performance Report

(UBPR), which reﬂects the information gath-

ered on Schedule RC-T. To further understand

the scope of ﬁduciary assets within an FHC/

BHC, an examiner should also look at informa-

tion reported on Schedules Y-11 and Y-9C with

respect to income derived from trust, ﬁduciary,

and asset-management activities. (See also page

4 of the Bank Holding Company Performance

Report (BHCPR) for the amount and percent-

ages of income from ﬁduciary activities to

adjusted operating income (tax-equivalent),

including the BHC’s corresponding peer-group

ratios.)

Peer analysis is also available at the bank

level. Examiners should refer to pages Trust 1

and Trust 1A of the UBPR. General comparison

information is also available on a lagged basis

in the FFIEC’s electronic report ‘‘Trust Assets

of Financial Institutions’’ (www2.fdic.gov/

structur/trust/index.asp). Aggregatedataare listed

by year back to 1996.

BHC Supervision Manual December 2003

Page 1

3120.0.1 ON-SITE INSPECTIONS

Trust companies are normally engaged in activi-

ties such as management of funds for individu-

als. These activities are signiﬁcant to the integ-

rity of the banking system and involve signiﬁcant

potential liability to the bank holding company

if not properly conducted. Therefore, periodic

on-site inspections should be performed. If the

trust company is examined by a state banking

department, then alternate-year examination pro-

cedures may apply. If nationally chartered, a

review of the periodic on-site examinations of

the Comptroller of the Currency will generally

sufﬁce. If the trust company is not subject to a

regular examination by another federal banking

agency (i.e., if it is an uninsured, state-chartered

nonmember trust company), the Reserve Bank

should perform regular on-site inspections to

include, at a minimum, full-scope reviews of the

trust activity. The inspections would use proce-

dures such as those used in the examinations of

trust activities of state member banks. This por-

tion of the inspection should be performed by

examiners specially trained in trust examina-

tions. Holding company inspectors should spe-

ciﬁcally review trust activities for compliance

with any conditions imposed by the Board in

connection with the approval of an application.

Section 4(c)(8) of the BHC Act (Trust Services) 3120.0

BHC Supervision Manual December 2003

Page 2

Section 4(c)(8) of the BHC Act

(General Financial and Investment Advisory Activities) Section 3130.0

The main sections that follow (sections 3130.1

through 3130.9) address all ﬁnancial and invest-

ment advisory activities under section 4(c)(8) of

the BHC Act and section 225.28(b)(6) of Regu-

lation Y that have been authorized by the Board.

This section provides general inspection objec-

tives and procedures that relate to such ﬁnancial

and investment advisory activities. These objec-

tives and procedures can be applied to the BHC

inspection of every advisory activity when advi-

sory activities are not listed separately in any of

this manual’s individual advisory sections.

Any commitments that were made by the

bank holding company or its nonbank subsidi-

aries to the Federal Reserve System pertaining

to its ﬁnancial and investment advisory non-

banking activities should be reviewed by the

examiner for compliance and applicability, in

accordance with the current statutory and regu-

latory provisions. Any existing commitments or

conditions that relate to the ﬁnancial resources

of a bank holding company or its subsidiaries or

to commitments or conditions that relate to the

risk-management policies of the organization

should remain intact and should be reviewed

by an examiner for compliance during each

inspection.

The Board’s Regulation Y, effective April

1997, resulted in a structural reorganization of

ﬁnancial and investment advisory nonbanking

activities. The provision of discretionary invest-

ment advice is no longer limited to institutional

customers. Bank holding companies and their

subsidiaries may engage in ﬁnancial and invest-

ment advisory activities without restriction. Bank

holding companies can manage retail customer

accounts outside of the trust department of an

afﬁliated bank (to the extent permitted by law).

Further, bank holding companies may engage in

any combination of permissible nonbanking

activities listed in Regulation Y. Accordingly,

bank holding companies may provide ﬁnancial

and investment advice jointly with permissible

agency transactional service, investment or trad-

ing transactions as principal, or any other listed

nonbanking activity.

The rules in Regulation Y provide examples

of ﬁnancial and investment advisory activities

that are illustrative rather than exclusive. With

regard to the examples, a bank holding company

may act as an investment or ﬁnancial adviser

without restriction to any person, including

1. serving as an investment adviser (as deﬁned

in section 2(a)(20) of the Investment Com-

pany Act of 1940) to an investment company

registered under that act, including sponsor-

ing, organizing, and managing a closed-end

investment company;

2. furnishing general economic information and

advice, general economical statistical fore-

casting services, and industry studies;

3. providing advice in connection with mergers,

acquisitions, divestitures, investments, joint

ventures, leveraged buyouts, recapitaliza-

tions, capital structurings, ﬁnancing transac-

tions and similar instruments, and conduct-

ing ﬁnancial-feasibility studies;

4. providing information, statistical forecasting,

and advice with respect to any transaction in

foreign exchange, swaps, and similar transac-

tions, commodities, and any forward con-

tract, option, future, option on a future, and

similar instrument;

5. providing educational courses and instruc-

tional materials to consumers on individual

ﬁnancial-management matters; and

6. providing tax-planning and tax-preparation

services to any person.

Sections 3130.1 through 3130.9 include many

historical examples of various ﬁnancial and

investment advisory activities that have been

approved by the Board. These examples are to

be viewed as historical references. They should

be considered as to their applicability to current

statutory and regulatory provisions. Some

examples include, but are not limited to, provid-

ing ﬁnancial advice in rendering fairness opin-

ions and providing valuation services in connec-

tion with mergers, acquisitions, divestitures,

investments, joint ventures, leveraged buyouts,

recapitalizations, and capital structurings. Other

examples include providing advice on ﬁnancing

and similar transactions with respect to private

and public ﬁnancings and loan syndications;

conducting ﬁnancial-feasibility studies; and pro-

viding ﬁnancial advice to state and local govern-

ments with respect to the issuance of their

securities.

3130.0.1 INSPECTION OBJECTIVES

1. To review the adviser’s organizational struc-

ture and the qualiﬁcations of its management

to conduct business, and to determine whether

they are satisfactory.

BHC Supervision Manual June 1998

Page 1

2. To determine the status of the adviser’s

ﬁnancial condition and the adequacy of

internal controls, general accounting poli-

cies, and reporting procedures, and to deter-

mine if they reﬂect the guidelines estab-

lished by management.

3. To determine whether fee income is accu-

rately computed and reported on a consis-

tent basis.

4. To determine what ﬁnancial effect the activ-

ity has on the parent holding company and

the bank subsidiaries.

5. To review and evaluate investment prac-

tices considering the adviser’s investment

responsibilities for the selection and alloca-

tion of investments for various types of

accounts to determine whether they are

appropriate.

6. To evaluate funding sources, including

indebtedness, and their management with

respect to maturities and interest rates.

7. To determine the adequacy of internal and

external audits.

8. To determine whether the adviser company

has adequate policies and procedures to pre-

vent self-dealing and similar improper

conﬂicts.

9. To determine whether operating practices

provide for adequate legal documents and

agreements such that the account activities,

in general, are consistent with the contrac-

tual responsibilities and authorities.

10. To determine if any litigation is pending

against the company and the possible impact

of an unfavorable court decision.

11. To evaluate compliance with applicable bank

holding company laws, regulations, and

interpretations, including compliance with

the standards of care and conduct applica-

ble to ﬁduciaries as required by Regula-

tion Y.

3130.0.2 INSPECTION PROCEDURES

1. Review System approval and activities for

conformance with any limitations. Deter-

mine if the activity is conducted through a

separately incorporated subsidiary of the

bank holding company that—

a. refrains from taking positions for its own

account;

b. observes the standards of care and con-

duct applicable to ﬁduciaries with respect

to its advisory and transactional services;

and

c. avoids executing customer transactions

when acting in an advisory capacity.

2. Prepare ﬁnancial statements for the last two

ﬁscal years, plus interim if appropriate.

Analyze for adverse trends and evaluate for

negative effects on afﬁliates.

3. Evaluate asset quality when warranted, docu-

menting the scope and detailing asset review.

Compile classiﬁcation data, write up classi-

ﬁcations if appropriate, and evaluate reserve

adequacy.

4. Obtain documentation for all indebtedness.

Evaluate funding sources for maturity mis-

match, dependence on afﬁliates’ concentra-

tions, and dependability. Review borrow-

ings from afﬁliate banks for compliance

with section 23A of the Federal Reserve

Act.

5. Review income and expense accounts and

transactions with afﬁliates for compliance

with section 23B of the Federal Reserve

Act.

6. Review the company’s revenue sources to

determine that it has not taken positions and

does not, itself, execute transactions when

acting in an advisory capacity.

7. Evaluate contracts and service agreements

with afﬁliates. Identify whether the com-

pany receives or provides services or prod-

ucts. Determine that the services or prod-

ucts are needed and received or provided,

and that the contract or agreement terms

represent market rates.

8. Review the company’s fee schedule for pro-

viding advice and the fees charged by afﬁli-

ated banks to conduct transactions for the

company’s customers. Determine whether

the bank is being adequately compensated

for executing trades, or whether these prof-

its are accruing largely to the beneﬁt of the

company.

9. Review checking-account statements for all

accounts at afﬁliate banks for overdrafts

since the previous inspection.

10. Evaluate whether the nonbank activities are

being performed by afﬁliate bank personnel

or are using bank assets. If so, is the bank

adequately compensated?

11. Identify off-balance-sheet activities and con-

tingent liabilities, and assess the risk to the

company and any afﬁliate.

12. Obtain a listing of litigation against the

company or any individuals who represent

the company from the company’s legal coun-

sel, and evaluate potential effects on the

ﬁnancial condition.

13. Obtain and review internal and external

audit reports and workpapers.

Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0

BHC Supervision Manual June 1998

Page 2

14. Obtain and review internal and external

asset-review reports.

15. Obtain and review copies of the board of

directors’ and senior management’s poli-

cies and procedures.

16. Review a sample of recommendations to

determine that a reasonable basis exists for

the company’s recommendations.

17. Review the advisory contracts to determine

if there are any conﬂicts of interests involv-

ing the parent company or afﬁliates, as well

as the ofﬁcers, directors, or principal share-

holders and their related interests of the

holding company and its afﬁliates.

18. Evaluate insurance for adequacy.

19. Obtain or verify that workpapers contain

the following permanent documentation:

a. System approval letters

b. date of incorporation or date acquired

c. date activity commenced

d. articles of incorporation and by-laws

e. commitments

f. supervisory actions

g. other pertinent correspondence

20. Obtain and review a listing of shareholders

for each class of stock outstanding, and a

schedule of ofﬁcers, directors, and their re-

lated interests.

Section 4(c)(8) of the BHC Act (General Financial and Investment Advisory Activities) 3130.0

BHC Supervision Manual June 1998

Page 3

Section 4(c)(8) of the BHC Act

(Investment or Financial Advisers) Section 3130.1

WHAT’S NEW IN THIS REVISED

SECTION

This section is revised to amend section 3130.1.6,

Laws, Regulations, Interpretations, and Orders.

The table references a 2015 Board order that

authorizes the merger of two bank holding com-

panies and the acquisition of a bank, which

were immediately followed by the acquisition of

nonbank subsidiaries authorized to be engaged

in ﬁnancial and investment advisory activities

under section 225.28(b)(6) of Regulation Y.

A bank holding company or its nonbank subsid-

iary that engages in investment or ﬁnancial

adviseractivitiesis subjectto section 225.28(b)(6)

of Regulation Y. The purpose of an inspection

of a company providing investment or ﬁnancial

advice is to determine that it is operating accord-

ing to applicable laws, regulations, and interpre-

tations, and to determine that the company is

subject to an adequate audit program. Regula-

tion Y allows a bank holding company to serve

as an investment adviser as deﬁned in section

2(a)(20) of the Investment Company Act of

1940 (15 U.S.C. 80a-2(a)(20)), which deﬁnes an

‘‘investment adviser’’ of an investment com-

pany as ‘‘...any person who pursuant to contract

with such company regularly furnishes advice

to such company with respect to the desirability

of investing in, purchasing or selling securities

or other property, or is empowered to determine

what securities or other property shall be pur-

chased or sold by such company...’’

The Board has issued an interpretive rule

regarding the investment adviser activities of

bank holding companies under Regulation Y

(12 C.F.R. 225.125). The following is a list of

some of its provisions:

1. Bank holding companies, including their

bank and nonbank subsidiaries, may act as

investmentadvisersto various typesof invest-

ment companies such as mutual funds and

closed-end investment companies. Mutual

funds and closed-end investment compa-

nies are described in the interpretation.

2. Bank holding company investment adviser

activities are limited by the Glass-Steagall

Act (Banking Act of 1933 (12 U.S.C. 24,

78, 377, 378)). This act generally prohibits

member banks from engaging in the pur-

chase or sale of equity securities other than

in an agency capacity.

3. A bank holding company may not sponsor,

organize, or control a mutual fund. This

does not apply to closed-end investment

companies so long as they are not primarily

or frequently engaged in the issuance, sale,

or distribution of securities.

4. A bank holding company should not act as

investment adviser to an investment com-

pany which has a name similar to the bank

holding company or any of its subsidiary

banks, unless the prospectus of the invest-

ment company contains certain required

disclosures. In no case should a bank hold-

ing company act as investment adviser to an

investment company that has either the

same name as the name of the bank

holding company or any of its subsidiary

banks, or that has a name that contains the

word ‘‘bank.’’

5. Since investment adviser activities may cre-

ate potential conﬂicts of interest, the Board

determined that a bank holding company

and its subsidiaries should not purchase in

their sole discretion, in a ﬁduciary capacity

(including as managing agent), securities of

any investment company for which the bank

holding company acts as investment adviser,

unless the purchase is speciﬁcally autho-

rized by (1) the terms of the instrument

creating the ﬁduciary relationship, (2) court

order, or (3) the law of the jurisdiction

under which the trust is administered.

6. A bank holding company may not engage,

directly or indirectly, in the underwriting,

public sale, or distribution of securities of

any investment company for which it or any

nonbank subsidiary acts as investment

adviser, except in compliance with section

20 of the Glass-Steagall Act. The Board has

determined, however, that the conduct of

securities brokerage activities by a bank

holding company or its nonbank subsidi-

aries, when conducted individually or in

combination with investment advisory

activities, is not deemed to be the under-

writing, public sale, or distribution of secu-

rities prohibited by the Glass-Steagall Act.

7. A bank holding company or any of its non-

bank subsidiaries that have been authorized

by the Board under the Bank Holding Com-

pany Act to conduct securities brokerage

activities (either separately or in combina-

tion with investment advisory activities)

may act as agent, upon the order and for the

account of customers of the holding com-

BHC Supervision Manual January 2016

Page 1

pany or its nonbank subsidiary, to purchase

or sell shares of an investment company for

which the bank holding company or its

subsidiaries act as an investment adviser.

8. A bank holding company or any of its non-

bank subsidiaries that have been authorized

by the Board under the Bank Holding Com-

pany Act to provide investment advice to

third parties generally (either separately or

in combination with securities brokerage

services) may provide investment advice to

customers with respect to the purchase or

sale of shares of an investment company for

which the holding company or any of its

subsidiaries acts as an investment adviser.

9. A bank holding company or its subsidiary

bank, at the time a service is provided, must

caution customers to read the prospectus of

the investment company before investing.

Customers must be advised in writing that

the investment company’s shares are not

insured by the Federal Deposit Insurance

Corporation and are not deposits, obliga-

tions, or endorsed or guaranteed in any way

by any bank (unless that is the case). The

role of the company or afﬁliate as adviser to

the investment company must be disclosed

in writing. Such disclosures may be done

orally, but the cusotomer must be given

such disclosures in writing immediately

thereafter.

10. Because of potential conﬂicts of interest, a

bank holding company which acts both as

custodian and investment adviser for an

investment company should exercise care

to maintain at a minimum level demand

deposit accounts of the investment com-

pany which are placed with a bank afﬁliate,

and should not invest cash funds of the

investmentcompany in time deposit accounts

(including certiﬁcates of deposit) of any

bank afﬁliate.

3130.1.1 REAL ESTATE

DEVELOPMENT ADVISERS FOR

STATE AND LOCAL GOVERNMENTS

Advising state and local governments about

methods available to ﬁnance real estate develop-

ment projects, and evaluating projected income

to determine if debt resulting from proposed

development projects can be adequately ser-

viced is permissible if the activities are autho-

rized under section 225.28(b)(6) of Regula-

tion Y.

Before this activity was incorporated into

Regulation Y, in 1980, the Board had received

certain comments noting that certain aspects of

these advisory services may be within the scope

of the activity of ‘‘management consulting.’’

The Board had found that it was not permissible

for bank holding companies to offer manage-

ment consulting services to nonafﬁliated compa-

nies.Certainmanagement consulting advicecould

be provided to unafﬁliated depository institu-

tions, however. In view of the relationship that

had traditionally existed between banks and

state and local governments, and the net public

beneﬁts that would result from provision of

advice to such governments by bank holding

companies, the Board indicated that it would be

more ﬂexible in determining what particular

services constitute ‘‘providing ﬁnancial advice’’

rather than ‘‘management consulting’’ when the

services are solely for state and local govern-

ments rather than other nonbank organizations.

With the Board’s April 1997 revision of Regula-

tion Y, investment and ﬁnancial advisory activi-

ties were grouped together and a bank holding

company could act as an investment or ﬁnancial

adviser without restriction.

The Board also allowed the provision of

management consulting services regarding any

ﬁnancial, economic, accounting, or audit matter

to any company. These ﬁnancial activities are

directly related to the activities and expertise of

bank holding companies. Management consult-

ing services are subject to a revenue limitation,

however. They may be provided to any cus-

tomer on any matter, provided that the total

annual revenue derived from the management

consulting services does not exceed 30 percent

of the company’s total annual revenue derived

from management consulting activities. Thus,

any services provided to state and local govern-

ments that are deemed management consulting

services are subject to this revenue limitation.

3130.1.2 INSPECTION OBJECTIVES

1. To review the adviser’s organizational struc-

ture and the qualiﬁcations of management

toconductbusiness,and to determine whether

they are satisfactory.

2. To determine the status of the adviser’s

ﬁnancial condition and the adequacy of

internal controls, general accounting poli-

cies, and reporting procedures, and to deter-

mine if they reﬂect the guidelines estab-

lished by management.

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2016

Page 2

3. To determine whether fee income is accu-

rately computed and reported on a consis-

tent basis.

4. To determine what ﬁnancial effect the activ-

ity has on the parent holding company and

the bank subsidiaries.

5. To review and evaluate investment prac-

tices considering the adviser’s investment

responsibilities for the selection and alloca-

tion of investments for various types of

accounts, and to determine whether they are

appropriate.

6. To evaluate funding sources, including

indebtedness, and their management based

on maturities and interest rates.

7. To determine the adequacy of internal and

external audits.

8. To determine whether the adviser company

has adequate policies and procedures to pre-

vent self-dealing and similar improper con-

ﬂicts.

9. To determine whether operating practices

provide for adequate legal documents and

agreements such that the account activities,

in general, are consistent with the contrac-

tual responsibilities and authorities.

10. To determine if any litigation is pending

against the company and the possible impact

of an unfavorable court decision.

11. To evaluate compliance with applicable bank

holding company laws, regulations, and

interpretations, including compliance with

the standards of care and conduct applica-

ble to ﬁduciaries as required by Regula-

tion Y.

3130.1.3 INSPECTION PROCEDURES

1. Obtain the company’s policy and procedure

manuals, and distribute relevant portions to

the examiners for review and compliance

evaluation.

2. Review the minutes of meetings of the

board of directors, audit committees, and

any ofﬁcer-level committees. Ensure that

examiners performing other portions of the

inspection review relevant minutes or sum-

maries thereof.

3. Obtain, review, and evaluate the adequacy

of internal and external audit procedures,

reports, and workpapers.

4. Prepare ﬁnancial statements for the last two

ﬁscal years, plus the interim period, if

appropriate. Analyze and evaluate the infor-

mation for adverse trends and for negative

effects on afﬁliates.

5. Obtain, review, and evaluate internal and

external asset-review reports.

6. Evaluateasset qualitywhere warranted, docu-

menting the scope and detailing asset review.

Compile classiﬁcation data, write up classi-

ﬁcations if appropriate, and evaluate the

adequacy of contra asset allowances.

7. Obtain documentation for all indebtedness.

Evaluate funding sources for maturity mis-

match, dependence on afﬁliates, concentra-

tions, and dependability. Review borrow-

ings from afﬁliate banks for compliance

with section 23A of the Federal Reserve

Act.

8. Review checking-account statements for all

accounts at afﬁliate banks, checking for

overdrafts since the previous inspection.

9. Complete the inspection checklist (see the

sections beginning at 3130.1.3.2) based on

the guidance provided in section 3130.1.3.1.

10. Identify off-balance-sheet activities and con-

tingent liabilities, and assess the risk to the

company and any afﬁliate.

11. Obtain a listing of litigation against the

company or any individuals who represent

the company from the company’s legal coun-

sel, and summarize the matters in litigation

(or in threatened litigation) and any com-

promiseactions.Evaluate the potentialeffects

on the company’s ﬁnancial condition.

12. Evaluate contracts and service agreements

with afﬁliates. Identify whether the com-

pany receives or provides services or prod-

ucts. Determine that the services or prod-

ucts are needed and received or provided,

and that the contract or agreement terms

represent market rates.

13. Review income and expense accounts and

transactions with afﬁliates for compliance

with section 23B of the Federal Reserve

Act.

14. Evaluate whether the nonbank activities are

being performed by afﬁliate bank personnel

or whether bank assets are being used. If so,

is the bank adequately compensated?

15. Review FR System approvals, and check

conformance with any speciﬁed limitations

or commitments.

16. Review a sample of recommendations to

determine that a reasonable basis exists for

the company’s recommendations.

17. Review the advisory contracts to determine

if there are any conﬂicts of interests involv-

ing the parent company or afﬁliates, as well

as the ofﬁcers, directors, or principal share-

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2016

Page 3

holders and their related interests of the

holding company and its afﬁliates.

18. Evaluate insurance, including bond cover-

age, for adequacy. Determine the extent of

current liability insurance relating to the

adviser function, and evaluate the adequacy

of such coverage—particularly the extent to

which possible signiﬁcant surcharges would

be covered by such insurance.

19. Obtain a listing of shareholders for each

class of stock outstanding and a schedule of

ofﬁcers, directors, and their related interests.

20. Obtain or update biographical and experi-

ence information for key management per-

sonnel, together with overall stafﬁng and

salary levelsas appropriate for fullevaluation.

21. Determine whether operating practices pro-

vide for adequate legal documents and agree-

ments such that the account activities, in

general, are consistent with contractual

responsibilities.

22. Ascertain if senior management is aware, or

has adopted the procedures necessary to

become aware, of its current and potential

responsibilities in connection with any

regulatory-reporting and/or regulatory-

compliance requirements.

23. Obtain or verify that workpapers contain

the following permanent documentation:

a. System approval letters

b. date of incorporation or date acquired

c. date activity commenced

d. articles of incorporation and by-laws

e. commitments

f. supervisory actions

g. other pertinent correspondence

3130.1.3.1 Scope of Inspection

It is expected that inspections of investment

adviser subsidiaries will generally be conducted

as part of regularly scheduled bank holding

company inspections. If, however, the invest-

ment adviser subsidiary provides portfolio man-

agement services for a signiﬁcant portion of

trust assets held by a state member bank, the

Reserve Bank should inspect the investment

adviser subsidiary at the same time it examines

the trust operations of the bank subsidiary. The

scope of the inspection should be based on a

review of the nature and complexity of the

ﬁnancial services provided to customers. An

adviser which merely provides investment advice

and does not provide any additional ﬁnancial

services, such as portfolio management, safe-

keeping, recordkeeping, or trading services, may

not require an inspection. However, an adviser

which provides portfolio management, safekeep-

ing, or other services will require an inspection.

To determine the scope of the inspection, it is

essential to identify what types of services are

being offered to customers and to assess the

risks associated with those services.

The examiner needs to understand the advis-

er’s operations, including how it represents itself

to clients and whether the adviser has any vested

interests in the ﬁnancial services which it offers.

Examiners should use their discretion to sched-

ule inspections based on the size and complex-

ity of the adviser’s operations. Most section

4(c)(8) BHC subsidiaries will be subject to SEC

registration requirements. (See SR-91-4 (SA).)

Appropriate checklist questions should be com-

pleted for registered investment advisers which

provide investment advice to afﬁliated banks or

trust companies and for investment advisers

which engage in activities which could have a

signiﬁcant impact on the bank holding company’s

ﬁnancial safety and soundness. The checklist

should also be completed for all advisers that

manage investment portfolios for their custom-

ers. The checklist is only a guideline and some

of the sections in the checklist may not be

applicable. Conversely, the scope of such

examinations is not limited to the items included

in this checklist.

3130.1.3.2 Inspection Checklist

The questions in this checklist will assist the

examiner in evaluating various areas of supervi-

sory concerns.

3130.1.3.2.1 Review of Fundamental

Policies and Procedures

The investment adviser’s policies and proce-

dures should be reviewed using the following

checklist to ensure that fundamental policies

and procedures have been established and

implemented.

1. Are adequate minutes of the board and board

committee meetings prepared?

2. Is the adviser properly chartered and

registered?

3. Does the adviser have sufﬁcient blanket bond

or other ﬁdelity or liability coverage in place?

4. Is corporate and regulatory reporting per-

formed on a timely basis?

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2013

Page 4

5. Does the above reporting fairly present the

accounting and supplemental data reﬂected

by the corporate records?

6. Are internal accounting controls, provided

by a segregation of duties or a need for

administrative approvals, adequate?

7. Are duties properly segregated in the receiv-

ing, disbursing, and recording of cash and

cash transactions?

8. Are fee calculations and billing procedures

adequate to ensure accuracy and propriety?

9. Are all security transactions authorized or

approved by the appropriate management

level, and is there documented evidence of

the authorization or approval?

3130.1.3.2.2 Supervision and

Organization

Supervision refers to the conduct of an adviser’s

board of directors and senior management in

establishing, communicating, and enforcing a

system of policies, procedures, and practices

suitable to its business objectives and legal

requirements. Organization may be character-

ized as the framework of committees and the

assigned responsibilities through which supervi-

sion functions. The examiner should (1) review

the structure of the organization for adequacy of

management information systems and (2) the

organization framework as both relate to meet-

ing the entity’s stated responsibilities as well as

generally accepted standards of conduct. The

examiner should review the supervisory func-

tion by ﬁrst identifying the duties and

responsibilities of the board of directors. The

directors owe the duty of reasonable supervi-

sion, including appropriate attention to areas in

which the adviser is assuming sensitive and

complex ﬁduciary responsibilities. The next level

of review is the committee and ofﬁcer positions

to which certain authority has been delegated. In

reviewing this level of supervision, the exam-

iner should keep in mind that certain functions

cannot be delegated; for example, approval of

signiﬁcant new services or lines of business,

approval of formal policies designed to ensure

that the adviser operates in basic compliance

with laws and regulations, and the selection and

supervision of senior management cannot ordi-

narily be delegated. Informal delegations and

operating practices represent the last level of

review. In reviewing both formal and informal

delegations, consideration should be given to

the institution’s size and complexity. A ﬁnal

determination of the adequacy of supervision

and organization must be based on ﬁndings of

the entire inspection of the bank holding com-

pany or its nonbank subsidiaries. While topics

that have direct or indirect impact on the ade-

quacy of director supervision and management

competence are of particular sensitivity, examin-

ers nevertheless have a responsibility to care-

fully address and comment upon such issues.

During the course of the inspection, the exam-

iner should review the supervisory and organi-

zational structure of the bank holding company,

with particular reference to investment-related

activities. The examiner should determine

whether the board of directors has developed

adequate objectives and policies.

3130.1.3.2.2.1 Supervision and Organization

Checklist

1. If the board of directors does not directly

supervise investment adviser activities—

a. has a responsible board committee(s)

been named to exercise this function?

b. are any delegations consistent with by-

law provisions and other appropriate

principles?

c. do the board’s minutes neverthelessreﬂect

periodic but timely review of the con-

duct and operating results of the function?

2. Do minutes of the board, or its commit-

tee(s), reﬂect that members—

a. attend meetings with reasonable

frequency?

b. require and approve, where necessary,

appropriate written policies, strategic

plans, and management reports relating

thereto?

c. review audit and regulatory reports (and

management proposals and corrective

measures in response thereto), litigation

developments, earnings and expense

reports, and changes to fee schedules?

3. Through adoption of formal policies and

provisions for auditing, does the board

adequately seek to ensure the integrity of

the organization’s records and operational

systems?

4. Are policies and procedures adequately com-

municated to ofﬁcers and staff?

5. Does the board or a board committee con-

sider, periodically review, and provide for

insurance protection?

6. Does the bank holding company maintain

access to competent legal counsel and, where

appropriate, obtain written opinions on sig-

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niﬁcant legal questions such as—

a. pending or threatened litigation?

b. account agreements whose terms are

unclear or ambiguous or raise compli-

cated points of law?

c. proposed actions or policies involving

matters such as conﬂicts of interest,

restricted securities, ERISA, and other

mattersinvolvingpossible legalexposure?

7. If an account’s securities are registered in a

nominee name(s)—

a. is the nominee agreement current?

b. is the nominee registered with the Ameri-

can Society of Corporate Secretaries (to

guard against duplication of the nominee

name) and state authorities (where

required by local law)?

8. Is stafﬁng adequate, in terms of both num-

bers and qualiﬁcations, to handle the cur-

rent volume of business?

9. Is there adequate provision for management

succession, or for continuing operations in

case of the loss of key personnel?

10. Is senior management aware of its responsi-

bilities in connection with, and has it estab-

lished written policies and procedures to

ensure compliance with, any applicable

regulatory-reporting requirements?

11. Are signiﬁcant functions of the investment

adviser subject to either internal or external

audit? If not, ascertain whether an audit

program should either be developed or

expanded.

12. When appropriate in light of the size and

complexity of the adviser’s operations, has

management had an audit of ﬁnancial state-

ments performed by certiﬁed public

accountants?

13. Have all signiﬁcant exceptions and recom-

mendations in audits or examinations or

inspection reports been corrected, imple-

mented, or otherwise satisfactorily resolved?

3130.1.3.2.3 Portfolio Management

Investment selection is the process whereby the

adviser evaluates, selects, and reevaluates those

securities or other ﬁnancial assets it will buy or

sell for its clients, or for which it will make

recommendations. It includes the process of

researching and selecting recommended indi-

vidual stocks and bonds, and setting objectives

or strategies for diversiﬁcations by types and

classes of securities into general or specialized

portfolios, as well as the process of communi-

cating and executing overall strategies for par-

ticular accounts.

When an adviser holds itself out as a profes-

sional, the adviser will be held to a high stan-

dard of prudence and expertise in the investment-

selectionand -review process. Therefore,advisers

must carefully consider policies and procedures

in this area in accordance with the size and

character of the investment-selection responsi-

bilities undertaken. In furnishing portfolio invest-

ment advice, particularly to retail clients, an

investment adviser should observe the standards

of care and conduct applicable to ﬁduciaries.

3130.1.3.2.3.1 Investment Standards and

Research

1. Are the general investment standards and

review and selection responsibilities deﬁned

and approved by the board of directors?

2. Does management or senior investment per-

sonnel review overall investment policy and

potential investment problems at least

annually?

3. Is portfolio management policy adequately

communicated to appropriate personnel (for

example, by including it in committee min-

utes, directives, or memoranda circulated to

such personnel)?

4. Does the institution, where appropriate,

diversify investments according to—

a. types of assets, such as common stocks,

ﬁxed-income securities, and real estate?

b. types of securities by characteristics such

as income, growth, and size of company?

c. types of securities by industry and speciﬁc

companies within industries?

d. maturities of debt securities?

e. geographic location of companies of issue,

such as utilities?

f. tax-exempt income?

5. If the institutionhasa list of securitiesapproved

for purchase, retention, and/or sale—

a. are recommendations for additions to or

deletions from such list(s) approved by a

committee or group with appropriate

authority and expertise?

b. are periodic reviews made of the lists of

1. The term ‘‘portfolio investment’’ is intended to refer

generally to the investment of funds in a ‘‘security’’ as deﬁned

in section 2(1) of the Securities Act of 1933 (15 U.S.C. 77b)

or in real property interests, except when the real property is

to be used in the trade or business of the person being advised.

In furnishing portfolio investment advice, bank holding com-

panies and their subsidiaries shall observe the standards of

care and conduct applicable to ﬁduciaries.

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securities approved for purchase, reten-

tion, or sale to assess the current appropri-

ateness of the investments listed?

6. If the institution uses any research or analy-

sis in its general investment-review and

-selection process—

a. are appropriate factors taken into account?

b. is appropriate documentation obtained and

ﬁledto reﬂect consideration of such factors?

7. If the size and character of the entity’s discre-

tionary investment responsibilities are such

that the type of detailed research consider-

ations and ﬁles envisioned in the previous

question are not relied on, does it use ratings

by acceptable ﬁnancial-rating agencies, such

as Moody’s or Standard and Poor’s, together

with evaluation of basic relevant factors per-

taining to the type of security under

consideration?

8. Where appropriate, does the organization dif-

ferentiate its investment-selection process as

to the type of account in question, such as

those for which the need for growth or income

is paramount, or for taxable versus tax-free

trusts or retail versus institutional accounts?

9. Do personnel possess sufﬁcient expertise

and experience to properly implement the

ﬁrm’s investment-selection systems and

responsibilities?

3130.1.3.2.3.2 Account Administration

Special consideration has to be given to accounts

subject to the Employee Retirement Income

Security Act of 1974 (ERISA), which imposes

ﬁduciary responsibilities upon any person who

has any power of control, management, or dis-

position over the funds or other property of any

employee beneﬁt fund. When an adviser exer-

cises investment discretion over such plans, the

extensive ﬁduciary responsibility and prohibited

transaction rules of ERISA will apply.

1. Does the adviser have portfolio manage-

ment procedures which provide for—

a. consideration of the needs and objectives

of particular types of accounts, such as

the need for income versus growth or

taxable versus tax-free income?

b. conformity with investment provisions

of governing instruments?

c. consideration of the liquidity needs of

the account for anticipated distributions?

d. appropriate diversiﬁcation, including

avoidance or elimination of concentra-

tions in individual securities and by type

and subclass of securities?

2. When assets in discretionary accounts are

considered unsuitable, is a program of pru-

dent and timely sale of such assets followed

unless retention is required?

3. In order to determine the advisability of

retaining or changing assets, does the adviser

have procedures for periodic reviews?

4. Do minute books or other records—

a. identify reviewed accounts?

b. report written conclusions on the advis-

ability of retaining or disposing of assets

in the accounts?

5. As appropriate to the size and character of

business, are account synopses and histori-

cal data used in the review of account

assets?

6. Does the investment-review information

include—

a. amount and description of investment?

b. categories of investment, such as bonds

and stocks?

c. types of investments within each cate-

gory, such as industry groups for stocks?

d. cost?

e. market or appraised value at review date?

f. annual income?

g. yield at market?

h. rating of recognized ﬁnancial service?

7. For accounts in which the adviser makes

investments at the direction of the client,

does the adviser—

a. review the account to detect illegal, non-

conforming, substandard, or otherwise

unsuitable investments?

b. advise the power holder of any improper

investments?

c. inform parties at interest in the account

if any improper investment is not dis-

posed of, and seek legal relief, if

necessary?

d. resign from the account if corrective

action is not taken concerning improper

investments?

8. Have proxy voting policies and procedures

as listed below been established for ERISA

accounts that are suitable in relation to

assumed responsibilities?

a. voting of routine proxies?

b. identiﬁcation and handling of proxy or

tender determinations when sensitive

social issues, conﬂicts of interest, signiﬁ-

cant increases in management power or

perquisites, or merger or buy-out propos-

als are involved?

NOTE: For requirements relating to

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proxy processing and the Shareholder

Communications Act of 1985, see

Operations and Internal Controls in the

Trust Examination Manual. For ques-

tions relating to the voting of afﬁliate

stock, see Conﬂicts of Interest in the

Trust Examination Manual.

When an adviser invests accounts in

options and/or futures, the following check-

list questions (numbers 9 through 13) should

be completed. For additional information as

to appropriate uses of options and futures

contracts, see SR-83-2(SA) and SR-83-

39(SA).

9. When an adviser uses options and/or futures,

has the board of directors or a directors’-

level committee approved a policy and strat-

egy for their use? Does the policy address—

a. the investment objectives to be accom-

plished by the use of these contracts?

b. the speciﬁc types of contracts to be used?

c. the types of accounts authorized to use

these contracts?

d. restrictions and/or conditions upon use

of contracts, such as selection of broker-

age houses, position limits, time frames,

leveraging, etc.?

10. Was adequate disclosure made and adequate

authorization obtained to execute contract

transactions for various types of participat-

ing accounts?

11. Are adequate systems and controls in effect

to ensure—

a. proper tax treatment?

b. proper segregation of securities and/or

monies?

c. conformance with account objectives?

d. adherence to adopted strategy, position

limits, and related program parameters?

e. periodic management evaluation and

reporting systems with respect to—

• results of contract activities upon over-

all investment performance?

• market developments, including cur-

rent liquidity of relevant futures and

options contracts in which positions

are taken?

• ﬁnancial condition, fee competitive-

ness, and performance of involved

broker-dealers?

12. Does the accountingsystem accuratelyreﬂect

contract activities with respect to—

a. transaction details?

b. current gains or losses on open contract

positions?

c. necessary tax information?

13. Do operating personnel appear sufﬁciently

knowledgeable relative to the level of

contract-transactions activity?

3130.1.3.2.4 Conﬂicts of Interests

The inspection of an investment adviser subsid-

iary which provides services to an afﬁliated trust

company or bank with a trust department requires

expandedinspectionprocedures. Often the invest-

ment adviser subsidiary was organized for the

purpose of providing investment advice and ser-

vices for the trust accounts held at one or more

of its afﬁliates. These subsidiaries often employ

the same individuals who worked in the banks

or trust company which they advise.

Conﬂict-of-interest problems may arise when

the adviser exercises any ‘‘discretion’’ when

there are mutually opposing interests. The most

serious conﬂict of interest is self-dealing, which

could include transactions such as an investment

in afﬁliated banks or the purchase of securities

from or through an afﬁliate. To resolve conﬂicts

of interest, such transactions and the fees associ-

ated with them must be fully disclosed and

authorized by the appropriate parties.

Potential conﬂict-of-interest situations are not

limited to transactions between afﬁliates, but

can be between the adviser and any of its direc-

tors, ofﬁcers, or employees individually. Due to

the complexity, sensitivity, and exposure involved

in conﬂicts of interest, it is particularly impor-

tant that an adviser develop the awareness and

policies and procedures to identify and deal

with conﬂicts situations. Therefore, it is consid-

ered highly desirable, even when not speciﬁ-

cally required by regulation, that written poli-

cies be adopted and periodically revised as

necessary.

3130.1.3.2.4.1 Self-Dealing

1. Has the adviser—

a. acquired any assets from itself or its

afﬁliates?

b. acquired any assets from directors, ofﬁ-

cers, or employees of the organization or

its afﬁliates, or from any other individu-

als with whom a connection exists that

might affect their best judgment?

2. Has the adviser sold or transferred any

account assets, by loan or otherwise, to—

a. any afﬁliates?

b. directors, ofﬁcers, or employees of any

afﬁliates?

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c. other individuals or corporations with

whom such a connection exists or other

organizations in which such an interest

exists that might affect the exercise of its

best judgment?

3. Has the company purchased any securities

for a customer account from any member of

an undivided syndicate for which the adviser

or any of its afﬁliates are participating, or

from a private placement which the adviser

assisted?

4. Does the company have satisfactory poli-

cies and procedures, in terms of its size and

character of business, to address the preced-

ing situations?

5. If the company directs extra fee-producing

business to itself or an afﬁliate (for exam-

ple, brokerage services or options-trading

services), or if it charges separate fees to

accounts for securities transactions or other

services commonly provided as part of gen-

eral account administration (for example,

fees for cash management or investments in

mutual funds when management or admin-

istration fees are received by the company

or an afﬁliate)—

a. has it identiﬁed those accounts which

may properly participate in such services

in accordance with adopted policy, legal

opinion, a Department of Labor ruling,

and/or other necessary determinations?

b. has it made appropriate prior disclosures

and obtained adequate speciﬁc authoriza-

tions for those accounts identiﬁed as

entitled to the services?

6. Have any assets held by the company in one

account been sold to another account?

NOTE: The transaction may be permissible

if appropriate disclosure is made, authoriza-

tion is received, and the law or the govern-

ing instrument do not prohibit it. However,

an interaccount transaction for ERISA

accounts may be a prohibited transaction. In

addition, difﬁcult problems can arise in

establishing or documenting a ‘‘fair’’ price

for the transaction, particularly if the asset

is a thinly traded security or is a unique

asset.

7. Does the company have appropriate poli-

cies and procedures to ensure—

a. its discretionary accounts are not left in

uninvested cash positions beyond a mini-

mum period of time?

b. its accounts are invested in afﬁliate

interest-bearing deposits only for appro-

priate temporary or other purposes?

NOTE: To the extent the company has

long-term afﬁliate deposits or signiﬁcant

aggregate holdings, a special review

should be made of the company’s docu-

mentation evidencing the suitability of

such investments in view of available

alternate vehicles.

8. Are securities of afﬁliates only purchased

upon proper direction or speciﬁc authoriza-

tion in account instruments?

9. When the adviser purchases securities which

are underwritten by an afﬁliate, does the

adviser do so only upon proper direction

and speciﬁc authorization of the customer?

10. Does the company act as investment adviser

to an open-end or closed-end investment

company that is registered under the Invest-

ment Company Act of 1940? If so, do its

activities conform with the Board’s inter-

pretation at 12 C.F.R. 225.125, which deﬁnes

the scope of permissible activities?

3130.1.3.2.4.2 Broker Selection

1. When volume of activity warrants, is alloca-

tion of brokerage business controlled through

an approvedlist which is periodically reviewed

and approved by the company’s board or a

senior-ofﬁcer-level committee?

2. Does management attempt to obtain the best

service for customers, including periodic

evaluations of broker qualiﬁcations such as—

a. ﬁnancial condition?

b. past record of good and timely delivery

and payment on trades?

c. quality of execution and ability to handle

specialized transactions?

d. quality of research received, if applicable?

3. Are there procedures to monitor or periodi-

cally survey available negotiated commis-

sion prices in order to ascertain reasonable

costs for the execution requirements of its

accounts?

4. If commissions higher than the ‘‘lowest’’

available negotiated commissions are being

paid for executions in order to receive goods

and/or services—

a. have such goods and/or services been

determined to reasonably qualify as ‘‘bro-

kerage and research services’’ as deﬁned

in section 28(e)(3) of the Securities

Exchange Act of 1934?

b. does an appropriate committee periodi-

cally (at least annually) review and deter-

mine that the value of the goods and ser-

vices justiﬁes the payment of the higher

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brokerage commissions?

5. Does the entity periodically review and main-

tain records of all goods and/or services

received from brokers or third parties in

return for brokerage and/or dealer business

allocated to particular ﬁrms?

6. Do policies and procedures preclude—

a. selection of broker-dealers on the basis of

deposit balances?

b. agreements or understandings for alloca-

tion of speciﬁc amounts of business to a

broker-dealer such that the adviser com-

pany would not be able to cease allocating

business to the ﬁrm if it were no longer

providing acceptable execution?

7. Are auditing and other monitoring controls

and reporting procedures in effect to verify

the compliance of traders with policies

regarding broker selection and payment of

commissions? NOTE: Under section 28(e)

of the Securities Exchange Act of 1934, the

adviser may also legitimately pay more than

the lowest-available commission for reasons

of execution, ﬁnancial soundness, and efﬁ-

ciency of delivery and payment.

8. In addition to advisory services, are broker-

age services provided for customers pursuant

to section 225.28(b)(7)(i) of Regulation Y? If

so, the examiner should refer to the securities

brokerage inspection procedures and check-

list questions for the inspection of brokerage

activities.

3130.1.3.2.4.3 Trading Policies and Practices

1. When trading specialists are employed, are

there adequate written or unwritten standards

of competence, education, and training for

such individuals?

2. When specialists are not employed, are the

individuals responsible for trading reason-

ably trained and informed in relation to the

volume and character of trading activity they

are required to perform?

3. When transactions are permitted to be crossed

between accounts, are procedures adequate

to ensure fair pricing of the transactions? If it

is not clear the transactions are permitted,

has the company determined through counsel

that crossing is permissible under applicable

law?

4. When specialists are employed and volume

of activity permits, are block trades consid-

ered in order to obtain more favorable trade

prices and execution prices for accounts?

5. If applicable, do procedures, including estab-

lishment of time frames in advance of such

trading, require special authorization and

attention for large or block trades which are

to be executed in a number of transactions?

6. If procedures permit the combining of pur-

chase or sale orders of the same security—

a. are resulting beneﬁts in price and/or

execution costs applied on a pro rata or

average basis to the participating accounts?

b. are allocable shares similarly pro-rated to

participating accounts when a combined

trade is not executed at once, but in a

number of transactions over a period of

time?

7. Does the adviser maintain policies ‘‘reason-

ably designed to prevent the misuse of mate-

rial non-public information?’’

3130.1.3.2.5 Recordkeeping

Registered investment advisers are subject to

extensive recordkeeping requirements. SEC Rule

204-2 imposes recordkeeping standards and

requires that registered investment advisers keep

accurate records. In addition to this recordkeep-

ing, the adviser is subject to the ‘‘brochure rule’’

(Rule 204-3). This rule requires an investment

adviser to deliver a speciﬁed disclosure state-

ment with respect to its background and busi-

ness practices to every client or prospective

client. In addition to an initial disclosure, the

adviser must offer annually to deliver a current

disclosure statement upon request. Those advis-

ers which have custody or possession of securi-

ties of any client must maintain certain addi-

tional records, including separate ledger accounts

for each client, copies of conﬁrmations, and a

position record showing the interest of each

client and the location of the securities.

1. Does the investment adviser make and keep

current appropriate books and records

including—

a. journals or summary journals?

b. a memorandum of each order given by the

ﬁrmor instructions received,showing terms

and conditions of the orders?

c. all checkbooks, bank statements, canceled

checks, and cash reconciliations?

d. all bills or statements, paid or unpaid?

e. trial balances, ﬁnancial statements, and

internal audit papers?

f. written communications received or sent

by the ﬁrm?

g. list of discretionary accounts?

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h. powers of attorney and discretionary

powers?

i. written agreements?

j. copies of each notice, circular, advertise-

ment, newspaper article, investment letter,

bulletin, or other communication recom-

mending the purchase or sale of a security?

2. Does the adviser maintain a record of every

transaction in which the adviser or any

‘‘advisory representative’’ has a direct or

indirect beneﬁcial interest?

3. Are partnership articles, articles of incorpora-

tion, charter, minute books, and stock certiﬁ-

cate books maintained at the adviser’s princi-

pal ofﬁce?

4. If required books and records are photo-

copied or microﬁlmed, or if they are pro-

duced or reproduced on computer storage

media—

a. are such media indexed and arranged to

permit immediate location of any particu-

lar record?

b. were any copies or printouts of such re-

cords promptly provided on request?

c. is at least one copy of the original records

that are now on such media stored in a

separate location from the original for the

time required?

d. does the adviser maintain procedures for

the maintenance and preservation of, and

access to, records so as to reasonably safe-

guard them from loss, alteration, or

destruction?

e. does the adviser have facilities for the

immediate, easily readable projection of

microﬁlmed records and for producing

easily readable facsimile enlargements?

5. Do the entries in the general ledger and jour-

nals properly reﬂect payments or receipts of

monies or other goods or services?

6. Do the ﬁnancial statements, canceled checks,

deposit slips, and check register properly

reﬂect payments or receipts of monies or

other goods or services?

7. When the adviser’s ﬁnancial records indicate

that it is capitalized with client funds (through

either loans or equity), have adequate disclo-

sures been made to clients about the risks

and conﬂicts of interest involved?

3130.1.3.2.6 Security Storage and

Processing

Investment advisers generally do not take pos-

session and control of client funds and securi-

ties. However, in those cases in which such

responsibilities are assumed, the inspection must

evaluate those internal controls which are in

place for the safeguarding of client funds and

securities. Controls and related processing pro-

cedures must be appropriately designed and

implemented by the adviser to efﬁciently and

safely facilitate such operations.

1. Does the adviser have custody of client

funds or securities?

2. Does the adviser gain effective access to

client assets through practices, arrange-

ments, or relationships with clients, such as

trustee, executor, or account signator?

3. When the adviser has custody of client

funds or securities, does the adviser main-

tain the following records:

a. a record reﬂecting all purchases, sales,

receipts, and deliveries of securities, and

all debits and credits to such accounts?

b. a separate ledger account for each client,

showing purchases, sales receipts, and

deliveries of securities?

c. copies of conﬁrmations of all transac-

tions for such clients?

d. a record for each security in which any

client has a position, reﬂecting the name

of the client, amount of interest, and

location of security?

4. When the adviser renders investment-

management services, are the following re-

cords maintained:

a. for each client, a record of securities

purchased and sold, containing the date,

amount, and price of each transaction?

b. a record for each security in which any

client has a current position, showing the

name of each client and current interest

or number of shares owned by each

client?

5. Are client assets physically segregated from

the adviser’s own assets?

6. For the vault and other related security-

processing areas, are adequate controls/

safeguards in effect which include the

following:

a. Are assets maintained under a system of

joint custody or dual control?

b. Is access to these areas restricted to

designated/authorized personnel?

c. As appropriate, are other controls/

safeguards systems in place (for exam-

ple, rotation of assignments, key/lock

combinations, or vault or area entrance

log(s))?

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d. Is a security-ticket system used as a vault

and asset-movement control system?

7. If a security-ticket system is used, are

adequate controls/safeguards in effect which

include the following:

a. Are security tickets prenumbered?

b. Does each copy of the security ticket

clearly indicate its destination to ensure

prompt and accurate delivery?

c. Does the security ticket provide the nec-

essary information to ensure proper pro-

cessing and recording of the transaction?

d. Does the security ticket contain sufﬁ-

cient copies to ensure that sound internal

control is maintained over the physical

security-movement process by providing

the following with a copy (or copies):

• portfolio managers who initiated the

transactions?

• appropriatevault/operationspersonnel?

• the audit/asset control function?

e. Are unissued security tickets properly

safeguarded and subject to adequate

numeric controls?

8. Does the control of security ticket/

transaction cancellation and replacement

include—

a. restricting the ability to initiate such

action to supervisory personnel?

b. reporting such activity to the audit/asset

control function and other function(s)

affected by such action?

c. procedures to ensure that securities are

returned to the vault or that funds charged

from an account are redeposited, or that

the securities or funds are immediately

placed under the control of a new secu-

rity ticket/transaction?

d. identifying a replacement security ticket

by recording such information on the

replacement ticket?

e. requiring all copies of the replaced secu-

rity ticket to be forwarded to the audit/

asset control function?

9. For assets received, are adequate controls/

safeguards in effect which include the

following:

a. Are all assets received promptly placed

under joint custody or control?

b. Is appropriate documentation required

and on ﬁle for all assets received, and is

it compared to actual assets received and

posted to control ledgers?

c. As applicable, are procedures in place

for controlling and properly handling

assets received by other means, includ-

ing delivery by mail or messenger?

d. If assets are not to be physically held

or issued (for example, mutual fund

shares), is a receipt, statement, or acknow-

ledgment obtained from the issuer or

holder and processed by receipt ticket

or other means to ensure proper

accountability?

e. If securities received are not properly

registered in the company’s nominee

name, are procedures in place to ensure

prompt re-registration, control, and

follow-up until re-registration?

10. For the delivery of assets, are adequate

control/safeguards in place which include

the following:

a. Are appropriate receipts obtained and on

ﬁle for securities delivered?

b. Are procedures in place to ensure that

bearer securities are not mailed in amounts

in excess of the company’s insurance

limits?

11. Do vault custodians—

a. compare securities received/withdrawn

to the security ticket?

b. for withdrawals, verify that the security

ticket is signed (initialed) by authorized

personnel?

c. for securities temporarily withdrawn from

the vault (for example, for transfer,

re-registration, or account/portfolio man-

ager review), is a copy of the security

ticket retained by vault personnel pend-

ing the return of the security to the vault?

12. For pending security transactions, are

adequate controls in effect which include

the following:

a. Are pending items periodically reviewed

by operations personnel?

b. Do procedures provide for prompt

follow-up on items which have not been

completed within established time

periods?

c. Are exceptions promptly reported and

resolved by appropriate personnel (for

example, management, supervisors,

and/or the audit/asset control function)?

d. Are current pending security items

in compliance with established proce-

dures for reporting exceptions, and are

those transactions which have not

been completed within established time

periods been followed up satisfactorily?

NOTE: Examiner judgment should be

used in determining the scope of this

review. However, at a minimum, the

review should include procedures for

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2013

Page 12

handling security transactions pending

30 days or more.

13. Does the security-processing system—

a. contain a sufﬁcient number of controls/

safeguards to properly reﬂect the current

status of and limit an individual’s con-

trol over a security transaction?

b. contain sufﬁcient information to identify,

locate, and trace the movement of each

asset?

c. provide for adequate segregation of duties

and responsibilities?

14. Has individual accountability or responsi-

bility been properly assigned for the physi-

cal protection of the securities and related

cash ﬂow, if applicable, throughout the

security-processing system?

15. Do procedures require that orders for trades

originate with account or portfolio manag-

ers, with the signature or initials of the

authorizing party shown on the order form

or purchase/sale ticket?

16. Are transactions made on a ﬁrst-in, ﬁrst-out

basis (that is, executed in order of receipt),

except when combined in blocks for execu-

tion pursuant to appropriate written

procedures?

17. Do operations personnel perform indepen-

dently of account or portfolio managers

to—

a. reconcile trade tickets to brokers’

conﬁrmations?

b. monitor and promptly follow up on any

outstanding transactions, such as conﬁr-

mations not received within speciﬁed

time periods or purchases/sales which

have not settled on settlement date?

c. promptly post payments for purchases/

sales to the recordkeeping system and

promptly record/remove assets?

3130.1.3.2.7 Other Matters

1. Is the adviser or any of its principals involved

in litigation or arbitration which will have an

impact on its ability to fulﬁll its contract with

clients?

2. Were any matters of a material nature found

in the adviser’s correspondence, such as sig-

niﬁcant client complaints?

3. Did a review of customer-complaint ﬁles

reveal any possible areas for special inspec-

tion focus?

4. Did a review of the adviser’s current ﬁnan-

cial condition raise concerns as to the advis-

er’s solvency or its ability to otherwise con-

tinue to provide advisory services?

5. Are there any other aspects of the adviser’s

operations, or the operations of an afﬁliate,

which raise concerns?

3130.1.4 INSPECTION FINDINGS

A written summary of the subsidiary’s activities

should be presented to the examiner in charge of

the bank holding company inspection and should

be included in the inspection report or its sup-

porting workpapers. Material exceptions should

be noted with management’s responses under an

appropriate caption in the open section of the

report. Any comments in the report regarding

the scope of the investment advisory inspections

should note that such inspections are primarily

focused on safety-and-soundness considerations

and not on compliance with securities laws.

In those cases in which a separate Report of

Bank Holding Company Inspection on Invest-

ment Advisory Activities is prepared, examiners

may use the Uniform Interagency Trust Rating

System (see SR-98-37 FRB, revised October

13, 1998, and effective January 1, 1999), which

provides a basis for the evaluation of critical

areas of supervisory concern. The rating system

is generally used by federal supervisory agen-

cies to assess the condition of trust companies.

However, the system can be adopted to report

on advisory operations as well. When the

inspection uncoverssigniﬁcant deﬁciencieswhich

require corrective action, and the inspection was

not done in conjunction with a concurrent bank

holding company inspection, a separate report

should be prepared and delivered to the inspected

nonbank adviser. Send a copy of the summary

and any report comments to the Trust Activities

Program, Washington, DC 20551.

3130.1.5 ON-SITE INSPECTION BY

TRUST EXAMINERS

An investment advisory subsidiary of a bank

holding company will normally be registered as

an investment adviser under the federal securi-

ties laws, and will be subject to examinations of

its advisory activities by the Securities and

Exchange Commission (SEC). Nevertheless,

because investment responsibility is involved in

any investment adviser’s activities, and since

the SEC’s routine examinations may be infre-

quent, periodic on-site inspections should be

conducted as an integral part of BHC inspections.

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2013

Page 13

Consideration should be given to using trust

examiners to conduct, or at least participate in,

on-site inspections of ﬁnancial and investment

advisory nonbank subsidiaries, especially when

the subsidiary provides services to an afﬁliate

bank trust department examined by the Board of

Governors of the Federal Reserve System. If the

bank holding company has to ‘‘spin off’’ the

investment research and selection process of its

banks’ trust departments into an investment

advisory subsidiary, there may be a need to

review the activities of the trust departments

together with those of the advisory subsidiary

through an on-site inspection.

The companies being advised on a contrac-

tual basis and which were sponsored by the

holding company or any afﬁliate are also deﬁned

as afﬁliates in sections 23A and 23B of the

Federal Reserve Act. The examiner should there-

fore be alert to any intercompany transactions

between a bank subsidiary and the advised com-

pany. A review of ﬁnancial statements of such

companies is warranted.

3130.1.6 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Limitations and

activity approval

15 U.S.C.

80; section

23A FRA

371c

225.28(b)(6)

225.125

4–177 1997 FRB 275

1971 FRB 512

1972 FRB 149,

571

Activity approval—

real estate development

advisers for state

and local governments

225.28(b)(6) 1997 FRB 275

1980 FRB 962

and 984

Merger of two BHCs

under Section 3 of the

BHC Act, acquisition

of a bank, and followed

by the acquisition of non-

banking subsidiaries

engaged in ﬁnancial and

investment advisory

activities

1843(c)(8)

and (j)

225.28(b)(6) 225.125 2015 FRB 82

(Board Order

No. 2015-26

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Investment or Financial Advisers) 3130.1

BHC Supervision Manual January 2016

Page 14

4(c)(8)—Advice on Mergers and Similar Corporate Structurings,

Capital Structurings, and Financing Transactions Section 3130.3

This section renders inspection guidance on

ﬁnancial and investment advisory activities that

are provided in connection with mergers, acqui-

sitions, divestitures, investments, joint ventures,

leveragedbuyouts, recapitalizations,capitalstruc-

turings, and ﬁnancing transactions and similar

transactions, and on conducting ﬁnancial-

feasibility studies.

This section also provides

historical examples of ﬁnancial and investment

advice previously approved by Board order. The

examples consist of various kinds of advice

with regard to mergers and similar corporate

transactions under the current Regulation Y, sec-

tion 225.28(b)(6)(iii). Some of the examples of

advisory nonbank activities were approved for

inclusion into Regulation Y long before the

revision of Regulation Y that was effective April

21, 1997. The reader of these examples must

only take into consideration the current provi-

sions of Regulation Y. There should be no reli-

ance on Board order commitments, old regula-

tory provisions, supervisory policies, and

interpretationsmade before April 21, 1997, unless

they were not revised. Certain former provisions

or commitments may no longer be applicable.

The historical examples discussed in this section

have been revised according to the new regula-

tory provisions.

If inspection objectives and procedures are

stated in a speciﬁc section, the examiner should

use this specialized guidance. In addition, the

examiner should use the generalized inspection

objectives and procedures in section 3130.0,

which are generally applicable to all advisory

activities.

3130.3.1 ADVISER TO A MORTGAGE

OR REAL ESTATE INVESTMENT

TRUST

An adviser to a mortgage or real estate invest-

ment trust (REIT) furnishes expertise in the

areas of funds acquisition, lending, investing,

and servicing that is similar to the role of adviser

to a mutual fund. The contracted service is

performed on a fee basis that is generally based

on a percentage of the trust’s total assets. The

intention of the exemption, found in section

225.28(b)(iii) of Regulation Y, is to allow the

relationship to be advisory in nature as opposed

to controlling. However, in some instances, the

relationship between trusts and their advisers

has gone beyond the parameters of advice and

resulted in legal entanglements, conﬂicts of

interest, and ﬁnancial exposure for the bank

holding company. Because of the potential risk

exposures which may result when a bank hold-

ing company or its subsidiary engages in this

activity, the overall relationship must be subject

to particular scrutiny during an inspection.

REITs were established by the U.S. Congress

in 1960, effective January 1, 1961. A REIT is a

hybrid form of an investment vehicle which is

essentially a ﬁnancial intermediary specializing

in real estate lending and investment. A REIT

obtains funds by borrowing from ﬁnancial insti-

tutions or other lenders or by issuing shares

(equity capital). It invests the funds in real

estate, either as a lender or equity owner. REITs

are usually owned by passive owners, not opera-

tors. REITs are designed to take advantage of

beneﬁts within the federal Internal Revenue

Code.

There are generally four types of REITs:

equity, mortgage, hybrid, and ‘‘ﬁnite-life.’’ An

equity REIT acquires income-producing proper-

ties, deriving its earnings mostly from rents. A

mortgage REIT provides ﬁnancing to real estate

projects that are owned by others, deriving its

earnings from interest charged on the loans. A

hybrid REIT combines the equity REIT and the

mortgage REIT. The ﬁnite-life REIT is struc-

tured to self-liquidate within an established time

frame.

By meeting certain prescribed requirements

during a taxable year, a REIT may function as a

conduit with respect to income distributed to its

beneﬁciaries. If at least 95 percent of the trust’s

income is distributed to the beneﬁciaries (exclud-

ing capital gains), the trust pays no taxes on the

distributed income, thus avoiding the double

taxation associated with corporations. There-

fore, this investment vehicle has the tax advan-

tage of a partnership but offers the limited liabil-

ity and perpetuity of a corporation.

A REIT must be a corporation (other than an

insurance company or bank), an association, or

a trust, or it must be managed by at least one

trustee, with transferable shares of beneﬁcial

interest as form and evidence of ownership.

There must be at least 100 beneﬁcial owners,

and the trust must elect to be treated as a REIT

for tax purposes. A REIT must meet the follow-

ing threefold gross income test. At least 95 per-

1. Feasibility studies do not include assisting management

with the planning or marketing for a given product or provid-

ing general operational or management advice.

BHC Supervision Manual June 1998

Page 1

cent of the trust’s income must come from real

property rentals, dividends, abatements and

refunds of real property taxes, interest on loans,

or gains from the sale of securities or real estate,

with the further stipulation that no less than

75 percent of the trust’s income must be directly

related to real property. Also, less than 30 per-

cent of the trust’s income can be derived from

the sale of any securities held for less than six

months and from foreclosure property and real

property held for less than four years that is not

involuntarily converted.

In addition to the threefold gross income test,

there is a twofold investment test which must be

met. First, at least 75 percent of the value of the

trust’s total assets must be real estate assets,

government securities, and cash. Second, 25 per-

cent of the trust’s total assets may be securities,

but the trust cannot hold securities from one

issuer which amount to greater than 5 percent of

the trust’s total assets and more than 10 percent

of the outstanding voting securities of the issuer.

3130.3.1.1 Evaluating Advisory Activities

for a REIT

A bank holding company may have an insigniﬁ-

cant amount of capital invested in the advisory

company. However, if the bank holding com-

pany or its subsidiaries have extensions of credit

or unfunded commitments outstanding, an evalu-

ation of the credit may be needed using normal

classiﬁcation criteria as to their collectibility,

particularly if there is substantial risk exposure.

Examination/inspection reports of subsidiaries

should be reviewed to determine the consoli-

dated exposure. The holding company or its

banking subsidiaries may be participating in

exchanges or swaps with the advised REIT,

whereby trust assets are exchanged for forgive-

ness of bank debt. Such pending asset swaps

should be considered in conjunction with the

credit evaluations. The swaps may be for the

purpose of reducing the REIT’s liabilities, which

can involve an exchange of assets with the

lender. The lender’s balance sheet reﬂects an

exchange of one asset for another together with,

possibly, a lump-sum payment of cash to the

trust. If a swap is pending, review the criteria

that the holding company used to (1) determine

the beneﬁt of the swap to the company and

(2) select which of the REIT’s assets would be

considered for the swap. Also, determine the

amount of any cash or earning assets that will be

given to the trust.

A holding company and a trust have separate

and distinct shareholders but common manage-

ment. The potential exposure in such cases may

be pronounced. Such relationships should be

reviewed for conﬂicts of interest. Loans may be

booked by the holding company or its subsidi-

ary and subsequently sold to the trust. The credit

decision may have been made by the subsidiary,

and the REIT’s purchase of the loans may have

been approved by the afﬁliated adviser. The

beneﬁts to the holding company may include

receiving the origination fee and selling the loan

to the trust, thereby increasing the REIT’s assets,

upon which the holding company’s advisory fee

is based. Following receipt of the sale’s pro-

ceeds, the process may be repeated. If the hold-

ing company has participated in this type of

process, there is potential for a conﬂict of inter-

est. The holding company or its subsidiary may

have to repurchase the credit.

Theatened or pending litigation may result

from loans that were originated by the holding

company or its subsidiaries or that were recom-

mended by the adviser. The number of such

loans together with the current payment status

of the credit should be determined. If there are

numerous loans on a nonaccrual status, the hold-

ing company may have accumulated a signiﬁ-

cant loss. Finally, any suit involving the adviser

which pertains to services it performed should

be explored as to its validity and potential ﬁnan-

cial exposure.

3130.3.2 INSPECTION OBJECTIVES

1. To determine the level of risk involved when

the bank holding company or its subsidiaries

have extensions of credit and unfunded com-

mitments outstanding to the advised trust.

2. To review for conﬂicts of interests in cases

when a holding company and a trust have

separate and distinct shareholders but com-

mon management.

3. To review all threatened or pending litigation

involving loans originated by the holding

company or its subsidiaries that were recom-

mended by the adviser.

4. To review all covered transactions between a

bank holding company’s subsidiary bank and

a REIT, if the REIT is sponsored and advised

on a contractual basis by the bank or any

subsidiary or afﬁliate of the bank, to ensure

that transactions are permitted pursuant to

sections 23A and 23B of the Federal Reserve

Act.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual June 1998

Page 2

5. To determine whether the REIT has been

advised to sell real estate in the ordinary

course of business and, if so, whether the

appropriate liability account for corporate

federal and state taxes has been established

by the advised subsidiary.

6. To determine whether the REIT adviser is

providing the appropriate advice to the REIT

to generate nonspeculative high yields;

adequate liquidity; portfolio diversiﬁcation;

sufﬁcient cash ﬂow to pay dividends; con-

tinuous repricing; and adequate public dis-

closure, including the extent of risk involved.

7. To determine the adequacy and quality of

professional management and the level of

management’s equity stake in the REIT.

8. To determine the effect on net earnings from

ﬂoating interest rates on asset yields that may

have been caused by prepayment risk.

3130.3.3 INSPECTION PROCEDURES

1. Determine if there are any signiﬁcant exten-

sions of credit or unfunded commitments

outstanding. If so—

a. evaluate the credit using normal classiﬁ-

cation criteria as to collectibility;

b. review examination or inspection reports

of the holding company’s subsidiaries and

determine the consolidated exposure; and

c. review any pending asset swaps in con-

junction with the credit evaluations, if the

holding company or its banking subsidi-

aries are participating in exchanges or

swaps with the advised REIT whereby

trust assets are exchanged for forgiveness

of bank debt.

• Review the lender’s balance sheet to

make certain that it reﬂects an exchange

of one asset for another, as well as any

lump-sum payment of cash to the trust.

• Review the criteria the holding com-

pany used to (1) determine the beneﬁt

of the swap to the company and (2) select

which of the REIT’s assets would be

considered for the swap.

• Determine the amount of any cash or

earning assets that will be given to the

trust.

2. Determine and evaluate any signiﬁcant con-

ﬂicts of interests in cases when a holding

company and a trust have separate and dis-

tinct shareholders but common management.

a. Determine if there are any loans booked

by the holding company or its subsidiary

and subsequently sold to the trust, if the

credit decision was made by the subsidi-

ary, and if the REIT’s purchase of the

loans was approved by the afﬁliated adviser.

b. If signiﬁcant conﬂicts of interest exist,

determine whether the holding company

or its subsidiary must repurchase any

associated credit.

3. Review all threatened or pending litigation

involving loans originated by the holding

company or its subsidiaries that were recom-

mended by the adviser.

a. Determine the number and amount of

such loans together with the current pay-

ment status of the credit and whether any

loans are on a nonaccrual status.

b. Evaluate any suit involving the adviser

that pertains to services it performed as to

the suit’s validity and potential ﬁnancial

exposure.

4. Evaluate the effect on net earnings and divi-

dends that declining rates (ﬂoating-rate assets)

have on the prices of ﬂoating-rate mortgage

assets. Determine the results and the nature

of any hedging strategies that are used to

offset a decline in net earnings.

See also the inspection procedures in sections

3130.0 and 3130.1.

3130.3.4 FINANCIAL ADVICE ON

ISSUING SECURITIES OF FOREIGN

GOVERNMENTS IN THE UNITED

STATES

3130.3.4.1 Financial Advice to the

Canadian Federal, Provincial, and

Municipal Governments

An example of providing ﬁnancial and invest-

ment advisory activities is a Board order that

was previously approved (now authorized under

section 225.28(b)(6)(iii) of Regulation Y). The

order speciﬁcally authorized the providing of

ﬁnancial advice to the Canadian federal and

provincial governments for issuing their securi-

ties in the United States. Also, the Board’s

Regulation K authorizes the provision of such

investment, ﬁnancial, or economic advisory ser-

vices to foreign governmental entities (see sec-

tion 211.10(a)(8)). The Board approved the pro-

posed activity on February 12, 1988 (1988 FRB

249).

Another Board order authorized a foreign

bank, subject to the BHC Act, to acquire a

securities ﬁrm to engage in this activity, but to

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual June 2002

Page 3

expand the activity to include the providing of

such advice to the Canadian municipal govern-

ments in addition to the federal and provincial

governments. The Board concluded that the

slight modiﬁcation would not alter the activity

to render it less closely related to banking. The

Board approved the order on March 28, 1988

(1988 FRB 334). Other approved Board orders

for this activity are 1988 FRB 500 and 1988

FRB 571.

3130.3.4.2 Providing Financial Advice to

the Japanese National and Municipal

Governments and Their Agencies

Another example of providing advice to foreign

governments is a bank holding company that

applied for the Board’s approval to engage,

through its wholly owned securities subsidiary,

in certain securities-related, foreign-exchange,

and investment and ﬁnancial advisory activities.

The activity, which consisted of providing ﬁnan-

cial advice to the Japanese national and munici-

pal governments, had not previously been autho-

rized for bank holding companies. When making

its decision, the Board referred to similar orders

as well as to the facts provided. It approved

these advisory services by order on June 4,

1990. (See 1990 FRB 654.)

The Board, effective September 10, 1992,

added the providing of ﬁnancial advice to for-

eign governments, such as advice with respect

to the issuance of their securities, to the activi-

ties permissible by Regulation Y, currently autho-

rized by section 225.28(b)(iii).

3130.3.5 PROVIDING

FINANCIAL-FEASIBILITY STUDIES

AND VALUATION SERVICES

The following provides an example of a bank

holding company that was authorized to provide

ﬁnancial-feasibility studies and valuation ser-

vices, including expert-witness testimony in con-

nection with the valuation services. A bank

holding company (the applicant) had requested

the Board’s approval to acquire 100 percent of

the voting shares of a company (the company)

that engaged in investment advisory, investment

management, and ﬁnancial advisory services.

The company engaged in providing (1) ﬁnan-

cial-feasibility studies for speciﬁc projects of

private corporations, (2) valuations of compa-

nies and of large blocks of utility stock for a

variety of purposes, and (3) expert-witness testi-

mony on behalf of utility companies in rate

cases.

In providing ﬁnancial-feasibility studies, all

ﬁnancial aspects of the particular project were

evaluated, including economic conditions, sales

and earnings statements, balance sheets, and

cash-ﬂow data. Each engagement involved ana-

lyzing and projecting the income to be gener-

ated by a particular project. The Board believed

that this activity was functionally similar to the

ﬁnancial advice traditionally offered by banks to

their commercial lending customers. The appli-

cant provided evidence revealing that certain

major banks perform similar ﬁnancial-feasibility

analysis services for their customers. The Board

thus approved the provision of such ﬁnancial-

feasibility studies for corporations. Certain com-

mitments were made to guard against any pos-

sible conﬂicts of interests and related adverse

effects between the applicant’s credit-extending

subsidiaries and the company, acting as an adviser

regarding the ﬁnancial-feasibility studies.

Included was the condition that the company’s

ﬁnancial advisory activities would not encom-

pass the performance of routine tasks or opera-

tions for a customer on a daily or continuous

basis.

Upon consideration of the above, the Board

also determined the activity of providing valua-

tions of companies, as well as the expert-witness

testimony incidental to such valuations, to be

permissible. The commercial lending and trust

departments of banks commonly make valua-

tions of a broad range of tangible and intangible

property, including the securities of closely held

companies. The applicant provided evidence

that numerous banks compete directly with the

company in offering corporate valuations for a

fee.

The Board, effective September 10, 1992,

added the providing of ﬁnancial-feasibility stud-

ies to the list of nonbanking activities permitted

by Regulation Y (see section 225.28(b)(6)(iii)).

With the Regulation Y revisions, effective April

1997, the Board speciﬁcally determined that

feasibility studies do not include assisting man-

agement with the planning or marketing for a

given project or providing general operational

or management advice. The 1992 amendment to

this regulation permitted bank holding compa-

nies to conduct feasibility studies for high net

worth individuals, as well as corporations, and

ﬁnancial and nonﬁnancial institutions. With the

April 1997 amendment, such services could be

provided to any person.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual June 2002

Page 4

3130.3.5.1 Valuation Services

The valuation services included the following

activities:

1. the valuation of a company for purposes of

acquisitions, mergers, and divestitures

2. tender-offer evaluations

3. advice for management or for a bankruptcy

court on the viability and capital adequacy of

ﬁnancially troubled companies and on the

fairness of bankruptcy reorganizations

4. valuation opinions on transactions in pub-

licly held securities

5. valuationson thefairmarketvalue of employee

stock ownership trusts

6. periodic valuation of stock of privately owned

companies held in pension or proﬁt-sharing

plans, charitable trusts, or venture-capital

funds

7. the valuation of a privately owned company

or of a large block of publicly owned securi-

ties for estate-tax purposes

8. for estate-tax purposes, valuations of a

company’s common stock and other securi-

ties for recapitalization of a privately held

company

3130.3.5.2 Utility-Rate Testimony in

Support of Utility-Company Valuations

The company frequently provided expert wit-

ness testimony on behalf of utility ﬁrms in rate

cases. The company’s personnel were retained

to give expert testimony on ﬁnancial matters

such as the cost of capital, economic conditions,

and the rate of return expected by investors in

utility securities. The Board believed that to a

large degree the activity may be considered

incidental to the company’s general provision of

economic information and advice which is per-

missible under section 225.28(b)(6)(ii) of Regu-

lation Y. Also, banks routinely calculate the cost

of capital for customers to advise them regard-

ing ﬁnancial alternatives.

3130.3.6 EDUCATION-FINANCING

ADVISORY SERVICES

Four bank holding companies (collectively, the

notiﬁcants)gave notice pursuant to section4(c)(8)

of the Bank Holding Company Act (BHC Act)

(12 U.S.C. 1843(c)(8)) and section 225.23 of the

Board’s Regulation Y (12 C.F.R. 225.23) of

their intention to each acquire more than 5 per-

cent of a company (the company) that would

provide education-ﬁnancing advisory services.

The company would enable state governments

to assist parents in ﬁnancing the higher educa-

tion of their children.

The company will (1) develop and manage an

educational savings and lending program on

behalf of the state, (2) design and provide neces-

sary computer software for the program, (3) pro-

vide marketing and program materials, and

(4) train state personnel to implement the pro-

gram. The notiﬁcants would eventually provide

the services to various state governments

nationwide.

As part of developing the education savings

and lending program, the company would assist

in formulating and deﬁning its overall scope;

provide the research necessary to begin opera-

tions; design the program’s operations; and

organize the program in cooperation with all

interested parties, including coordinating partici-

pation among the state authorities. The com-

pany would also coordinate key functions of a

college-funding program, such as marketing,

public relations, training, investment, lending,

legal documentation, ﬁnancial recordkeeping,

and ongoing program evaluation. In addition,

the company would design, install, and maintain

the computer software necessary to implement

the program’s services. The company’s compen-

sationwouldbe based on applicationfees received

by a state educational assistance authority and

the amount of investment and loan balances

held by the program.

All of the intended services are integrally

related to advising and administering student-

loan and college-savings programs. Banks offer-

ing their own student-loan and college-savings

programs engage in many of the planned activi-

ties and are uniquely suited to advise and assist

other potential providers, including state gov-

ernments, in structuring and implementing

student-loan and college-savings programs.

The

Board previously concluded that bank holding

companies may provide similar advisory and

support services to state authorities that are

engaged in making student loans.

Accordingly,

2. The notiﬁcants would have varying ownership interests

in excess of 5 percent. Other individual ownership interests of

less than 5 percent would be held by various banks and

savings institutions located in one state. Each notiﬁcant com-

mitted that the company would be treated as a subsidiary

within the meaning of the BHC Act (12 U.S.C. 1841(d)).

3. See 12 C.F.R. 225.28(b)(1) and (6).

4. See 1985 FRB 725.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual December 1998

Page 5

based on all the facts of record, the Board

concluded that the proposed activities are closely

related to banking under section 4(c)(8) of the

BHC Act. The Board approved the notice on

September 25, 1995 (1995 FRB 1042). Approval

of this proposal is speciﬁcally conditioned on

the notiﬁcants’ compliance with the commit-

ments made in connection with this notice.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual December 1998

Page 6

3130.3.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Providing ﬁnancial-feasibility stud-

ies, valuation services, utility-rate

testimony, but not ‘‘public’’ credit

ratings

225.28(b)(6)(iii) 1985 FRB 118,

120

Financial-feasibility studies for

issues of tax-exempt revenue

bonds

and private corporations

1987 FRB 59

Advice in connection with merger,

acquisition/ divestiture, and ﬁnanc-

ing transactions and advice regard-

ing loan syndications, interest-rate

swaps, and interest-rate-cap

transactions

225.28(b)(6)(iii) 1987 FRB 59

Providing ﬁnancial advice to the

Canadian federal, municipal, and

provincial governments, such as

with respect to the issuance of their

securities in the United States

225.28(b)(6)(iii) 1988 FRB 249

1988 FRB 334

Financial advice to the Japan-

ese national and municipal

governments

225.28(b)(6)(iii) 1990 FRB 654

Financial advice to state and local

governments

225.28(b)(6)(iii) 1973 FRB 701

Financial advice vs. management

consulting

1972 FRB 674,

676

Investment advice pertaining to

income-producing real property

1983 FRB 564

Investment advisory activities and

joint ventures with securities ﬁrms

225.28(b)(6)(iii) 1994 FRB 638

Education-Financing Advisory

Services

1995 FRB 1042

Regulation Y revision 62 Federal

9290 to 9307

(February 28,

1997)

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Advice on Mergers and Similar Corporate Structurings, Capital Structurings, and Financing Transactions

3130.3

BHC Supervision Manual December 1998

Page 7

4(c)(8)—Informational, Statistical Forecasting, Advisory Services for Transactions in

Foreign Exchange and Swaps, Commodities, and Derivative Instruments Section 3130.4

3130.4.1 INFORMATIONAL,

STATISTICAL FORECASTING, AND

ADVICE ON SUCH TRANSACTIONS

AS FOREIGN EXCHANGE, SWAPS,

COMMODITIES, AND DERIVATIVES

Providing ﬁnancial and investment advisory

activities may consist of a bank holding compa-

ny’s providing information, statistical forecast-

ing, and advice with respect to any transaction

in foreign exchange, swaps, caps, and similar

transactions, commodities, and any forward con-

tract, option, future, option on a future, and

similar instruments.

The Board has found ﬁnan-

cial advice regarding interest-rate swap and cap

transactions to be permissible. The Board has

also found that providing advice in connection

with currency swaps is permissible,

as well as

providing advice regarding loan syndications.

This section provides an example of a February

16, 1983, Board order permitting a bank holding

company to establish a de novo subsidiary to

offer certain informational, advisory, and trans-

actional services including the provision of the

following:

1. General economic information and statistical

forecasting with respect to foreign exchange

and money markets through time-sharing

networks. The services included the analysis

of foreign-exchange and money market trends

in the context of economic and political

developments and the provision of informa-

tion with respect to foreign exchange.

2. Advisory services designed to assist custom-

ers in monitoring, evaluating, and managing

their foreign-exchange exposure, including

making recommendations regarding policies

and procedures to enhance a customer’s abil-

ity to identify, measure, and manage ﬁnan-

cial risks in a multicurrency environment.

The newly formed subsidiary would also pro-

vide advice on the timing of purchases and

sales of foreign exchange in both spot and

forward markets.

3. Transactional services with respect to foreign-

exchange exposures. The subsidiary would

arrangeforeign-exchange transactions by anaf-

ﬁliated bank holding company and other

commercial banks.

As a condition for approval, the applicants were

required to seek the Board’s authorization if

they engaged in any additional activities within

the United States. (See 1983 FRB 221.)

Effective February 6, 1984, the Board amended

Regulation Y to allow bank holding companies

to offer foreign-exchange advisory and transac-

tional services that include providing general

information andstatistical forecastingwith respect

to foreign-exchange markets. The activity

included arranging for ‘‘swaps’’ among custom-

ers with complementary foreign-exchange expo-

sures and the execution of foreign-exchange

transactions, provided the activity would be con-

ducted through a separately incorporated subsid-

iary of the bank holding company that will

observe the standards of care and conduct appli-

cable to ﬁduciaries with respect to its foreign-

exchange advisory and transactional services.

3130.4.1.1 Inspection Objectives

1. To determine the ﬁnancial effect of the activ-

ity on the parent BHC and its bank subsidi-

ary (or subsidiaries).

2. To determine that the speciﬁc activities pro-

vided by the company are permissible.

3. To determine that the company is not expos-

ing itself to conﬂicts of interest between its

own role of recommending foreign-exchange

positions to its customers and any role its

afﬁliates may have in executing foreign-

exchange transactions.

3130.4.1.2 Inspection Procedures

1. Review the company’s ﬁnancial statements

for accuracy, and determine if there are any

factors or trends that could have an adverse

impact on the parent holding company or the

bank subsidiary (or subsidiaries).

2. Review the company’s policies and proce-

dures to determine that the following are

present:

a. adequate minutes of the board and board

committee meetings

b. adequate blanket bond coverage

3. Review a sample of recommendations to

determine that a reasonable basis exists for

the company’s recommendations.

1. See 62 Federal Register 9,290 (February 28, 1997) (12

C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

2. See 1989 FRB 308.

3. See 1987 FRB 220.

BHC Supervision Manual June 1998

Page 1

4. Review the company’s fee schedule for pro-

viding advice and the fees charged by afﬁli-

ated banks to conduct foreign-exchange trans-

actions for the company’s customers.

Determinewhether bank subsidiaries are being

adequately compensated for executing trades,

or whether these proﬁts are accruing largely

to the beneﬁt of the bank holding company

or its nonbank subsidiaries.

5. Review the company’s revenue sources to

determine that it has not taken foreign-

exchange positions and does not execute

foreign-exchange transactions.

3130.4.2 FINANCIAL ADVICE AS TO

THE STRUCTURING OF AND

ARRANGING FOR LOAN

SYNDICATIONS, INTEREST-RATE

SWAPS, CAPS, AND SIMILAR

TRANSACTIONS

A bank holding company may provide informa-

tion, statistical forecasting, and advice with

respect to any transaction in swaps, caps, and

similar transactions; commodities; and any for-

ward contract, option, future, option on a future,

and similar instruments.

The Board has found

ﬁnancial advice regarding interest-rate swap and

cap transactions to be permissible.

The Board

has also found the provision of advice regarding

loan syndications to be permissible.

An example of a Board order regarding pro-

viding ﬁnancial advice is one in which a bank

holding company (BHC) applied for the Board’s

approval to establish its company de novo as a

ﬁnancial advisory ﬁrm. The Board had not pre-

viously approved the structuring of and arrang-

ing for loan syndications (see section

225.25(b)(6)(ii) of Regulation Y) or arranging

for interest-rate ‘‘swaps’’ and interest-rate caps,

and similar transactions (see section 225.28

(b)(6)(iv) of Regulation Y). Interest-rate caps

are contractual agreements wherein the seller of

a cap agrees to make payment to the purchaser

of a cap if a particular interest-rate index (prime)

exceeds a predetermined level, with payments

calculated on an assumed principal amount for a

deferred time period. The caps and swaps are

typically used to manage or hedge outstanding

positions in the ﬁnancial markets.

The Board’s authorization included the fol-

lowing conditions:

1. The advice rendered by the company on an

explicit fee basis will be rendered without

regard to correspondent balances maintained

by the customers of the company at any

depository institution subsidiary of the BHC.

2. Company’s ﬁnancial advisory activities shall

not encompass the performance of routine

tasks or operations for a customer on a daily

or continuous basis. The Board, on Novem-

ber 28, 1986, approved the activity by order

(1987 FRB 59). (See 1990 FRB 756.) The

Board subsequently, effective September 10,

1992, added this nonbanking activity to the

list of activities permitted by Regulation Y.

(See section 225.28(b)(6)(iii) for loan syndi-

cations and 225.28(b)(6)(iv) for interest-rate

swaps and caps.)

Reference can also be made to another Board

order (1991 FRB 184) relating to providing

advice on joint ventures, leveraged buyouts,

restructurings, recapitalizations, and other cor-

porate transactions (see 225.28 (b)(6)(iii) of

Regulation Y), as well as to providing advice

regarding the structuring and arranging of swaps,

caps, and similar transactions relating to interest

rates, currency and exchange rates and prices,

and economic and ﬁnancial indexes (see

225.28(b)(6)(iv) of Regulation Y).

3130.4.3 ADVICE RELATING TO THE

STRUCTURING OF AND

ARRANGING FOR CURRENCY

SWAPS

A foreign bank subject to the BHC Act applied

for the Board’s approval to acquire a company

engaged in certain securities, foreign-exchange,

and ﬁnancial advisory activities. The Board pre-

viously determined the activities proposed by

the BHC, except for providing advice relating to

the structuring of and arranging for currency

swaps, to be closely related to banking. As for

advice on currency swaps, it was noted that

most banks that provide advicerelatingto interest-

rate swaps also provide advice relating to cur-

rency swaps. Providing advice as to currency

swaps was deemed to be functionally and opera-

tionally similar to providing advice relating to

the structuring of and arranging for interest-

4. See 62 Federal Register 9,290 (February 28, 1997) (12

C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

5. See 1989 FRB 308.

6. See 1987 FRB 220.

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services

3130.4

BHC Supervision Manual June 1998

Page 2

rate swaps. Both transactions have the common

objectives of securing low-cost funds and con-

verting one type of risk to another, and both

transactions require similar documentation. The

Board approved the activity by order on Febru-

ary 13, 1989 (1989 FRB 308). The Board, effec-

tive September 10, 1992, added providing advice

as to currency swaps to the nonbanking activi-

ties permitted by regulation. See section

225.28(b)(iv) of Regulation Y.

3130.4.4 ADVICE WITH RESPECT TO

FUTURES CONTRACTS

3130.4.4.1 Limited Advisory Services

with Respect to Futures Contracts on

Stock Indexes and Options on Such

Futures Contracts

The following is an example of a bank holding

company that applied to the Board to engage de

novo, through a wholly owned subsidiary, in the

provision of advisory services with respect to

futures contracts on stock indexes and options

thereon. The advisory services to be provided

consisted of general research and advice on

market conditions and hedging strategies, client-

account information and reconciliation of trades,

and communication linkage between clients and

exchange ﬂoors in connection with the subsid-

iary’s futures commission merchant activities.

The services offered to customers were pro-

vided either as part of an integrated package of

services or for a separate fee.

The futures advisory services were essentially

identical to the advisory services previously

approved by the Board by regulation and order

with respect to other ﬁnancially related futures

contracts. The Board concluded the applicant’s

provision of advisory services for futures con-

tracts on stock indexes and for options thereon

to be permissible (1987 FRB 220 and section

225.28(b)(6)(iv) of Regulation Y).

Previously, the Board had approved the

execution and clearance of futures contracts on

stock indexes and options thereon (1985 FRB

251). At that time, however, the Board had not

approved a proposal to provide investment advi-

sory services in connection with the execution

and clearance of such instruments.

3130.4.4.2 Advice on Certain Futures and

Options on Futures

This section is a historical example of a bank

holding company that requested the Board’s

approval to provide de novo investment advice

concerning futures and options on futures con-

tracts on foreign exchange, government securi-

ties, and bullion and money market instruments.

In addition, the company would provide port-

folio investment advice, for which applicant had

previously received authorization pursuant to

Regulation Y (the authorization is currently

included in section 225.28(b)(6)(iv)).

Previously, the Board had approved the

provision of investment advice as a futures com-

mission merchant (FCM) (section 225.28(b)(7)

(iv)(A)) or as a commodity trading adviser (CTA)

registered with the Commodity Futures Trading

Commission (CFTC). The provision by an FCM

or CTA of such advice could include providing

counsel, publications, written analyses, and

reports relating to the purchase and sale of

futures contracts and options on futures con-

tracts that bank holding company futures com-

mission merchant subsidiaries are permitted to

execute and clear. Such advisory services could

also consist of providing written or oral presen-

tations on the historical relationship between the

cash and futures markets or the functions of

futures as hedging devices, demonstrating

examples of ﬁnancial futures uses for hedging,

and assisting in structuring a hedging strategy

for a cash position. FCMs and CTAs are subject

to registration with and regulation by the Com-

modity Futures Trading Commission pursuant

to the Commodity Exchange Act, as amended.

(7 U.S.C. 1).

Before incorporation of the advisory activity

into Regulation Y (see 1986 FRB 369), the

Board had determined by order that the provi-

sion of futures and options advice by FCMs is

permissible and closely related to banking (see

1985 FRB 168 and 111, 1984 FRB 780, and

1984 FRB 369). A CTA could provide such

advice even though it is not acting as an FCM.

The issue presented by this latter proposal

was whether the conduct of this activity by

company would be a proper incident to banking

if company, serving as an adviser, did not meet

the former Regulation Y requirement of regis-

tering with the CFTC as a CTA or FCM. The

applicant expected to qualify for a statutory

exemption (7 U.S.C.6m) from the registration

under section 4m of the Commodity Exchange

Act. This exemption provides that any person

who, during the previous 12 months, has not

furnished commodity advisory services to more

than 15 persons and has not represented himself

or herself to the public as a CTA is exempt from

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services

3130.4

BHC Supervision Manual January 2013

Page 3

the registration requirements for CTAs under

the act. The applicant’s proposal permitted com-

pany to provide commodity trading advice with-

out those safeguards. The Board held that it

expects the adviser to disclose to its customers

substantially the same information required for

registered CTAs, including the CTA’s perfor-

mance record, conﬂicts of interest, possible trad-

ing risks, and civil and criminal actions against

the CTA.

The Board concluded that the possible adverse

effects would be further minimized by the fol-

lowing conditions:

1. Company will remain subject to the antifraud

provisions of the Commodity Exchange Act

as well as other restrictions in the act.

2. The adviser will not trade for its own account

(except to hedge), will limit its advice to

instruments that banks deal in extensively

(foreign exchange, bullion, government secu-

rities, and money market instruments), and

will only serve customers that are ﬁnancially

sophisticated and have signiﬁcant dealings or

holdings in the underlying commodities or

instruments. The Board approved the appli-

cation by order on October 18, 1988 (1988

FRB 820).

3130.4.5 PROVIDING

DISCRETIONARY PORTFOLIO

MANAGEMENT SERVICES ON

FUTURES AND OPTIONS ON

FUTURES ON NONFINANCIAL

COMMODITIES

With respect to the Regulation Y provisions

effective April 21, 1997, discretionary portfolio

management advice is not separately listed in

section 225.28(b)(6)(iv). Discretionary invest-

ment advice is discussed, however, within the

preamble to the ﬁnal rule. The preamble empha-

sizes that such advice may be provided to any

person (such advice is no longer limited to

institutional investors) regarding contracts relat-

ing to ﬁnancial and nonﬁnancial assets.

Foreign banking organizations (applicants)

subject to the BHC Act provided notice to

engage through their subsidiary (company) in

providing investment advisory services with

respect to futures and options on futures on

ﬁnancial and nonﬁnancial commodities, includ-

ing discretionary portfolio management ser-

vices.

The Board previously determined that

the proposed activities, with the exception of

providing discretionary portfolio management

services with respect to futures and options on

futures on nonﬁnancial commodities, are closely

related to banking.

The Board had permitted bank holding com-

panies to provide investment advice with respect

to futures and options on futures on both ﬁnan-

cial and nonﬁnancial commodities. (See section

225.28(b)(6)(iv) of Regulation Y.) The Board

also previously approved providing discretion-

ary portfolio management services with respect

to futures and options on futures on ﬁnancial

commodities. (See 1995 FRB 386.) In addition,

the Ofﬁce of the Comptroller of the Currency

permits national banks to engage in discretion-

ary funds management with respect to futures

and options on futures on nonﬁnancial com-

modities. (See OCC Interpretive Letter No. 494

(December 20, 1989).)

In this regard, applicants committed that com-

pany would provide the proposed discretionary

portfolio management services only at the request

of the customer. Applicants also committed that

company would comply with applicable law,

including ﬁduciary principles. In addition,

applicants proposed that company exercise its

discretionary portfolio management authority

only in purchasing and selling exchange-traded

futures and options on futures contracts previ-

ously approved by the Board. The Board gave

its approval on June 30, 1995 (1995 FRB 803).

3130.4.6 COMBINATION OF

PROVIDING ADVICE WITH OTHER

NONBANKING ACTIVITIES

3130.4.6.1 Providing Nonﬁnancial

Futures Advice and the Combining of

Foreign-Exchange, Government Securities

Advisory, and Execution Services

A BHC applicant requested the Board’s permis-

sion to engage in trading options on foreign

exchange and offering investment advice on

ﬁnancial and nonﬁnancial options and futures

contracts, securities, and interest-rate and cur-

rency swaps. The applicant applied to provide

these advisory services through a partnership, of

which it would own 80 percent of its equity.

7. Company does not trade futures or options on futures for

its own account or provide futures commission merchant

execution or clearance services.

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services

3130.4

BHC Supervision Manual January 2013

Page 4

This partnership would provide these advisory

services only to the applicant, its afﬁliates, and

the applicant’s partner, a commodity trading

organization. The partnership would provide

execution services only to the applicant and its

afﬁliates, not to the applicant’s partner.

The Board had not previously approved the

provision of nonﬁnancial futures advice for bank

holding companies. The Board noted that the

Ofﬁce of the Comptroller of the Currency (OCC),

by OCC Interpretive Letter 494 (December 20,

1989), determined that a national bank could

provide execution, clearing, and advisory ser-

vices for customer transactions in standardized,

exchange-traded ‘‘nonﬁnancial’’ futures con-

tracts and options, such as futures on oil and

agricultural products. The OCC determined that

the contracts are ﬁnancial products and that the

provision of investment advice was essentially

the same as the advice given with respect to

ﬁnancial futures contracts. The OCC contends

that investment advice is incidental to the bank’s

authority to purchase and sell the instruments on

behalf of its customers.

The Board has permitted bank holding com-

panies to provide advice with respect to futures

and options on futures relating to bank-eligible

securities, bullion, and foreign exchange (12

C.F.R. 225.28(b)(6)(iv)). The Board also has

permitted bank holding companies to provide

investment advice with respect to options and

futures contracts based on broad-based indexes

of stock and bonds (1990 FRB 770). The Board

thus determined that the provision of investment

advice with respect to investing in options and

futures, based on nonﬁnancial instruments, to be

the functional equivalent of providing advice on

options and futures based on ﬁnancial instru-

ments. In each case, the bank holding company

subsidiary is furnishing advice with respect to

trading of a ﬁnancial instrument. The partner-

ship would not provide advice to third parties

without Federal Reserve approval. The Board

thus approved the providing of investment advice

on nonﬁnancial futures, options, and options on

futures.

The applicant also proposed that the partner-

ship provide execution services to the appli-

cant’s wholly owned subsidiary and to the appli-

cant’s U.S. branches with respect to—

1. over-the-counter options on foreign exchange,

U.S. government securities, and other money

market instruments, and indexes on such

securities and instruments;

2. exchange-traded transactions in futures,

options, and options on futures on foreign

exchange, U.S. government securities, and

other money market instruments, and indexes

on such securities and instruments; and

3. spot and forward transactions in foreign

exchange.

The Board previously approved the combina-

tion of advice and execution for—

1. foreign-exchange transactions (1990 FRB

649),

2. transactions on derivative instruments based

on U.S. government securitiesand other money

market instruments (1990 FRB 664), and

3. securities brokerage (1989 FRB 396).

The Board approved by order the providing of

the combination of foreign-exchange and gov-

ernment securities advisory and execution ser-

vices on December 21, 1990 (1991 FRB 126).

For these reasons, the Board approved the

providing of discretionary portfolio manage-

ment services with respect to futures and options

on futures on nonﬁnancial commodities on June

30, 1995. (See 1995 FRB 803).

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services

3130.4

BHC Supervision Manual December 1999

Page 5

3130.4.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Provide information and advice on

foreign operations and arrange

foreign-exchange transactions

1983 FRB 221

Foreign-exchange and advisory and

transactional services added to

Regulation Y

225.28(b)(6)(iv)

Financial advice as to the structur-

ing of, and arranging for loan syn-

dications, interest-rate swap, caps,

and similar transactions

225.28(b)(6)(iii)

and (iv)

1987 FRB 59

1990 FRB 756

Advisory services with respect to

futures contracts on stock indexes

and options on such futures

contracts

225.28(b)(6)(iv) 1987 FRB 220

Providing discretionary portfolio

management services on futures

and options on futures on nonﬁ-

nancial commodities

225.28(b)(6)(iv) 1995 FRB 803

Providing nonﬁnancial futures

advice and the combining of

foreign-exchange, government

securities advisory, and execution

services

225.28(b)(6)(iv) 1995 FRB 803

Advice in connection with cur-

rency swaps

225.28(b)(6)(iv) 1989 FRB 309

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(8)—Informational, Statistical Forecasting, and Advisory Services

3130.4

BHC Supervision Manual December 1999

Page 6

4(c)(8)—Providing Educational Courses and Instructional Materials

for Consumers on Individual Financial Management Section 3130.5

The ﬁnancial and investment advisory nonbank-

ing activity of consumer ﬁnancial counseling

may consist of providing advice, educational

courses, and instructional materials to individu-

als on consumer-oriented ﬁnancial-management

matters, including debt consolidation, applying

for a mortgage, bankruptcy, budget manage-

ment, real estate tax shelters, tax planning,

retirement and estate planning, insurance, and

general investment management. The authority

for this advisory activity is currently derived

from section 225.28(b)(6)(v) of Regulation Y.

This nonbanking activity was added to the

Regulation Y ‘‘laundry list’’ in 1986. Previ-

ously, the Board authorized the provision of

consumer ﬁnancial counseling services by order.

(See 1979 FRB 65, 1979 FRB 265, 1985 FRB

253, and 1985 FRB 662. These references are

only historical examples.) A bank holding com-

pany may provide information, statistical fore-

casting, and advice with respect to any transac-

tion in foreign exchange, swaps, caps, and similar

transactions, commodities, and any forward con-

tract, option, future, option on a future, and

similar instruments.

The Board has found ﬁnan-

cial advice regarding interest-rate swap and cap

transactions to be permissible. The Board has

also found that providing advice in connection

with currency swaps is permissible,

as well as

providing advice regarding loan syndications.

The revised Regulation Y, effective April 1997,

deleted restrictions on consumer-counseling ser-

vices that prohibited bank holding companies

from promoting speciﬁc products and services,

and from obtaining or disclosing conﬁdential

customer information without the customer’s

consent. These restrictions do not apply to banks

that engage in the above activities.

Prudent management should take into consid-

eration certain actions to prevent potential con-

ﬂictsfromarising.Whenconsidering these orders,

the Board was concerned that the provision of

consumer ﬁnancial counseling activities could

potentially result in unfair competition, conﬂicts

of interest, and other adverse effects. (See 1979

FRB 267.) Examiners should be alert to prob-

lems that may arise from such conﬂicts as they

review this nonbanking activity. Further, the

examiner should determine whether counselors,

as a general practice, are advising each cus-

tomer that they are not required to purchase any

services from afﬁliates, and determine whether

customers have the option to exclude them-

selves from service and product offerings pro-

vided by afﬁliates.

3130.5.1 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Providing ﬁnancial-management

courses, counseling, and related

instructional materials

1979 FRB 265

Engaging, through an acquired

bank, in consumer ﬁnancial

counseling

1985 FRB 253

Providing consumer ﬁnancial coun-

seling services as a permissible

nonbanking activity

225.28(b)(6)(v) 1986 FRB 833

1985 FRB 662

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

1. See 62 Federal Register 9,290 (February 28, 1997) (12

C.F.R. 225.28 (b)(6)) or 1997 FRB 275.

2. See 1989 FRB 308.

3. See 1987 FRB 220.

BHC Supervision Manual June 1998

Page 1

4(c)(8)—Tax-Planning and Tax-Preparation Services

Section 3130.6

Financial and investment advisory services

include tax-planning and tax-preparation ser-

vices. Tax planning involves providing advice

and strategies designed to minimize tax liabili-

ties. For individuals, this includes analysis of

the tax implications of retirement plans, estate

planning, and family trusts; for corporations, it

includes analysis of the tax implications of

mergers and acquisitions, the portfolio mix, spe-

ciﬁc investments, previous tax payments, and

year-end tax planning. Tax preparation involves

the preparation of tax forms and advice concern-

ing liability based on records and receipts sup-

plied by the client. This nonbanking activity

was included in the Regulation Y ‘‘laundry list’’

in 1986. (See section 225.28(b)(6)(vi).) Such

services may be provided to any person. Effec-

tive April 21, 1997, certain restrictions were

removed. These Regulation Y revisions deleted

restrictions in the area of tax-planning and tax-

preparation services that prohibited bank hold-

ing companies from promoting speciﬁc products

or services and from obtaining or disclosing

conﬁdential customer information without the

customer’s consent. These restrictions do not

apply to banks. This fact needs to be considered

when referring to the historical examples that

follow.

The Board had previously approved, by order

(1985 FRB 168), the activity of tax-preparation

services for individuals. Since tax-preparation

services for corporations is functionally or

operationally similar to the tax-preparation ser-

vices that banks already provide to individuals

as well as to their afﬁliates and other ﬁnancial

institutions, the Board approved the providing

of corporate tax-preparation services. When the

nonbanking activity was incorporated into Regu-

lation Y in 1986, tax-planning and tax-

preparation services were authorized, not only

for individuals and corporations, but for noncor-

porate businesses, such as partnerships and sole

proprietorships and tax-exempt nonproﬁt orga-

nizations. Tax-planning and tax-preparation ser-

vices must be conducted in accordance with

applicable jurisdictional law.

3130.6.1 INSPECTION OBJECTIVES

1. To ascertain whether the customer has the

option to be excluded from promotions of

other speciﬁc products and services.

2. To determine what ﬁnancial effect the activ-

ity has on the parent company and its

subsidiaries.

3. To determine whether the company has for-

mal written policies and procedures to ensure

accurate, timely, and conﬁdential preparation

and maintenance of customers’ tax returns.

4. To determine whether the tax-return prepar-

ers are appropriately qualiﬁed to provide

such tax services, and to determine the extent

of management’s involvement in the activity.

6. To identify the potential and extent of off-

balance-sheet risk associated with the activity.

3130.6.2 INSPECTION PROCEDURES

1. Review the company’s ﬁnancial statements

for accuracy, and determine if there are any

factors or trends that could have an adverse

impact on the parent company or the bank

subsidiaries.

2. Determine whether bonding and other insur-

ance coverage is adequate in relation to the

risks associated with the activity.

3. Review pertinent contracts, client lists, pub-

lic advertising and information, correspon-

dence, and other documentation representing

the services provided,and determine if charges

for the tax-preparation service are on an

explicit fee basis that is not dependent on the

amount of tax savings achieved.

4. Determine if the client has a written legal

opinion on ﬁle certifying that the activity is

not considered the practice of law.

5. Review pertinent correspondence and the

minutes of board of directors and board com-

mittee meetings, and determine if any signiﬁ-

cant law suits, Internal Revenue Service

adverse actions, or other potential or contin-

gency losses are pending and probable because

of inaccurate tax-return preparation. Analyze

their probable effect in relation to the ﬁnan-

cial condition of the company.

6. Review the company’s formal written poli-

cies and procedures for assurance of profes-

sional competence in providing sound tax-

planning advice and the accurate, timely, and

conﬁdential preparation and maintenance of

customer’s tax returns. The policies and pro-

cedures should require that tax-planning

advice be clearly communicated by persons

who are adequately supervised and who pos-

sess the necessary professional technical train-

ing and experience needed to provide tax-

planning advice.

BHC Supervision Manual June 1998

Page 1

3130.6.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Preparation of tax returns in a non-

ﬁduciary capacity is closely related

to banking

1985 FRB 168

Permissible nonbanking activity 225.28(b)(6)(vi) 1986 FRB 833

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(8)—Tax-Planning and Tax-Preparation Services 3130.6

BHC Supervision Manual June 1998

Page 2

Section 4(c)(8) of the BHC Act

(Leasing Personal or Real Property) Section 3140.0

WHAT’S NEW IN THIS REVISED

SECTION

This section has been revised (subsection

3140.0.2.2) to include a brief summary of a June

10, 2016, Board order (FRB Order no. 2016-07)

that approved a notice by a foreign bank holding

company and its foreign wholly owned subsidi-

ary bank to engage in permissible nonbanking

activities under section 4(c)(8) of the BHC Act

and section 225.24 of the Board’s Regulation Y.

The nonbanking activities include railcar leas-

ing and the provision of certain railcar ﬂeet

management services pursuant to section

225.28(b)(3) of Regulation Y (leasing personal

property and acting as an agent, broker, or advi-

sor in leasing personal property) and section

225.21(a)(2) (engaging in incidental activities

that are necessary to carrying on permissible

nonbanking activities). The table of Laws, Regu-

lations, Interpretations, and Orders has been

amended to include the order in subsection

3140.0.7.

3140.0.1 LEASING AUTHORIZATIONS

WITHIN REGULATION Y

Leasing is a form of ﬁnancing that provides a

lessee (the customer) the right to use land or

depreciable assets without tying up working

capital. As a result of the tax beneﬁts that can

arise from the ownership of equipment, real

property, or tangible personal property, leasing

provides the lessor (the owner of the property)

with a generally higher rate of return than what

could be achieved through lending. In 1971,

‘‘leasing personal property or acting as agent,

broker, or adviser in leasing such property’’ was

added to the Regulation Y list of permissible

nonbanking activities for bank holding compa-

nies. In 1974, the authority to engage in this

activity was expanded to include the leasing of

real property.

In 1997, restrictions on leasing activities were

removed to permit greater ﬂexibility to acquire

leaseable property in quantity and to sell or

re-lease property upon the lease’s expiration.

The removed restrictions consisted of the maxi-

mum lease term, maximum holding period for

leased property, limit on acquisitions of prop-

erty to speciﬁc leasing transactions, restriction

on leases to those that served as the functional

equivalent of extensions of credit, and 100 per-

cent limit on the amount of reliance that could

be placed on the value of leased property. The

added clariﬁcations consisted of more details on

the requirements for a nonoperating lease, par-

ticularly those for automobile rentals.

3140.0.2 PERMISSIBLE LEASING

ACTIVITIES

Two types of leasing activities are permissible

for bank holding companies: full-payout leasing

and high-residual-value leasing. A full-payout

lease is the functional equivalent of an exten-

sion of credit that relies primarily on rental

payments and tax beneﬁts to recover the cost of

the leased property and related ﬁnancing costs.

High-residual-value leasing may involve sig-

niﬁcant reliance on the expected residual value

of the leased property—on average, under 50 per-

cent. However, this value can extend up to the

full original cost of the property (that is, to

recover the full acquisition cost of the leased

property plus related ﬁnancing costs).

When leasing personal or real property, or

acting as agent, broker, or adviser, only those

leasing transactions meeting the following crite-

ria are considered permissible:

1. The lease must be on a nonoperating basis.

2. The initial lease term must be at least 90 days.

3. For leasing involving real property—

a. at the inception of the initial lease, the

effect of the transaction must yield a return

that will compensate the bank holding

company, as lessor, for its full investment

in the property plus the estimated total

cost of ﬁnancing the property over the

term of the lease (this includes rental pay-

ments, estimated tax beneﬁts, and the esti-

mated residual value of the property at the

expiration of the initial lease); and

b. the estimated residual value (yield) of the

property at the expiration of the initial

term of the lease may not exceed 25 per-

cent of the acquisition cost of the property

to the bank holding company (lessor).

With respect to leasing personal or real property

on a nonoperating basis, the bank holding com-

pany or its subsidiary may not engage in operat-

ing, servicing, maintaining, or repairing leased

property during the lease term. A bank holding

company, however, can arrange for a third party

BHC Supervision Manual January 2017

Page 1

to provide the services or products. (See Regula-

tion Y, section 225.28(b)(3).)

As for automobiles, a bank holding company

may not (1) provide servicing, repair, or mainte-

nance of the leased vehicle during the lease

term; (2) purchase parts and accessories either

in bulk or for an individual vehicle after its

delivery to the lessee; (3) provide the loan of an

automobile duringthe vehicle’sservicing; (4) pur-

chase insurance for the lessee; or (5) provide for

the renewal of the vehicle’s license (registra-

tion) without authorization from the lessor.

3140.0.2.1 Automobile Fleet Leasing and

Fleet-Management Services

A foreign banking organization (FBO) that is

treated as a bank holding company requested an

opinion from the Board’s staff regarding leasing

activities that the Board has determined to be

permissible under section 225.28(b)(3) of Regu-

lation Y. (See 12 C.F.R. 225.28(b)(3).) In con-

nection with its automobile-leasing activities,

the FBO provides, through a wholly owned

automobile ﬂeet leasing subsidiary (AFLS), ﬂeet-

management services to its automobile ﬂeet

leasing customers. In connection with making

automobile and equipment leases that conform

with the requirements of Regulation Y, AFLS

engages in the business of commercial lending

and ﬁnancial leasing of motor vehicle ﬂeets and

equipment located throughout the United States,

and providing ﬂeet-management services to com-

panies that lease corporate automobile ﬂeets.

AFLS and other participants in the business

market and deliver the three services as a bundled

service to clients.

To better provide ﬂeet-management services

to its automobile-leasing customers (in connec-

tion with leases that conform with Regulation

Y), AFLS acquired another ﬂeet-management-

services subsidiary company (FMSS) that

(1) arranges for third parties to provide vehicle

maintenance, accident-management services, and

safety-management services and (2) directly

provides client-support services in connection

with the services arranged by AFLS. FMSS, in

addition to permissible leasing activities, con-

ducts some ﬂeet-management services for auto-

mobiles that are owned by the client and that are

not, therefore, subject to a lease.

As represented, approximately 90 percent of

the vehicles serviced by FMSS are leased and

10 percent are client-owned. Revenues earned

from ﬂeet-management services that are pro-

vided for client-owned vehicles are less than

2 percent of the AFLS’s total revenues. The

FBO asked whether it would be permissible for

it to provide ﬂeet-management services with

regard to automobile ﬂeets if the customer owns

rather than leases the vehicles.

In an opinion issued on December 19, 2003,

Board staff noted that Regulation Y, as a general

matter, permits a bank holding company to

engage in any incidental activities that are nec-

essary to carry on an activity permitted by the

regulation.

Board staff stated also that, in light

of the nature of the practices in the ﬂeet-

management industry and the difﬁculty in con-

tinually monitoring the migration between leased

and owned vehicles in the same ﬂeet, some

ability to perform ﬂeet servicing for owned

vehicles is necessary to retain customers in con-

nection with AFLS’s ﬂeet-leasing activities.

Board staff determined, in view of all the facts

of record, including this necessity, the minimal

amount of revenue earned from servicing owned

vehicles,

and the fact that the activity is primar-

ily an agency activity, that the FBO could pro-

vide ﬂeet-management services to owned vehi-

cles as an activity incidental to the FBO’s

authorized leasing activities. In a December 19,

2003, opinion, Board staff stated that the provi-

sion of ﬂeet-management services on owned

vehicles is subject to the same restrictions set

forth in Regulation Y for leased vehicles.

3140.0.2.2 Railcar Leasing and Railcar

Fleet Management Services

On June 10, 2016, the Board approved a notice

(FRB Order no. 2016-07) by a foreign bank

holding company and its foreign wholly owned

subsidiary bank to engage in nonbanking activi-

ties under section 4(c)(8) of the BHC Act and

section 225.24 of the Board’s Regulation Y.

Fifty percent of the voting shares of a rail trans-

1. The Board previously found providing ﬂeet-

management services to be permissible if the ﬂeet involves

vehicles that are under a lease that conforms to Regulation Y.

(See 12 C.F.R. 225.28(b)(3).) Permissible leases are consid-

ered to be the ﬁnancial equivalent of a loan.

2. See 12 C.F.R. 225.21(a)(2). Staff also noted that the

courts have recognized the authority of bank holding compa-

nies to engage in incidental activities that are reasonably

necessary to the conduct of closely related activities.

3. AFLS has stated that it will limit its ﬂeet-management

services involving vehicles not subject to a Regulation Y

permissible lease to no more than 15 percent of the ﬂeet-

management revenues and to 5 percent of the total leasing

revenues of AFLS.

4. See 12 C.F.R. 225.28(b)(3).

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 2

port company (Delaware Corporation) would be

acquired, thereby acquiring its wholly owned

Illinois corporate subsidiary that engages in rail-

carleasingand relatedactivitiesin NorthAmerica.

As a result of the acquisition, the wholly owned

subsidiary bank would engage in certain non-

banking activities. The nonbanking activities

include railcar leasing and the provision of cer-

tain railcar ﬂeet management services pursuant

to section 225.28(b)(3) of Regulation Y (leasing

personal property and acting as an agent, broker,

or advisor in leasing personal property) and

section 225.21(a)(2) (engaging in incidental ac-

tivities that are necessary to carrying on permis-

sible nonbanking activities).

3140.0.3 ACCOUNTING FOR LEASES

Leasing has become a prominent ﬁnancing vehi-

cle. Lessors have employed a number of differ-

ent methods in structuring and accounting for

leases. Standards for lease accounting are set

forthin AccountingStandards Codiﬁcation(ASC)

Topic 840, “Leases” (formerly FASB Statement

No. 13, “Accounting for Leases,” as amended

and interpreted).

Accounting for leases must be viewed from

the perspective of the parties involved in the

leasing transaction, the lessee and the lessor.

Negotiations and closing costs incurred with

respect to the lease should be written off over

the life of the lease. In applying ASC Topic 840,

certain terminology is used. Basic terms that

should be considered are described below.

Inception of a lease. The inception of a lease

refers to the date the lease contract was signed

or to the date that the construction was com-

pleted, or, if earlier, to the date of the written

commitment stating the signiﬁcant terms.

Term of the lease. The lease term consists of

the noncancelable term and the period compris-

ing the bargain renewal option.

Fair value of lease property. The fair value of

a lease consists of the price that the property

could be sold in an arm’s-length transaction.

Economic life of the leased property. The

economic life of the leased property represents

the period over which the property is expected

to be economically beneﬁcial to one or more

users for its intended purpose.

Estimated residual value of the leased prop-

erty (ERV). The residual value is the estimated

fair value of the leased property at the expira-

tion of the lease term.

Interest rate implicit in the lease. The implicit

interest rate is the discount rate that causes

the sum of the minimum lease payments and the

unguaranteed residual value at the end of the

lease term to be equal to the fair value of the

property at the beginning of the lease term.

Lessee’s incremental borrowing rate. The

incremental borrowing rate is the interest rate at

which the lessee could borrow the funds to

purchase the leased property.

3140.0.3.1 Accounting for Leases by a

Lessee

The two methods for accounting for leasing

transactions by a lessee are the operating method

and the capitalized-lease method.

3140.0.3.1.1 Operating Method of

Accounting for Leases

The operating accounting method merely re-

cords the cost of the rental payments as an

expense when it is required to be paid in accor-

dance with the terms of the lease agreement.

Example: Assume that equipment is leased for $100,000 per year for three years. Under this

method, the annual cost would be recorded as a rental expense on the income statement:

Dr. Rent $100,000

Cr. Cash $100,000

To record an annual payment of rent based on an operating-lease agreement.

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 3

3140.0.3.1.2 Capitalized-Lease Method of

Accounting for Leases

3140.0.3.1.2.1 When a Lessee Is to Use the

Capitalized-Lease Method

If any one of the following conditions exist, the

lessee must capitalize the lease:

1. The asset is owned by the lessee at the end

of the lease term.

*2. The lease term is equal to or more than

75 percent of the estimated economic life of

the asset.

3. The lessee can purchase the asset below its

fair market value before or at the end of the

lease term (bargain purchase option).

*4. The present value of the minimum lease

payments at the beginning of the least term

is equal to or more than 90 percent of the

fair market value of the property.

* If the lease begins in the remaining 25 percent of

the asset’s estimated economic life, these items do not

apply; such leases are considered operating leases.

Using this method, the lease is recorded as an

asset at the lesser of the present value of the

rental and other minimum lease payments or the

fair value of the leased property as though the

lease obligation was being purchased on credit.

The payment made is treated as a payment made

on an installment debt. At the same time, the

asset is being amortized over the lease term. The

lease obligation is treated as a long-term debt.

The discount rate that is used to capitalize the

lease is the lessee’s incremental borrowing rate

or the interest rate implicit in the lease agreement.

Example #1: This example illustrates the capitalized-lease method using the same example as

above with the added fact that the lease agreement contains an interest rate of 10 percent. Assume

that the interest rate of the lease agreement is the same as the lessee’s marginal borrowing rate.

Dr. Capitalized Lease $248,685

Cr. Lease Obligation $248,685

To record an equipment lease obligation under a capitalized-lease agreement.

(Present value of $100,000 per year for three years at a 10 percent interest rate)

1st Year

Interest Expense $ 24,869

Lease Obligation 75,131

Cash $100,000

To record the ﬁrst year’s payment on an equipment lease obligation.

($248,685 2 .10 = $24,869)

Dr. Equipment Lease Amortization $ 82,895

Cr. Capitalized Lease $ 82,895

To record the annual amortization of a capitalized equipment lease.

($248,685/3 years)

2nd Year

Dr. Interest Expense $ 17,355

Dr. Lease Obligation 82,645

Cr. Cash $100,000

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 4

To record the second annual lease payment under a three-year capitalized-lease agreement.

(Interest = $248,685 + 24,869 2 $100,000 = $173,554 2 .10 = $17,355)

Dr. Lease Amortization $ 82,895

Cr. Capitalized Lease $ 82,895

To record the second year’s lease amortization under a three-year capitalized lease.

3rd Year

Dr. Interest Expense $ 9,091

Dr. Lease Obligation 90,909

Cr. Cash $100,000

To record the third year’s lease payment under a three-year capitalized-lease obligation.

(Interest = $173,554 + $17,355 = $190,909 2 $100,000 = $90,909 2 .10 = $9,091)

The ﬁnancial statements are to include foot-

notes that disclose the present value of noncan-

celable lease commitments where the lessor

either recovers more than 75 percent of the

economic life of the asset leased or recovers the

investment plus a reasonable return.

3140.0.3.2 Accounting for Leases by a

Lessor

3140.0.3.2.1 Operating Lease (Lessor)

A lessor would have the following accounting

entries for an operating lease:

Dr. Cash $xxx,xxx

Cr. Rent Income on Leased Assets

$xxx,xxx

Dr. Depreciation Expense $xxx,xxx

Cr. Accumulated Depreciation—Leased Assets $xxx,xxx

In order for the lessor to be able to capitalize

a direct-ﬁnancing lease, any one of the same

four criteria for a lessee must apply along with

two additional criteria:

5. Any rent received in advance would be initially credited

to “unearned rent revenue.”

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 5

1. Collectibility of the minimum lease pay-

ments must be reasonably predictable.

2. No important uncertainties exist as the amount

of unreimbursable costs incurred.

In accounting for the lessor’s capitalized lease

transactions, there are some common accounts

that are used. These are described below.

Unearned income from lease ﬁnancing

receivables. Unearned income represents the

unearned interest liability account that is netted

against the total of lease payments receivable

which includes the estimated residual value for

balance-sheet presentation. It represents the

‘‘interest’’ income equal to the excess of rentals

receivable over the fair value of the property at

the inception of the lease.

Lease ﬁnancing receivables. This asset account

is established in the amount of total lease pay-

ments to be received from the lessee. The amount

by which the rentals receivable exceeds the cost

of the property is the functional equivalent of

interest and represents a portion of the income

to be recognized over the life of the lease. In the

example below, the cost of the property is tem-

porarily charged to a ﬁxed asset account, then

transferred to lease payments receivable.

Throughout the lease term, the rentals receiv-

able account is periodically reduced by the full

amount of each rental payment received.

3140.0.3.2.2 Direct Financing

Capitalized Lease

In this situation, a ﬁnance company purchases

equipment from a manufacturer (recorded as

equipment [asset] when purchased). The ﬁnance

company (lease ﬁnancing nonbanking subsidi-

ary) then leases that equipment and records it as

a normal ﬁnancing lease. There is no dealer

proﬁt from the sale of the asset. Unearned inter-

est income is recognized over the life of the

lease using the effective interest method. Since

the lessor has ‘‘sold’’ the asset, no depreciation

is recorded.

Example #1: Lease with No Guaranteed Residual Value by the Lessee

Assume that the ﬁnance company purchases equipment costing $100,000. It then leases the

equipment to a lessee under a ﬁve-year lease agreement that requires annual payments of $25,000

per year. At the end of the lease term, the lessee will own the equipment. The implied interest rate is

7.931 percent (comparison of the present value of the equipment of $100,000 against the $25,000

annual payment for ﬁve years).

Dr. Equipment $100,000

Cr. Cash $100,000

To record the purchase of equipment to be leased

Dr. Lease Financing Receivables $125,000

Cr. Equipment $100,000

Cr. Unearned Income from Lease Financing Receivables 25,000

To record the initial lease

Year 1

Dr. Cash $ 25,000

Cr. Lease Financing Receivables $ 25,000

Dr. Unearned Income from Lease Financing Receivables $ 7,931

Cr. Income from Lease Financing Receivables 7,931

To record the receipt of the ﬁrst equipment lease payment.

Lease Payments Receivable $125,000

Unearned Interest Revenue 225,000

$100,000 2 .07931 = $7,931

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 6

Year 2

Dr. Cash $ 25,000

Cr. Lease Financing Receivables $ 25,000

Dr. Unearned Income from Lease Financing Receivables $ 6,577

Cr. Income from Lease Financing Receivables $ 6,577

To record the receipt of the second equipment lease payment.

Lease Payments Receivable $100,000

Unearned Interest 217,069 ($25,000 2 7,931)

(Present Value of Remaining Receivable $ 82,931) 2 .07931 = $6,577

Year 3

Dr. Cash $ 25,000

Cr. Lease Financing Receivables $ 25,000

Dr. Unearned Income from Lease Financing Receivables $ 5,116

Cr. Income from Lease Financing Receivables $ 5,116

To record the receipt of the third equipment lease payment.

Lease Payments Receivable $ 75,000

Unearned Interest 210,492 ($17,069 2 $6,577)

(Present Value of Remaining Receivable $ 64,508) 2 .07931 = $5,116

Year 4

Dr. Cash $ 25,000

Cr. Lease Financing Receivables $25,000

Dr. Unearned Income from Lease Financing Receivables $ 3,539

Cr. Income from Lease Financing Receivables $ 3,539

To record the receipt of the fourth equipment lease payment.

Lease Payments Receivable $ 50,000

Unearned Interest 25,376 ($10,492 2 $5,116)

(Present Value of Remaining Receivable $ 44,624) 2 .07931 = $3,539

Year 5

Dr. Cash $ 25,000

Cr. Leases Financing Receivables $ 25,000

Dr. Unearned Income from Lease Financing Receivables $ 1,837

Cr. Income from Lease Financing Receivables $ 1,837

To record the receipt of the ﬁfth equipment lease payment.

Lease Payments Receivable $ 25,000

Unearned Interest 21,837 ($5,376 2 $3,539)

(Present Value of Remaining Receivable $ 23,163) 2 .07931 = $1,837

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

A lessor acquires property to be leased for $14,000 (its fair value at the inception of the lease).

The estimated economic life of the property is ﬁve years. The lease has a noncancelable lease term

of four years with a rental payment due of $3,649 at the end of each year. The lessee guarantees the

residual value at the end of the four-year lease term in the amount of $4,000. The lessor’s implied

rate of interest in the lease is 10.8695 percent. The present value of the minimum lease payments at

this interest rate and monthly payments exceeds 90 percent of the fair value of the property at the

inception of the lease (.90 2 $14,000 = $12,600).

Year 1

January 1, 19x1

Dr. Equipment $ 14,000

Cash $ 14,000

To record purchase of equipment for the purpose of a ﬁnancing lease.

Dr. Lease Financing Receivables $ 18,596

Cr. Equipment $ 14,000

Cr. Unearned Income from Lease Financing Receivables 4,596

To record investment in direct-ﬁnancing lease

December 31, 19x1

Dr. Unearned Income from Lease Financing Receivables $ 1,521

Cr. Income from Lease Financing Receivables $ 1,521

To recognize the portion of unearned income that is earned at the end of the ﬁrst year of investment.

(Fair value of property at inception of the lease of $14,000 2 10.8695% = $1,521)

Dr. Cash $ 3,649

Cr. Lease Financing Receivables $ 3,649

To record receipt of the ﬁrst year’s rental

Year 2

Dr. Unearned Income from Lease Financing Receivables $ 1,290

Cr. Interest Income from Lease Financing Receivables $ 1,290

To recognize the portion of unearned income that is earned at the end of the second year of

investment

($14,000 + 1,521 2 3,649 = $11,872 2 10.8695% = $1,290)

Dr. Cash $ 3,649

Cr. Lease Financing Receivables $ 3,649

To record the receipt of the second year’s rental

Year 3

Dr. Unearned Income from Lease Financing Receivables $ 1,034

Cr. Income from Lease Financing Receivables $ 1,034

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

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

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To recognize the portion of unearned income that is earned at the end of the third year of investment

Dr. Cash $ 3,649

Cr. Lease Financing Receivables $ 3,649

To record the receipt of the third year’s rental.

Year 4

Dr. Unearned Income from Lease Financing Receivables $ 751

Cr. Income Lease Financing Receivables $ 751

To recognize the portion of unearned income that is earned at the end of the fourth year of

investment.

($9,513 + 1,034 2 $3,649 = $6,898 2 10.8695% = $751)

Dr. Cash $ 3,649

Cr. Lease Financing Receivable $ 3,649

To record the receipt of the fourth year’s rental.

Dr. Cash $4,000

Cr. Lease Financing Receivables $ 4,000

To record the receipt of the lessor’s guaranteed residual value (guaranteed by the lessee) at the end

of the lease term.

($6,898 + 751 2 $3,649 = $4,000)

3140.0.3.2.3 Balance-Sheet Presentation

The lease payments receivable would be reported

on the balance sheet as a single amount ‘‘net

investment’’ (Lease Financing Receivables less

the balance of the Unearned Income from Lease

Financing Receivables). If the lessor has estab-

lished an allowance for possible lease losses,

this amount is shown separately as a deduction

from the net investment. The net investment

in the direct ﬁnancing lease is $18,000 for

example #2 above. It consists of the gross

investment of $18,596 ($3,649 2 4 annual

rental payments) plus the $4,000 residual value

less the unearned income of $4,596.

3140.0.3.2.4 Classiﬁcation

If it is deemed appropriate to classify a lease,

the amount to be classiﬁed (in example #2

above) would be the net investment. For illustra-

tion, assume that two of the four payments had

been received on the lease, that income has been

recognized monthly according to the effective

interest rate method, and that the lease is now

considered a loss. Further assume that the third

payment should have been received eight months

ago. It is determined during the inspection that

the lease should be classiﬁed as doubtful of

collection. The balance to be classiﬁed is the net

investment of $7,728. This consists of the bal-

ance of Lease Financings Receivable of $9,513

(includes the $4,000 estimated guaranteed resi-

dual value) less the balance of Unearned Income

from Lease Financings Receivable of $1,785

($1,034 + $751 = amount due on regular pay-

ment intervals) or a net investment of $7,728.

3140.0.3.2.5 Delinquency

It is considered appropriate to state in the

inspection report the percentage of delinquency

in the lease portfolio. The percentage is calcu-

lated by deviding the aggregate rentals receiv-

able on delinquent leases (less unearned income

on the delinquent leases) by the total of rentals

receivable on all leases (less their unearned

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income). Estimated realizable values would not

be included in the delinquent amounts unless

they were guaranteed by the lessee.

3140.0.4 LEVERAGED LEASES

The lessor can ‘‘leverage’’ a lease transaction by

borrowing a substantial portion of the acquisi-

tion cost from a long-term lender, with the rent-

als and the property pledged as collateral for the

loan. The lessor borrows in order to ﬁnance a

leasing transaction with a small, or perhaps, a

negative equity in the property to be leased.

The initial step in accounting for this type of

lease involves calculating the cash ﬂows over

the term of the lease. The cash ﬂows include

the income tax effects of tax deductions to the

lessor, the lessor’s initial investment in the prop-

erty, the rental receipts net of debt service, and

the proceeds expected to be received from the

sale of any residual. The next step in accounting

for a leverage lease involves determining the

applied interest rate that, when applied to the net

investment in the years that the net investment

will be positive, would precisely allocate the net

income to the positive years. See appendix E of

SFAS 13 for an example as to how to account

for a leveraged lease.

3140.0.5 INSPECTION OBJECTIVES

1. To determine the effect of the investment in

the leasing subsidiary upon consolidated

operations, and indirectly upon the bank sub-

sidiaries’ safety and soundness.

2. To determine if the company is operating in

compliance with applicable laws and regula-

tions, and to ensure that corrective action is

initiated if warranted.

3. To determine if policies, procedures, and

controls are adequate to protect the company

from mismanagement, unnecessary risk, and

loss.

4. To assess the management’s ability to oper-

ate the company in a safe and sound manner.

5. To determine that accounting practices do

not overstate income.

3140.0.6 INSPECTION PROCEDURES

The decision whether the operations of a leasing

subsidiary will be inspected ‘‘on-site’’ is based

on the availability and adequacy of leasing com-

pany data at the ofﬁces of the parent company.

Item 1 below provides a listing of information

necessary to the inspection process. If this and

any other information necessary to assess the

overall condition of the subsidiary is available

at the parent’s ofﬁce or can be obtained through

a written request to the subsidiary, an on-site

inspection may not be necessary. The inspection

frequency requirements, found in section

5000.0.4, should be reviewed in making such a

determination.

1. The following information should be avail-

able at the start of the inspection:

a. trial balance of all leases and outstanding

credits,

b. listing of accounts on which payments

are delinquent 30 days or more, or on

which payments are otherwise not being

made according to schedule,

c. comparative interim and ﬁscal ﬁnancial

statements of the leasing company,

d. listing of unbooked assets and contin-

gent liabilities,

e. cash-ﬂow projections for the current ﬁs-

cal year and the next ﬁscal year,

f. listing of available lines of credit,

g. copies of the most recent internal and

external audit reports, and

h. minutes of board and executive commit-

tee meetings since the date of the previ-

ous inspection.

2. Establish a ‘‘credit line’’ above which all

leases will be reviewed. The line can be set

at an amount that will cause a certain per-

centage of the dollar volume of the lease

portfolio to be reviewed (e.g.,between70 per-

cent and 80 percent), or at an amount that

will cause the review of each lease exceed-

ing a certain percentage of gross capital.

Leases on which payments are delinquent

are to be reviewed regardless of amount.

3. Analyze the creditworthiness of the lessees.

Consideration is given to the ﬁgures derived

from the lessee’s ﬁnancial statements, as

well as cash ﬂow, trends and projections of

growth in sales and income, and the qualiﬁ-

cations of management.

Delinquency on a lease obligation is

potentially more serious than delinquency

on a conventional loan. If the property

under lease is necessary for the lessee’s

continued production of income, as is fre-

quently the case, the lessee’s ﬁnancial con-

dition will be seriously deteriorated before

the lessee is willing to risk losing the prop-

erty by default.

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4. For those leases which might result in loss

to the lessor, or for which ﬁnancial informa-

tion was not adequate to make such a deter-

mination, transcribe the following informa-

tion to line sheets:

a. name and line of business of lessee

b. name of guarantor(s)

c. original date of the lease contract

d. original amount of the rentals receivable

e. ERV of the property

g. book value of the investment in the lease

as of the inspection date

h. cost of the property

i. description and location of the property

j. amount and frequency of rental payments

k. original amount, term, rate, and schedule

of amortization of any nonrecourse debt

associated with the lease

l. lessor’s percentage of equity participa-

tion in the lease obligation, if applicable

m. summary ﬁnancial data indicating the

creditworthiness of the lessee, and guar-

antors, if applicable

5. Before the conclusion of the inspection,

discuss with management all classiﬁed leases.

Inadequate or negative cash ﬂow and unfa-

vorable trends reﬂected in ﬁnancial state-

ments of the lessee are usually indicative of

a substandard lease. Leases classiﬁed doubt-

ful typically include those on which pay-

ments are delinquent for an extended period

and those on which the lessor’s recovery of

investment is dependent upon an event of

unknown probability, such as a pending

lawsuit or insurance claim.

A loss classiﬁcation results from the les-

see’s inability or refusal to continue making

payments.

6. Prepare a write-up to support the classiﬁca-

tions. The write-up should include the les-

see’s type of business, present ﬁnancial sta-

tus, circumstances which led to the

classiﬁcation, the probability that the terms

of the lease can be met, and the amount of

protection afforded by sale or re-lease of the

underlying property.

7. Review a sample of the lessor’s computa-

tions of lease yields to determine whether

the lessor will recover not less than the full

investment in the property plus the esti-

mated total cost of ﬁnancing the property

over the term of the lease. This includes

rental payments, estimated tax beneﬁts, and

the estimated residual value of the property

at the expiration of the initial lease.

With respect to the full-payout lease,

governmental entities may be prohibited

from entering into leases for periods exceed-

ing one year. In that case, the bank holding

company or its subsidiary (as lessor) should

demonstrate that the lease is expected to be

continually renewed until the cost is fully

recovered.

8. Ascertain whether title to the property rests

with the lessor, and that the lessor has taken

steps to protect its ownership rights. Evi-

dence of ﬁling under the Uniform Commer-

cial Code, where appropriate, should be

found in the documentation ﬁle. Aircraft

should be registered with the FAA, inter-

state vehicles with the ICC, and ships with

the Coast Guard.

9. Check for cancellation or other provisions

in the contract which could jeopardize the

full-payout status of the lease. There is no

need to take exception to a cancellation

provision which provides for payment by

the lessee of an amount which allows the

lessor to recover fully its investment in the

property.

10. Check that insurance coverage is effective

on leased property and is provided by the

lessee in compliance with all insurance pro-

visions of the contract in an amount sufﬁ-

cient to protect against loss from property

damage. Public liability insurance should

also be provided to protect against loss from

lawsuits which could arise from situations

such as the crash of leased aircraft.

11. Review the lessee’s duties under the con-

tract with respect to repairs and taxes. Deter-

mine whether the lessor has instituted pro-

cedures to check that the lessee’s required

duties are being performed.

12. Review the status of all property acquired

for lease purposes but which is not now

under lease. Determine the reason for the

‘‘off-lease’’ status of the property, ascertain

the realizable value of the property, and

investigate whether the off-lease property

will be sold or re-leased within the required

two-year period.

13. Investigate the lessor’s procedures for

periodic review of the reasonableness of the

estimated residual value. The estimate should

be reviewed at least annually and reduced

in amount on the books if the value has

declined on a presumably permanent basis.

14. Review past operations of the lease company

to determine if projections of income and

ERV have been realistic in light of actual

experience.

15. Review the minutes of the meetings of the

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

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Page 11

board and executive committees to deter-

mine whether purchases of property and

delinquent leases are reported to the board.

16. Determine if the company has entered into

leases with companies owned or controlled

by any director, ofﬁcer, or 10 percent share-

holder of the leasing company or holding

company. Compare the rates and terms on

such leases to the rates and terms offered on

leasesto companiesof similarcredit standing.

17. Check for lease concentrations to any one

lessee or industry and prepare a comment

for the inspection report if any concentra-

tion is considered unwarranted.

18. Determine whether the company has

established limits for the maximum amount

of ‘‘credit’’ to be extended to a single les-

see. If such limits have been established,

investigate whether the company adheres to

them. If they have not been established,

inquire as to the company’s policy on this

matter.

19. Provide the examiner-in-charge with

information to be included in the inspection

report, including:

a. scope of the inspection (on- or off-

premises)

b. comments concerning any policies or

conditions having an adverse effect on

the leasing company or parent company

c. brief history of the company and a

description of its activities

d. summary analysis of ﬁnancial factors of

the company, including trends in the

volume and classiﬁcation of receivables,

adequacy of capital and reserves, return

on assets, and contribution to consoli-

dated income and consolidated assets

e. statutory authority under which the com-

pany operates

f. details of all borrowings of the company

from within the holding company sys-

tem and from external sources

g. details of any litigation in which the

company is a defendant

h. scope and frequency of audit of the

company by both internal and external

auditors

20. Compare current earnings performance and

balance-sheet ratios of the company with

past performance and industry composites.

21. Determine whether cash ﬂows of the com-

pany are adequate to service all debts.

22. Assess the adequacy of internal controls

over the company’s operations.

23. Check for action taken on matters criticized

in the most recent audit reports and the

previous inspection report. Determine if

leases classiﬁed ‘‘loss’’ were removed from

the books.

24. Investigatewhetherany afﬁliatedbanks main-

tain compensating balances for lines of credit

of the leasing company, and if so, whether

the leasing company compensates the bank

for maintenance of the balances. If ‘‘loss’’

leases have not been removed from the

books, discuss with management the rea-

sons why the charge-offs were not made.

Determine whether the ﬁnancial statements

and reports submitted to the Board of Gov-

ernors were misstated as a result of the ‘‘no

charge-off’’ decision.

25. For higher residual value leasing, determine

that—

a. the residual values have been estimated

accurately;

b. residual values are reviewed and adjusted

annually;

c. the initial terms of the lease are at least

90 days;

d. the lessor relies on a residual value of

the leased property that will recoup the

acquisition cost of the property and any

related ﬁnancing or other associated

costs;

e. the aggregate book value of all tangible

personal property held for such a lease,

having an estimated residual value in

excess of 25 percent of the acquisition

cost of the property, does not exceed

10 percent of the BHC’s consolidated

domestic and foreign assets;

f. the BHC maintains separately identiﬁ-

able records of the leasing transactions

and activities; and

g. each company maintains capitalization

fully adequate to meet its obligations

and support its activities, and that its

capital levels are commensurate with

industry standards for companies engaged

in comparable leasing activities.

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

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3140.0.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Automobile Leasing 1976 FRB 930

Consumer leasing 15 U.S.C. 1667

Higher residual value

leasing

1991 FRB 490, 187

1990 FRB 462, 960

Personal or real property

leasing activities of bank

holding companies

225.28(b)(3)

Special-purpose leasing

corporation

3-712

Railcar leasing, railcar ﬂeet

management services

(leasing personal property

and acting as agent,

broker, or adviser in

leasing personal property)

225.28(b)(3) 2016 FRB Q2 Board

Order 2016-07

Engaging in incidental

activities reasonably

necessary to carrying on

permissible nonbanking

activities

225.21(a)(2)

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Leasing Personal or Real Property) 3140.0

BHC Supervision Manual January 2017

Page 13

Section 4(c)(8) of the BHC Act

(Community Welfare Projects) Section 3150.0

The Board considers the making of equity and

debt investments in corporations or projects

designed ‘‘primarily to promote’’ community

welfare as an activity closely related to banking.

The Board includes such investments in the list

of permissible nonbanking activities in Regula-

tion Y; however, bank holding companies must

obtain prior approval to engage in these activi-

ties. The Board, effective April 21, 1997, included

the provision of advisory and related services

for programs designed primarily to promote

community welfare into Regulation Y. Such

advisory activities had previously been permit-

ted only by Board order. For examples of advi-

sory services approved for community develop-

ment projects, see 1990 FRB 671, 1989 FRB

576, and 1988 FRB 140.

3150.0.1 INVESTMENTS IN

CORPORATIONS OR PROJECTS TO

PROMOTE COMMUNITY

WELFARE—BOARD

INTERPRETATION

The Board also provides guidance with regard

to investments in community welfare projects

through its interpretation (see section 225.127

of Regulation Y (12 C.F.R. 225.127)). This

interpretation describes projects that the Board

has considered as promoting community wel-

fare as their primary intent. These include but

are not limited to—

1. projects to construct or rehabilitate housing

for low- or moderate-income persons,

2. projects for construction or rehabilitation of

ancillary local commercial facilities neces-

sary to provide goods or services principally

to persons residing in low- or moderate-

income housing, and

3. projects designed explicitly to create improved

job opportunities for low- or moderate-

income groups.

Because the Board believes that bank holding

companies should take an active role in the

quest for solutions to the nation’s social prob-

lems, it has not deﬁned other types of invest-

ments designed primarily to promote the com-

munity welfare in order to give bank holding

companies greater ﬂexibility in developing new

and creative approaches to resolving community

problems. Accordingly, the Board has main-

tained the ﬂexibility to determine whether an

activity is primarily designed to promote the

community welfare. Factors that the Board might

consider include whether the activity beneﬁts

low- and moderate-income individuals in areas

such as housing and employment and the need

for specialized community development activi-

ties in different localities. The Board will con-

sider a range of different activities, but will

probably not approve a proposal that does not in

some way either beneﬁt low- or moderate-

income individuals or beneﬁt the specialized

needs of local communities.

Once a bank holding company has obtained

Board approval to engage in community devel-

opment activities pursuant to Regulation Y, the

holding company may, without further System

approval, engage either directly or through a

subsidiary in certain community development

activities, so long as such activities do not

exceed 5 percent of the bank holding company’s

total consolidated capital stock and surplus.

A bank holding company may invest and

provide ﬁnancing—

1. to a corporation or project or class of corpo-

rations or projects that the Board previously

has determined is a public welfare project

pursuant to paragraph 23 of section 9 of the

Federal Reserve Act (12 U.S.C. 338a);

2. to a corporation or project that the Ofﬁce of

the Comptroller of the Currency previously

has determined, by order or regulation, is a

public welfare investment pursuant to sec-

tion 5136 of the Revised Statutes (12 U.S.C.

24 (Eleventh));

3. to a community development ﬁnancial insti-

tution (other than a bank or bank holding

company) pursuant to section 103(5) of the

Community Development Banking and Finan-

cial Institutions Act of 1994 (12 U.S.C.

4702(5));

4. for the development, rehabilitation, manage-

ment, sale, and rental of residential property

if a majority of the units will be occupied by

low- and moderate-income persons or if the

property is a ‘‘qualiﬁed low-income build-

ing’’ as deﬁned in section 42(c)(2) of the

Internal Revenue Code (26 U.S.C. 42(c)(2));

5. for the development, rehabilitation, manage-

ment, sale, and rental of nonresidential real

property or other assets located in a low- or

moderate-income area provided the property

BHC Supervision Manual December 1997

Page 1

is used primarily for low- and moderate-

income persons;

6. to one or more small businesses located in a

low- or moderate-income area to stimulate

economic development;

7. for the development of, and to otherwise

assist with, job training or placement facili-

ties or to foster programs designed primarily

for low- and moderate-income persons;

8. to an entity located in a low- or moderate-

income area if that entity creates long-term

employmentopportunities, a majorityof which

(based on full-time equivalent positions) will

be held by low- and moderate-income per-

sons; and

9. forproviding technical assistance, credit coun-

seling, research, and program development

assistance to low- and moderate-income per-

sons, small businesses, or nonproﬁt corpora-

tions to help achieve community development.

3150.0.2 EXAMPLES OF

BOARD-APPROVED ACTIVITIES

DESIGNED TO PROMOTE

COMMUNITY WELFARE

With its primary thrust to promote community

welfare rather than creating a focus on a collat-

eral effect, economic rehabilitation and develop-

ment should focus on providing housing, ser-

vices, or jobs for low- or moderate-income

residents or groups. Examples of projects previ-

ously approved by the Board include an invest-

ment in—

1. an agricultural test farm (testing crops, equip-

ment, alternative farming methods and chemi-

cals, and providing student agricultural

research opportunities and ﬁnancial planning

workshops for farmers (see 1990 FRB 671);

2. an entity that provides education to young

persons (see 1991 FRB 70) through a non-

proﬁt, tax-exempt bank holding company

(educational programs consisted of the Ameri-

can economic system, how to start a busi-

ness, college ﬁnancial planning, and career

opportunities in banking);

3. the acquisition and redevelopment of a sole

medical clinic in a small rural town without

public transportation that was located 30

miles from another facility and was needed

to attract new physicians to replace those

retiring (see 1991 FRB 63); and

4. a limited partnership to develop a nearly

vacant ofﬁce building into a hotel complex

within a major city, located adjacent to a

public housingproject.Commitmentsincluded

providing training to welfare recipients resid-

ing in public housing projects and employing

low- and moderate-income individuals at the

hotel complex, and donating a portion of the

proﬁts to a nonproﬁt corporation designated

to provide low-cost housing, employment,

and business opportunities for disadvantaged

residents. (See 1996 FRB 679.)

3150.0.3 EXAMPLES OF

INVESTMENTS VIEWED AS NOT

PROMOTING COMMUNITY

WELFARE

The Board has indicated that some investments

are not designed primarily to promote commu-

nity welfare unless there is substantial evidence

to the contrary, even though the investment may

beneﬁt the community to some extent. Examples

include investments to build or rehabilitate high-

income housing or commercial, ofﬁce, or indus-

trial facilities which are not designed explicitly

to create job opportunities for low-income per-

sons, even though the investment may beneﬁt

the community to some extent. This latter point

was made in an order (see 1996 FRB 679)

whereby the Board denied an application by a

bank holding company to acquire an investment

in an industrial development corporation

involved in the construction of a shopping and

ofﬁce complex in an urban renewal area. The

Board identiﬁed the critical issue as whether the

project was devised primarily to promote the

community welfare or primarily designed as a

proﬁt-making venture in which the beneﬁts to

the community were merely a collateral effect.

In another case, the Board denied a proposal

intended to acquire a company that indirectly

acted as a managing general partner of a private

development venture. The venture was a large-

scale, urban redevelopment initiative, jointly

sponsored by government and private entities,

that was intended to revitalize a geographic area

that was largely abandoned within a working

middle-class community. (See 1990 FRB 672.)

3150.0.4 INSPECTION OBJECTIVES

1. To determine that new investments and ﬁnanc-

ing in community development and other

corporations and projects are designed pri-

marily to promote community welfare.

2. To determine that previous investments and

ﬁnancings continue to meet the standards

Section 4(c)(8) of the BHC Act (Community Welfare Projects) 3150.0

BHC Supervision Manual December 1997

Page 2

imposed by section 225.28(b)(12) of Regula-

tion Y.

3. To determine that the activity remains within

the scope of regulatory approval when such

approval involves speciﬁc rather than gen-

eral investments.

4. To determine that advisory and related ser-

vices for programs designed primarily to pro-

mote community welfare are being con-

ducted within the scope of their regulatory

approval.

3150.0.5 INSPECTION PROCEDURES

As is standard practice in the examination of

other subsidiaries engaged in nonbanking activi-

ties,a thoroughreview of pertinentbooks,records,

contracts, and ﬁnancial statements should be

undertaken by the examiner. To fulﬁll the

inspection objectives concerning this activity,

the examiner may have to go beyond routine

investigative practices. Since this activity

encompasses a wide variety of programs, proce-

dures will have to be developed on an ad hoc

basis. When federal or state approval of the

program is required, the examiner may wish to

review applications and other materials submit-

ted to such authorities. The terms or conditions

imposed by such bodies as well as the subsid-

iary’s continued eligibility may also be of

importance. Contact with responsible federal or

state ofﬁcials may be deemed appropriate in

certain cases. Such contacts, however, should be

initiated only in accordance with respective

Reserve Bank procedures. When a community

welfare project or ﬁnancing does not include the

involvement of another governmental body, the

examiner will need to verify directly whether

goals essential to the nature of the activity, such

as providing housing for the elderly or jobs for

low- or moderate-income people, are being met.

In this regard, the burden should be on the

holding company to provide such data. In some

instances, an on-site visit to the project may be

appropriate.

Section 4(c)(8) of the BHC Act (Community Welfare Projects) 3150.0

BHC Supervision Manual December 1997

Page 3

3150.0.6 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Permissible investments

described

1701 225.28(b)(12)

225.127

4–178 1972 FRB 495

1978 FRB 45

1984 FRB 452

Provision of community

development advice on a

fee-for-service basis

1988 FRB 140

1989 FRB 576

Purchase of land

for agricultural

testing activities

1990 FRB 672

Nonproﬁt, tax-

exempt BHC—educational

programs in economics,

starting businesses,

ﬁnancial planning,

career opportunities in

banking

1991 FRB 70

Projects to create

improved job opportunities

for low- or moderate-

income groups

1992 FRB 619

Approval of community

development converting an

ofﬁce building into a

hotel complex, located

next to a public

housing project

designated as

‘‘difﬁcult to develop’’

1996 FRB 679

Denial of a bank

holding company

formation by a

community development

corporation

1976 FRB 639

Denial of a venture

that would revitalize

an abandoned area

in a middle-class

community

1994 FRB 733

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Community Welfare Projects) 3150.0

BHC Supervision Manual December 1997

Page 4

Section 4(c)(8) of the BHC Act

(EDP Servicing Company) Section 3160.0

3160.0.1 PROVISION OF DATA

PROCESSING AND TRANSMISSION

SERVICES

Under section 4(c)(8) of the BHC Act, the per-

missibility of bank holding company data pro-

cessing activities is generally predicated upon

the type of data processed or transmitted. Sub-

sidiaries formed under this section may engage

in business directly with outside customers,

unlike section 4(c)(1) subsidiaries, which can

act only as servicers for afﬁliates

and cannot

deal directly with outside customers.

The intent of section 4(c)(8) is to permit bank

holding companies and their nonbank subsidi-

aries to directly provide to customers ﬁnancially

or economically oriented services (or services

that are similar to these services) that banks

have traditionally used in their own internal

operations and provided to their customers. Such

services (with prior approval) are unrestricted as

to location and may be provided from out-of-

state locations.

3160.0.2 INCIDENTAL ACTIVITIES

The Board regards the following as incidental

activities necessary to carrying on permissible

data processing activities:

1. Making excess computer time available to

anyone as long as the only involvement by

the bank holding company system is furnish-

ing the facility and the necessary operating

personnel. This stipulation applies when—

a. the equipment is not purchased solely for

the purpose of creating excess capacity to

sell;

b. hardware is not offered in conjunction

with excess capacity; and

c. the facilities for the use of the excess

capacity do not include providing any

software other than systems software

(including language), network communi-

cations support, and the operating person-

nel and documentation necessary for main-

taining and using these facilities.

2. Selling byproducts of permissible data pro-

cessing and data transmission activities when

theyare notdesigned,or appreciably enhanced,

for the purpose of marketability.

3. Furnishing any data processing service upon

request of a customer if the service is not

otherwise reasonably available in the rel-

evant market area.

3160.0.3 SECTION 4(c)(8) vs.

SECTION 4(c)(1)

Section 4(c)(1) data processing subsidiaries,

which do not require prior approval, are limited

as follows:

1. They can furnish computer services only for

the internal operations of the bank holding

company and its bank afﬁliates.

2. Direct computer services to nonafﬁliated cus-

tomers are not permitted. Any contract to

furnish services to nonafﬁliated customers

must be between the afﬁliate bank and its

customer, with the data processing subsidiary

acting as a servicer for its afﬁliate bank. In

addition, the kinds of services furnished are

limited to those that a bank can normally

provide.

Section 4(c)(8) data processing subsidiaries

may deal directly with the customer. In accor-

dance with section 4(c)(8) of the BHC Act and

section 225.28(b)(14) of Regulation Y, the kinds

of services nonbank subsidiaries of bank hold-

ing companies may provide to others are—

1. data processing and transmission services,

facilities (including hardware, software, docu-

mentation, or operating personnel), data-

bases, advice, and access to such services,

facilities, or databases by any technological

means, if—

a. the data to be processed or furnished are

ﬁnancial, banking, or economic data and

b. the hardware provided in connection with

the data processing and transmission ser-

vices is offered only in conjunction with

software designed and marketed for the

processing and transmission of ﬁnancial,

banking, or economic data, and the general-

purpose hardware does not constitute more

than 30 percent of the cost of any pack-

aged offering.

2. data processing, data storage, and data trans-

mission services for a third party that are not

ﬁnancial, banking, or economic related if the

subsidiary’s total annual revenue derived from

1. In this context, ‘‘afﬁliates’’ is limited to other organiza-

tions that have subsidiaries of the same parent bank holding

company as the servicer.

BHC Supervision Manual June 2004

Page 1

those activities does not exceed 30 percent of

its total annual revenues derived from data

processing, data storage, and data transmis-

sion activities. On November 26, 2003, the

Board approved an increase of this limit to

49 percent, effective January 8, 2004. See

1993 FRB 1158, 2004 FRB 55, and section

3160.2. The Board currently recognizes that,

in certain situations, a bank holding com-

pany may have bona ﬁde operational reasons

for conducting its ﬁnancial and related nonﬁ-

nancial data processing activities through

separately incorporated subsidiaries. In these

cases, bank holding companies may request

permission to administer the 49 percent rev-

enue test on a business-line or multiple-

entity basis. See section 225.28(b)(14) of

Regulation Y (12 C.F.R. 225.28(b)(14)).

3160.0.4 MINICOMPUTER

ACTIVITIES

Some data processing subsidiaries are actively

engaged in placing minicomputers with some of

their customers. However, if the subsidiary acts

as sales agent for the manufacturer and receives

a commission, it is in violation of section

225.28(b)(14) of Regulation Y and should be

advised to cease the practice.

3160.0.5 HARDWARE AND

SOFTWARE AS AN INTEGRATED

PACKAGE

Customers of data processing services require

that suppliers provide them with hardware and

software as an integrated package. Providing

general-purpose hardware is permissible only if

the cost of the hardware does not exceed 30 per-

cent of the cost of the packaged offering, and

only in conjuction with permissible software.

When hardware is provided in a specialized

form (such as ATMs), its provision meets the

National Courier test and is closely related to

banking and therefore not subject to the 30 per-

cent limitation.

3160.0.6 PACKAGED FINANCIAL

SYSTEMS

The Board found that providing packaged ﬁnan-

cial systems, including data processing hard-

ware and software, to be installed on the prem-

ises of the customer is closely related to banking

if conducted within the limits of Regulation Y.

3160.0.7 EXCESS CAPACITY

The sale of excess computer time is currently

treated in a Board interpretation as a permissible

incidental activity. The interpretation (12 C.F.R.

225.123(e)(1)) currently permits a bank holding

company to make excess computer time avail-

able to anyone so long as the only involvement

of the holding company is furnishing the facility

and the necessary operating personnel. Data

processors that process time-sensitive data must

maintain sufﬁcient capacity to meet peak

demand and provide backup in case of equip-

ment failure. Excess capacity necessarily results

from such needs; thus the sale of excess capac-

ity is necessary to reduce costs and to remain

competitive. Bank holding companies are lim-

ited in the sale of excess capacity as follows:

1. A bank holding company may not purchase

data processing equipment solely for the pur-

pose of creating excess capacity.

2. A bank holding company may not sell hard-

ware in conjunction with excess capacity.

3. A bank holding company may provide only

limited types of software in connection with

its sale of excess capacity. This includes sys-

tems software (that is, software designed

only to control and operate the hardware and

not to perform substantive operations), net-

work communications support, and the oper-

ating personnel and documentation neces-

sary for maintaining and using these facilities.

3160.0.8 BYPRODUCTS

The sale of byproducts for the development of a

program for a permissible data processing activ-

ity is treated in a Board interpretation (12 C.F.R.

225.123(e)) as a permissible incidental activity.

Byproducts may be data, software, or data pro-

cessing techniques or information developed by

the bank holding company. Byproducts may not

be designed or appreciably enhanced for the

purpose of marketability.

3160.0.9 REQUIREMENT OF

SEPARATE RECORDKEEPING

The Board’s data processing interpretation is

designed to minimize any possibility of unfair

Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0

BHC Supervision Manual June 2004

Page 2

competition. A bank holding company subsidi-

ary or related entity that provides permissible

data processing and data transmission activities

(services, facilities, byproducts, or excess

capacity) must keep separate books and records

and provide the documents to any new or renewal

customer upon request.

3160.0.10 SUMMARY

Holding company EDP proposals are evaluated

from the standpoint of whether the proposed

data processing activities involve banking, ﬁnan-

cial, or related economic data within the mean-

ing of the Board’s Regulation Y. Processing,

storing, and transmitting data for third parties,

when the data are not ﬁnancial, banking, or

economic, is permissible if the revenues derived

from those activities do not exceed 49 percent

of the subsidiary’s total annual revenues derived

from data processing, data storage, and data

transmission activities. For examples of previ-

ous Board authorizations for data processing

and transmission services in accordance with

Regulation Y, see sections 3160.1 through 3160.5.

The data processing that is permissible under

Regulation Y encompasses various data pro-

cessing services, including sales analysis, inven-

tory analysis, freight payment, municipal tax

billing, credit union accounting, and savings

and mortgage company bookkeeping and pay-

roll processing.

3160.0.11 INSPECTION OBJECTIVES

1. To determine that the full range of EDP

services performed are permissible ﬁnan-

cially oriented activities in compliance with

applicable laws and regulations.

2. To review the relationship between the data

processing subsidiary and its afﬁliates and

the effect of those relationships on the affairs

and soundness of the bank afﬁliate.

3. To determine if operating policies are adequate

and if management is operating in conform-

ance with the established policies.

4. To initiate corrective action when policies,

practices, procedures, or internal controls are

deﬁcient or when violations of law or regula-

tion have been noted.

NOTE:All bank-relatedEDP servicers receive

EDP examinations conducted by the primary

bank regulator; these examinations cover detailed

operations, audit, proper backup, and overall

computer operations. The bank holdingcompany–

related inspection should focus on the types and

permissibility of services performed, the rev-

enue limitations of section 225.28(b)(14) of

Regulation Y, the types of customers serviced,

and transactions between afﬁliates. The inspec-

tion should also provide an overall ﬁnancial

evaluation.

3160.0.12 INSPECTION PROCEDURES

3160.0.12.1 Pre-Inspection

1. Where available, review the EDP examina-

tion report in conjunction with the lead bank

examination for details of the subsidiary’s

operations and management.

2. Review correspondence ﬁles and the

application memo for the history of the

subsidiary.

3160.0.12.2 On-Site

3. Have a brief meeting with the chief execu-

tive ofﬁcer of the subsidiary to establish

contact and present a brief indication of the

scope of the inspection.

4. Ask the controller of the company for the

schedules and other information requested

in the entry letter.

5. Request the followinginformation and sched-

ules in addition to what was requested in

the entry letter:

a. complete list of the computer applica-

tions the subsidiary performs

b. list of customers

c. policy and procedures manual, if any

d. copy of the latest internal and external

ﬁnancial and operational audits and

internal control reviews

e. copy of the types of management

reports the subsidiary submits to the par-

ent company and directors

f. internal management organization chart

g. copy of the agreement executed with the

afﬁliates concerning the services pro-

vided and the fees collected

6. Review minutes of meetings of the board of

directors and of the executive committee to

determine the broad types of the company’s

operations.

7. Determine the scope of the inspection, based

on evaluations of—

a. corporate minutes,

b. schedules,

Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0

BHC Supervision Manual June 2004

Page 3

c. accounting records,

d. internal controls, and

e. the scope of the work performed by the

internal auditor.

8. Review the trial balances and compare them

with the respective general ledger control

accounts.

9. Where necessary, interview pertinent divi-

sion heads.

10. Determine if management information sys-

tems are adequate and if regular periodic

reports are made available. Determine if the

reports provide sufﬁcient segregated details

on the annual revenues earned from (1) ﬁnan-

cial-, banking-, or economic-related data

processing and data transmission services

and (2) third-party nonﬁnancial data pro-

cessing and data transmission services.

Ascertain whether the information will allow

veriﬁcation of compliance with the revenue

limitations found in section 225.28(b)(14)

of the Board’s Regulation Y.

11. Verify that the subsidiary of the bank hold-

ing company is complying with the revenue

limitations found in section 225.28(b)(14)

of Regulation Y.

12. Review the data processing, data storage,

and data transmission services provided to

customers for violations of the Board’s regu-

lations and interpretations. Obtain sufﬁcient

documentation for the workpapers.

13. Prepare a statement of condition with a

minimum two-year comparison. More than

two years may be prepared if the informa-

tion is available and meaningful.

14. Prepare a statement of income using the

same procedures outlined above.

15. Reviewall signiﬁcant internalpolicies. Deter-

mine if the policies were developed inter-

nally or by the parent company.

16. Review the subsidiary’s management reports

to the parent company. Is the reporting com-

plete and frequent (at least quarterly)? Is the

parent company fully aware of the subsid-

iary’s operations or problems?

17. Review the adequacy of internal and exter-

nal ﬁnancial and operational audits and

internal control reviews. Interview the EDP

auditor and review the audit reports and

CPA management letters (for the period of

the inspection). Also conduct interviews

with the auditors, including the EDP audi-

tor (if one was engaged).

18. Review the condition of the company’s

records, that is, their availability, complete-

ness, and accuracy. Deﬁciencies should be

discussed in detail with recommendations

for improvement.

19. Review all intercompany transactions. Be

consistently alert for any transactions with

afﬁliate bank(s) that would be a violation of

Federal Reserve Act sections 23A and 23B

and Regulation W.

20. Review signiﬁcant litigation and other con-

tingent liabilities.

3160.0.13 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

EDP auditing

225.28(b)(14)

Types of activities—incidental

activities

225.123 and

225.123(a)

4–176 1975 FRB 215

Data processing as an activity

closely related to banking

225.123(e) 1974 FRB 58

Section4(c)(1)typeof EDP services 225.118 4–195

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0

BHC Supervision Manual June 2004

Page 4

Subject Laws

Regulations

Interpretations

Orders

Retention of data subsidiary 1972 FRB 318

Order authorizing a bank holding

company to engage in expanded

data processing and data transmis-

sion activities

1982 FRB 505

Amendment of Regulation Y for

expanded activities

225.28(b)(14) 1982 FRB 552

1997 FRB 275

Order authorizing a BHC to offer

ﬁnancial-ofﬁce service and the ser-

vice of designing and assembling

data processing hardware. Receipt

of hotel information and the ability

to make airline and hotel reserva-

tions is not related to the provision

of banking, ﬁnancial, and eco-

nomic data.

225.28(b)(14) 1986 FRB 497

Order authorizing engaging in elec-

tronic beneﬁt services, stored-

value-card services, and electronic

data interchange services

1993 FRB 1158

Order authorizing the provision of

a network for the processing and

transmission of medical payment

data

1994 FRB 139

Order authorizing the provision of

traveler’s checks and postage

stamps via an ATM card and

terminal

1994 FRB 1107

Order allowing a BHC to process

certain nonﬁnancial data—

personnel information for ﬁnancial

institutions for use in their internal

operations

1995 FRB 295

Order authorizing optical scanning

and database preparation

1995 FRB 1049

Order authorizing engaging in the

development, production, and pro-

vision of customer home banking—

personal ﬁnancial management

using personal computers

1996 FRB 363

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0

BHC Supervision Manual June 2004

Page 5

Subject Laws

Regulations

Interpretations

Orders

Order allowing a

BHC to engage in—

(1) providing data processing and

data transmissionservicesto non-

afﬁliated ﬁnancialinstitutions and

1996 FRB 674

(2) assisting the institutions in

offering their customers banking

and ﬁnancial services over the

Internet

1996 FRB 680

Order approving limited nonﬁnan-

cial data processing and transmis-

sion services, including customer

identiﬁcation, account, and infor-

mation or veriﬁcation ﬁles for

detecting fraudulent use.

1996 FRB 348

Order approving the development

and provision of a data processing

and data transmission system

(‘‘gateway’’) to depository institu-

tions and their afﬁliates. The sys-

tem would make home banking

and other ﬁnancial services avail-

able to the institutions’ and afﬁli-

ates’customers.The gatewaywould

provide customers with an elec-

tronic link to an Internet provider.

1997 FRB 135

Order approving the development

and sale of computer software to

broker-dealers and ﬁnancial insti-

tutions that would allow customers

to purchase and sell securities over

the Internet using personal

computers.

1997 FRB 335

Amendment of Regulation Y to

expand the ability of BHCs, includ-

ing FHCs, to process, store, and

transmit nonﬁnancial data in con-

nection with data processing, stor-

age, and transmission activities.

2004 FRB 55

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (EDP Servicing Company) 3160.0

BHC Supervision Manual June 2004

Page 6

Section 4(c)(8) of the BHC Act (EDP Servicing—Network for the

Processing and Transmission of Medical Payment Data) Section 3160.1

A bank holding company applied for the Board’s

approval to acquire all the shares of a nonbank

data processing company to engage in the pro-

cessing and transmission of certain medical-

payment data. The nonbank subsidiary plans to

engage in activities that specialize in a range of

medical-payment electronic funds transfer ser-

vices, including the development of software

products related to the processing of medical-

claims payments.

Basic network services. The Board deter-

mined by order that a nonbank subsidiary of a

bank holding company may provide a network

for the processing and transmission of medical-

payment data between health-care providers

(such as physicians, hospitals, and pharmacies)

and entities responsible for paying medical

beneﬁts (such as health insurers, health main-

tenance organizations, and preferred provider

organizations). These nonbanking activities are

permissible under the Bank Holding Company

Act and the Board’s Regulation Y (12 C.F.R.

225.28(b)(14)). The information on the patient’s

medical-beneﬁts card (made available by paying

organizations) would be used to access the sys-

tem (similar to a debit or credit card). In gen-

eral, health-care providers would enter claims

information into the network with a request for

payment, and the payers would authorize elec-

tronic fund transfers for full or partial payment

of the claims.

The bank holding company’s nonbank sub-

sidiary would also process and transmit medical-

treatment data necessary for the processing of

claims, and would furnish providers with access

to a coverage-information database. The data-

base would transmit information about the terms

of a particular payer’s medical coverage con-

tract, such as the extent to which speciﬁc medi-

cal treatments are covered by the patient’s insur-

ance policy. While such medical and coverage

data are not ﬁnancial data, the processing and

transmission of these data are essential to the

transmission and processing of the medical pay-

ments and ﬁnancial information in the network.

Also, these data processing services allow the

electronic transfer of funds. The Board found

that the processing and transmission of the

medical and coverage data, in connection with

the nonbank subsidiary’s operation of a pay-

ments network, are permissible as incidental

activities. The Board further determined that the

nonbank subsidiary’s operation of a medical-

payments network would constitute permissible

data processing and data transmission activities

under the BHC Act.

Adjudication software. The Board also autho-

rized the bank holding company’s nonbank sub-

sidiary to furnish claims-adjudication software

to payers. The software is designed for the pro-

cessing of routine claims and would include

the basic rules of a payer’s coverage contract.

Claims-adjudication processing would involve

the interaction of ﬁnancial and banking data and

medical and coverage data as a necessary pre-

lude to electronic funds transfer. The Board

found that the processing of medical and cover-

age data involved in claims adjudication is an

integral and necessary part of the processing of

related ﬁnancial and banking information, and

the nonbank subsidiary’s processing of under-

lying payment transactions. The Board con-

cluded that the nonbank subsidiary’s provision

of claims-adjudication software is permissible

as an activity incidental to its provision of soft-

ware for the processing of banking and ﬁnancial

data and to its operation of a medical-payments

network.

Electronic data interchange. The bank hold-

ing company’s nonbank subsidiary also plans to

provide medical–payments system participants

with statistical and other data derived from the

information in its database. Each participant

would have on-line access to all of the data it

places into the system, and third parties desig-

nated by a payer or provider could also receive

access to the data owned by that customer. The

Board has previously stated that bank holding

companies may provide byproducts of permis-

sible data processing and data transmission

activities as long as the byproducts are not

designed, or appreciably enhanced, for the pur-

pose of marketability (12 C.F.R. 225.123(e)(2)).

The Board has also indicated that byproducts

include data, software, or data processing tech-

niques that may be applicable to the data pro-

cessing requirements of other industries.

The nonbank subsidiary may perform limited

selection, combination, and similar functions on

raw data so that the data can be transmitted to

the customer in a reorganized and more usable

form. It may also design software that would

enable customers to perform similar reorganiza-

tion functions on raw data. The Board con-

cluded that the proposed electronic data

interchange services would constitute permis-

sible byproducts of the nonbank subsidiary’s

primary data processing activities, and are there-

fore permissible as an incidental activity.

BHC Supervision Manual December 1997

Page 1

The Board’s approval of the application on

December 22, 1993, is based on the facts of

record and is subject to the commitments and

representations that were made by the applicant

and the conditions referred to in the order. (See

1994 FRB 139.)

4(c)(8) (EDP Servicing—Network for the Processing and Transmission of Medical Payment Data)

3160.1

BHC Supervision Manual December 1997

Page 2

Electronic Beneﬁt Transfer, Stored-Value-Card,

and Electronic Data Interchange Services Section 3160.2

Four bank holding companies (the applicants)

applied for the Board’s approval under section

4(c)(8) of the Bank Holding Company Act to

engage de novo, through their joint venture cor-

poration (the company), in nonbanking activi-

ties consisting of engaging in electronic beneﬁt

transfer services, stored-value-card services, and

electronic data interchange services. The appli-

cants proposed to engage in the activities through-

out the United States. The applicants provide

data processing and transmissionservices through

the company to retail merchants using point-of-

sale (POS) terminals and to banks who are

members of the company’s automated teller

machine (ATM) network.

3160.2.1 ELECTRONIC BENEFIT

TRANSFER SERVICES

The electronic beneﬁt transfer services would

involve data processing and transmission ser-

vices required to permit the delivery of govern-

mental program beneﬁts (such as welfare pay-

ments and food stamps) through the ATM and

POS terminals of participating merchants and

banks. Under a beneﬁts-services system, a bene-

ﬁt recipient would be issued a magnetically

encoded card similar to an ATM card, which

could be used to obtain access to a government

beneﬁt account maintained on behalf of the

recipient. The Board concluded that such activi-

ties are ﬁnancial activities that are operationally

and functionally similar to the electronic pay-

ment and data processing services provided by

banks and bank holding companies in the opera-

tion of ATM and POS networks. In particular,

the proposed beneﬁt services involve the pro-

cessing of access and authorization requests

submitted to, and the processing of electronic

payments originating from, ﬁnancial accounts

on the same basis as transactions initiated with

traditional credit and debit cards. The Board

thus concluded that such electronic beneﬁt trans-

fer activities are closely related to banking and

permissible for bank holding companies under

the BHC Act.

3160.2.2 STORED-VALUE-CARD

SERVICES

Stored-value-card services would involve data

processing and transmission services and elec-

tronic payment services related to stored-value

cards. These cards are similar to credit or debit

cards in which authorized funds can be trans-

ferred and credited using magnetic stripe or

computer chip technology. The services would

be provided in connection with both ‘‘closed’’

and ‘‘open’’ stored-value-card systems. Closed

systems include both single-vendor stored-value-

card systems and systems designed for single-

use sites. An open system, by contrast, refers to

multiple-vendor, multiple-site stored-value-card

systems.

3160.2.2.1 Stored-Value-Card Closed

Systems

In most current closed systems, cash must

be deposited in a particular vendor’s card-

dispensing terminal, and the card received from

the terminal may be used only for purchases

from that speciﬁc vendor. The card itself is

disposable, and the only account reconciliation

that may be required would involve the ven-

dor’s own cash receipts, the amount of funds

debited from the cards at turnstiles or other

points of sale, and the amount of the vendor’s

liabilities stored on outstanding cards. The com-

pany intended to play a role in the operation of

this basic type of closed system, as well as to

help develop and operate more complex closed

systems. These systems would use a plastic card

containing electronic technology, such as a com-

puter chip or magnetic stripe, to which funds

could be credited and from which funds could

be debited, for an indeﬁnite period of time. The

company proposed performing accounting func-

tions in customer accounts and accounting for

the level of the vendor’s stored liabilities. In

such a capacity, the company would be respon-

sible for the settlement and reconciliation of

these customer and vendor accounts. The com-

pany would also perform other functions, such

as embossing and issuing cards and arranging

for funds collection.

3160.2.2.2 Stored-Value-Card Open

Systems

The applicants anticipate that stored-value cards

eventually will operate in an open system simi-

lar to a POS network, which allows value stored

on a card to be used with a wide range of

participating vendors. The applicants expect that

BHC Supervision Manual June 2004

Page 1

the company’s principal stored-value-card

activities would involve the development and

operation of such open systems.

In an open system, customers’ debit cards

would hold an integrated computer chip or some

type of comparable technology capable of stor-

ing value for use in stored-value-card transac-

tions. Value could be placed on the card at an

ATM adapted to read and place value on the

chip, at a limited-purpose ATM-type machine

whose only functions would be to add value to

the chip and to transfer stored value back to the

customer’s account, or at a cash-to-card machine

or other value-transfer device (collectively, value

terminals). These value terminals would be

operated, in at least some cases, by the com-

pany. Once value is placed on a card, equivalent

funds could be transferred to the company,

which would hold the funds for payment of

stored-value-card transactions. Stored value

would leave the chip when the customer pur-

chases goods or services either at a POS termi-

nal (which may be operated by the company) or

at a vending machine, telephone booth, mass

transit turnstile, or other unmanned delivery

location (collectively, reader terminals), or when

the customer transfers funds back to an account

at a value terminal. Reader terminals generally

would be ofﬂine devices not connected to the

company’s ATM or POS networks. Instead of a

direct electronic connection, a reader terminal

would retain, for a period of time, value repre-

senting the amount of customer purchases at the

terminal. Then, at the vendor’s convenience, the

company, the vendor, or a third party would

collect value from the reader terminals using

specially designed collection cards issued by the

company. The collection cards would then be

submitted to the company so that funds can be

properly credited. Once these transactions occur,

the company would be responsible for making

settlement by transferring funds to the accounts

of participating merchants and other appropriate

parties.

The Board concluded that the company’s

activities in providing stored-value-card ser-

vices, in both closed and open systems, are

closely related to banking. The activities involve

processing debits and credits to the stored-value

cards and performing related accounting and

settlement functions, and are thus a data pro-

cessing activity. Financial balances are main-

tained and adjusted at POS and other terminals

as the customer purchases various items or adds

value to the card, and the activity constitutes the

processing of banking, ﬁnancial, or economic

data within the meaning of Regulation Y. In

addition, aspects of the company’s stored-value-

card services are functionally similar to the issu-

ance and sale of consumer payment instruments

such as traveler’s checks, which are activities

that banks conduct and that the Board has previ-

ously determined to be closely related to bank-

ing within the meaning of the BHC Act. The

Board concluded that the company’s proposed

services in connection with stored-value cards,

in either an open system or a closed system, are

closely related to banking.

3160.2.3 ELECTRONIC DATA

INTERCHANGE SERVICES

The company also proposes to furnish retail

merchants with data collected from sales trans-

actions consummated at the merchant’s place of

business (data services). The data collected and

furnished would relate to speciﬁc items and

quantities of products purchased by the cus-

tomer, as well as to customer-purchasing pat-

terns over a period of time. The data would be

formatted so that it could be used by the mer-

chant for inventory control, targeted marketing,

and other purposes. The company’s data ser-

vices generally would be furnished to merchants

as an adjunct to its POS-transaction-processing

services and would be rendered through a retail

merchant’s POS terminals. The company does

not intend to offer data services independently.

In addition, the data that are collected by the

company would be furnished only to the mer-

chant that is a party to the underlying sales

transaction; that is, the company does not intend

to provide such information to third parties.

The company’s data services would be lim-

ited to capturing, formatting, and furnishing data

collected from sales transactions consummated

at a particular merchant’s place of business. In

addition, the data collected would be furnished

only to that merchant and only in accordance

with the merchant’s speciﬁc instructions. The

company does not intend to provide software,

render advice, or provide other services associ-

ated with the marketing or other uses of the

data. The applicants do anticipate, however, that

the company could provide additional related

functions, such as issuing store coupons or cred-

its related to a merchant’s marketing programs

at POS terminals. Based on the facts presented,

the Board determined that the sales data that

would be processed under the proposed data

services are ﬁnancial and economic data within

the meaning of Regulation Y.

Electronic Beneﬁt Transfer, Stored-Value-Card, and Electronic Data Interchange Services

Section 3160.2

BHC Supervision Manual June 2004

Page 2

3160.2.4 BOARD APPROVAL

Based on all the facts of record, the Board

approved the applications. The Board’s approval

is speciﬁcally conditioned on compliance with

the commitments made in connection with the

applications and with the conditions referred to

in the order. (See 1993 FRB 1158.)

Regulation Y provides that a bank holding

company may render advice to anyone on pro-

cessing and transmitting banking, ﬁnancial, and

economic data. On November 26, 2003, the

Board approved an amendment to section

225.28(b)(14) of Regulation Y to expand the

ability of all bank holding companies, including

ﬁnancial holding companies, to process, store,

and transmit nonﬁnancial data in connection

with their ﬁnancial data processing, storage, and

transmission activities. The Board raised the

total annual revenue limit from 30 percent to the

49 percent limit that applies to nonﬁnancial data

processing activities. Speciﬁcally, a company (a

nonbank subsidiary of a bank holding company)

conducting data processing, data storage, and

data transmission activities may conduct nonﬁ-

nancial data processing, data storage, and data

transmission activities (those that are not ﬁnan-

cial, banking, or economic in nature) if the total

annual revenue derived from those activities

does not exceed 49 percent of the company’s

total annual revenues derived from data process-

ing, data storage, and data transmission activi-

ties. (See 12 C.F.R. 225.28(b)(14).)

Electronic Beneﬁt Transfer, Stored-Value-Card, and Electronic Data Interchange Services

Section 3160.2

BHC Supervision Manual June 2004

Page 3

Data Processing Activities: Obtaining Travelers’ Checks and Postage

Stamps Using an ATM Card and ATM Terminal Section 3160.3

Eleven bank holding companies (the applicants)

applied for the Board’s approval to engage

through a joint venture corporation (the com-

pany) in certain nonbanking activities related to

the operation of a retail electronic funds transfer

network, including data processing and data

transmission activities related to automated teller

machine (ATM) and point-of-sale (POS) trans-

actions, as well as electronic beneﬁt transfer,

stored-value card, and electronic data capture

and interchange services. (A complete list of the

proposed activities is found at 1994 FRB 1110–

1111.)

The applicants also proposed to offer through

the company certain data processing and data

transmission services not previously considered

by the Board. Those services consisted of allow-

ing customers to use their ATM cards at an

ATM terminal to withdraw funds from a bank

account in the form of travelers’ checks or post-

age stamps. Payment for the transactions would

be accomplished by a debit to a cardholder’s

deposit account.

The transactions would occur at terminals

that would not be owned and operated by the

company. Cardholders buying postage stamps

or travelers’ checks at an ATM terminal would

purchase those products from the bank owning

the ATM. The decision on which travelers’

checks to issue would remain with the bank that

owns the ATM terminal, and the company would

not be the issuer of the travelers’ checks.

The company’s primary activities would be

processing and transmitting access requests and

payment authorizations. The company would

also provide terminal-driving services, load ATM

terminals with postage stamps and travelers’

checks, and market the products through the

network.

The Board determined that the proposed

activities involved the processing of access and

authorization requests submitted to deposit

accounts on the same basis as other transactions

initiated with a traditional debit card. The activ-

ity is operationally and functionally similar to

the data processing services provided by banks

and bank holding companies in their operation

of ATM and POS networks. Traditionally, banks

have been permissibly engaged in the sale of

travelers’ checks and postage stamps. The Board

thus found the company’s proposed data pro-

cessing and transmission activities, with respect

to these transactions, to be closely related to

banking. (See 1994 FRB 1107.)

BHC Supervision Manual June 1997

Page 1

Providing Data Processing for ATM Distribution of Tickets, Gift Certiﬁcates,

Telephone Cards, and Other Documents Section 3160.4

Five bank holding companies (the applicants)

applied for the Board’s approval to engage,

through a joint venture subsidiary (the com-

pany), in certain data processing activities pur-

suant to Regulation Y. The applicants, through

the company, would provide data processing

and related services to banks and other auto-

mated teller machine (ATM) owners in connec-

tion with the distribution through ATMs of tick-

ets, gift certiﬁcates, prepaid telephone cards,

and other documents evidencing a prepayment

for goods or services.

The company would provide the software and

telecommunications channels necessary to trans-

mit cardholder requests, card-issuer authoriza-

tions, and related switching and account recon-

ciliation services. Speciﬁcally, the company

would provide terminal driving services that

include—

• establishing and maintaining an electronic

link between an ATM and a telecommunica-

tions switch to transmit cardholder requests

and card-issuer authorizations; and

• operating the feature and functions displays

on an ATM screen using computer software to

permit an ATM to dispense various products

in addition to currency.

The company would also provide switching ser-

vices and transaction processing to transmit

account debiting, transaction authorization, and

settlement data between the ATM owner, or its

bank, and the cardholder’s bank.

A typical transaction would consist of an

ATM cardholder selecting a particular product,

such as a concert ticket, from a menu displayed

on the ATM screen. The electronic commands

transmitted by the company would verify that

the deposit account or line of credit designated

by the cardholder had sufﬁcient funds to effect

the purchase. Following authorization, the ATM

would dispense the product and issue a receipt.

The card-issuingbank would then debit an amount

equal to the cost of the purchase from the card-

holder’s designated account and transfer the

funds to the account of the merchant or ATM

owner, using settlement procedures established

by the company’s ATM network.

The Board previously determined that a bank

holding company could provide data processing

and related services necessary to permit custom-

ers to use an ATM card to debit a deposit

account or line of credit at an ATM terminal for

cash and credit transactions, and for the pur-

chase of travelers’ checks, money orders, and

postage stamps. The Board has further deter-

mined that a bank holding company may pro-

vide data processing services that support the

use of credit cards by consumers in the direct

purchase of goods and services from a mer-

chant. (See 1995 FRB 492, 1990 FRB 549, and

1985 FRB 113.)

The data processing proposed in this case

involves the same type of data processing sup-

port as the Board has previously approved for

credit card transactions and other more tradi-

tional types of ATM transactions. The Board

thus concluded that the activities proposed by

the applicants are permissible, consisting of data

processing and transmission services encom-

passed within the Board’s Regulation Y, and are

thus closely related to banking within the mean-

ing of section 4(c)(8) of the Bank Holding Com-

pany Act. (See 1996 FRB 848.)

1. The tickets would include public transportation tickets

and tickets to entertainment events. Gift certiﬁcates and pre-

paid telephone cards would be issued in ﬁxed denominations

for a speciﬁc merchant or group of merchants, and they would

evidence prepayment of the purchase price of merchandise or

services to be selected by the bearer at some time in the

future. The ATM owners would also sell products that could

be offered for sale directly by a ﬁnancial institution, such as

mutual fund shares or insurance policies, where permitted by

applicable law.

BHC Supervision Manual June 1997

Page 1

Section 4(c)(8) of the BHC Act

(Engage in Transmitting Money) Section 3160.5

3160.5.1 ENGAGE IN TRANSMITTING

MONEY IN THE UNITED STATES

A bank holding company gave notice under

section 4(c)(8) of the Bank Holding Company

Act (BHC Act) (12 U.S.C. 1843(c)(8)) and sec-

tion 225.23 of the Board’s Regulation Y (12

C.F.R. 225.23) to engage de novo through two

companies (the companies) in the activity of

transmitting money for customers within the

United States and its territories (‘‘domestic money

transmission services’’) to third parties located

in foreign countries.

The activity was to be

conducted at ﬁrst through a network of approxi-

mately 1,200 ‘‘outside representative ofﬁces’’

located in California, Florida, Illinois, and Texas

that are under contract with the companies to

provide money transmission services.

The bank

holding company proposes to engage in the

planned activity nationwide. The companies are

corporations that currently engage in the busi-

ness of money transmission to Mexico through

representatives in California, Florida, Illinois,

and Texas.

Domestic money transmission services would

be provided in the following manner: A cus-

tomer would contact the companies directly by

means of a dedicated telephone located in the

outside representative ofﬁce to request that the

companies transmit funds to a third party for a

fee. The outside representative would collect

cash and a fee from the customer, issue a receipt,

and deposit funds in an account maintained by

the outside representative solely for the purpose

of receiving funds in trust to be transmitted to a

third party. The outside representative may main-

tain this account at any bank, including a subsid-

iary bank, but would have no agreement with

any bank to accept deposits on its behalf. Nei-

ther the outside representatives nor the compa-

nies would be FDIC-insured institutions.

The companies would collect funds deposited

in an outside representative’s account daily

through an automated clearinghouse (ACH) or

similar transaction and deposit an amount equal

to the amount to be transmitted into an account

they maintain at a bank, which may include one

of its subsidiary banks, located near the third

party receiving the funds. The third party would

be notiﬁed that money is available at a local

disbursement site, which could include a bank

subsidiary of the bank holding company or con-

sumer ﬁnance ofﬁce or an unafﬁliated check-

cashing, ﬁnance, or other type of ofﬁce. Funds

would be made available to the third party by a

check drawn on the companies’ account almost

immediately after the transmission order is placed

by the customer.

A customer would not transmit funds to any

bank account maintained by the customer or any

third party. Thus, the bank holding company

would not use this service to collect deposits for

customers of its subsidiary banks or any other

bank.

There was no agreement between a customer

and a bank to accept money in an account for

use by the bank in connection with the proposed

domestic money transmission services. The com-

panies and their outside representative would

accept money from a customer for the sole

purpose of transmitting funds to a third party. A

customer would not give funds to the companies

with the expectation that the companies would

permit the customer to reclaim the funds on

demand or after a period of time. Moreover, the

companies would not maintain balances or pay

interest on the money they receive, and they

would only hold funds long enough to transmit

them to the designated third party.

The Board previously determined that money

transmission abroad is closely related to bank-

ing.

The Ofﬁce of the Comptroller of the Cur-

rency (OCC) also has concluded that it is per-

missible for a national bank to accept money

from nonbank afﬁliates for the purpose of trans-

mitting the funds to a foreign country and that a

1. The Board previously approved the bank holding com-

pany’s acquisition of a company to engage in the activity of

transmitting funds to third parties in Mexico by using an

unafﬁliated foreign bank to make the cash payments. See

1995 FRB 974.

2. Outside representative ofﬁces would be expanded to

include consumer ﬁnance ofﬁces in addition to existing

grocery stores, travel agencies, pharmacies, and insurance

agencies.

3. The domestic money transmission services do not involve

lending money because only funds provided by the customer

would be transmitted to a third party. The plan does not

involve the paying of checks. Although the third party re-

ceives money by means of a check drawn on an account

maintained by the companies, the receipt of funds in check

form is not the payment of a check (see Independent Bankers

Ass’n of America v. Smith, 534 F.2d 921, 943–45 (D.C. Cir.

1976)).

4. Many states permit companies that are not chartered as

banks to transmit money without deeming this activity to

involve the taking of deposits. The bank holding company is

required to conduct the proposed activities in compliance with

licensing and other requirements of relevant state law.

5. See 1990 FRB 270.

BHC Supervision Manual December 1998

Page 1

nonbankafﬁliate that participates withthenational

bank in transmitting money abroad would not

become a branch of the bank.

Based on all the

facts of record and for the reasons discussed in

this and the Board’s previous orders, the Board

concludes that domestic money transmission

services are closely related to banking. The

Board has relied on the fact that the companies

are subject to licensing and examination by state

authorities.

The companies have committed to

comply with all applicable reporting require-

ments, including reporting all transactions over

$10,000 to the Internal Revenue Service. The

bank holding company committed to apply the

internal controls currently in place at the ﬁnan-

cial services company to ensure compliance

with the Bank Secrecy Act.

Based on the foregoing and all the facts of

record, the Board approved the notice on Octo-

ber 17, 1995 (see 1995 FRB 1130). The Board’s

decision was speciﬁcally conditioned on the

bank holding company’s complying with all the

commitments made in connection with the notice

and obtaining all necessary approvals from state

regulators.

6. The OCC has reasoned that nonbank ofﬁces that trans-

mit funds through a national bank to a third party do not

constitute ‘‘branches’’ under federal law.

7. This order was speciﬁcally conditioned on requiring the

bank holding company to obtain all necessary state licenses.

8. These procedures include a weekly review of all transac-

tions over $10,000. In addition, the companies will require

customer identiﬁcation,includingthecustomer’scurrentaddress

and occupation, for all transmissions above $3,000. The com-

panies also will run a computer match of all remitters and

recipients by name and Social Security number so that report-

ing requirements cannot be evaded by means of a series of

transactions.

Section 4(c)(8) of the BHC Act (Engage in Transmitting Money) 3160.5

BHC Supervision Manual December 1998

Page 2

Support Services—Printing and Selling

MICR-encoded items Section 3165.1

The Board has included within Regulation Y

(section 225.28(b)(10)(ii)(B)) the authority for

bank holding companies to engage in the print-

ing and selling of magnetic ink character recog-

nition (MICR)-encoded items as part of support

services. This activity includes this primary

activity and also the printing and selling of

corporate image checks, cash tickets, voucher

checks, deposit slips, savings withdrawal pack-

ages, and other forms that require MICR encod-

ing. The activity was initially authorized as a

permissible activity by Board order, whereby

such documents were to be printed for and sold

exclusively to depository institutions. The appli-

cant associated with that Board order proposed

to acquire a controlling interest in a printing

company that prints and sells checks and related

documents. It planned to engage in a joint ven-

ture with another company that engages in check

printing and other printing activities. The Board

concluded for that application that checks and

other MICR-encoded documents used in the

payments process are provided in specialized

form and that they are an integral part of a

fundamental banking service, and thus the activ-

ity is deemed closely related to banking. See

1986 FRB 794. The Board included the non-

banking activity in the Regulation Y ‘‘laundry

list,’’ effective April 1997.

BHC Supervision Manual December 1998

Page 1

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of

Bank Holding Companies) Section 3170.0

3170.0.1 INSURANCE ACTIVITIES

PERMISSIBLE FOR BANK HOLDING

COMPANIES

Before the enactment of the 1970 amendments

to the Bank Holding Company Act, the Board

by order authorized certain bank holding com-

panies to engage in insurance activities. The

speciﬁc type of permissible insurance activity

for each bank holding company was described

in its Board order. These few bank holding-

companies that commenced insurance agency

activities before January 1, 1971, have grand-

father rights under the current statutes and regu-

lations (section 4(c)(8)), exemption G and 12

(CFR 225.28(b)(11)(vii)). These bank holding

companies may, with the prior approval of the

Board, engage in general insurance agency

activities without restriction as to location or to

type of insurance sold. (See section 3170.0.3.7)

The 1970 amendments to the Bank Holding

Company Act authorized the Board to deter-

mine permissible nonbanking activities under

section 4(c)(8). Subsequently, on September 1,

1971, the Board amended Regulation Y to per-

mit bank holding companies to engage in cer-

tain insurance agency activities.

The Board further amended the section of

Regulation Y concerning permissible insurance

agency activities on September 1, 1981. The

1981 amendments limited permissible insurance

activities previously authorized by Regulation

Y. The ﬁrst amendment deleted from the Board’s

regulations the authority for bank holding com-

panies to act under section 4(c)(8) of the Bank

Holding Company as agent for the sale of insur-

ance for themselves and their subsidiaries. This

amendment reﬂected a court decision of the

United States Court of Appeals for the Fifth

Circuit that acting as agent for the sale of insur-

ance for the bank holding company and its

nonbanking subsidiaries was impermissible (per-

missible for banks, however). Such insurance is

permissible, however, if conducted pursuant to

section 4(c)(1)(C) of the BHC Act.

The second

1981 amendment deleted from the Board’s regu-

lations the authority to act as agent for insurance

sold as a matter of convenience to the public.

The opinion also found that the part of the

Board’s regulation relating to the sale of ‘‘con-

venience insurance’’

exceeded the scope of the

provisions of section 4(c)(8) of the Bank Hold-

ing Company Act. The sale of this other insur-

ance was considered impermissible.

On October 15, 1982, Congress enacted the

Garn–St Germain Depository Institutions Act

(Public Law 97-320). Title VI of that act amended

section 4(c)(8) of the Bank Holding Company

Act.This amendment statedthatinsurance agency,

brokerage, and underwriting activities are not

‘‘closely related’’ to banking within the mean-

ing of section 4(c)(8) of the Bank Holding Com-

pany Act. However, the amendment provided

for seven exceptions to the general prohibition

of bank holding companies engaging in insur-

ance activities. One of the seven exceptions

contains grandfather exemptions for insurance

agency activities conducted on May 1, 1982, or

for those insurance activities approved by the

Board on or before May 1, 1982. As a result,

bankholdingcompanies receivingBoard approval

on or before May 1, 1982, may continue to

engage in their insurance agency activities. (See

section 3170.0.3.4)

The seven types of insurance activities

allowed as permissible for bank holding compa-

nies are as follows:

1. Acting as agent, broker, or principal (i.e.,

underwriter) for credit-related life, accident

and health, or unemployment insurance.

2. For bank holding company ﬁnance subsidi-

aries, acting as agent or broker for credit-

related property insurance in connection with

loans not exceeding $10,000 ($25,000 in the

case of a mobile home loan) made by ﬁnance

company subsidiaries of bank holding com-

panies. (The Board interpreted this provision

as permitting only the sale of insurance that

does not exceed the outstanding balance of

the loan—vendor’s single interest insurance

rather than general property insurance that

covers the borrower’s equity interest.)

1. The Board’s Regulation Y was amended as of Decem-

ber 1983 to include the sale of insurance for a holding

company based on the services provision of section 4(c)(1)(C)

of the BHC Act, which did not require any prior Board

approval. Included in the regulation were the services of

selling, purchasing, or underwriting such insurance as blanket

bond insurance, group insurance for employees, and property

and casualty insurance for the bank holding company or its

subsidiaries.

2. ‘‘Convenience insurance’’ consisted of insurance that

was sold as a matter of convenience to the purchaser. The

premium income from the sale of this insurance was expected

to constitute less than 5 percent of the aggregate insurance

premium income of the holding company. The sale of this

insurance was not designed to permit entry into the general

insurance-agency business.

BHC Supervision Manual December 1997

Page 1

3. Acting as agent for the sale of any type of

insurance in a place with a population not

exceeding 5,000, or with insurance agency

facilities that the bank holding company dem-

onstrates to be inadequate.

4. Any insurance agency activity engaged in by

a bank holding company or its subsidiaries

on May 1, 1982 (or approved as of May 1,

1982), including (i) insurance sales at new

locations of the same bank holding company

or subsidiaries in the state of the bank hold-

ing company’s principal place of business or

adjacent states or any state or states in which

insurance activities were conducted by the

bank holding company or any of its subsidi-

aries on May 1, 1982, or, (ii) insurance cov-

erage functionally equivalent to those engaged

in or approved by the Board as of May 1,

1982.

5. Acting, on behalf of insurance underwriters,

as supervisor of retail agents who sell ﬁdelity

insurance and property and casualty insur-

ance on holding company assets or group

insurance for the employees of a bank hold-

ing company or its subsidiaries.

6. Any insurance agency activities engaged in

by a bank holding company having total

consolidated assets of $50,000,000 or less.

Life insurance and annuities sold under this

provision, however, must be authorized by

(1), (2), or (3) above.

7. Any insurance agency activity that is per-

formed by a registered bank holding com-

pany, which was engaged in some insurance

activity before January 1, 1971, pursuant to

the approval of the Board.

These seven types of insurance allowed by

the amendment to section 4(c)(8) of the Garn–

St Germain Act are generally consistent with

the types of insurance activities previously autho-

rized by the Board. The one general exception

related to the prohibition of the sale of property

and casualty insurance.

3170.0.2 INSURANCE AGENCY

ACTIVITIES

Insurance agency activities are among the most

widely practiced nonbank activities engaged in

by bank holding companies. Many bank holding

companies are involved in the sale of insurance

at some level in the organization; however, the

inspection focuses on these activities only when

performed by the parent company or by a non-

bank subsidiary (excluding bank-owned subsid-

iaries). Many of the smaller bank holding com-

panies engage directly in these activities rather

than through insurance agency subsidiaries. In

either arrangement, however, sales are usually

conducted on the premises of the subsidiary

bank by personnel who most often serve as

ofﬁcers or employees of the bank or parent

company.

Performance of insurance agency activities

has been proﬁtable for most bank holding com-

panies with many of the smaller companies rely-

ing heavily on the commissions generated to

service acquisition or other related indebted-

ness. In most cases, little or no expenditures for

ﬁxed assets are required since the premises of

the subsidiary banks or parent company are

utilized. Likewise, little or no liabilities are

incurred since there are minimal assets to be

ﬁnanced.

3170.0.3 PERMISSIBLE TYPES OF

COVERAGE INCLUDING

GRANDFATHER PRIVILEGES

As noted above, the Board, effective November

7, 1986, approved a revision of speciﬁc insur-

ance agency and underwriting activities permis-

sible for bank holding companies under section

4(c)(8) of the BHC Act (section 225.28(b)(11)

of Regulation Y). In clarifying the scope of

insurance activities that are closely related to

banking and permissible for bank holding com-

panies under the Garn–St Germain Act, the

Board included in its revised Regulation Y the

seven speciﬁc exemptions contained in that

statute.

3170.0.3.1 Insurance Activities

Permissible for Bank Holding Companies

per Section 225.28(b)(11)(i) of the

Board’s Regulation Y

Permissible insurance agency activities include

the sale of life, accident and health, and involun-

tary unemployment insurance that is directly

related to an extension of credit by a bank

holding company with respect to its own exten-

sions of credit and those of its subsidiaries. For

the purpose of determining what activities are

permissible, the Board interpreted the term

‘‘extension of credit’’ to include direct loans to

borrowers, loans purchased from other lenders,

and leases of real or personal property so long

as the leases meet all the criteria contained in

section 225.28(b)(3) of Regulation Y, which

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 2

deﬁnes leases as the functional equivalent of an

extension of credit. (See the discussion of leas-

ing in section 3140.0.)

The regulation requires that insurance cover-

age be limited to the ‘‘outstanding balance due’’

on an extension of credit. The ‘‘outstanding

balance due’’ is calculated as follows:

1. Include:

a. principal and interest

b. reasonable administrative fees outstand-

ing on the loan

c. the balance of payments due in a lease

transaction

2. Exclude:

a. the residual value of the leased item (since

the lessor owns the leased item and the

lessee is not obligated to purchase the

item by paying the residual value)

The insurance may provide for total repay-

ment of the extension of credit in the event of

the death of the borrower or for periodic pay-

ments on the extension of credit when the bor-

rower is temporarily disabled or unemployed.

Such single or periodic payments may not exceed

the balance on the loan and thus provide for

additional general life or accident coverage.

While ordinarily such credit-related insurance

coverage would be declining term as payments

reduce the balance due on an extension of credit

(loans in connection with ﬁrst mortgages), a

bank holding company may write or sell a level

term policy on nonamortizing loans. Policies

written or sold pursuant to this paragraph, more-

over, may be individual rather than group poli-

cies, and the premiums on such policies may be

age-related. The Board continues to require that

insurance policies sold or written to cover the

‘‘outstanding balance due’’ insure only named

borrowers or lessees of a particular bank hold-

ing company. Accordingly, such policies could

cover both spouses jointly only if both spouses

were actual borrowers or lessees under the

terms of the agreement with the bank holding

company.

The Board permits, with regard to an exten-

sion of credit, the sale and underwriting of

credit-related life, accident and health, and

involuntary unemployment insurance (1) with

respect to lease transactions, as previously dis-

cussed, when such lease transactions are the

equivalent of loans; (2) in connection with loans

secured by residential ﬁrst mortgages; and (3) in

connection with the servicing of loans origi-

nated or purchased by the applicant bank hold-

ing company and subsequently sold.

The regulation explicitly permits the sale of

life, disability, and involuntary unemployment

insurance with respect to a lease transaction,

provided the lease is the type of nonoperating,

full payout lease described as permissible for

bank holding companies in section 225.28(b)(3)

of Regulation Y. The Board has determined that

such leases are the ‘‘functional equivalent of an

extension of credit.’’ It believes that this type of

lease is encompassed in the term ‘‘extension of

credit’’ as it is used in exemption A of the

Garn–St Germain Act.

As discussed previously, the ﬁrst exemption

of the Garn–St Germain Act permits the sale

of any type of life, disability, and involuntary

unemployment insurance relating to an exten-

sion of credit, including home mortgage redemp-

tion insurance. Home mortgage insurance

insures the repayment of the unpaid balance of a

residential ﬁrst mortgage loan in the event of the

death or disability of the mortgagor. The Board

has determined that home mortgage redemption

insurance is closely related to banking because

it supports the lending function (1986 FRB 339

and 671) by providing for repayment of residen-

tial mortgage loans at a time when the death or

disability of the borrower may delay or disrupt

the scheduled repayment of such loans. Home

mortgage redemption insurance in connection

with residential mortgage loans is considered as

fulﬁlling the same function as credit life and

credit accident and health insurance with respect

to other types of loans. The Board recognized

that such insurance functions as credit insurance

in supporting a bank’s lending function (see

the Board’s approval for the sale of such insur-

ance by bank holding companies within 1975

FRB 45).

In approving the activity of home mortgage

redemption insurance by order, the Board previ-

ously relied on commitments by applicants to

inform, in writing, borrowers who are prospec-

tive purchasers of such insurance that home

mortgage redemption insurance is not required

and that, if desired, it may be purchased from

other sources. The Board has also relied on a

commitment for written notice to borrowers that

the insurance contract may be rescinded at any

time after the loan commitment is made and

before closing. The Board continues to require

that such notices be provided to borrowers. In

addition, the Board continues to rely on the fact

that premiums for such insurance are payable

periodically during the term of the extension of

credit, so as to increase the borrowers’ ability to

rescind the insurance and to limit premium

ﬁnancing as an incentive to sell such insurance.

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Page 3

The Board considers an ‘‘extension of credit’’

as covering loans that are made or purchased by

the bank holding company or its subsidiaries.

Credit-related insurance may be continued on

the loans that were sold, and are now only being

serviced, provided that they were made or pur-

chased by the bank holding company or its

subsidiaries. The Board permits bank holding

companies to sell credit-related life, accident

and health, and involuntary unemployment

insurance where the bank holding company pre-

viously placed funds at risk. In this situation, the

bank holding company must continue to limit its

insurance coverage to the outstanding balance

due on the extension of credit by the borrower.

A bank holding company may not sell or

underwrite insurance when merely servicing a

loan and it has never placed its funds at risk

either by originating or purchasing the loan; the

bank holding company is permitted to collect

and transmit insurance premiums, act as inter-

mediary in renewing existing policies or adjust-

ing coverages, and engage in other activities

which are incidental to the servicing of loans.

The bank holding company may collect a fee for

such services, providing that the fee is based on

the provision of the service and is not a pre-

mium for insurance sold. In that case, the bank

holding company would be engaging in loan

servicing rather than insurance activities.

3170.0.3.2 Section 225.28(b)(11)(ii) of

Regulation Y—Sale of Credit-Related

Property Insurance by Finance Company

Subsidiaries of a BHC

The Garn–St Germain Act restricts the authority

of bank holding companies to engage in prop-

erty and casualty insurance activities. Before

1982, the Board approved the sale of property

and casualty insurance that was directly related

to an extension of credit by a bank or bank-

related ﬁrm in the bank holding company sys-

tem. The sale of property insurance is now

limited to an extension of credit made by a

ﬁnance company that is a subsidiary of a bank

holding company, acting as agent or broker. A

ﬁnance company subsidiary may only engage in

the sale of such property insurance if—

1. the insurance is limited to assuring repay-

ment of the outstanding balance on such

extension of credit in the event of loss or

damage to any property used as collateral for

the extension of credit;

2. the extension of credit is not more than

$10,000, or $25,000 if it is to ﬁnance the

purchase of a residential manufactured home

and the credit is secured by the home; and

3. the applicant commits to notify borrowers in

writing that—

a. they are not required to purchase such

insurance from the applicant;

b. such insurance does not insure any interest

of the borrower in the collateral; and

c. the applicant will accept more comprehen-

sive property insurance in place of such

single interest insurance.

3170.0.3.2.1 Deﬁnition of a Finance

Company

A ‘‘ﬁnance company’’ for purposes of the sale

of property insurance includes all non-deposit-

taking ﬁnancial institutions that engage in a

signiﬁcant degree of consumer lending (exclud-

ing lending secured by ﬁrst mortgages) and all

ﬁnancial institutions speciﬁcally deﬁned by indi-

vidual states as ﬁnance companies that engage

in a signiﬁcant degree of consumer lending.

Finance companies, under this provision, include

those entities that may be authorized to accept

limited types of time or savings deposits under

state law but which a state has deﬁned to be a

ﬁnance company. Since exemption B of the

Garn–St Germain Act is directed to consumer

loans, the regulation requires that a qualifying

company be engaged in that type of lending to a

signiﬁcant degree as measured by either number

of loans, percentage of loans, percentage of loan

amounts outstanding, or some similar measure.

The Board will evaluate the amount of the con-

sumer lending on a case-by-case basis.

3170.0.3.2.2 Property Insurance a

Finance Company May Sell

Section 225.28(b)(11)(ii) of Regulation Y per-

mits ﬁnance company subsidiaries of bank hold-

ing companies to engage in the sale of single-

interest property insurance that insures against

damage or loss only to the extent of the lender’s

interest in the property that serves as collateral-

for a loan. The Garn–St Germain Act limits the

permissible insurance coverage to ‘‘the out-

3. These limitations increase at the end of each year, begin-

ning with 1982, by the percentage increase in the Consumer

Price Index for Urban Wage Earners and Clerical Workers

published by the Bureau of Labor Statistics.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 4

standing balance due on an extension of credit.’’

It does not contemplate general property insur-

ance that covers the entire value of the property,

including the balance due the lender and the

equity interest of the borrower/owner. Generally

such insurance is declining balance and the only

interest in the collateral property that may be

insured is that of the lender.

The sale of single-interest insurance is per-

mitted provided that the BHC ﬁnance company

subsidiary does not require such insurance of

borrowers who have adequate property insur-

ance on the loan collateral. In addition, the

ﬁnance company subsidiary is required to dis-

close in writing that such insurance, if required,

need not be purchased from the lender and that

such insurance does not cover the borrower’s

interest in the property. The requirement is also

imposed by the Board’s Regulation Z, section

226.4(d)(2), if the premium is excluded from

the ﬁnance charge.

3170.0.3.3 Section 225.28(b)(11)(iii) of

Regulation Y—Insurance in Small Towns

Engaging in any insurance activity is permitted

in a place where the bank holding company or a

subsidiary of the bank holding company has a

lending ofﬁce in a community that—

1. has a population not exceeding 5,000 (as

shown by the last preceding decennial cen-

sus) or

2. has inadequate insurance-agency facilities,

as determined by the Board, after notice and

opportunity for hearing.

In order to provide insurance agency activi-

ties in a town with a population not exceeding

5,000, or in a community that has inadequate

insurance agency facilities, the bank holding

company must have a lending ofﬁce that serves

the public in the small town. The regulation

speciﬁcally requires that the ofﬁce be a lending

ofﬁce in order to provide the bank holding com-

pany with a link to the town, to avoid remote

operation from a central location of a network

of small-town insurance agencies, and generally

to maintain insurance as a fee-generating activ-

ity to help sustain a small-town lending ofﬁce as

an independent, viable proﬁt center.

The current requirement does not limit the

sale of insurance to a ‘‘principal place of bank-

ing business’’ located in a community not

exceeding a population of 5,000. Also, a bank

holding company insurance agency is not pre-

cluded from selling insurance to those residing

outside the community who initiate the transac-

tion at the agency’s place of business in the

town of less than 5,000. Advertising in the

community newspaper or a telephone book that

may serve an area larger than the community of

5,000 is also not prohibited. The current regula-

tion requires that the bank holding company or a

subsidiary thereof establish or have a lending

ofﬁce in the community that has a population

not exceeding 5,000.

3170.0.3.4 Section 225.28(b)(11)(iv) of

Regulation Y—Insurance Agency

Activities Conducted on May 1, 1982

This provision of the regulation includes engag-

ing in any speciﬁc insurance agency activity

the bank holding company, or subsidiary con-

ducting the speciﬁc insurance agency activity,

conducted the insurance agency activity on

May 1, 1982, or received Board approval to

conduct the insurance agency activity on or

before May 1, 1982. Activities engaged in on

May 1, 1982, include activities carried on subse-

quently as the result of an application to engage

in such activities pending before the Board on

May 1, 1982, and approved subsequently by the

Board or as the result of an acquisition by such

company pursuant to a binding written contract

entered into on or before May 1, 1982, of

another company engaged in such activities at

the time of the acquisition.

A bank holding company or subsidiary

engaging in a speciﬁc insurance-agency activity

under section 225.28(b)(11)(iv) of Regulation Y

may—

1. engage in such speciﬁc insurance-agency

activity only at locations—

a. in the state in which the bank holding

company has its principal place of busi-

ness (as deﬁned in 12 U.S.C. 1842(d));

b. in any state or states immediately adjacent

to such state; and

c. in any state in which the speciﬁc insurance-

agency activity was conducted (or was

4. Nothing in paragraph (iv) precludes a BHC subsidiary

that is authorized to engage in a speciﬁc insurance-agency

activity under this clause from continuing to engage in the

particular activity after merger with an afﬁliate, if the merger

was for legitimate business purposes and prior notice has been

provided to the Board.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 5

approved to be conducted) by such bank

holding company or subsidiary thereof or

by any other subsidiary of such bank hold-

ing company on May 1, 1982; and

2. provide other insurance coverages that may

become available after May 1, 1982, so long

as those coverages insure against the types of

risks as (or are otherwise functionally equiva-

lent to) coverages sold or approved to be sold

on May 1, 1982, by such bank holding com-

pany or subsidiary.

This provision of the regulation parallels

exemption D of the Garn–St Germain Act and

grandfathers those insurance agency activities in

which individual bank holding companies were

engaged on May 1, 1982. Under this provision,

a bank holding company or subsidiary thereof

may continue to engage in particular types of

insurance agency activities that were permis-

sible before the passage of the Garn–St Germain

Act but which are now prohibited by that act. A

qualifying bank holding company may engage,

for example, in the sale of property and casualty

insurance on property serving as collateral for

loans made by a lending subsidiary of the hold-

ing company.

A qualifying bank holding company may

also engage in grandfathered insurance related

to the provision of ‘‘other ﬁnancial services’’

previously authorized under section

225.28(b)(11)(i)(B) of Regulation Y. This type

of insurance is not considered to be related to an

extension of credit under the Garn–St Germain

Act. As a result, the Board no longer permits the

sale of insurance related to the provision of the

general ﬁnancial services offered by a bank or

bank-related ﬁrm. Such insurance included, for

example, insurance on the contents of safe deposit

boxes, or savings completion insurance on cer-

tiﬁcates of deposit, Christmas club accounts,

individual retirement accounts, tuition comple-

tion plans, or credit-related insurance for ser-

viced loans. Prior to the Garn–St Germain Act,

insurance related to the provision of general

ﬁnancial services was permitted to be sold to

borrowers whose loans were neither purchased

nor originated, but may have been serviced by

the bank holding company. Insurance with respect

to loan servicing was the primary type of insur-

ance previously permitted by the Board as related

to such ﬁnancial services. Now, the Garn–St

Germain Act limits the sale of insurance by

bank holding companies in general to insurance

related to an extension of credit.

3170.0.3.4.1 Limitations on Expansion of

Grandfather Rights

Exemption D provides for limited expansion of

grandfathered insurance agency activities in order

to permit qualifying bank holding companies to

remain effective insurance agent competitors.

The exemption presented three issues that the

Board resolved in paragraph (iv) of the regula-

tion: (1) deﬁning which subsidiaries of a bank

holding company may engage in otherwise

impermissible insurance agency activities under

exemption D; (2) the scope of permissible geo-

graphic expansion; and (3) the scope of product-

line expansion.

Speciﬁc Subsidiaries That May Engage in

Grandfathered Activities

Grandfather rights do not inure to the beneﬁt of

the entire holding company system by virtue of

the fact that a particular subsidiary was engaged

in insurance agency activities before May 1,

1982. Only the subsidiary of the bank holding

company that was engaged in insurance activi-

ties on May 1, 1982, or received Board approval

to engage in insurance activities before May 1,

1982, has grandfather status.

The Board believes that the emphasis in the

legislative history on the transfer of grandfather

rights shows the intent of Congress to prohibit

not only the transfer of such rights from ‘‘grand-

fathered’’ subsidiaries to those afﬁliates wholly

without grandfather rights, but also to prohibit

the transfer of grandfather rights with respect to

particular kinds of insurance from one ‘‘grand-

fathered’’ subsidiary to another. Thus, a subsidi-

ary that sold only credit life insurance before the

grandfather date should not acquire grandfather

rights to sell property and casualty insurance

solely because an afﬁliate sold property and

casualty insurance before the grandfather date.

The grandfather rights of a particular subsidiary

are limited to the precise activities (or their

functional equivalent) engaged in before May 1,

1982. This requirement does not preclude the

transfer of grandfather rights in the case of a

bona ﬁde merger (1983 FRB 554, 555).

Section 225.28(b)(11) of the Board’s Regula-

tion Y is only intended to clarify the exemptions

in title VI of the Garn–St Germain Act. It does

not authorize any bank holding company to

commence any insurance activity, or to acquire

a company with insurance activities, without

compliance with the notice and application

requirements of section 4(c)(8) of the BHC Act.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

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Page 6

Geographic Expansion by a Grandfathered

Subsidiary of a Bank Holding Company.

The language of exemption D of the Garn–

St Germain Act, while limiting the grand-

fathered activities to those agency activi-

ties conducted by the speciﬁc grandfathered

subsidiary, does allow expansion into states

where such speciﬁc types of agency activities

‘‘were conducted by the bank holding company

or any of its subsidiaries on May 1, 1982 . . .’’ If

a bank holding company subsidiary is selling

a particular type of insurance in a given

state, the Board does not believe there is

any regulatory or business purpose served by

restricting another grandfathered subsidiary

from engaging in the same activity in the same

location.

Product-Line Expansion

The Board’s regulation provides for product-

line expansion. A grandfathered subsidiary of

a bank holding company may seek approval

from the Board to engage in the sale of

new types of insurance that protect against the

same types of risks as, or are otherwise function-

ally equivalent to, insurance sold on the grand-

father date.

3170.0.3.4.2 Transfer of Grandfather

Rights among Subsidiaries

A grandfathered subsidiary of a bank holding

company (or its successor) may retain its

grandfather rights after merger with an afﬁliate,

if such merger is based on legitimate business

concerns, for example, centralized management

or increased efﬁciency, rather than as a means of

extending insurance powers. The regulation fur-

ther provides that bank holding companies must

advise the Board before any such merger for

legitimate business purposes in order to conﬁrm

the transfer of grandfather rights.

3170.0.3.5 Section 225.28(b)(11)(v) of

Regulation Y—Bank Holding Company’s

Insurance Coverage for Internal

Operations

The Garn–St Germain Act approved, and the

revised Regulation Y included, insurance agency

activities where the activities are solely limited

to supervising on behalf of insurance underwrit-

ers the activities of retail insurance agents who

sell—

1. ﬁdelity insurance and property and casualty

insurance on the real and personal property

used in the operations of the bank holding

company or its subsidiaries and

2. group insurance that protects the employees

of the bank holding company or any of its

subsidiaries.

This provision of Regulation Y is reﬂective

of an intent on the part of Congress to avoid

preempting certain practices permissible under

Texas law. This insurance relates to a particular

situation that may have little applicability

elsewhere.

3170.0.3.6 Section 225.28(b)(11)(vi) of

Regulation Y—Small Bank Holding

Companies

The Board has determined in section

225.28(b)(11)(vi) of its Regulation Y that

engaging in any insurance agency activity is

permissible if the bank holding company has

total consolidated assets of $50 million or less.

A bank holding company performing insurance

agency activities under this paragraph may not

engage in the sale of life insurance or annuities

except as provided in section 225.28(b)(11)(i)

and (iii) of Regulation Y, and it may not con-

tinue to engage in insurance agency activities

pursuant to that provision more than 90 days

after the end of the quarterly reporting period in

which total assets of the holding company and

its subsidiaries exceed $50 million.

A bank holding company is required to cease

general insurance-agency activities pursuant to

this provision within 90 days after the end of the

quarterly reporting period in which the bank

holding company’s total assets exceed $50 mil-

lion. Thereafter, the bank holding company may

continue to engage in the sale of insurance

pursuant to other exemptions.

3170.0.3.7 Section 225.28(b)(11)(vii) of

Regulation Y—Insurance Agency

Activities Conducted before 1971

The Board has determined in section

225.28(b)(11)(vii) of its Regulation Y that any

insurance agency activity performed at any loca-

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 7

tion in the United States directly or indirectly by

a bank holding company that was engaged in

insurance agency activities before January 1,

1971, as a consequence of approval by the

Board before January 1, 1971, is permissible.

3170.0.3.7.1 Agency Activities

The Board adopted a position in section

225.28(b)(11)(vii)permitting any qualifying bank

holding company to engage in general insurance-

agency activities without restriction as to loca-

tion or to type of insurance sold (1985 FRB 171

and 1984 FRB 235, 470). A company qualiﬁes

under this provision if it was engaged in insur-

ance agency activities as a consequence of Board

approval before January 1, 1971. A very limited

number of active bank holding companies

received such Board approval in the period from

passage of the BHC Act in 1956 until January 1,

1971.

The regulation does not limit the insurance

agency activities of a qualifying company by

requiring that the company engage only in the

sale of such types of insurance as it sold before

1971 from such locations as it conducted insur-

ance agency activities before 1971. The Board’s

regulation permits the limited number of quali-

fying companies to engage in general insurance-

agency activities pursuant to exemption G

regardless of their precise insurance agency

activities before 1971 (1985 FRB 171 and 1984

FRB 470).

3170.0.4 INCOME FROM THE SALE

OF CREDIT LIFE INSURANCE

3170.0.4.1 Policy Statement on Income

from Sale of Credit Life Insurance

Effective May 1, 1981, the Board adopted a

policy statement (1981 FRB 431) generally pro-

hibiting employees, ofﬁcers, directors, or others

associated with a state member bank from prof-

iting personally from the sale of life insurance

in connection with loans made by the bank.

The bank may, however, allow their employ-

ees and ofﬁcers to participate in the income

under a bonus or incentive plan not to exceed

5 percent of the recipient’s annual salary.

Income from the sale of credit-related life

insurance should most appropriately be

credited to the bank, or alternately to a bank

holding company or other afﬁliate of the bank

so long as the bank receives reasonable compen-

sation for its role in selling the insurance. As a

general rule, ‘‘reasonable compensation’’ means

an amount equivalent to at least 20 percent of

the afﬁliate’s net income attributable to the

bank’s credit life insurance sales. (Insurance

agency activities engaged in directly by a

bank subsidiary are regulated by the chartering

authority. However, intercompany transactions

should be reviewed by BHC inspection

personnel.)

3170.0.4.2 Disposition of Credit Life

Insurance Income

The Comptroller of the Currency has issued a

regulation dealing with sales of credit life, health,

and accident insurance by national banks which

prohibits transfer of insurance commissions to

an afﬁliate of the bank unless commission income

in proportion to the shares held by the bank’s

minority shareholders is placed in trust and paid

to them periodically. Where the subsidiary bank

is wholly owned by a bank holding company,

however, the regulation allows the commissions

to be credited to the holding company or to its

wholly owned subsidiaries (12 C.F.R. 2).

3170.0.5 INSPECTION OBJECTIVES

1. To determine the extent of insurance opera-

tions and the overall condition of subsidi-

aries engaged in insurance agency and under-

writing activities.

2. To determine whether the types of insurance

sold are in accordance with the provisions of

section 225.28(b)(11) of Regulation Y.

3. To determine the impact of the performance

of the activities on the parent bank holding

company and its subsidiaries.

4. To suggest corrective action when necessary

in the areas of policies, procedures, or laws

and regulations.

3170.0.6 INSPECTION PROCEDURES

Where the insurance activities are performed

through an insurance agency or underwriting

subsidiary, perform the following activities:

1. Compare the company’s general ledgers with

statements prepared for the latest FR Y-6 and

the annual report to the state insurance

department.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 8

2. Review minutes of the board of directors

meetings.

3. Review the activity’s compliance with the

Board’s policy statement on income from the

sale of credit life insurance (See section

3170.0.4.1) and the Comptroller of the Cur-

rency’s regulation dealing with the sales of

credit life, health, and accident insurance by

national banks (12 C.F.R. 2).

4. Review any agreements, guarantees, or

pledges between the subsidiary and its parent

holding company or afﬁliates.

Where the insurance activities are performed

through an insurance agency or underwriting

subsidiary or directly by the parent company,

perform the following procedures:

1. Obtain copies of insurance policies issued to

determine that the types and terms of insur-

ance coverage sold are within the scope of

those permitted by the Board under section

225.28(b)(11) of Regulation Y.

2. Check for compliance with section 106(b) of

the 1970 Amendments to the BHC Act (pro-

hibition against tie-in arrangements).

3170.0.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

General description of permissible

insurance agency and underwriting

activities

225.28(b)(11) 4–050.1 1986 FRB 829

Garn–St Germain Depository

Institutions Act, title VI amending

section 4(c)(8) of the BHC Act

1843(c)(8)

Insurance agency activities

permitted for national banks

Section 13,

paragraph 11

of the Federal

Reserve Act

Permissibility of some types of

mortgage insurance

40 Federal

1975 FRB 45

1975 FRB 678

Impermissibility of mortgage

guarantee insurance

40 Federal

Court review of activity 533 F. 2d 224

(5th Circuit, 1976)

558 F. 2d 729

(5th Circuit, 1977)

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 9

Subject Laws

Regulations

Interpretations

Orders

Level term credit life insurance 39 Federal

39 Federal

40 Federal

Permissible insurance coverage

limited to actual debtors

39 Federal

Sale of home mortgage redemption

insurance

1986 FRB 339,

671

1975 FRB 45

Joint credit life insurance 39 Federal

1974 FRB 138

Tie-in arrangements Section 106(b)

of the Bank

Holding

Company Act

Amendments

of 1970

225.7 38 Federal

1975 FRB 693,

678, 686

Permissibility of selling insurance

in small communities

44 Federal

Policy statement on income from

sale of credit life insurance

3–1556 1981 FRB 431

Transfer of insurance agency

grandfather rights in the case of a

bona ﬁde merger

1983 FRB 554,

555

Permissibility of credit-related property

and casualty insurance activities

1984 FRB 452

Insurance agency activities conducted

before 1971—BHCs permitted to

engage in insurance agency activities

without restriction as to location or to

type of insurance sold

1985 FRB 171

1984 FRB 235,

470

General insurance-agency subsidiary

qualiﬁes for grandfather privileges

under exemption D of the Garn–St

Germain Act; grandfather privileges

do not terminate upon its acquisition

by a nongrandfathered BHC

1987 FRB 276,

672

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Insurance Agency Activities of BHCs) 3170.0

BHC Supervision Manual December 1997

Page 10

Section 4(c)(8) of the BHC Act

(Insurance Underwriters) Section 3180.0

3180.0.1 INSURANCE

UNDERWRITING ACTIVITIES

On December 11, 1972, after consideration of

a public hearing held on March 24, 1972, the

Board amended Regulation Y to add the activity

of underwriting credit life insurance and credit

accident and health insurance to the list of

activities in which a bank holding company may

engage, provided that such insurance is directly

related to an extension of credit by the holding

company system. Such insurance ensures a bank

or bank-related ﬁrm of repayment of a credit

extension in the event of death or disability

while at the same time providing the borrower

with ﬁnancial security in either event. In approv-

ing this activity, the Board set forth, in a foot-

note to Regulation Y, requirements to ensure

that performance of the activity would result in

demonstrable beneﬁts to the public. The Board

stated that applications to engage in underwrit-

ing activities would be approved only in cases

in which the applicant demonstrates that such

approval would beneﬁt the consumer or result in

other public beneﬁts and that normally such a

showing would be made by a projected reduc-

tion in rates charged the public for the insurance

or an increase in other public beneﬁts resulting

from bank holding company performance of this

service.

On October 3, 1986, the Board adopted a

revision of the provisions of Regulation Y that

deals with permissible insurance agency and

underwriting activities for bank holding compa-

nies. The general revision of the insurance pro-

visions of Regulation Y combined both the

insurance agency and insurance underwriting

activities reﬂects amendments to the Bank Hold-

ing Company Act by the Garn–St Germain

Depository Institutions Act of 1982. The revi-

sion of the provisions relating to insurance

underwriting eliminated the rate-reduction

requirement that previously applied to those

companies engaged in the underwriting of credit

life, credit accident and health, and involuntary

unemployment insurance. Accordingly, bank

holding companies engaging in this activity may

charge premiums as permitted by the states.

In order for insurance underwriting (includ-

ing home mortgage redemption insurance) to be

permissible in accordance with section

225.28(b)(11) of the Board’s revised Regulation

Y, the insurance must—

1. be directly related to an extension of credit

by the bank holding company or any of its

subsidiaries and

2. be limited to ensuring the repayment of the

outstanding principal balance due on the

extension of credit in the event of the death,

disability, or involuntary unemployment of

the debtor.

3180.0.1.1 Insurance Underwriting

Activities Permissible for Bank Holding

Companies per Section 225.28(b)(11)(i)

of the Board’s Regulation Y—Credit

Insurance

The Board permits the insurance underwriting

activities described above as well as the insur-

anceagencyactivities describedin section 3170.0.

In section 225.28(b)(11)(i) of Regulation Y,

the Board issued three signiﬁcant interpretations

of the term ‘‘extension of credit’’ as contained

in the Garn–St Germain Act. It permits the

underwriting of credit-related life, accident and

health, and involuntary unemployment insur-

ance (1) with respect to lease transactions where

such lease transactions are the equivalent of

loans (leasing is addressed in section 3140.0),

(2) in connection with loans secured by residen-

tial ﬁrst mortgages, and (3) in connection with

the servicing of loans originated or purchased

by the applicant bank holding company and

subsequently sold.

Permissible insurance underwriting requires

that the credit insurance must be directly related

to an extension of credit by the bank holding

company or any of its subsidiaries. An ‘‘exten-

sion of credit’’ includes direct loans to borrow-

ers, and the lease of real or personal property,

and loans purchased from other lenders. The

ﬁrst signiﬁcantinterpretation, notedabove,allows

the inclusion of leasing personal or real prop-

erty, provided the lease is a nonoperating and

full-payout lease, the insurance ensuring the

payment of the remaining lease payments that

are due in the event of the death, disability, or

involuntary unemployment of the lessee.

1. ‘‘Extension of credit’’ includes direct loans to borrow-

ers, loans purchased from other lenders, and leases of real or

personal property so long as the leases are nonoperating and

full-payout leases.

BHC Supervision Manual December 1997

Page 1

The interpretation thus deﬁnes leases as the

functional equivalent of an extension of credit.

The second interpretation in paragraph (i)

of the regulation involving the deﬁnition of

‘‘extension of credit’’ is the permissibility of

underwriting home mortgage insurance, which

ensures the repayment of the unpaid balance of

a residential ﬁrst mortgage loan in the event of

the death or disability of the mortgagor. Exemp-

tion A of the Garn–St Germain Act permits the

underwriting of any type of life, disability, and

involuntary unemployment insurance related to

an extension of credit by a bank holding com-

pany as long as the face value of the insurance

policy does not exceed the ‘‘outstanding balance

due’’ on the extension of credit. The Board

continues to require that insurance policies writ-

ten insure only named borrowers or lessees of a

particular bank holding company. Such policies

could cover both spouses jointly, but only if

both spouses were actual borrowers or lessees

under the terms of the agreement with the bank

holding company (see 1974 FRB 138).

The Board had previously held that the under-

writing of home mortgage insurance is not closely

related to banking in part because it is more like

general life insurance than credit life insurance

and in part because banks have not generally

underwritten such insurance (see 1980 FRB 660

and 1982 FRB 318). Recently, however, the

Board permitted bank holding companies to

underwrite such insurance (see 1986 FRB 339

and 1986 FRB 671). In permitting this activity

by order, the Board provided detailed ﬁndings

that the underwriting of home mortgage

redemption insurance is permitted by exemption

A of the Garn–St Germain Act, is closely related

to banking, and does not present the possibility

of such signiﬁcant adverse effects that it should

not be added to the list of activities permissible

for bank holding companies. The Board also

found that home mortgage insurance supports

the lending function. The Board thus believes,

for the reasons cited in the above-cited orders,

that the underwriting of home mortgage

redemption insurance is permissible for bank

holding companies.

In approving the underwriting of home mort-

gage insurance by order, the Board relied on

commitments by applicants to inform, in writ-

ing, borrowers who are prospective purchasers

of such insurance that home mortgage redemp-

tion insurance is not required and that, if desired,

it may be purchased from other sources. The

Board has also relied on a commitment for

written notice to borrowers that the insurance

contract may be rescinded at any time after the

loan commitment is made and before closing. In

processing applications to engage in the under-

writing of home mortgage redemption insurance

pursuant to the current regulation, the Board,

and the Reserve Banks acting pursuant to del-

egated authority, will continue to require that

such notices be provided to borrowers. In addi-

tion, the Board will continue to rely on the fact

that premiums for such insurance are payable

periodically during the term of the extension of

credit, so as to increase the borrower’s ability to

rescind the insurance and to limit premium

ﬁnancing as an incentive to sell and underwrite

such insurance.

A third signiﬁcant interpretation of the term

‘‘extension of credit’’ found in exemption A of

the Garn–St Germain Act involves the under-

writing of insurance in connection with the ser-

viced loans (see section 3170.0.3.1) The Garn–

St Germain Act limits bank holding companies

in general to insurance related to an extension of

credit. The term ‘‘extension of credit’’ is used in

exemption A to describe transactions in which

the funds of the bank holding company or its

subsidiaries have been placed at risk, including

direct loans or leases or loans that have been

purchased. Loans that are merely being serviced

by the bank holding company generally would

not be covered by this deﬁnition.

The underwriting of insurance on loans being

serviced is necessary only when the term of the

insurance was originally shorter than that of the

loan. The bank holding company that is selling

and underwriting insurance on the loan that it

originated and is servicing is, in effect, only

extending the term of its original insurance pol-

icy to be coterminous with the duration of the

loan. It is providing insurance that it could have

provided previously. A bank holding company

may not underwrite insurance in the case where

it is merely servicing a loan and it has never

placed its funds at risk either by originating or

purchasing the loan.

3180.0.2 LIMITED PROPERTY

INSURANCE RELATED TO AN

EXTENSION OF CREDIT (FINANCE

COMPANY SUBSIDIARY OF A BANK

HOLDING COMPANY)

The Board’s revised regulation does not permit

the underwriting of this type of insurance. See

section 225.28(b)(11)(ii) of Regulation Y and

section 3170.0.3.1 for information on autho-

rized insurance agency activities.

Section 4(c)(8) of the BHC Act (Insurance Underwriters) 3180.0

BHC Supervision Manual December 1997

Page 2

3180.0.3 INSURANCE ACTIVITIES

BEFORE 1971

The Board’s revised regulation (section 225.28(b)

(11)(vii)), as it relates to exemption G of the

Garn–St Germain Act, does not authorize under-

writing activities for bank holding companies.

See section 3170.0.3.7 for information on the

respective authorized insurance-agency activi-

ties under exemption G.

3180.0.4 UNDERWRITING AS

REINSURER

The majority of bank holding company subsidi-

aries engaged in insurance underwriting are

reinsurers rather than direct underwriters. As

reinsurer, these companies engage a direct insurer

to issue the policies, collect the premiums, pay

claims, maintain accounting books and records,

prepare federal and state tax returns, and per-

form other services necessary to conduct the

insurance activities. Usually, such reinsurance

companies will have executed a reinsurance

agreement and a service agreement with the

direct underwriter which spell out all services to

be performed and set the fees to be paid for such

services. The above arrangement involves a

minimum of activity by the reinsurer and is

probably most often chosen by bank holding

companies since it does not place additional

burdens on management and precludes hiring

actuaries and other professional personnel to

manage the insurance company.

There are many ratios or measures used to

evaluate the condition of insurance underwrit-

ers. The National Association of Insurance Com-

missioners has developed a system consisting of

nine ratios that measure various aspects of life

and health insurance companies’ ﬁnancial con-

dition and stability (The Early Warning System

for Life and Health Insurance Companies). These

tests establish benchmarks which are likely to

distinguish between troubled and sound compa-

nies. The examiner may wish to compare the

subject company’s ratios to these benchmarks.

When making comparisons, however, the exam-

iner should recognize that one insurer may require

a somewhat better ratio than another due to

greater underwriting andinvestment risks.Smaller

companies will generally maintain a proportion-

ately larger surplus account since loss experi-

ence on a small volume of business tends to

ﬂuctuate more widely.

Another possible source of information avail-

able to help determine a company’s condition is

Best’s Insurance Reports. The report is pub-

lished annually and provides pertinent ﬁnancial

and historical data for legal reserve life insur-

ance companies operating in the United States

and Canada. It assigns a rating for each com-

pany in the report. Information presented in the

report is taken from annual statements ﬁled with

the state insurance departments. It should be

noted that reports ﬁled with the insurance

departments are prepared using the statutory

method of ﬁnancial accounting and presentation

rather than generally accepted accounting prin-

ciples. Beginning in 1973, insurance companies

were required to adhere to generally accepted

accounting principles for certiﬁcation of ﬁnan-

cial statements (see Audits of Stock Life Insur-

ance Companies, American Institute of Certi-

ﬁed Public Accountants), however, they continue

to report under the statutory method to the state

insurance departments. The statutory method is

basically a cash-basis accounting presentation

which generally depicts a more conservative

position. Certain assets are ‘‘not admitted’’ by

regulatory authorities in the ﬁnancial presenta-

tion because they are not readily convertible

into cash for the payment of claims and expenses.

Policy reserves represent the primary liability

portion of underwriters’ balance sheets. There

are several acceptable methods permitted by

state authorities for calculating these reserves.

Most of these methods are rather complicated

and a description of their calculation is beyond

the scope of this manual. However, insurance

companies are generally closely regulated by

state authorities, which place primary impor-

tance on determining the adequacy of the policy

reserves. A review of the latest available insur-

ance examination report should give an evalua-

tion of the adequacy of the reserves.

Reinsurance arrangements may distribute the

insurance and losses in many different ways

between the direct insurer and the reinsurer. An

understanding of such arrangements is essential

in determining the extent of risk incurred by the

company being inspected.

3180.0.5 INSPECTION OBJECTIVES

1. To determine the extent of underwriting

activities and the overall condition of subsid-

iaries engaged in underwriting.

2. To determine whether the activities per-

formed are within the scope of those permit-

ted under section 225.28(b)(11) of Regula-

tion Y.

Section 4(c)(8) of the BHC Act (Insurance Underwriters) 3180.0

BHC Supervision Manual December 1997

Page 3

3. To determine the impact of the underwriting

operations on the parent bank holding com-

pany and its subsidiaries.

4. To suggest corrective action where necessary

in the areas of policies, procedures, or laws

and regulations.

3180.0.6 INSPECTION PROCEDURES

Where the insurance underwriting activities are

performed through an underwriting subsidiary,

perform the following procedures:

1. Compare the company’s general ledgers with

statements prepared for the latest FR Y-6.

(Generally, records are maintained on the

statutory accounting basis and are more eas-

ily tied to the ﬁnancial statements in the

annual report to the state insurance

department).

2. Review minutes of the board of directors

meetings.

3. Review the quality and liquidity of the sub-

sidiary company’s investments in CDs, stocks,

bonds, or other marketable securities.

4. Review intercompany transactions, including

balances maintained with or assets purchased

from afﬁliated banks.

5. Reviewany agreements, guarantees,or pledges

between the company and its parent holding

company or afﬁliates.

Where the insurance activities are performed

either directly or through an underwriting sub-

sidiary, perform the following procedures:

1. Review copies of any reinsurance and/or ser-

vice agreements executed with other insurance

companies.

2. Review the latest annual report submitted to

the state insurance department.

3. Review the latest report of examination pre-

pared by the state insurance department.

4. Check calculation of premium charges by a

random sample of policies for adherence to

the state rate structure.

5. Obtain copies of insurance policies issued to

customers to determine that the types of

insurance coverage and terms offered are

within the scope of those permitted under

section 225.28(b)(11) of Regulation Y.

3180.0.7 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Permissible underwriting

activities

12 U.S.C.

1843(c)(A)–(G)

225.28(b)(11) 4–050.1

Underwriting of permissible

credit-related home

mortgage insurance

1986 FRB 671,

339

Nonpermissibility of

mortgage guarantee

insurance

1974 FRB 727

Underwriting of joint credit

life insurance

4–337 39 Federal

1974 FRB 138

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Insurance Underwriters) 3180.0

BHC Supervision Manual December 1997

Page 4

Section 4(c)(8) of the BHC Act

(Courier Services) Section 3190.0

Courier activities are permissible for bank hold-

ing companies if the items being transported by

the courier are themselves related to bank opera-

tions. Examples of such items are drafts, money

orders, travelers’ checks, commercial papers,

written instruments, and data processing mate-

rial. Currency and bearer-type negotiable instru-

ments which require more than normal security

measures may not be transported by the company.

If the courier company operates under the

exemptive provision of section 4(c)(8) of the

Bank Holding Company Act, the following

restrictions are placed on its operations to ensure

competition:

1. The company must be a separate, indepen-

dent corporate entity.

2. The company must be proﬁt-oriented and not

subsidized by the holding company system.

3. Services of the company must be performed

on a speciﬁc-fee basis with direct payment

from the customer. Payment may not be

made indirectly such as through maintenance

by the customer of deposit balances at an

afﬁliated bank.

4. Upon request, the company must furnish

comparable services at comparable rates to

ﬁrms which compete with banking or data

processing subsidiaries of its parent com-

pany, unless compliance with the request

would be beyond the practical capacity of the

company.

The last restriction was intended to prevent

use of bank-afﬁliated courier services for the

purpose of gaining an advantage over competi-

tors to whom courier services were not other-

wise available.

3190.0.1 INSPECTION OBJECTIVES

1. To determine if the company is operating in

compliance with applicable laws and regula-

tions, and ensure that corrective action will

be taken, if appropriate.

2. To determine if courier services are provided

to competing institutions upon their

request if courier services are not otherwise

available.

3190.0.2 INSPECTION PROCEDURES

1. Determinewhetherthe company makes known

to its customers its minimum rate schedule

for services and its general pricing policies.

2. Determine whether the company maintains

for a period of two years or more the records

of each request for service which it has

denied to ﬁrms competing with the banking

and data processing subsidiaries of its parent

company. The reasons for the denial must

also be recorded and maintained for a like

period.

3. Review income statements of the company

to ascertain whether the company is operat-

ing proﬁtably, without a subsidy in any man-

ner from any entity within the holding com-

pany system. Any operating losses sustained

over an extended period of time are inconsis-

tent with continued authority to engage in

courier services.

4. Determine whether the materials transported

by the company are restricted to those which

would normally be exchanged among banks

and banking institutions, including audit and

accounting media of a banking or ﬁnancial

nature, and other business records or docu-

ments used in processing such media.

BHC Supervision Manual December 1997

Page 1

3190.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Courier activities of bank

holding companies

225.28(b)(10) 1973 Fed.

Reg. 32136

1975 Fed.

Reg. 36309

Conditions of entry into

courier activities

225.129 4–180

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Courier Services) 3190.0

BHC Supervision Manual December 1997

Page 2

Section 4(c)(8) of the BHC Act

(Management Consulting and Counseling) Section 3200.0

On February 26, 1974, the Board amended

Regulation Y to permit bank holding companies

to engage in the activity of providing bank

management consulting services to nonafﬁliated

commercial banks. The advisee institution must

be a ‘‘bank’’ as that term is deﬁned by section

2(c) of the BHC Act or an operations subsidiary

of such an institution. (See 12 C.F.R. 250.141.)

Effective April 20, 1982, the Board expanded

this activity by permitting holding companies to

provide management consulting advice to non-

bank depository institutions. When expanding

the activity to include management consulting

advice to nonbank depository institutions, the

Board indicated that the advisory services pro-

vided to nonbank institutions should generally

be the services that were then being provided to

banks.

Effective April 21, 1997, management con-

sulting was expanded in Regulation Y (section

225.28(b)(9)) to allow bank holding companies

to provide management consulting services to

any customer on any matter so long as the total

annual revenue derived from third-party man-

agement consulting services by a nonbank sub-

sidiary of the bank holding company is less than

30 percent of the subsidiary’s total annual rev-

enues derived from all management consulting

activities. The Board continues to view ‘‘man-

agement consulting’’ as including, but not lim-

ited to, providing analysis or advice as to a

ﬁrm’s—

1. purchasing operations, such as inventory con-

trol, sources of supply, and cost minimiza-

tion subject to constraints;

2. production operations, such as quality con-

trol, work measurement, product methods,

scheduling shifts, time and motion studies,

and safety standards;

3. market operations, such as market testing,

advertising programs, market development,

packaging, and brand development;

4. planning operations, such as demand and

cost projections, plant location, program plan-

ning, corporate acquisitions and mergers, and

determination of long-term and short-term

goals;

5. personnel operations, such as recruitment,

training, incentive programs, employee com-

pensation, and management-personnel rela-

tions;

6. internal operations, such as taxes, corporate

organization, budgeting systems, budgeting

control, evaluation of data processing sys-

tems, and efﬁciency evaluations; and

7. research operations, such as product develop-

ment, basic research, and product design and

innovation.

By interpretation, the Board previously deter-

mined that it considers bank management con-

sulting advice to include, but not be limited to,

advice concerning (1) bank operations, systems,

and procedures; (2) computer operations and

mechanization; (3) implementation of electronic

funds transfer systems; (4) site planning and

evaluation; (5) bank mergers and the establish-

ment of new branches; (6) operation and man-

agement of a trust department; (7) international

banking and foreign-exchange transactions;

(8) purchasing policies and practices; (9) cost

analysis, capital adequacy, and planning;

(10)auditing;(11) accountingprocedures;(12) tax

planning; (13) investment advice as authorized

in section 225.28(b)(6) of Regulation Y;

(14) credit policies and administration, includ-

ing credit documentation, evaluation, and debt

collection; (15) product development, including

specialized lending provisions; (16) marketing

operations, including research, market develop-

ment, and advertising programs; (17) personnel

operations including recruiting, training, evalua-

tion, and compensation; and (18) security mea-

sures and procedures. Providing management

consulting advice on compliance with laws and

regulations may be accomplished only when

these activities are incidental to a primary con-

sulting activity and when such advice would not

constitute the rendering of legal advice.

In general, those consulting services that cor-

respondent banks traditionally have provided to

their respondents (both bank and nonbank deposi-

tory institutions) are considered to be included

within the scope of Regulation Y as permissible

services to be provided by nonbank holding

company subsidiaries to nonafﬁliated bank and

nonbank depository institutions.

3200.0.1 MANAGEMENT

CONSULTING LIMITATIONS

Recognizing the potential for conﬂict-of-interest

situations, such as the possibility for anticom-

petitive cooperative arrangements, improper use

of conﬁdential information, and similar abuses

that this activity could entail, the Board incorpo-

rated in Regulation Y a few restrictions on a

BHC Supervision Manual June 2004

Page 1

bank holding company. With regard to afﬁlia-

tion status, neither the bank holding company

nor any of its subsidiaries may own or control

directly or indirectly more than 5 percent of the

voting securities of the client institution. The

prohibition would not apply when the shares

were acquired in satisfaction of a debt previ-

ously contracted or to shares acquired in a ﬁdu-

ciary capacity without sole discretionary voting

authority. A bank holding company may offer

consulting advice to a client institution whose

shares it holds in a ﬁduciary capacity with sole

discretionary voting rights if said holding com-

pany does not hold more than 5 percent of the

voting shares of that institution. Bank holding

companies are permitted to have common man-

agement ofﬁcials with the client institution to

which they provide management consulting ser-

vices if such interlocks would be permissible

under exceptions found in the Board’s Regula-

tion L (Management Ofﬁcial Interlocks) that

apply to such institutions in need of manage-

ment or operating expertise (12 C.F.R. 212.4(b)).

Management consulting services may not be

provided to a client on a daily or continuing

basis except where necessary to instruct the

client on how to perform the services for itself.

The Board has informed bank holding compa-

nies that their management consulting subsidi-

aries should refrain from entering relationships

on a daily or continuing basis even when the

client institution may be experiencing ﬁnancial

or managerial difﬁculties. Particular caution

should be exercised when a bank holding com-

pany contemplates the subsequent acquisition of

the client institution. However, when a bank

holding company is attempting to acquire a

troubled depository institution, limited manage-

ment consulting services may be offered via an

on-premises bank holding company employee.

Nevertheless, the representative should not have

the authority to lend or make personnel deci-

sions. Failure to heed these guidelines not only

would cause the bank holding company to exceed

the permissible bounds of the activity, but also

could cause the BHC to acquire control of the

client institution that might constitute an acqui-

sition of a subsidiary within the meaning of

section 3(a) of the BHC Act. Section

225.31(d)(2)(i) of Regulation Y indicates that a

rebuttable presumption of control shall exist

when a company enters into an agreement, such

as a management contract, with a bank or other

company pursuant to which the ﬁrst company or

any of its subsidiaries exercises signiﬁcant inﬂu-

ence over the general management or overall

operations of the bank or other companies.

Reserve Bank personnel are encouraged to con-

tact the Board’s applications section to discuss

the restrictions on this activity whenever a BHC

proposes to have its personnel assist a troubled

or problem institution.

Whenevaluatinga BHC’sapplicationtoengage

in management consulting, it is important to

note whether the applicant bank holding com-

pany has exhibited the necessary expertise in

operating its own subsidiaries—and whether this

expertise qualiﬁes it to offer advice to others.

3200.0.2 INSPECTION OBJECTIVES

1. To verify that the bank holding company is

performing only those types of management

consulting services at the locations for which

it received prior regulatory approval.

2. To verify that the advice being provided is

within the scope of the approval and consis-

tent with the activities of the interpretation

(12 C.F.R. 225.131) and section 225.28(b)(9)

of Regulation Y.

3. To determine that the bank holding company

does not own or control, directly or indi-

rectly, securities of its client depository insti-

tutions except for shares acquired as the

result of a default on a debt previously con-

tracted or shares held in a ﬁduciary capacity

(within certain limits), provided the holding

company does not have sole discretionary

authority to vote more than 5 percent of the

client’s shares. (See 12 C.F.R. 225.131.)

4. To determine that the bank holding company

does not control the activities of a client

institution by virtue of nonexempt interlock-

ing directors.

5. To determine that services rendered to the

client institutions are not being provided on a

daily or continuing basis.

6. To determine that disclosure is made to each

client of (1) the names of all depository

institutions that are afﬁliates of the consult-

ing company and (2) the names of all exist-

ing client institutions located in the same

county (or counties) or standard metropolitan

statistical area (or areas) (SMSA) as the cli-

ent institution.

3200.0.3 INSPECTION PROCEDURES

A thorough review of pertinent records, con-

tracts, lists of clients, and documentation of the

Section 4(c)(8) of the BHC Act (Management Consulting and Counseling) 3200.0

BHC Supervision Manual June 2004

Page 2

services being provided to clients should be

undertaken to determine that adequate manage-

ment information systems and detailed revenue

and other reports are available to verify the

BHC’s compliance with the Board’s rule on the

revenue limitations in section 225.28(b)(9) of

Regulation Y. Determine that services are being

provided to the appropriate customer base and

within the scope of the Board’s approval. Fur-

ther, the examiner should ascertain the existence

of procedures to inform each potential client of

the names of all depository and client institu-

tions that are afﬁliates of the consulting com-

pany and of the names of all existing clients

located in the same market area as the prospec-

tive client.

For management consulting services that do

not involve any ﬁnancial, economic, account-

ing, and auditing matters, verify that the rev-

enues earned are within the limits permitted by

the Board’s regulations and interpretations. The

basis for any fee structure should be determined

to ascertain that the advice is being rendered on

an explicit-fee basis, such as an hourly or daily

rate. Such fees should not be affected by factors

not directly related to the service, such as bal-

ances maintained by the client at any subsidiary

depository institution of the bank holding com-

pany. The extent of the consultant company’s

involvement in the day-to-day affairs and opera-

tion of the client should also be reviewed.

The absence of parent company control, direct

or indirect, over the clients of the management

consulting subsidiary should be established. The

examiner should compare listings of directors

and principal ofﬁcers of the bank holding com-

pany, its various afﬁliates, and the clients with

due regard to exempt interlocks. The examiner

should determine the extent of ownership or

control by the bank holding company and its

afﬁliates of any equity securities in its clients by

requesting a listing of all shares owned in out-

side organizations. Overall conclusions, includ-

ing recommendations concerning the operation,

apparent violations, and any possible control of

client institutions and conﬂicts of interest, should

be discussed with parent company management

and detailed in the inspection report.

3200.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Orders, interpretation preceding

permissibility of bank manage-

ment consulting

225.131

225.113

4–194 1972 FRB 676

1972 FRB 674

Bank management consulting

authorized as permissible nonbank

activity

225.28(b)(9) 4–181 1974 FRB 226

1974 FRB 675

Presumption of control 225.31(d)

Exemption from section 8 of Clay-

ton Act for banks in low-income

areas

3–830

Bank management consulting as

possible rendering of legal advice

39 Fed. Reg.

41586

Other approvals 39 Fed. Reg.

39106

39 Fed. Reg.

36508

1976 FRB 725

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Management Consulting and Counseling) 3200.0

BHC Supervision Manual June 2004

Page 3

Subject Laws

Regulations

Interpretations

Orders

Justice Department concern over

possible conﬂicts of interest

1977 FRB 950

Limitations on activity when

acquisition of bank is involved

1976 FRB 699

1977 FRB 1088

Permissible interlocking directors 212.4(a)(1) 1979 FRB 654

Deferral of decision to consider

offering of management consulting

advice to unafﬁliated savings banks

as a permissible activity

42 Fed. Reg.

22560

Expanding activity to include non-

bank depository institutions

1982 FRB 237

and 238

Management consulting to failed

savings associations

1988 FRB 771

Expansion of the activity to

include—

1. services regardingﬁnancial,eco-

nomic, accounting, or audit mat-

ters to any company;

2. the ability of the BHC’s non-

bank subsidiary to provide lim-

ited management consulting ser-

vices to any third-party customer

on any matter.

225.28(b)(9)(i) 1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Management Consulting and Counseling) 3200.0

BHC Supervision Manual June 2004

Page 4

Section 4(c)(8) of the BHC Act

(Employee Beneﬁts Consulting Services) Section 3202.0

Within Regulation Y (section 225.28(b)(9)(ii)),

management consulting and counseling activi-

ties include employee beneﬁts consulting ser-

vices. These employee beneﬁts consulting ser-

vices include providing consulting services to

employee beneﬁt, compensation, and insurance

plans, including designing plans, assisting in the

implementation of plans, providing administra-

tive services to plans, and developing employee

communication programs for plans.

The initial Board orders that were issued to

permit employee beneﬁt consulting services are

summarized here as historical examples of the

nonbanking activity. Commitments made in those

Board orders should not be relied upon. Refer

only to the provisions within the current Regula-

tion Y, as cited above.

3202.0.1 BOARD ORDERS

INVOLVING EMPLOYEE BENEFITS

CONSULTING

A bank holding company (the applicant) applied

for the Board’s approval under section 4(c)(8)

of the BHC Act and Regulation Y to acquire

100 percent of the voting shares of a company

that provides a full range of services involving

employee beneﬁts plans. The services are divided

into four basic types of activities:

1. Plan design. Designing employee beneﬁt

plans, including determining actuarial fund-

ing levels and cost estimates.

2. Plan implementation. Providing assistance in

implementing plans, including assistance in

the preparation of plan documents and in the

implementation of employee beneﬁt

administration systems.

3. Administrative services. Providing adminis-

trative services with respect to plans, includ-

ing recordkeeping services, calculating and

certifying employment reports and govern-

ment ﬁlings pursuant to ERISA, and provid-

ing information to a client’s legal counsel in

labor relations and negotiations.

4. Employee communications. Developing

employee communication programs with

respect to plans for the beneﬁt of the client.

The applicant represented that all of the pro-

posed activities were included in trust com-

pany or ﬁnancial or investment advisory service

activities permissible under Regulation Y.

Although certain employee beneﬁts consult-

ing activities (as conducted by the company

being acquired, particularly activities involving

plan administration) are conducted by trust

companies or trust departments of banks in their

capacities as trustees or custodians of employee

beneﬁt plans and investment managers of plan

assets, it was not apparent that the complete

range of employee beneﬁts consulting ser-

vices were generally conducted by trust compa-

nies or authorized by the Board as permis-

sible trust company activities under Regulation

The Board believed that employee beneﬁts

consulting was essentially a ﬁnancial planning

activity involving preparing and conveying ﬁnan-

cial data to a client, which it had previously

determined to be closely related to banking and

permissible under Regulation Y in the areas of

investment advisory services, data processing

services, and courier services. The record did

not indicate, however, that employee beneﬁts

consulting is wholly encompassed within any or

all of those activities. The Board, therefore, did

not agree with the applicant that all of the

proposed activities were currently authorized

for bank holding companies under existing pro-

visions of Regulation Y.

A review of the four basic types of activities

revealed that many of the proposed employee

beneﬁts consulting activities either were already

speciﬁcally engaged in by banks and trust com-

panies, or were functionally related to activities

in which banks and trust companies were regu-

larly engaged. The Board recognized, however,

that the actuarial aspect of the employee bene-

ﬁts consulting activities is not generally included

in trust company or bank activities. Such activi-

ties are limited in scope and purpose in that they

are conducted primarily as a means to ensure

adequate funding of deﬁned beneﬁts plans. In

this case, they were performed solely as a means

for the applicant to provide a full range of

beneﬁts-planning activities for its clients. The

acquired company’s actuarial services would not

be conducted as an independent activity, but

only as a necessary and integrally related com-

ponent of employee beneﬁts consulting.

1. As part of its acquisition, the bank holding company

proposed to assist ﬁrms in IRS audits of plans; inform clients

of developments in employee beneﬁt programs through news-

letters and other correspondence and through participation in

seminars, public programs, and other forums; and engage in

professional actuarial activities and other activities incidental

BHC Supervision Manual June 2004

Page 1

In Association of Data Processing Organiza-

tions, Inc. v. Board of Governors, 745 F.2d 277

(D.C. Cir. 1984), the court of appeals held that

the Board may permit those activities that are ‘‘a

part of’’ the overall permissible activity where,

as here, ‘‘in both market contemplation and

technological reality, the service is a unitary

one.’’ Based on this ruling, the Board concluded

that the applicant’s proposed activities are per-

missible as closely related to banking, and were

approved on June 19, 1985 (1985 FRB 656).

Another Board order permitting the provision

of employee beneﬁts consulting services, which

is slightly different from the order cited above,

is found in 1986 FRB 337. See also 1986 FRB

729 and 1987 FRB 158, 681.

to the actuarial profession. The activities are generally related

to the type of actuarial activities performed for purposes of

engaging in employee beneﬁts consulting and that would not

generate any signiﬁcant income. Such activities were, there-

fore, permissible as incidental to the bank holding company’s

approved activities. The applicant also proposed to provide

expert actuarial opinions of a general nature for purposes such

as divorce actions and personal injury litigation. The Board

believed that such activities were beyond the scope of inciden-

tal activities and were not permissible.

Section 4(c)(8) of the BHC Act (Employee Beneﬁts Consulting Services) 3202.0

BHC Supervision Manual June 2004

Page 2

Section 4(c)(8) of the BHC Act (Employee Beneﬁts Consulting Services) 3202.0

BHC Supervision Manual June 2004

Page 3

Section 4(c)(8) of the BHC Act

(Career Counseling) Section 3204.0

Career counseling services may be provided

to—

1. a ﬁnancial organization

and individuals cur-

rently employed by, or recently displaced

from, a ﬁnancial organization;

2. individuals who are seeking employment at a

ﬁnancial organization; and

3. individuals who are currently employed in or

who seek positions in the ﬁnance, account-

ing, and audit departments of any company.

The initial Board order that was issued to permit

the provision of career counseling services is

summarized below as a historical example on

the origination of this nonbanking activity. Com-

mitments made in the Board order should not be

relied upon. See the current provisions of Regu-

lation Y (section 225.28(b)(9)(iii)) for that pur-

pose.

3204.0.1 CAREER COUNSELING—

INITIAL BOARD ORDER

A bank holding company (the applicant) applied

for the Board’s approval under section 4(c)(8)

of the BHC Act and the Board’s Regulation Y

to provide career counseling services to unafﬁli-

ated parties through its wholly owned nonbank

subsidiary. The applicant proposed to expand its

employee beneﬁts consulting services to include

career counseling activities. The nonbank sub-

sidiary currently provides these services to the

applicantand its afﬁliates under section 4(c)(1)(C)

of the BHC Act. It plans to expand the provision

of these services nationwide to unafﬁliated com-

panies and individuals in a wide array of indus-

tries. The services would provide assistance to

individuals who are employed and seeking

advancement in their careers and to unemployed

individuals who are seeking new employment.

The nonbank subsidiary plans to provide these

services directly to companies and advise these

companies on effective methods of providing

career counseling services to their employees.

The nonbank subsidiary will advise unafﬁli-

ated organizations on the advantages of includ-

ing career counseling services as part of a com-

prehensive employee beneﬁts plan. It will assist

these organizations in establishing their own

facilities to implement career counseling ser-

vices for their current or former employees. If

the organization does not want to operate its

own counseling facility, the nonbank subsidiary

will provide the services directly to the organi-

zation’s current or former employees at the non-

bank subsidiary’s career assistance center.

The proposed career counseling services

include (1) assessing an individual’s education,

prior business experience, salary history, inter-

ests, and skills to aid in ﬁnding employment or

evaluating opportunities for career development;

(2) assisting in the preparation of re´sume´s and

cover letters; (3) contacting employers regard-

ing employment opportunities and making this

information available to clients; (4) conducting

general workshops on the ﬁnancial aspects of

unemployment, current economic trends, the

process of ﬁnding a job, and alternative career

options; and (5) providing individual counseling

on setting and obtaining employment goals.

The issue presented to the Board was whether

the proposed activities are closely related to

banking. The Board had not previously deter-

mined whether providing career counseling

services to unafﬁliated parties is closely related

to banking under section 4 of the BHC Act

and permissible for bank holding companies.

The Board viewed the applicant’s proposal

in four parts: (1) career counseling services for

ﬁnancial organizations (that is, banks, bank hold-

ing companies and their subsidiaries, thrift

institutions, and thrift holding companies and

their subsidiaries) and employees of ﬁnancial

organizations; (2) career counseling services for

individuals who are unemployed or employed

outside the banking industry and who seek

employment at banks and other ﬁnancial institu-

tions; (3) career counseling for individuals seek-

ing ﬁnancial positions (such as chief ﬁnancial

ofﬁcer, cash management positions, and account-

ing and auditing personnel); and (4) career coun-

seling services generally for any individual

seeking any type of employment at any type of

company.

The Board determined that career counseling

services are closely related to banking when

they are provided for (1) ﬁnancial organiza-

tions and individuals currently employed at, or

recently displaced from, a ﬁnancial organiza-

tion; (2) individuals who seek employment at a

ﬁnancial organization; and (3) individuals who

1. Financial organization means insured depository institu-

tion holding companies and their subsidiaries, other than

nonbanking afﬁliates of diversiﬁed savings and loan holding

companies that engage in activities not permissible under

section 4 (c)(8) of the BHC Act.

BHC Supervision Manual June 1999

Page 1

are currently employed in, or who seek, ﬁnan-

cially related positions at any company. The

Board concluded that the record does not pres-

ently support a ﬁnding that general career coun-

seling services are otherwise closely related to

banking.

The applicant will provide career counseling

services on a fee basis with no guarantee of

employment. The Board approved the order on

November 8, 1993. As a condition to its

approval, the applicant must comply with all

commitments made in connection with the appli-

cation, as well as with other conditions stated

within Regulation Y and the Board’s order.

(1994 FRB 51)

2. When providing career counseling for an individual

within one of the three proposed categories, the applicant

was permitted to provide limited career counseling services

regarding positions outside of these categories as ‘‘incidental’’

to the proposed career counseling services. However, the

applicant is not permitted to hold itself out as a provider of

general career counseling services for individuals seeking

career opportunities outside the banking or ﬁnancial indus-

tries. Regulation Y and judicial decisions construe ‘‘incidental

activities’’ as activities that must be necessary to the provision

of a closely related activity in order to be considered inciden-

tal. (See 12 C.F.R. 225.21(a)(2) and National Courier Asso-

ciation v. Board of Governors, 516 F.2d 1229, 1240–41 (D.C.

Cir. 1975).)

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

BHC Supervision Manual June 1999

Page 2

Section 4(c)(8) of the BHC Act (Money Orders, Savings Bonds,

and Travelers’ Checks) Section 3210.0

The Board has included in Regulation Y (see

section 225.28(b)(13)) the authority to issue and

sell at retail money orders and similar consumer-

type payment instruments; the sale of U.S. sav-

ings bonds; and the issuance and sale of travel-

ers’ checks. Previously, the Board, through

various orders, had authorized over time various

nonbanking activities in this regard. Initially, it

permitted by order and then the Board had

included in the list of permissible activities the

sale and issuance at retail of money orders hav-

ing a face value of not more than $1,000, the

sale of U.S. savings bonds, and the issuance and

sale of travelers’ checks. In its original order,

effective February 26, 1979, the Board did not

include the issuance of travelers’ checks. How-

ever, after overwhelmingly favorable responses

to its proposal to include the issuance of travel-

ers’ checks to the list of permissible activities,

the Board included this activity effective Decem-

ber 21, 1981. As part of the Board’s regulatory

review of Regulation Y, and its subsequent over-

haul, which was ﬁnalized and made effective

February 4, 1984, the issuance of money orders

was listed as a permissible activity. On March

16, 1984, the Board, by order, increased the face

value of the payment instruments that the bank

holding company could issue to $10,000, if the

bank holding company agreed to meet certain

weekly reporting requirements (1984 FRB 364).

Also, by order dated December 16, 1985, the

Board allowed the sale of ofﬁcial checks with

no maximum limitation as long as the proceeds

of checks in excess of $10,000 were deposited

in a demand account and the bank holding com-

pany made weekly reports of these checks as

well as money orders that had a face value of up

to $10,000 (1986 FRB 148). The Board later

authorized the issuance and selling of variably

denominated payment instruments without limi-

tation as to face value. (See 1993 FRB 42.) As

part of the comprehensive revision of Regula-

tion Y, effective April 21, 1997, the Board

removed the limitation of the face amount of

payment instruments. (See section 225.28(b)(13)

of Regulation Y.)

3210.0.1 INSPECTION OBJECTIVES

1. To determine that the scope of the activity

is within the parameters established by the

Board.

2. To determine if there is any loss exposure

due to the lack of systems and controls.

3210.0.2 INSPECTION PROCEDURES

In determining whether a signiﬁcant degree of

risk exposure to the BHC exists, the examiner

should address the following questions to man-

agement, when considered appropriate:

1. Are there written agreements between the

bank and its parent concerning the obliga-

tions of each for the sale of money orders

and U.S. savings bonds and for the issuance

and sale of travelers’ checks? Do the agree-

ments provide information on the fees,

reimburseable expenses, sharing of over-

head expenses, and taxes?

2. Who prints the travelers’ checks and money

orders?

3. Is the printerbondedor coveredby insurance?

4. Is the newly printed inventory of travelers’

checks and money orders received in dual

custody?

5. If check inventory sent to outlets is on a

consignment basis, does the consignee

acknowledge receipt on a ‘‘trust receipt’’?

6. Does the consignment ‘‘inventory invoice’’

describe, in complete detail, the number of

checks, serial numbers, and denominations?

7. How are inventories and sales monitored at

the outlet level?

8. What are the maximum dollar shipments

for the day, per outlet and per package?

9. Does the subsidiary bank maintain the settle-

ment account?

10. What procedures are in effect to establish

the checks that have been sold?

11. What are the remittance requirements for

the agents for checks sold?

12. If losses and redemptions exceed proceeds

from sales, who makes up the deﬁciency?

13. Does the parent invest the settlement

account’s ﬂoat, generated by the excess of

proceeds received over checks redeemed, in

long-term investments?

14. If a nonbank subsidiary acts as agent on

behalf of its parent, what fee is paid by the

parent other than commissions on the sale

of checks?

15. Is the subsidiary reimbursed for its expenses?

16. What has been the history of losses?

17. How long are losses carried in suspense

accounts before being charged off?

18. Does the subsidiary bank maintain compen-

sating balances in ﬁnancial institutions as

BHC Supervision Manual December 1998

Page 1

an inducement for the ﬁnancial institutions

to carry the holding company’s travelers’

checks? If so, does the parent compensate

the bank for lost income?

19. What internal audit procedures are in place?

Discuss frequency, scope, and follow-up.

Section 4(c)(8) (Money Orders, Savings Bonds, and Travelers’ Checks) 3210.0

BHC Supervision Manual December 1998

Page 2

3210.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Adding activity to

permissible list (excluding

issuance of travelers’

checks)

225.28(b)(13) 1979 FRB 265

Adding the issuance of

travelers’ checks to

permissible list

225.28(b)(13) 1981 FRB 912

Increased face value or

payment instruments to

$10,000, if weekly reports

provided

1984 FRB 364

Sale of ofﬁcial checks with

no maximum amount, if

checks in excess of

$10,000 deposited in

demand deposit account, if

weekly reports of checks

made as well as money

orders with face value

up to $10,000

1984 FRB 148

Sale of ofﬁcial checks with

no maximum limitation

provided the proceeds of

checks in excess of

$10,000 were deposited in

a demand account and that

weekly reports of the ofﬁcial

checks were made as well

as the total value of ofﬁcial

checks with face values

exceeding $10,000

1986 FRB 148

Issuing and selling drafts

and wire transfers

in foreign currencies

1988 FRB 252

Issuing and selling variably

denominated payment

instruments without limitation

as to face value

1993 FRB 42

Removal of the limitation

on the face amount of

payment instruments

225.28(b)(13) 1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) (Money Orders, Savings Bonds, and Travelers’ Checks) 3210.0

BHC Supervision Manual December 1998

Page 3

Section 4(c)(8) of the BHC Act

(Payment Instruments) Section 3210.1

As noted in section 3210.0, the Board has autho-

rized the issuance and sale of various payment

instruments. This section provides brief histori-

cal summaries of the initial Board orders that

led to the incorporation of the activity into the

Regulation Y ‘‘laundry list.’’ Provisions within

the Board orders, including commitments and

any regulatory references, should not be relied

upon as provisions that are currently authorized.

For the current regulatory authorization, see sec-

tion 225.28(b)(13) of Regulation Y, effective

April 1997.

3210.1.1 ISSUING CONSUMER-TYPE

PAYMENT INSTRUMENTS HAVING

A FACE VALUE OF NOT MORE

THAN $10,000

A bank holding company applied for the Board’s

approval under section 4(c)(8) of the BHC Act

and section 225.23 of the Board’s Regulation Y

to engage de novo in the issuance and sale of

variably denominated payment instruments with

a maximum face value of $10,000. The instru-

ments would be sold in U.S. dollars and foreign

currency by the holding company’s subsidiaries

and unafﬁliated ﬁnancial institutions and would

consist of domestic and international money

orders and ofﬁcial checks. They would also be

used for certain internal transactions, such as

payroll. The Board had recently amended Regu-

lation Y to include on the list of permissible

nonbanking activities the issuance or sale of

money orders and other similar consumer-type

instruments with a face value not exceeding

$1,000. The Board concluded that an increase in

the denomination of such instruments would not

affect their fundamental nature.

As a condition to its approval, the Board

required the bank holding company to ﬁle with

the Board weekly reports of daily data on the

activity. The issuance of such instruments with a

face value of more than $1,000 could have an

adverse effect on the bank holding company’s

reserve base. Because reserve requirements serve

as an essential monetary policy tool, the Board

was concerned that the proposal might result in

adverse effects resulting from an erosion of

reservable deposits within the banking system

(1984 FRB 364).

3210.1.2 ISSUING AND SELLING

OFFICIAL CHECKS WITH NO

MAXIMUM FACE VALUE

Effective December 16, 1985, the Board ap-

proved by order a bank holding company’s

application to sell ofﬁcial checks with no maxi-

mum limitation on the face value, so long as the

proceeds of checks in excess of $10,000 were

deposited in a demand account at its subsidiary

until the respective payment instrument was

paid. To address the Board’s monetary policy

concerns about the activity potentially causing a

signiﬁcant reduction in the reserve base or

resulting in other adverse effects on the conduct

of monetary policy, the bank holding company

agreed to make weekly reports of all outstand-

ing instruments (including money orders and

ofﬁcial checks) with face values of up to $10,000,

and also the aggregate value of all ofﬁcial checks

with face values exceeding $10,000 (1986 FRB

148).

3210.1.3 ISSUING AND SELLING

DRAFTS AND WIRE TRANSFERS

PAYABLE IN FOREIGN CURRENCIES

A foreign bank subject to the BHC Act applied

for the Board’s approval under section 4(c)(8)

of the act and section 225.23(a)(3) of Regula-

tion Y to engage de novo through a wholly

owned subsidiary in the issuance and sale of

foreign drafts and wire transfers with unlimited

face amounts that are payable in foreign cur-

rencies. The applicant proposed to conduct

these activities through the subsidiary as well as

through a nationwide network of unafﬁliated

selling agents, including commercial banks, thrift

institutions, and others.

The Board previously determined that the

issuance and sale of money orders and similar

payment instruments with a maximum face value

of $1,000 is closely related to banking. (See

former section 12 C.F.R. 225.25(b)(12).)

The

Board also approved by order a limited number

of applications to engage in the issuance and

sale of (1) payment instruments with a $10,000

maximum face amount (see 1987 FRB 727) and

1. Effective April 21, 1997, the $1,000 limit was elimi-

nated. The revised Regulation Y (see section 225.28(b)(13))

authorizes the issuance of payment instruments of any amount.

BHC Supervision Manual December 1998

Page 1

(2) payment instruments with unlimited face

amounts, subject to certain operational and

reporting requirements (see 1986 FRB 148).

In considering the previous applications, the

Board expressed concern that the issuance of

payment instruments in denominations larger

than $1,000

would have an adverse effect on

the reserve base because such instruments are

not subject to the transaction reserve account

requirements of the Board’s Regulation D. The

Board noted that because reserve requirements

serve as an essential monetary policy tool, the

conduct of monetary policy could be adversely

affected by the erosion of reservable deposits in

the banking system.

To address the concerns expressed in previ-

ous Board orders, the applicant committed that

the proceeds of all sales of foreign-currency-

denominated instruments will be held in demand

deposit accounts at U.S. commercial banks.

Deposits stemming from the sale of instruments

with denominations of $10,000 or less are to be

swept daily into nonreservable instruments. The

total proceeds of the sale of any payment instru-

ments with denominations greater than $10,000

will be deposited in a demand deposit account at

a U.S. depository institution, to be used to pur-

chase foreign currency for each particular pay-

ment instrument at the time of the transaction.

The Board determined that these commitments

and other procedures outlined in the order

adequately addressed its concerns about the

potential adverse effects on the reserve base.

The Board approved the application on Febru-

ary 3, 1988, subject to the continued evaluation

of its potential for adverse effects on the con-

duct of monetary policy (1988 FRB 252).

3210.1.4 ISSUING AND SELLING

VARIABLY DENOMINATED

PAYMENT INSTRUMENTS WITHOUT

LIMITATION AS TO FACE VALUE

A bank holding company applied for the Board’s

approval under section 4(c)(8) of the BHC Act

to engage both directly and indirectly through a

bank holding company nonbank subsidiary in

the issuance and sale of variably denominated

payment instruments without limitation as to

face value and without the reporting and reserv-

able deposit requirement previously imposed by

the Board on issuers of such instruments.

The Board previously determined by regula-

tion that the issuance and sale of money orders

and other similar consumer-type payment instru-

ments with a face value not exceeding $1,000

is an activity that is closely related to banking

and is therefore permissible for bank holding

companies (see former section 225.25(b)(12) of

Regulation Y (12 C.F.R. 225.25(b)(12))).

Effective December 22, 1992, the Board

amended Regulation D to impose reserve

requirements on teller’s checks. The Board’s

notice amending Regulation D stated that bank

holding companies that had received prior

approval under section 4(c)(8) of the BHC Act

to issue and sell variably denominated payment

instruments—subject to the demand deposit

requirement, reporting requirement, or limits on

the denomination of payment instruments—

could request relief by letter from those condi-

tions. The Board believes that the adverse effect

of erosion of the reserve base is addressed in the

Regulation D revisions, and special reporting

and demand deposit requirements previously

imposed by the Board in connection with

approvals to engage in the issuance and sale of

variably denominated payment instruments in

amounts over $10,000 are no longer needed. As

a result, the Board determined not to impose

those requirements on the applicant and to grant

the applicant’s request for relief from the report-

ing requirement to which it was subject. The

Board approved the application on Novem-

ber 12, 1992, subject to the Regulation D effec-

tive date of December 22, 1992, and the con-

ditions and commitments stated in the order

(1993 FRB 42).

2. See footnote 1. 3. See footnote 1.

Section 4(c)(8) of the BHC Act (Payment Instruments) 3210.1

BHC Supervision Manual December 1998

Page 2

Section 4(c)(8) of the BHC Act (Arranging Commercial

Real Estate Equity Financing) Section 3220.0

Effective September 1, 1982, the Board approved

an application of a bank holding company to

engage in, through a nonbank subsidiary, the

activity of arranging equity ﬁnancing for certain

types of income-producing properties (1982 FRB

647). The Board limited the activity by requir-

ing that the holding company act only as an

intermediary between developers and investors

to arrange ﬁnancing, and imposed certain other

conditions to prevent the holding company from

engaging in real estate development or syndica-

tion. At that time, however, the Board did not

expand the Regulation Y list of permissible

activities for bank holding companies to include

this activity.

In February 1984, the Board added the

arranging of commercial real estate equity ﬁnanc-

ing to the list of permissible nonbanking activi-

ties in Regulation Y (section 225.28(b)(2)(ii)).

Regulation Y incorporated the limitations placed

on the activity by the Board’s 1982 order, which

is discussed below.

Equity ﬁnancing involves arranging for the

ﬁnancing of commercial or industrial income-

producing real estate through the transfer of the

title, control, and risk of the project from the

owner or developer to one or more investors. In

performing the equity-ﬁnancing activity for com-

mercial or industrial income-producing real

estate, consultations should be made with the

owner or developer to determine the nature,

objectives, and ﬁnancing arrangements for the

property or project. The project’s concept, archi-

tectural design, building layout, suitability for

its purpose and prospects, trafﬁc ﬂow, as well as

competing projects,source(s)of customers, nature

of the market, projected rentals and income

ﬂows, timetables for completion, and the avail-

ability of construction and long-term ﬁnancing

for the property, have to be carefully reviewed.

Financing alternatives, including equity ﬁnanc-

ing, should be predetermined.

The Board has found that the particular exper-

tise and analysis required to provide equity

ﬁnancing for large commercial or industrial

income-producing properties is functionally and

operationally similar to the analysis and exper-

tise that is required when a bank provides tradi-

tional mortgage ﬁnancing services for such prop-

erties. This ﬁnding is supported by the fact that

equity ﬁnancing can be viewed as an economic

substitute for long-term mortgage ﬁnancing. The

Board’s view is that equity ﬁnancing, subject to

the limitations described below, bears a func-

tional relationship to investment advisory ser-

vices that are traditionally and lawfully per-

formed by commercial banks with respect to

commercial and industrial real estate.

The Board therefore, in 1984, approved add-

ing the arranging of commercial real estate

equity ﬁnancing to the list of permissible non-

banking activities in Regulation Y. On April 21,

1997, the comprehensive revision of Regulation

Y removed certain restrictions from this non-

banking activity. The activity currently consists

of acting as an intermediary for the ﬁnancing of

commercial or industrial income-producing real

estate by arranging for the transfer of title, con-

trol, and risk of such a real estate project to one

or more investors, if the bank holding company

and its afﬁliates do not have an interest in, or

participate in, managing or developing a real

estate project for which it arranges equity

ﬁnancing, and do not promote or sponsor the

development of the property.

BHC Supervision Manual December 1997

Page 1

3220.0.1 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Application to engage

in equity-ﬁnancing

activities

1982 FRB 647

1983 FRB 817

1984 FRB 50

Adding activity to

permissible list

225.28(b)(2)(ii) 1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) (Arranging Commercial Real Estate Equity Financing) 3220.0

BHC Supervision Manual December 1997

Page 2

4(c)(8)—Agency Transaction Services for Customer

Investments (Securities Brokerage) Section 3230.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2008, this section has been revised

to incorporate a name change to the Financial

Industry Regulatory Authority, or FINRA (for-

merly, the National Association of Securities

Dealers, or NASD).

3230.0.1 OVERVIEW OF SECURITIES

BROKERAGE AS A NONBANKING

ACTIVITY

In addition to providing a full panoply of ﬁnan-

cial services to their customers, banks and bank

holding companies seek ‘‘off-balance-sheet’’ or

non-asset-building sources of revenue. Securi-

ties brokerage is one type of endeavor perceived

to have growth and proﬁt potential. The main

reasons for this are easy market entry, low

start-up costs, and maximum use of a branch

system and customer base.

After the deregulation of brokerage commis-

sions in 1975, certain brokers began to compete

for securities business by drastically reducing

their commissions. In order to reduce operating

expenses, yet still remain proﬁtable at reduced

commission rates, these ﬁrms ceased investment

research and offered their customers a reduced

level of service by ‘‘unbundling’’ brokerage ser-

vices and offering only the execution of securi-

ties transactions. Brokers who offer this reduced

level of service have come to be known as

‘‘discount brokers.’’

The Board, in 1983, added ‘‘securities broker-

age’’ to the list of permissible activities for bank

holding companies shortly after it approved the

application of BankAmerica Corporation to

acquire Charles Schwab & Co., as discussed

below. In 1984, the U.S. Supreme Court sus-

tained the Board’s approval order and ruled that

it is not a violation of the Glass-Steagall Act for

banks and bank-afﬁliated brokers to buy and sell

securities as agent for customers (SIA v. Board

of Governors, 104 S. Ct. 3003). For additional

historical information regarding the expansion

of securities brokerage nonbank activities by

Board order or by incorporation into Regulation

Y, see sections 3230.1 through 3230.3.

Before April 21, 1997, Regulation Y differen-

tiated between securities brokerage services pro-

vided alone (that is, discount brokerage ser-

vices) and securities brokerage services provided

in combination with investment advisory ser-

vices (that is, full-service brokerage activities).

Regulation Y no longer distinguishes between

discount and full-service brokerage activities.

Regulation Y currently authorizes securities

brokerage services (including securities clearing

and/or securities execution services on an

exchange), whether alone or in combination

with investment advisory services and inciden-

tal activities (including such related activities as

securities credit, custodial services, individual

retirement accounts, and cash-management ser-

vices), if the services are restricted to buying

and selling securities solely as agent for the

account of customers and do not include securi-

ties underwriting or dealing. In addition to the

information and examiner guidance provided in

this section, see the American Institute of Certi-

ﬁed Public Accountants’ Audit and Accounting

Guide—Brokers and Dealers in Securities.

The

guide includes detailed information about the

securities industry, broker-dealer functions,

activities and operations, books and records,

accounting and auditing standards and consider-

ations, and other topics such as internal controls

and regulatory considerations.

3230.0.2 INITIAL BOARD ORDER

APPROVAL FOR SECURITIES

BROKERAGE

On January 7, 1983, the Board approved the

application of BankAmerica Corporation to

acquire Charles Schwab & Co., which engaged

in retail discount securities brokerage, securities

credit lending, and certain incidental activities

(1983 FRB 105). None of the proposed activi-

ties was among those the Board had previously

designated in Regulation Y as being closely

related to banking.

In its order approving the application, the

Board found that the brokerage and securities

credit activities were closely related to banking

for purposes of section 4(c)(8) of the Bank

Holding Company Act (‘‘BHC Act’’). That deci-

sion was based on the fact that many banks

provide various types of securities brokerage

services as an accommodation to customers and

as an agent for trusts and other accounts man-

aged by banks.

Banks also administer employee stock pur-

chases, dividend reinvestment, and automatic

1. Issued as of May 1, 2007.

BHC Supervision Manual July 2008

Page 1

investment service plans, which involve the

periodic purchase of a particular security or

securities from a ﬁxed list of securities, on

behalf of the customer. Banks often execute

orders involving securities not listed on an

exchange by dealing directly with dealers mak-

ing a market in a particular security or with

other third parties. In performing these services,

banks exercise the same type of discretion and

judgment with respect to the best method of

execution as brokers do with respect to similar

types of orders. Further, national banks are

expressly authorized by statute to purchase and

sell securities without recourse, solely upon the

order, and for the account of, customers (12

U.S.C. 24 (Seventh)).

The Board, in summary, noted that banks in

fact had generally provided securities brokerage

to some extent. The company that was acquired,

pursuant to the January 1983 order, provided

several other services incidental to its discount

brokerage activities.

3230.0.2.1 Margin Lending

Historically, banks have had a signiﬁcant amount

outstanding in loans to borrowers for the pur-

pose of purchasing or carrying securities. The

extension of such credit secured by stock and

other collateral, or margin lending, has long

been an important bank activity. The Board,

therefore, ruled that this activity was closely

related to banking and incidental to the securi-

ties brokerage activities of the company being

acquired.

3230.0.2.2 Maintenance of Customer

Securities Accounts

Charles Schwab & Co. offered various services

to its brokerage customers. These services

included individual retirement accounts for which

an unafﬁliated savings and loan associationserved

as a trustee; a ‘‘sweep’’ arrangement, pursuant

to which idle customer balances exceeding a

certain minimum were automatically invested in

an unafﬁliated money market mutual fund; the

payment of interest on net free balances await-

ing investment; and a specially named account

that combined the payment of interest on free

credit balances with customer access to such

balances through a debit card and checking

account offered under an arrangement with an

unafﬁliated commercial bank. Increasingly, these

types of services were being offered by other

brokerage ﬁrms. The Board found that each of

these services was identical, or functionally and

operationally equivalent to, services generally

offered by banks to customers directly or through

bank trust departments. Based on that ﬁnding,

the Board found that the provision of those

accounts was closely related to banking as well

as an incidental activity in connection with secu-

rities brokerage and margin lending activities.

3230.0.2.3 Custodial Services

The brokerage ﬁrm also provided various types

of securities custodial services involving the

safekeeping of customers’ securities, account-

ing for dividends or interest received on such

securities, and other ancillary services. Banks

generally offer securities custodial services in

connection with their trust departments and other

securities transaction services. Furthermore, in

extending margin credit, a lender is required to

maintain custody of the securities pledged to the

lender as collateral to secure the loan. Accord-

ingly, the Board found that the provision of

securities custodial services was closely related

to banking and that it was a necessary incident

to permissible margin lending activities.

3230.0.3 MARGIN CREDIT

ACTIVITIES AND SECURITIES

BROKERAGE

When securities brokerage was added to the

permissible activities within Regulation Y, it

was contemplated that a bank holding company,

or its nonbank subsidiary performing the permit-

ted securities brokerage activities, would be

required to register as a broker–dealer with the

Securities and Exchange Commission and that

its margin credit activities would therefore be

subject to the Board’s Regulation T. Regulation

T governs securities credit by broker–dealers

(12 C.F.R. 220).

3230.0.4 ACTIVITY ADDED TO

REGULATION Y

On August 10, 1983, the Board adopted a ﬁnal

rule deeming securities brokerage and margin

lending ‘‘closely related’’ to banking, consistent

with the Glass-Steagall Act, and are, therefore,

generally permissible for bank holding compa-

nies. To clarify that services incidental to bro-

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 2

kerage services are permissible, the Board did

include a list of permissible incidental services.

The list included services such as offering custo-

dial services, furnishing individual retirement

accounts, and cash-management services, pro-

vided that the securities brokerage services are

restricted to buying and selling securities solely

as agent for the account of customers and do not

include securities underwriting.

As for cash-management services, such ser-

vices are intended to include customer-account-

related functions, such as paying interest on net

free balances awaiting investment, providing

arrangements under which free credit balances

are automatically invested in money market

mutual funds, and establishing arrangements

under which access to such balances is provided

by debit card or checking accounts.

The list of incidental activities in the regula-

tion is not intended to be exhaustive. The Board

believes that to compete effectively with other

brokers, bank holding companies should have

the ﬂexibility to provide a full range of customer-

account and custodial services, provided such

services meet the test for permissible incidental

activities under section 4(c)(8) of the BHC Act

and are consistent with the Glass-Steagall Act.

As previously noted, Regulation Y, effective

April 21, 1997, permits securities brokerage

without distinguishing between discount and

full-service brokerage activities. The previous

regulatory requirement for certain disclosures

has been eliminated. Those disclosure require-

ments are in an interagency policy statement

that governs the sale of securities and other

nondeposit investment products on bank prem-

ises (see sections 2010.6.1.3.1 and 2010.6.2.9),

as well as in SEC rules. Similar disclosure

requirements are required by the Board’s policy

statement that governs a bank holding com-

pany’s sale of shares of mutual funds and other

investment companies that it advises (see sec-

tion 225.125 of Regulation Y).

3230.0.5 MARKET ENTRY INTO

SECURITIES BROKERAGE

There are three general methods of market entry

available to bank holding companies or non-

bank subsidiaries of bank holding companies

wishing to offer securities brokerage services:

(1) become associated with a brokerage ﬁrm,

(2) purchase an existing ﬁrm, or (3) establish

their own brokerage operations. The most com-

mon mode is broker association, which is less

costly and the most rapid form of entry. The

following broker relationships are presently

established:

1. Introducing broker. The ﬁrst level of involve-

ment occurs when a BHC or a nonbank sub-

sidiary of a BHC serves as an ‘‘introducing

broker’’ in effecting securities transactions

by accepting the customers’ orders and trans-

mitting the orders to the executing broker.

Order tickets and records of original entry

are prepared by the BHC or nonbank subsid-

iary. In this situation, the executing broker

generally produces customer conﬁrmations

and account statements. These documents

often prominently display the BHC or the

bank holding company’s nonbank subsidi-

ary’s name and logo. The executing broker,

the bank holding company, and/or its non-

bank subsidiaries may offer safekeeping ser-

vices and margin credit.

2. Omnibus account. A higher level of bank

holding company nonbank subsidiary involve-

ment occurs when the broker ‘‘carries’’ cus-

tomer accounts by accepting and transmit-

ting orders for execution, producing the

customer conﬁrmation, and maintaining all

customer records. When carrying customers’

accounts, the bank holding company’s non-

bank subsidiary may maintain a single cus-

tomer account, called an omnibus account,

with the executing broker. Safekeeping and

margin credit services may be offered.

3. Separately incorporated broker–dealer sub-

sidiary afﬁliate. The highest level of involve-

ment occurs when a bank holding company

organizes or acquires a separately incorpo-

rated broker–dealer subsidiary or afﬁliate,

whichtransactsbusiness like any otherbroker–

dealer. This would include its own customer

lists, both retail and wholesale; possible

exchange membership; and executing and

clearing its own transaction.

3230.0.6 PURPOSE OF INSPECTION

OF SECURITIES BROKERAGE

ACTIVITIES

The purpose of the inspection is to evaluate

2. There is a lower level of involvement wherein the BHC

or nonbank subsidiary is responsible for making the brokerage

services available to customers by advertising the distributing

customer account applications. Account acceptances are gen-

erally made by the unafﬁliated broker who will receive orders

directly from customers.

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 3

any potential liability due to wrongful or negli-

gent performance of responsibilities, to assess

the level of management expertise, and to deter-

mine the degree of compliance with legal and

policy parameters necessary to protect investors.

3230.0.7 INSPECTION OBJECTIVES

1. To determine the scope and nature of ser-

vices provided.

2. To evaluate operations, audits, and controls.

3. To review the sufﬁciency of administrative

policies and procedures.

4. To determine the level of responsibility.

5. To appraise the quality of management and

staff.

6. To ascertain earnings, volume of business,

and prospects.

7. To review compliance with applicable laws,

regulations, and policies.

3230.0.8 SCOPE OF INSPECTION

The scope of inspection will vary depending on

the nature of the brokerage operation. In deﬁn-

ing the scope of inspection, it is ﬁrst necessary

to determine the extent of activities performed

and the corporate structure. Any bank holding

company subsidiary (that is not a bank), which

functions as a securities broker, is required to

and Exchange Commission (SEC).

In developing the scope of inspection, it is

emphasized that Reserve Bank examiners can

rely on the applicable self-regulatory organiza-

tion’s examination with respect to investor pro-

tection, compliance with SEC and SRO rules,

and Regulation T. The self-regulatory organiza-

tions do not furnish an examination report, but

instead furnish a registered broker–dealer with a

letter pertaining to examination ﬁndings. Hence,

the scope of inspection for a registered broker–

dealer will commence with a review of a self-

regulatory organization’s most recent letter deal-

ing with its examination of brokerage activities.

A broker–dealer belonging to more than one

self-regulatory organization will be examined

only once in each examination cycle. Serious

violations that could endanger a banking organi-

zation (for example, fraudulent activities that

could subject the organization to losses or law-

suits) or signiﬁcant violations that have not yet

been corrected, should be noted in the bank

holdingcompanyinspectionreport.ReserveBank

staff are responsible for evaluating all other

aspects of securities brokerage activities.

The actual scope of this portion of the inspec-

tion will range from a brief visit for a lim-

ited service ‘‘arranger’’ relationship to extensive

review for an omnibus relationship or registered

broker–dealer.

3230.0.9 MATERIALS REQUIRED FOR

INSPECTION

When commencing the securities brokerage por-

tion of a bank holding company or its nonbank

subsidiary inspection, the following material

should be obtained:

1. contractual agreement with the executing

and/or clearing broker

2. recent activity report (for at least six months)

3. income and expense reports

4. written policies and procedures regarding—

a. order processing,

b. settlements,

c. account reconciliations,

d. audit coverage, and

e. trust department relationship

5. account application forms

6. customer disclosure documents

7. organization chart

8. fee schedule

9. internal and external audit reports

10. a copy of the contingency plan for continu-

ance in emergencies

11. the most recent SRO letter pertaining to the

last brokerage examination

3230.0.10 INSPECTION PROCEDURES

If applicable, the following areas should be cov-

ered during the inspection.

3. A broker–dealer registered with the SEC (registered

broker–dealer) is subject to SEC recordkeeping and conﬁrma-

tion rules, fair practice rules, professional qualiﬁcation rules

for individuals associated with securities ﬁrms, and the

uniform net capital rule. Registered broker–dealers are also

required to pay for insurance coverage on customers’ assets

by the Securities Investor Protection Corporation (SIPC) and

are required to be members and subject to the rules of the

Financial Industry Regulatory Authority (FINRA), or other

self-regulatory organizations, such as the New York Stock

Exchange. These self-regulatory organizations (SROs) also

test for broker compliance with Regulation T (12 C.F.R. 220).

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 4

3230.0.10.1 Organization and

Management

Review carefully the contractual agreement with

the executing and/or clearing broker and list all

duties and obligations of the respective parties.

Determine that the agreement contains an

indemniﬁcation clause insulating against broker

error. Once the review is completed, the exam-

iner can identify the type of relationship and

plan the scope of the inspection.

Review the organization chart and match

responsibilities and operational functions to the

appropriate section. Evaluate management and

staff based upon their education, experience,

performance, and the proﬁtability and efﬁciency

of operations and any other relevant factors.

3230.0.10.2 Operations

A securities brokerage operation is organized

along functional lines including—

1. execution,

2. settlement,

3. delivery,

4. custody,

5. recordkeeping, and

6. audits and controls.

Before review, prepare a ﬂow chart of the opera-

tion to quickly overview the operational areas

and to locate control points and identify poten-

tial weaknesses.

3230.0.10.2.1 Execution

This area processes client orders. The orders

may be received by telephone at the nonbank

subsidiary or directly by the executing broker.

When the nonbank subsidiary accepts customer

orders, they can be transmitted by direct wire to

the executing broker. Completed transactions

initiated by the nonbank subsidiary are con-

ﬁrmed back to the nonbank subsidiary, which in

turn sends a conﬁrmation to the client. Examin-

ers should determine that proper safeguards are

in place to ensure valid orders are received,

pending orders are controlled, and completed

orders are reported for customer notiﬁcation and

record update. The examiner should also deter-

mine that the following are in place:

1. use of code numbers, names, or other veriﬁ-

cation devices when accepting orders

2. maintenance and reconcilement of a trade

log (orders received) and execution report

(orders completed)

3. taping of telephone orders

4. conﬁrmation of completed orders are con-

ﬁrmed to clients in a timely fashion

5. preparation and transmittal of input media

for record update

3230.0.10.2.2 Settlement

This area receives payments and proceeds, col-

lects dividends and interest, and, in some

instances, effects margin calls on broker instruc-

tion. Settlements are effected in two stages:

1. Broker vs. customer. Before settlement date,

the customer must send cash or securities to

the broker as requested in the broker’s cus-

tomer conﬁrmation. Cash or securities are

required to effect payment against delivery

or delivery against payment in accordance

with industry securities settlement procedures.

2. Broker vs. broker. When physical delivery of

securities is required, it is generally done on

a ﬁrm-to-ﬁrm basis or to a ﬁrm’s safekeeping

agent. Major equity securities, and an ever-

increasing number of debt securities, are eli-

gible for net settlement and securities immo-

bilization with depositories. Usually, a net

settlement account is used for cash and secu-

rities transactions; these accounts should be

reconcileddaily. Thesettlement processshould

include a procedure that veriﬁes execution

price and fees.

3230.0.10.2.3 Delivery

Securities are delivered to the executing broker

and purchased securities to clients. The exam-

iner should determine that safeguards provide

adequate control over certiﬁcates in process.

Proper fail-to-deliver/receive and completed

transaction records should be maintained.

The securities broker that accepts customer

orders generally is exposed to delivery risk by

customers. Basically, customers can take advan-

tage of the broker by placing an order to buy

securities when the customer has no funds avail-

able to purchase securities or by placing an

order to sell securities that are not owned by the

customer. Either type of transaction is permis-

sible in a margin account, provided that the

customer has the resources available to properly

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 5

margin the transaction. If the customer does not

have a margin account, the broker should not

purchase a security for the customer unless

(1) there are sufﬁcient funds in the customer’s

account or (2) the customer represents and the

broker ascertains that the customer will promptly

make full cash payment for the security before

selling it and that the customer does not contem-

plate selling it before making payment.

Alternatively, the broker should not sell a secu-

rity for a customer unless (1) the security is held

in the customer’s account, or (2) the broker

accepts in good faith the customer’s statement

that the security is owned by the customer and

that it will be promptly deposited into the account.

By not executing a purchase or sale until the

customer has deposited cash or securities,

customer-default risks can be avoided on cash

transactions. However, for competitive reasons,

many brokers would not wish to place such

stringent restrictions upon their customers—

especially with respect to the purchase of securi-

ties. Lack of proper account supervision can

lead to the fraudulent customer practice of ‘‘free

riding,’’ wherein the customer will buy securi-

ties in anticipation of a price rise. Before settle-

ment date, the customer will sell the securities

to take the proﬁts. If the market price of the

securities declines, the customer will dishonor

the trade, and thus attempt to leave the broker

holding the depreciated securities. Securities

brokerage procedures should be designed to

look for generally abusive practices by

customers.

3230.0.10.2.4 Recordkeeping

Any records that must be prepared by the broker

under inspection are subject to the Securities

and Exchange Commission’s recordkeeping and

conﬁrmation rules 17a-3 and 17a-4. Compliance

with those recordkeeping rules will be veriﬁed

by stock exchange or FINRA examiners during

their routine compliance inspections.

3230.0.10.2.5 Audits and Controls

Complete the ‘‘Securities Brokerage/Internal

Controls Checklist’’ to determine whether

operations are satisfactorilycontrolledand audited

by the bank holding company’s or nonbank

subsidiary’s audit staff. All signiﬁcant adminis-

trative and operational aspects should be cov-

ered. Management should receive reports of

audit ﬁndings and respond in writing as to

actions taken.

3230.0.10.3 Conﬂicts of Interest

Determine that policies have been effectively

implemented covering relationships with afﬁli-

ated trust departments, self-dealing, fee-splitting

or rebate arrangements, and ofﬁcer/employee

transactions.

3230.0.10.3.1 Relationship with Afﬁliated

Trust Departments

Questions may arise concerning the permissibil-

ity of a securities broker’s executing securities

transactions for an afﬁliated trust department. In

general, the receipt of commission income for

securities brokerage transactions entered into on

behalf of a trust account (in addition to the fee

received for account administration) raises

conﬂict-of-interest considerations to which tra-

ditional prohibitions of ﬁduciary law are directed.

When a securities broker afﬁliate is used, the

trust institution may be considered to share indi-

rectly in the commission income of the afﬁliate

even when there is no direct remittance of the

fee to the bank. The staff letter at 3–447.11 of

the Federal Reserve Regulatory Service pro-

vides guidance in determining whether and in

what circumstances use of afﬁliated discount

brokerage services may or may not be permis-

sible. If questionable trust department use of

afﬁliated broker services is disclosed, appropri-

ate trust examiner(s) should be notiﬁed.

3230.0.10.4 Earnings, Volume Trends,

and Prospects

Determine the present and future impact that the

securities brokerage activities may have on the

bank holding company and its subsidiaries. If

possible, a separate proﬁt center should be

established, thus providing a useful manage-

ment tool that facilitates analysis of current

proﬁtability, business volume, ﬁxed and vari-

able costs, and degree of goal actualization.

Periodic review of these factors will enable

management to direct available resources, aid in

the budget process, and provide a basis for

businessplanning.Prospectsfor proﬁtablegrowth

should be assessed by noting changes in aggre-

gate account levels and trade activity. The local

competitive environment should be gauged and

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 6

market-share information noted. In considering

these factors, the examiner should attempt to

determine what level of activity must be main-

tained or attained in order for the securities

brokerage function to break even. Present a

summary statement expressing an overall view

on the current state and future viability of the

operation.

3230.0.10.5 Compliance

The examiner should determine whether any

additional state regulations must be complied

with. Also determine that staff is aware of and

complying with applicable regulations and

laws, which may be outside the scope of an

examination conducted by a self-regulatory

organization.

3230.0.10.6 Presentation of Findings

The scope of inspection within the report should

note that securities brokerage activities were

reviewed. It should be noted that in order to

avoid duplication of examination procedures,

the inspection did not focus upon securities laws

compliance (as veriﬁed by FINRA, or stock-

exchange examiners), but instead focused upon

ﬁnancial and safety-and-soundness consider-

ations. Appropriate nonbank subsidiary pages

should be completed. Present a summary com-

ment in the conﬁdential section reﬂecting an

overall appraisal of the operation. The self-

regulatory organization responsible for examin-

ing the securities brokerage operation should be

identiﬁed. Identify also the associated broker, if

any, with whom the organization conducts busi-

ness. Any material exceptions should be noted

with management’s responses under an appro-

priate caption within the open section. Matters

of importance should be brought forward to the

Examiner’s Comments and Matters Requiring

Special Board Attention page. In addition, any

other signiﬁcant problems, detrimental prac-

tices, or potential liabilities that could have a

negative impact on the organization should be

commented upon.

3230.0.11 EXAMINATION

CHECKLISTS

Two checklists are provided for use by the

examiner to aid in evaluating securities broker-

age activities:

1. Securities Brokerage Inspections

2. Securities Brokerage/Internal Controls

Allquestions arenot applicable foreachbrokerage

subsidiary. The nature and scope of brokerage

activities determine the applicability of speciﬁc

questions. The term ‘‘banking organization’’ re-

fers to a bank holding company and any of its

nonbank subsidiaries.

3230.0.11.1 Securities Brokerage Inspection Checklist

Yes No

1. Is a contractual agreement between the banking organization and the

executing and/or clearing broker on ﬁle?

2. Does the agreement indemnify the banking organization against broker

error?

3. Does the agreement clearly deﬁne respective responsibilities of the

banking organization and broker?

4. Was the agreement reviewed by the banking organization’s counsel? *

5. Was the agreement approved by the board of directors?

If not, by whom?

6. Are written procedures covering brokerage activities in effect? *

7. Have job descriptions been prepared? *

8. Have speciﬁc policies been developed regarding—

*Response may require report comment.

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 7

Yes No

• relationships with afﬁliated bank trust depts?

• conﬂicts of interest? *

• investment advice? *

9. Are investment advice or research services being offered? *

10. Are income and expense records separately maintained? *

11. Are brokerage activities included in the audit program? *

12. Are customer orders placed with banking organization personnel? *

If so, is customer authorization on ﬁle? *

Are telephone conversations tape recorded? *

Are transaction records maintained by traders? *

13. How are payments effected? (check one)

direct charge to customer account

payment through the mail

other

14. What is the timeframe of payment?

prior to execution

upon verbal notiﬁcation of execution

upon customer’s receipt of conﬁrmation

after settlement date *

15. What is the frequency of settlement-account reconcilements?

daily

biweekly

weekly *

other

16. Does an afﬁliated trust department use the discount brokerage service? *

If yes, what type account?

discretionary trust **

discretionary agency **

custody

employee beneﬁt **

17. Is sufﬁcient insurance coverage in effect? *

Describe types and limits.

18. Does a review of records conﬁrm that the broker functions solely

as an agent, i.e., does not engage in underwriting or taking

positions for its own account?

19. Do monitoring and internal reporting procedures adequately track

proﬁtability and operating impact for management consideration?

*Response may require report comment.

**If available documentation reveals that afﬁliated trust depart-

ments use brokerage services to execute transactions for this

type of account, the appropriate federal regulator of trust activi-

ties should be notiﬁed.

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BHC Supervision Manual July 2008

Page 8

3230.0.11.2 Securities Brokerage/Internal Control Checklist

The following questions should be answered, to the extent applicable, in reviewing a securities

brokerage operation. Few brokers will perform all of the activities discussed below.

Yes No

1. Do internal audit procedures include the securities brokerage function?

2. Has the banking organization adopted procedures for the periodic

review of insurance coverage relating to securities brokerage activities

(e.g., errors and omissions, ﬁdelity bonding, and securities in transit)?

3. Has the banking organization adopted procedures with respect to the

accounts of directors, ofﬁcers, or employees or their immediate fami-

lies?

4. Are procedures in place to prevent internally generated credits to the

securities brokerage customers’ accounts from being automatically

recorded as collected funds?

5. Are procedures in place to ensure that acceptance of a relatively large

order will not be effected unless the order taker veriﬁes that the cus-

tomer placing the order has internal authorization to engage in large

trades?

6. Has the banking organization adopted written procedures prohibiting

employees from furnishing investment advice?

7. Are customer telephone orders tape recorded? *

8. Are tape recordings of telephone orders reviewed periodically to

verify that employees have not made securities recommendations or

furnished investment advice?

9. Are persons responsible for taking and transmitting orders precluded

from preparing accounting entries?

10. Is there adequate separation of duties between persons responsible for

making initial accounting entries and those responsible for making

subsequent adjusting entries to prevent a concealment of theft or

fraud?

11. Does the securities brokerage function monitor and reconcile safe-

keeping, clearing, payment, and income expense accounts on a regu-

lar basis?

12. Has management developed a contingency plan to ensure continued

brokerage operations of the securities brokerage operation in the

event of ﬁre, ﬂood, power failure, or some other unforeseen event?

13. With respect to termination of brokerage accounts, does the securities

brokerage operation have procedures in place to prevent an account

from being closed while an open securities order is outstanding?

14. Does the credit-approval process require a credit decision to be made

by someone who routinely makes credit decisions—as opposed to a

manager of a securities brokerage operation?

15. If securities received from customers are registered in the name of a

third party, are procedures in place to ensure that such securities are

accepted only upon satisfactory proof of ownership?

*Response may require report comment.

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 9

Yes No

16. Are procedures in place to ensure that customers delivering securities

registered in a ‘‘street name’’ have title to such securities (i.e., they are

not lost or stolen securities)?

17. Is only a limited number of responsible employees authorized to

execute or guarantee security assignments?

18. Is the use of facsimile signature devices adequately controlled? *

19. Are procedures in place to control cash, securities, and documents per-

taining to securities shipped for ‘‘delivery against payment’’?

20. Are adequate physical controls maintained over securities on hand

(e.g., restricted access to the ‘‘cage area’’)?

21. Are detail records pertaining to securities in transfer and those pledged

as collateral to borrowings agreed periodically (at least quarterly) with

the securities record?

22. Are security positions (and related general-ledger amounts) in suspense

accounts investigated and resolved on a timely basis?

23. Are fails to receive and fails to deliver periodically reviewed and

reconciled?

*Response may require report comment.

3230.0.12 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Board’s authority for rulemaking

and jurisdiction over BHCs

1843(c)(8),

1844(b)

Order approving the application of

a BHC to acquire a retail discount

securities broker

1983 FRB 105

Order approving acquisition of

retail discount broker by a BHC

1983 FRB 565

Securities brokerage as a permis-

sible activity

225.28(b)(7)(i)

Credit by brokers and dealers—

Regulation T

220

Order approving the provision of

combined securities brokerage,

investment advisory, and research

services

1986 FRB 584

Securities brokerage subsidiary can

exchange customer lists with afﬁli-

ates and conﬁdential customer

information (with customer

approval)

1988 FRB 571

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 10

Subject Laws

Regulations

Interpretations

Orders

Securities brokerage with discre-

tionary investment managment and

investment advisory services

1988 FRB 700

1987 FRB 930

1987 FRB 810

Full-service brokerage for institu-

tional and retail customers—bank-

ineligible securities

1989 FRB 396

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

4(c)(8)—Agency Transaction Services for Customer Investments (Securities Brokerage) 3230.0

BHC Supervision Manual July 2008

Page 11

4(c)(8)—Securities Brokerage (Board Decisions)

Section 3230.05

This section serves as a prelude to the securities

brokerage sections that follow. Sections 3230.1

through 3230.3 provide brief historical summa-

ries of Board decisions on securities brokerage;

these authorizations are now incorporated into

Regulation Y for this activity. The summaries

provide the reader with some historical perspec-

tive as to how and why the current provisions of

Regulation Y evolved. The conditions and com-

mitments within these orders may no longer

apply to the current provisions of Regulation Y.

Therefore, reference must be made to Regula-

tion Y, section 225.28(b)(7)(i).

Before the 1997 revisions of the Board’s

Regulation Y (12 C.F.R. 225), the Board’s rules

differentiated between securities brokerage ser-

vices provided alone (that is, discount brokerage

services) and securities brokerage services pro-

vided in combination with investment advisory

services (that is, full-service brokerage activi-

ties). The revisions to Regulation Y that became

effective in April 1997 permit securities broker-

age without distinguishing between discount and

full-service brokerage activities.

Another major change for securities broker-

age activities concerns the types of disclosures

required of bank holding companies. Before the

1997 revisions, bank holding companies provid-

ing full-service brokerage services were required

to make certain disclosures to customers regard-

ing the uninsured nature of securities and were

not permitted to disclose conﬁdential custo-

mer information without the customer’s con-

sent. Effective in April 1997, these disclosure

requirements were eliminated. The disclosure

requirements—along with a number of other

requirements that speciﬁcally address the poten-

tial for customer confusion, training require-

ments, suitability requirements, and other

matters—are already contained in an inter-

agency policy statement that governs the sale of

securities and other nondeposit investment prod-

ucts on bank premises, as well as in rules ad-

opted by the SEC. In addition, similar disclo-

sure requirements are required by the Board’s

policy statement governing the sale by bank

holding companies of shares of mutual funds

and other investment companies that the bank

holding company advises.

Banking organizations and their afﬁliates, in

general, are becoming more effective in imple-

menting the regulatory disclosure requirements.

Customers are also becoming increasingly aware

that such investment products purchased at bank-

ing organizations and their afﬁliates are not fed-

erally insured. Moreover, the Board and the

SEC have adequate supervisory authority to

ensure that bank holding companies comply

with the applicable regulatory disclosure

requirements. To the extent that disclosures to

customers are appropriate in areas not covered

by the regulatory policy statements or SEC

regulations, the Board will consider whether to

develop supervisory guidance.

BHC Supervision Manual June 1998

Page 1

4(c)(8) of the BHC Act—Securities Brokerage in Combination

with Investment Advisory Services Section 3230.1

Two bank holding companies jointly applied for

the Board’s approval under section 4(c)(8) of

the BHC Act and section 225.23(a)(3) of Regu-

lation Y to form a de novo subsidiary that would

engage in the following nonbanking activities:

1. providing portfolio investment advice to

‘‘institutional customers’’

2. providing securitiesexecution(brokerage)ser-

vices, related securities credit activities pur-

suant to the Board’s Regulation T, and inci-

dental activities

3. furnishing general economic information and

advice, general economical statistical fore-

casting services, and industry studies to insti-

tutional customers

4. serving as an investment adviser (as deﬁned

in section 2(a)(20) of the Investment Com-

pany Act of 1940) to investment companies

registered under that act

Separate fees are to be charged for the advi-

sory services and the securities brokerage ser-

vices. The company would also provide inciden-

tal services such as custodial and cash-

management services and acting as a registered

investment adviser. The services are to be pro-

vided throughout the United States. The provid-

ing of advisory services to retail clients was not

authorized by the Board. The applicant commit-

ted to create a ‘‘Chinese Wall’’ between the

afﬁliated bank and the securities afﬁliate.

The Board determined that the activities would

not violate Glass-SteagallAct prohibitions. Board

approval was conditioned with the requirement

that the standards of care and conduct applica-

ble to ﬁduciaries would be observed. The appli-

cant would not allow the exchange of conﬁden-

tial information between the de novo subsidiary

and its afﬁliates. The applicant further commit-

ted that employees of the de novo subsidiary

would not be given customer lists and other

conﬁdential information obtained by its afﬁli-

ates in connection with commercial banking

operations. Transmission of advisory research

and recommendations to the commercial lend-

ing department of any of the bank holding com-

pany’s afﬁliates was not permitted.

The proposal represented the combination of

activities, previously determined to be closely

related to banking, in such a way that the func-

tional nature and scope of the combined activi-

ties conducted would not be altered. By Board

order, the applicants’ application was approved

on June 13, 1986 (see 1986 FRB 584), subject

to the conditions stated therein. Other orders

were approved by the Board on August 5, 1987

(1987 FRB 810), and October 1, 1987 (1987

FRB 930), which also authorized a bank holding

company to engage in combined investment

advisory and securities brokerage activities. In

this order, the Board lowered the threshold for

deﬁning an ‘‘institutional investor’’ from $5 mil-

lion to $1 million.

The Board, effective September 10, 1992,

added this nonbanking activity to those activi-

ties that are permissible by regulation, currently

found in section 225.28(b)(7)(i) of Regula-

tion Y, subject to the disclosure requirements,

restrictions on exchanging conﬁdential customer

information, and other limitations stated therein.

BHC Supervision Manual June 1998

Page 1

4(c)(8)—Securities Brokerage with Discretionary Investment

Management and Investment Advisory Services Section 3230.2

A bank holding company applied to the Board

to expand the authority of its subsidiary to

engage in offering investment advisory services

for ‘‘institutional customers’’ and its afﬁliates

in conjunction with its previously approved

brokerage services. The Board previously

approved by order (1986 FRB 584) an applica-

tion for a different bank holding company to

offer the combination of investment advice and

securities execution services for institutional

customers.

The proposed activities in this order (1987

FRB 810) are similar except that the subsidiary

would additionally exercise limited investment

discretion at a customer’s speciﬁc request. Under

this plan, the subsidiary would offer as a ser-

vice, within deﬁned parameters established by

the client, discretion in buying and selling secu-

rities on behalf of the client.

Such investment discretion would be exer-

cised only at the request of a client; the subsidi-

ary does not plan to market or solicit managed

accounts. Each client will receive conﬁrmation

of each transaction, as well as monthly state-

ments which would indicate in detail the terms

of each transaction executed on its behalf. Each

client would always be aware of the scope of the

subsidiary’s activity for its account. The subsid-

iary would receive a single fee for the combined

activities of providing investment advice and

exercising limited investment discretion.

The application was approved on August 5,

1987, subject to the commitments made by the

applicant and the conditions (whether explic-

itly stated or incorporated by reference) in the

order.

The Board approved another order on Octo-

ber 1, 1987 (1987 FRB 930), similar to the

August 5, 1987, order, except that (1) the appli-

cant proposed to lower the test for institutional

customers from the $5 million threshold to

$1 million; (2) the applicant’s wholly owned

brokerage subsidiary would share customer lists

with its afﬁliates, but not conﬁdential informa-

tion obtained from the customer; and (3) the

brokerage subsidiary would have ofﬁcer and

director interlocks with the parent bank holding

company, but not with its bank afﬁliates. In the

Board’s view, these modiﬁcations did not alter

the underlying rationale of its earlier decision.

The Board approved another order on August

10, 1988 (1988 FRB 700). The principal differ-

ence between the August 5, 1987, order and this

proposal was the provision of such combined

services to retail as well as institutional custom-

ers. The provision of services to retail customers

does not include discretionary investment man-

agement. To further ensure the separation of the

BHC and its bank afﬁliates and to avoid poten-

tial conﬂicts of interests, the applicant made

several commitments, as detailed within the

order.

The Board, effective September 10, 1992,

added the providing of discretionary investment

management to the nonbanking activities that

are permitted by regulation, currently found in

section 225.28(b)(7)(i) of Regulation Y.

1. The provision of such services by the subsidiary to other

afﬁliates is a permissible servicing activity under section

225.22(a) of Regulation Y.

BHC Supervision Manual June 1998

Page 1

4(c)(8) of the BHC Act—Offering Full Securities Brokerage

Services for Bank-Ineligible Securities Section 3230.3

A bank holding company (applicant) applied for

the Board’s permission for its subsidiary to pro-

vide investment advisory and brokerage services

on a combined basis (‘‘full-service brokerage’’)

to institutional and retail customers and to engage,

to a limited extent, in underwriting and dealing

in one- to four-family mortgage-related securi-

ties and consumer receivable–related securities

(herein referred to as ‘‘ineligible securities’’).

The applicant committed to conduct its ineli-

gible securities underwriting and dealing activi-

ties subject to the revenue test and the pruden-

tial limitations established by the Board in 1987

FRB 473, except for a market-share limitation

which the Board decided not to require for this

BHC.

The Board determined previously that full-

service brokerage for both institutional and retail

customers is closely related and a proper inci-

dent to banking under section 4(c)(8) of the

BHC Act and does not violate the Glass-Steagall

Act (1988 FRB 700 and 1986 FRB 584). This

BHC’s proposal differs from prior cases in that

the subsidiary will provide full-service broker-

age to retail customers for ineligible securities

that it may hold as principal. The BHC has

committed that the subsidiary will provide full

and appropriate disclosure of its interest in the

transaction as required by the securities laws,

the National Association of Securities Dealers,

and ﬁduciary principles.

The Board had previously authorized an under-

writing subsidiary to provide full-service

brokerage with respect to ineligible securities

that it holds as principal, but only to institutional

customers (1988 FRB 695). Applicant made the

samecommitments regarding disclosures as found

in 1988 FRB 695. The BHC committed further

that its subsidiary would prominently disclose

in writing to each customer, at the commence-

ment of the relationship, that it is not a bank;

that it is separate from any afﬁliated bank; and

that the securities sold, offered, or recommended

by the subsidiary are not deposits, are not insured

by the FDIC, are not guaranteed by an afﬁliated

bank, and are not otherwise an obligation of an

afﬁliated bank, unless such is in fact the case.

The Board emphasized that conﬁrmations sent

to customers will state whether the subsidiary is

acting as agent or principal with respect to a

security. The Board concluded that such disclo-

sure commitments would be adequate. It recog-

nized that in performing the full-service broker-

age activity, the underwriting subsidiary would

be operating under a more extensive framework

of prudential limitations than would be the case

if the full-service brokerage activity were con-

ducted by a bank, a subsidiary of a bank, or by

another holding company subsidiary. Based on

the commitments made, the Board decided on

March 14, 1989, to approve the proposed activi-

ties (see 1989 FRB 396) subject to all the terms

and conditions found in 1987 FRB 473, except

for the market-share limitation.

Effective September 10, 1992, the Board added

this nonbanking activity to the activities permit-

ted by regulation, currently found in section

225.28(b)(7)(i) of Regulation Y and subject to

the Board’s disclosure and other requirements

and the limitations on exchanging conﬁdential

information, as stated therein.

BHC Supervision Manual June 1998

Page 1

Section 4(c)(8)—(Private-Placement

and Riskless-Principal Activities) Section 3230.4

This section discusses and provides a historical

reference of previous Board orders that initially

authorized, by order, a bank holding company’s

acting as agent in the private placement of secu-

rities and engaging in riskless-principal non-

banking activities. With the Board’s incorpora-

tion of private-placement and riskless-principal

activities into its adoption of changes to Regula-

tion Y, effective April 21, 1997, the majority of

the previous private-placement and riskless-

principal commitments are not effective. Only

those current requirements listed for private-

placement and riskless-principal activities in

section 225.28(b)(7) of Regulation Y (the laun-

dry list of permissible nonbanking activities)

should be used by the examiner in conducting

the supervision and inspection of bank holding

companies and their subsidiaries.

3230.4.1 ENGAGING IN

COMMERCIAL-PAPER PLACEMENT

ACTIVITIES TO A LIMITED EXTENT

A bank holding company (the applicant) applied

pursuant to section 4(c)(8) of the Bank Holding

Company Actandsection225.23(a) of the Board’s

Regulation Y to act as an agent and adviser to

issuers of commercial paper in connection with

the placement of commercial paper with institu-

tional purchasers. The commercial-paper-

placement activity, as proposed, is to be con-

ducted from a wholly owned commercial finance

subsidiary (the company) of the applicant’s direct

subsidiary.

The Board concluded that the proposed

commercial-paper-placement activity was so

functionally and operationally similar to the role

of a bank that arranges a loan participation

or syndication as to be a proper incident thereto

and that banking organizations are particularly

well suited to perform the commercial-paper-

placement function. The Board found that the

proposal, as limited by the applicant, was con-

sistent with section 20 of the Glass-Steagall Act,

and could reasonably be expected to result in

public beneﬁts that would outweigh possible

adverse effects. The Board found, further, that

the applicant could conduct the proposed activi-

ties to the extent and in the manner described in

the order. The Board’s approval (1987 FRB

138) extended only to the activities conducted

within the limitations proposed by the applicant

for company and the BHC’s subsidiary banks

and other subsidiaries. The placement of com-

mercial paper in any manner other than as

described within the limitations and conditions

of the order would not be within the scope of the

Board’s approval. The Board also required that

no lending afﬁliate of the company would dis-

close to the company any nonpublic customer

information concerning an evaluation of the

ﬁnancial condition of an issuer whose paper is

placed by the company or of any other customer

of the company, except as expressly required by

securities law or regulation.

On May 25, 1988, the Board approved an

order (1988 FRB 500) for a bank holding com-

pany to engage de novo, through a subsidiary, in

acting as an agent and adviser to issuers of

commercial paper in connection with the place-

ment of commercial paper with institutional cus-

tomers, as well as to engage in certain other

securities and ﬁnancial advisory activities. The

applicant proposed to place commercial paper in

accordance with all the terms and conditions of

the above order (1987 FRB 138), except one.

The applicant did not propose any quantitative

limitations on its placement activity. The Board

concluded that the proposed commercial-paper

placement did not constitute underwriting or

distributing under the Glass-Steagall Act and

that the quantitative limitations on the activity

were not necessary to ensure compliance with

that act. (See section 3230.4.2, in which a sub-

sidiary of a bank holding company was authorized

to privately place all types of debt and equity

securities.)

3230.4.2 ACTING AS AGENT IN THE

PRIVATE PLACEMENT OF ALL

TYPES OF SECURITIES AND ACTING

AS RISKLESS PRINCIPAL

A bank holding company (the applicant) applied

for the Board’s approval to transfer the private-

placement business of its commercial bank sub-

sidiary to its designated nonbanking subsidiary

for securities underwriting and dealing. The sub-

sidiary would act as agent in the private place-

ment of all types of securities, including the

providing of related advisory services, and buy

and sell all types of securities on the order of

investors as a riskless principal.

Because the section 20 subsidiary would be

afﬁliated through common ownership with a

member bank, it may not be ‘‘principally

BHC Supervision Manual December 2000

Page 1

engaged’’ in the ‘‘issue, ﬂotation, underwriting,

public sale, or distribution’’ of securities within

the meaning of the former section 20 of the

Glass-Steagall Act. In an earlier decision (1989

FRB 751), the Board determined that a subsidi-

ary is not engaged principally in section 20

activities if revenues from underwriting and

dealing in securities that banks are not autho-

rized to underwrite and deal in directly (bank-

ineligible securities) do not exceed 10 percent

of the subsidiary’s gross revenues (25 percent,

effective March 6, 1997). The applicant con-

tended that the proposed private-placement and

riskless-principal activities are not the kind of

securities activities described in section 20 and,

thus, should not be subject to the revenue limit

on bank-ineligible securities activities.

The private-placement market involves the

placement of new issues of securities with a

limited number of sophisticated purchasers in a

nonpublic offering. In private-placement trans-

actions, a ﬁnancial intermediary acts solely as

agent of the issuer in ﬁnding purchasers. The

intermediary does not purchase the securities

and then try to resell them.

Privately placed securities are not subject

to the registration requirements of the Securities

Act of 1933. Such securities are only offered to

ﬁnancially sophisticated institutions and indi-

viduals,

not to the public. The applicant stated

that all of the individuals with whom the securi-

ties would be placed will qualify as ‘‘accredited

investors’’ under SEC rules. The Board con-

cluded that the subsidiary’s private placement

of debt and equity securities within the limits

proposed did not involve the underwriting or

public sale of securities and that the revenues

from the proposed activities should not be sub-

ject to the 10 percent revenue limitation (25

percent, effective March 6, 1997) on bank-

ineligible securities activities.

The Board noted that other limitations on the

activity should ensure that securities would not

be offered to the public. First, the applicant

agreed that the subsidiary would not make any

general solicitation or advertisement to the pub-

lic regarding the placement of particular securi-

ties. Second, the minimum denomination of

securities to be placed would be $100,000. Third,

the applicant agreed that the subsidiary would

not privately place securities that are registered

under the Securities Act of 1933 and that the

subsidiary would be compelled to honor all pro-

visions of that act, particularly those that limit

the scope of private placements to nonpublic

transactions. Fourth, the subsidiary agreed not

to privately place as agent the securities of

investment companies which are sponsored or

advised by the applicant or its subsidiaries.

Fifth, the subsidiary will not purchase or repur-

chase for its own account the securities being

placed or will not inventory unsold portions of

such securities. Sixth, the applicant further agreed

to consult with its Federal Reserve Bank staff

before transferring its private-placement activi-

ties from the subsidiary to any other nonbank

subsidiary of the applicant to ensure that the

transfer did not evade any of the ﬁrewall provi-

sions committed to.

3230.4.3 INCORPORATION OF

PRIVATE-PLACEMENT

NONBANKING ACTIVITIES INTO

REGULATION Y

The Board has added the activity of acting as

agent in the private placement of securities to

the laundry list of nonbanking activities (see

12 C.F.R. 225.28(b)(7)(ii)). Regulation Y adopts

the deﬁnition of private-placement activities

that is used by the SEC and the federal securi-

ties laws. In taking this action, the Board removed

all but one restriction on private placement. The

remaining restriction prohibits a bank holding

company from purchasing for its own account

the securities being placed or holding in

inventory unsold portions of issues of these

securities. This restriction prevents a bank

holding company from classifying its securi-

ties underwriting activities as private-placement

activities.

3230.4.4 RISKLESS PRINCIPAL

‘‘Riskless principal’’ is a broker-dealer that,

after receiving an order to buy (or sell) a secu-

rity from a customer, purchases (or sells) the

security for its own account to offset a simulta-

neous sale to (or purchase from) the customer.

1. The subsidiary would not only place securities with

institutional customers but with individuals whose net worth

(or joint net worth with a spouse) exceeds $1 million. Such

placement activities with individuals would not, in the Board’s

opinion, result in a public offering.

Section 4(c)(8)—(Private-Placement and Riskless-Principal Activities) 3230.4

BHC Supervision Manual December 2000

Page 2

3230.4.4.1 Description of

Riskless-Principal Transactions

When acting as a dealer, the securities ﬁrm

maintains an inventory of securities for its own

account and buys and sells securities as princi-

pal. Riskless-principal transactions are usually

undertaken as an alternative method of execut-

ing orders by customers to buy or sell securities

on an agency basis. In this situation, when a

customer places an order to purchase securities

that the broker-dealer does not maintain in its

inventory, the ﬁrm must purchase the securities

from a third party. At this point, the broker-

dealer has the option of acting either as the

agent for the customer or a riskless principal in

making the purchase. If the decision is made to

act as a riskless principal, the broker-dealer will

purchase the securities from a third-party dealer

at the dealer’s ‘‘inside price’’ (conﬁrming the

transaction for its customer) and then, acting as

principal, resell them to the customer, adding a

markup over cost. If the broker-dealer does not

complete the purchase of the securities ordered

by the customer, it is not obligated to provide

the securities.

3230.4.4.2 Underwriting and Riskless

Principal

In riskless-principal transactions, the subsidiary

would execute orders by an investor and would

not act on behalf of an issuer of new securities.

The subsidiary would not be involved in making

any public offering of securities as agent for the

issuer. Thus, these activities would not consti-

tute underwriting for Glass-Steagall purposes.

3230.4.4.3 Summary of Board Action on

Acting as Agent in Private Placement and

as Riskless Principal in Buying and

Selling Securities

The Board concluded that the securities under-

writing and dealing of the subsidiary’s riskless-

principal activity did not constitute an under-

writing of securities. The riskless-principal

activity would not be a public sale or underwrit-

ing of securities and would not be viewed as a

bank-ineligible securities activity for purposes

of the current 25 percent revenue test. As a

condition for the approval of the riskless-

principal activity, the Board required the subsid-

iary to maintain speciﬁc records that would

clearly identify such transactions so that exam-

iners will be able to trace the resulting revenue.

The riskless-principal activity was found to be

closely related to banking. The Board further

concluded that the placement activity differed

only slightly in scope from those approved pre-

viously and that the operational limitations agreed

to by the applicant would ensure that the subsid-

iary would not become involved in the public

offering of any securities. The Board approved

the application on October 30, 1989 (1989 FRB

829). (See also 1997 FRB 146; 1996 FRB 350,

748; 1995 FRB 49, 880, 1133; 1994 FRB 554,

1014; 1993 FRB 1166; 1992 FRB 294, 335,

552, 868; 1991 FRB 61; and 1990 FRB 26, 79,

545, 567, 568 (footnote 7), 653, 659, 663, 667,

672, 674, 766, 857, 864.)

3230.4.4.4 1996 Changes to the

Underwriting Conditions for

Riskless-Principal Activities

In connection with a bank holding company

proposal considered by the Board on June 10,

1996, the Board reviewed the continued appro-

priateness of applying the underwriting con-

ditions to the conduct of riskless-principal

activities. In that case, the Board determined,

based on its experience in monitoring and exam-

ining the conduct of riskless-principal activities

by bank holding companies, that the underwrit-

ing conditions were not necessary to address

identiﬁable adverse effects. Accordingly, the

Board permitted the bank holding company to

engage in riskless-principal transactions through

a nonbank subsidiary without conducting this

activity in accordance with the underwriting

conditions (See 1996 FRB 748). The Board

noted that riskless-principal transactions are

essentially equivalent to securities brokerage

transactions and, therefore, must be conducted

in compliance with federal securities laws. The

Board concluded that the deﬁnitional limitations

(see section 225.28(b)(7)(ii) of Regulation Y)

would be all that is needed to purchase (or sell)

securities as a riskless principal. The conditions

are designed to ensure that bank holding com-

panies do not avoid the Glass-Steagall Act by

classifying underwriting and dealing activities

as riskless-principal activities. In the June 10

order, the bank holding company agreed that,

if riskless-principal services were provided in

combination with its advisory services, it would

provide its customers with the disclosures estab-

lished by the Board for full-service brokerage

activities of bankholding companies. Withrespect

Section 4(c)(8)—(Private-Placement and Riskless-Principal Activities) 3230.4

BHC Supervision Manual June 1997

Page 3

to its decision, the Board decided to grant iden-

tical relief to other bank holding companies

that had been previously approved to conduct

riskless-principal nonbanking activities.

3230.4.4.5 Incorporation of

Riskless-Principal Transactions into

Regulation Y

As part of the Board’s February 19, 1997, adop-

tion of the ﬁnal amendments to Regulation Y, it

retained the requirement that riskless-principal

transactions be conducted in the secondary mar-

ket. It further determined to eliminate all but

two restrictions with respect to riskless-principal

transactions. A bank holding company may thus

buy and sell in the secondary market all types of

securities on the order of customers as a riskless

principal, to the extent of engaging in a trans-

action in which the company, after receiving an

order to buy (or sell) a security from a customer,

purchases (or sells) the security for its own

account to offset a contemporaneous sale to (or

purchase from) the customer. This does not

include—

1. selling bank-ineligible securitiesat the order

of a customer that is the issuer of the securities,

or selling in any transaction in which the bank

holding company has a contractual agreement to

place the securities as agent of the issuer; or

2. acting as riskless principal in any trans-

action involving a bank-ineligible security for

which the bank holding company or any of its

afﬁliates acts as an underwriter (during the

period of the underwriting or for 30 days there-

after) or dealer. A bank holding company or its

afﬁliates may not enter quotes for speciﬁc bank-

ineligible securitiesin any dealerquotation system

in connection with the bank holding company’s

riskless-principal transactions, except that the

company or its afﬁliate may enter bid or ask

quotations, or publish ‘‘offering wanted’’ or

‘‘bid wanted’’ notices on trading systems other

than NASDAQ or an exchange, if the company

or its afﬁliate does not enter price quotations on

different sides of the market for a particular

security for any two-day period. (See 12 C.F.R.

225.28(b)(7)(ii).)

Section 4(c)(8)—(Private-Placement and Riskless-Principal Activities) 3230.4

BHC Supervision Manual June 1997

Page 4

Section 4(c)(8)—Acting as a Municipal Securities

Brokers’ Broker Section 3230.5

A BHC applied for the Board’s approval, pursu-

ant to section 4(c)(8) and 225.23(a) of the Board’s

Regulation Y, to acquire, through a securities

brokerage subsidiary, a 49 percent interest in a

joint venture partnership. The applicant was a

one-bank holding company formed over a bank-

ers’ bank. The shareholders comprised several

hundred banks. The joint venture partnership

(the company) proposed to engage in the activ-

ity of acting as a municipal securities brokers’

broker.

This consisted of providing municipal

securities brokerage services to other registered

securities brokers and dealers, including dealer

banks. The company would act as an undis-

closed agent in the purchase and sale of munici-

pal securities, including revenue bonds, for the

account of its customers.

The applicant’s proposal involved the pur-

chase and sale of municipal securities as agent

only and did not include dealing or otherwise

taking a position in such securities. The activity

fell within the third-party securities activities

permitted for member banks under section 16 of

the Glass-Steagall Act (12 U.S.C. 24), which

allows banks to purchase and sell securities

‘‘without recourse, solely upon the order, and

for the account of, customers.’’ National banks

had been permitted to engage in the activity of

acting as municipal securities brokers’ brokers.

The Board found the activity to be function-

ally similar to the retail securities brokerage

activities performed by banks for their custom-

ers as permitted under section 16 of the Glass-

Steagall Act. The Board thus concluded that the

activity was closely related to banking. The

Board’s approval of the order was based on

several commitments made by the applicant and

the other joint venturer. The Board approved the

application by order on June 26, 1985 (1985

FRB 651).

1. Rule 15c3-1(a)(8)(ii) implementing section 15(c)(3) of

the Securities and Exchange Act of 1934 deﬁnes a municipal

securities brokers’ broker as a ‘‘municipal securities broker or

dealer who acts exclusively as an undisclosed agent in the

purchase or sale of municipal securities for a registered broker

dealer or registered municipal securities dealer’’ who has ‘‘no

retail customers’’ and ‘‘maintains no municipal securities in

its proprietary or other accounts.’’ Municipal securities bro-

kers’ brokers are subject to the federal securities laws applica-

ble to securities brokers and are governed by the rules of the

Municipal Securities Rulemaking Board.

BHC Supervision Manual December 1998

Page 1

Section 4(c)(8) of the BHC Act (Acting as a Conduit

in Securities Borrowing and Lending) Section 3230.6

A foreign bank holding company (the appli-

cant), and its wholly owned subsidiary (the com-

pany),a commercial banking organizationlocated

in New York state, applied pursuant to section

4(c)(8) of the BHC Act and section 225.23(a) of

the Board’s Regulation Y for prior approval to

engage de novo on a domestic and international

basis, through the company, in the following

activities:

1. providing investment advisory services and

ﬁnancial advisory services, including advice

regarding mergers, acquisitions, and capital-

raising proposals by institutional customers,

pursuant to section 225.28(b) of Regu-

lation Y

2. providing securities brokerage services on an

individual basis as well as in combination

with investment advisory services (‘‘full-

service brokerage’’), including exercising lim-

ited investment discretion on behalf of insti-

tutional customers

3. purchasing and selling all types of securities

on the order of institutional and retail cus-

tomers as a ‘‘riskless principal’’

4. engaging in securities credit activities under

section 225.28(b)(6) of Regulation Y, includ-

ing acting as a ‘‘conduit’’ or ‘‘intermediary’’

in securities borrowing and lending

The Board previously determined by regula-

tion that engaging in the above-listed nonbank-

ing activities (1) and (2) is closely related to

banking under section 4(c)(8) of the BHC Act

(see section 225.28(b)(6) and (7) of the Board’s

Regulation Y). The Board previously deter-

mined by order that, subject to certain prudential

limitations, the proposed riskless-principal

activities (item 3) are so closely related to bank-

ing as to be a proper incident thereto within the

meaning of section 4(c)(8) of the BHC Act. The

applicant has committed that the company will

conduct its riskless-principal activities using the

same methods and procedures and subject to the

same prudential limitations established by the

Board in its orders that are found at 1989 FRB

829 and 1990 FRB 26.

Banks and BHCs are permitted to borrow and

lend securities held in their own portfolios (see

the FFIEC’s 1985 Supervisory Policy Statement

on Securities Lending, Federal Reserve Regula-

tory Service 3–1579.5). In this case, the appli-

cant proposed that the company borrow and

lend the securities of noncustomer third parties.

The company would seek out counterparties to

securities borrowing and lending transactions

and would assume much the same risk in these

transactions as if it was borrowing or lending its

own securities or its customers’ securities. In

this capacity, it would act as a ‘‘conduit’’ or

‘‘intermediary’’ in securities borrowing and lend-

ing. The company would supply—upon the

request of another broker-dealer who is unable

to obtain securities needed to satisfy customer

or investment or operational needs—securities

not available in the company’s accounts or cus-

tomer accounts by seeking out third-party non-

customer lenders. In addition to locating the

securities, the company proposes to coordinate,

on behalf of the borrowerand lender, the exchange

of securities and collateral that is necessary to

the transaction.

The Board, in its review of this application,

believed that banks generally perform services

that are operationally or functionally similar to

the proposed conduit services. The proposed

conduit activity was believed to be similar to the

securities borrowing and lending activities that

banks conduct. National and state banks are

permitted to lend securities from their own port-

folio, and with the customer’s consent, from the

accounts of customers, and banks regularly bor-

row securities to meet their needs and the needs

of customers. The fact that a third party is

substituted in place of a trust or other customer

of a bank would not change signiﬁcantly the

way in which the securities lending activity

would be conducted. The same steps and proce-

dures that would be necessary to effectuate the

loan of a customer’s securities would be fol-

lowed in loaning the securities of a noncustomer

third party.

The risk associated with the proposed activity

is the same risk that a bank would incur in

managing the lending of securities from its own

portfolio or the portfolio of a customer. The risk

to the company, in acting as a conduit, is limited

to ensuring that the collateral posted by the

1. The company agreed to coordinate this exchange through

accounts established at a speciﬁcally named, privately held

national clearinghouse for the settlement of transactions in

corporate and municipal securities. Once the company had

located the desired securities, the securities would be trans-

ferred to an account maintained by it at the clearinghouse and

simultaneously delivered to an account of the borrower, also

at that clearinghouse. At the same time, the borrower would

be required to post collateral, which the company would

receive into its clearinghouse account and simultaneously

deliver to an account maintained by the lender at the clearing-

house.

BHC Supervision Manual December 1998

Page 1

borrower continuously reﬂects the market value

of the securities loaned. The company commit-

ted to mark this collateral to market on a daily

basis and to make calls for supplemental collat-

eral where necessary.

The company also repre-

sented that it would not provide any indemniﬁ-

cation to noncustomer third-party lenders of

securities.

The Board determined, for the above reasons,

that the proposed conduit activity is closely

related to banking for the purposes of section

4(c)(8) of the BHC Act and approved the order

on October 9, 1992 (1992 FRB 955).

The Board’s approval was subject to the fol-

lowing speciﬁed conditions:

1. To minimize risk, the company is to act

as a conduit only when the potential bor-

rower and lender are matched before the

transaction. In addition, it will take various

measures to minimize operational risks,

including conducting its conduit activities in

accordance with the collateral requirements

imposed on the borrowers by the Board’s

Regulation T.

A conduit transaction will

commence only when a broker-dealer

approaches the company and needs to bor-

row securities. Securities will not be bor-

rowed in anticipation of a transaction.

2. At the end of each day, the company will

mark to market the collateral posted by the

borrower in all transactions in which it loaned

securities or acted as an intermediary for a

lender. As proposed, the company would

establish credit lines for potential borrowers

and lenders.

3. The applicant committed that the company

will conduct its conduit activities in compli-

ance with the FFIEC Supervisory Policy

Statement on Securities Lending (Federal

Reserve Regulatory Service 3–1579.5).

2. If the price of the borrowed securities increases, the

borrower is required under the Board’s Regulation T to pro-

vide additional collateral to the company. The company, in

turn, through transactions at the clearinghouse, will pass the

collateral to the initial lender of the securities. If the borrower

is unable to satisfy this requirement, the company is to have

the contractual right to terminate the borrowing transaction by

purchasing the securities in the open market and delivering

them to the lender, who will then be obligated to return the

borrower’s collateral to the company. Because the borrowed

securities will be marked to market daily by the company, the

maximum exposure to the company in directly or indirectly

borrowing or lending securities is one day’s change in the

price of the borrowed securities.

3. The applicant committed that the Board’s Regulation

T—which requires that all securities borrowing and lending

transactions be collateralized by at least 100 percent of the

value of the securities as computed on a daily basis—shall be

the company’s minimum guideline for posting collateral, and

that the company will require many transactions to be collat-

eralized in excess of 100 percent of the value of securities

marked to market.

4. These credit policies are to include a review of all

lenders and borrowers and the establishment of a credit com-

mittee that will determine limits on the credit exposure of any

single borrower. The applicant proposed that the company

would transact its business only with a select group of well-

capitalized broker-dealers that will not be brokerage custom-

ers of the company.

Section 4(c)(8) of the BHC Act (Acting as a Conduit in Securities Borrowing and Lending)

3230.6

BHC Supervision Manual December 1998

Page 2

4(c)(8)—Underwriting and Dealing in U.S. Obligations, Municipal

Securities, and Money Market Instruments Section 3240.0

The Board has authorized bank holding com-

pany subsidiaries to engage in investment or

trading transactions as principal to underwrite

and deal in certain securities and money market

instruments that are eligible for bank underwrit-

ing and dealing by state member banks. Basi-

cally, the Board has subjected dealer subsidi-

aries to the same restrictions that govern

underwriting and dealing by state member banks

pursuant to 12 U.S.C. 24 and 335. Permissible

activities include underwriting and dealing in

type I securities as deﬁned in 12 C.F.R. 1,

including obligations of the United States, gen-

eral obligations of states and their political sub-

divisions,

and type I municipal bonds; type II

securities as deﬁned in 12 C.F.R. 1, including, in

part, municipal revenue obligations for housing,

university, or dormitory purposes that do not

qualify as type I securities; and banker’s accep-

tances and certiﬁcates of deposit. In addition,

such dealer subsidiaries are subject to the appli-

cable capital restrictions (10 percent of the lead

bank’s capital and surplus) on dealing in type II

securities in 12 C.F.R. 1.7. These underwriting

and dealing activities were added to the permis-

sible activities section of Regulation Y, effective

February 6, 1984. Furthermore, dealer subsidi-

aries are permitted to furnish investment advice

with respect to these bank-eligible securities.

The Board has authorized bank-afﬁliated

securities dealers to underwrite, deal in, or pri-

vately place type III securities in separately

capitalized nonbank subsidiaries subject to

prudential limitations and restrictions to pre-

clude such subsidiaries from being principally

engaged in the underwriting and distribution of

securities. In addition, the Board has authorized

broker-dealer subsidiaries and brokerage subsid-

iaries to privately place any type of debt or

equity security.

3240.0.1 HISTORY OF BOARD

APPROVALS OF UNDERWRITING

AND DEALING IN GOVERNMENT

OBLIGATIONS AND MONEY

MARKET INSTRUMENTS

On February 27, 1978, the Board approved an

application to engage de novo in underwriting

and dealing activities then being conducted by

the bank holding company’s only subsidiary

bank. Thus, the formation of the subsidiary

transferred these operations from the bank to the

nonbank subsidiary. The activity included the

underwriting and dealing in obligations of the

United States and general obligations of various

states and of political subdivisions. The Board

determined that this activity is closely related to

banking. The Board also approved, on February

27, 1978, another application of a bank holding

company that would permit it to retain shares in

a ﬁrm engaged in U.S. government securities

underwriting activities.

On March 20, 1979, the Board approved an

application of a bank holding company to acquire

a company that would engage de novo in the

activities of underwriting and dealing in certain

government and municipal securities and in pro-

viding portfolio investment advice to individu-

als, associations, corporations, state and local

governments, and ﬁnancial institutions (‘‘non-

bank entities’’) and to unafﬁliated commercial

banks. The Board determined that the proposed

activities were closely related to banking.

On March 2, 1982, the Board approved an

application of a bank holding company to form

an incorporated securities company subsidiary

that would engage de novo in the activities of

soliciting, underwriting, dealing in, purchasing,

and selling obligations of the United States,

general obligations of various states, and money

market instruments such as banker’s accept-

ances and certiﬁcates of deposit. The Board

regarded the government securities activities

that the bank holding company proposed to

engage in as substantially the same as the activi-

ties that the Board had approved in previous

orders. Insofar as its proposal to deal in banker’s

acceptances, certiﬁcates of deposit, and other

money market instruments that state member

banks may from time to time be authorized to

underwrite and deal in (such instruments are not

regarded as ‘‘securities’’ subject to the prohibi-

tions in sections 16 and 21 of the Glass-Steagall

Act), the Board regarded such activities as closely

related to banking because banks engage in such

functions. The Board’s approval of the bank

holding company’s application was subjected to

the same restrictions and prudent limitations as

if the activity were conducted in the afﬁliate’s

lead bank. For example, the nonbank subsidiary

could not underwrite, deal in, or hold type II

1. The Gramm-Leach-Bliley Act authorized well-

capitalized state member banks to deal in, underwrite, pur-

chase, and sell all type I municipal securities and revenue

bonds without any limitations relative to the bank’s capital.

See section 2020.1 of the Commercial Bank Examination

Manual and SR-01-13.

BHC Supervision Manual June 2003

Page 1

securities of any issuer in amounts that would

not be permitted if such activities were con-

ducted by the subsidiary national bank, nor

would it be permitted to sell securities to trust

accounts of afﬁliated banks, except as permitted

by regulations of the Comptroller of the Cur-

rency. Type II securities can consist of certain

types of public housing and dormitory bonds of

states and municipalities. The amount of such

securities, of a single issue held by the bank,

may not exceed 10 percent of the bank’s capital

and surplus (12 U.S.C 24 (seventh) and (12

C.F.R. 1.3(d)). The Board further ruled that any

purchase of securities from the bank holding

company’s nonbank subsidiary by any of the

bank holding company’s subsidiary banks at

other than current market values would consti-

tute an unsafe or unsound practice.

3240.0.2 ADDING THE ACTIVITY

TO REGULATION Y

Effective February 6, 1984, underwriting and

dealing in U.S. government obligations and cer-

tain money market instruments was added to the

list of permissible activities of Regulation Y.

The regulation, which was amended in 1997,

continues to place the same limitations as would

be applicable if the activity were performed by

the bank holding company’s subsidiary member

banks or its subsidiary nonmember banks as if

they were member banks. (See Section

225.28(b)(8)(i) of Regulation Y.)

3240.0.3 REGULATION OF DEALER

ACTIVITIES

While municipal securities dealers and dealers

in government/agency securities are required

to register as broker-dealers pursuant to the

Securities Exchange Act of 1934, there are at

present no registration requirements for ﬁrms

that deal only in money market instruments.

Regardless of whether a bank holding company

subsidiary is registered as a broker-dealer with

the Securities and Exchange Commission (SEC),

Federal Reserve System examiners will conduct

inspections to determine whether the subsidiary

is in compliance with the provisions of Regu-

lation Y or any speciﬁc conditions in a bank

holding company order pertaining to the organi-

zation under inspection. In addition, examiners

will need to focus on ﬁnancial, managerial, and

safety-and-soundness considerations in any bank

holding company dealer subsidiary. In the event

a ﬁrm is a registered broker-dealer subject

to examination by the National Association of

Securities Dealers (NASD), the inspection should

be designed to prevent duplication of effort,

relying on work performed by NASD examiners

to the greatest extent possible, yet still evaluate

the factors discussed above that are relevant for

either registered or unregistered dealers.

Effective May 20, 1985, the Federal Reserve

Bank of New York adopted a Capital Adequacy

Guideline for U.S. Government Securities Deal-

ers. The Federal Reserve Bank of New York

recommends that U.S. government securities

dealers that are not subject to federal oversight

agree to comply voluntarily with the capital

adequacy guideline. Hence, it is expected that

any government securities dealer subject to Sys-

tem inspection will comply with the SEC’s Uni-

form Net Capital Rule (17 C.F.R. 240.15c3-1).

3240.0.4 DEALER ACTIVITIES

A ﬁrm operates as a dealer when it underwrites

or deals in securities or money market instru-

ments. Those activities are usually distinguished

as separate activities from normal investment

activities. If the ﬁrm holds itself out to other

dealers or investors as a dealer or engages in

a repetitive pattern of short-term purchases

and sales, the ﬁrm may be engaged in dealer

activities, regardless of its stated investment

activities.

As noted previously, when the Board added

to the Regulation Y list of permissible activities

the activities of underwriting and dealing in U.S.

government securities, certain money market

instruments, and municipal securities, the Board

added a restriction that such nonbank activities

be subject to the same restrictions as securities

and money market instrument activities of mem-

ber banks. Accordingly, the following discus-

sion focuses upon permissible securities activi-

ties of all member banks.

3240.0.5 GOVERNMENT AND

MUNICIPAL SECURITIES

The authority under which a bank may engage

in securities trading and underwriting is found

in section 5136 of the Revised Statutes (12

U.S.C. 24). That authority is restricted by limi-

tations on percentage holding of classes of

securities as found in 12 C.F.R. 1.3. That regu-

lation allows banks to deal in, underwrite,

purchase, and sell type I securities without

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limit and type II securities limited to 10 per-

cent of its capital and unimpaired surplus. Banks

are prohibited from underwriting or dealing

in type III securities for their own accounts.

(See section 2020.1 of the Commercial Bank

Examination Manual for further information on

type I, II, and III securities.)

There are three major types of securities

transactions in which banks are involved. First,

the bank may buy and sell securities on behalf

of a customer. Those are agency transactions in

which the agent (bank) assumes no substantial

risk and is compensated by a prearranged com-

mission or fee. Second, as a dealer, the bank

buys and sells securities for its own account.

That is termed a principal transaction because

the bank is acting as a principal, buying or

selling qualiﬁed securities through its own inven-

tory and absorbing whatever market gain or loss

is made on the transaction. The third type of

securities transaction frequently executed by

banks is a contemporaneous ‘‘riskless-principal

trade.’’ The dealer buys and sells qualiﬁed secu-

rities as a principal, with the purchase and sale

originating almost simultaneously. Exposure to

market risks is limited by the brief period of

actual ownership, and proﬁts result from dealer-

initiated markup, the difference between the pur-

chase and sale prices.

Dealers’ securities transactions involve cus-

tomers and other securities dealers. The word

‘‘customer,’’ as used in this section, means an

investor. Transactions with other dealers are not

considered customertransactions unlessthe dealer

is buying or selling for investment purposes.

The following subsections include general

descriptions of signiﬁcant areas of permissible

trading and underwriting activities.

3240.0.6 U.S. GOVERNMENT

SECURITIES TRADING

U.S. government security trading inventories are

generally held with the objective of making

short-term gains through market appreciation

and dealer-initiated markups. The size of a

transaction, the dealer efforts extended, and the

nature of the security are common factors that

affect the markup differential. Markups on gov-

ernment securities generally range between one

and four thirty-seconds of a point. Long matu-

rity issues may have higher markups.

The market risk inherent in U.S. government

trading portfolios should be controlled by pol-

icy. Standards should be established to limit the

total securities inventory and the amount of

securities with similar yield or maturity char-

acteristics. Limits imposed by policy should

include commitments to purchase new govern-

ments on a when-issued basis.

Payments for and deliveries of U.S. govern-

ment and most agency securities are settled on

the business day following the trade. Govern-

ment dealers and customers can negotiate same-

day or delayed settlement for special situations,

but the industry recognizes standard settlement

as occurring on the trade date plus one business

day.

3240.0.6.1 ‘‘When-Issued’’ Trading

A signiﬁcant source of risk to dealers involves

‘‘when-issued’’ (WI) trading in government

securities. WI trading is the buying and selling

of securities in the one- to two-week interim

between the announcement of an offering and

the security issuance and payment date. The

Dealer Surveillance Staff at the Federal Reserve

Bank of New York began to require WI position

reports from primary government securities deal-

ers and request voluntary WI reports from cer-

tain other government securities dealers in 1984.

At the time the reporting requirements were

adopted, a senior ofﬁcial stated, ‘‘The opportu-

nity to trade with several dealers simultaneously

without making payment could result in trading

losses which exceed a participant’s ability to

settle.’’ In essence, the fact that settlement date

can extend to almost two weeks—as opposed to

the ordinary next-day settlement—presents an

opportunity for ﬁrms to engage in a large vol-

ume of trading without drawing on the ﬁrm’s

ability to purchase securities or effect delivery

against short positions. Hence, there is increased

credit risk in such transactions. Consequently,

the dealer’s trading position limits should include

WI limits to protect against the increased credit

risk associated with WI trading.

3240.0.6.2 Due Bills

A ‘‘due bill’’ is an obligation that results when a

ﬁrm sells a security or money market instrument

and receives payment, but does not deliver the

item sold. Due bills issued should be considered

as borrowings by the issuing ﬁrm, and, alterna-

tively, due bills received should be considered

as lending transactions.

Registered broker-dealers are subject to the

SEC’s rule 15c3-3 (17 C.F.R. 240.15c3-3), ‘‘Cus-

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tomer Protection—Reserves and Custody of

Securities.’’ Basically, this rule states the prin-

ciple that a broker-dealer needs to safeguard

customer assets and cannot use such assets to

fund its own business activities. While this rule

is not directly applicable to unregistered U.S.

government securities or money market instru-

ment dealers, the principle is transferable. Deal-

ers should not issue due bills as a means of

obtaining operating funds or where the under-

lying security can be delivered at settlement.

Customers of the dealer enter transactions with

an implicit understanding that securities transac-

tions will be promptly executed and settled

unless there is a clear understanding to the con-

trary. Consequently, dealers should promptly

disclose the issuance of a due bill to a customer

when funds are taken but securities or money

market instruments are not delivered to the cus-

tomer. Such disclosure should reference the

applicable transaction; state the reason for the

creation of a due bill; describe the collateral, if

any, securing the due bill; and indicate that to

the extent the market value of the collateral is

insufﬁcient, the customer may be an unsecured

creditor of the dealer.

3240.0.6.3 Clearance

Securities clearance services for the bulk of U.S.

government and federal-agency security transac-

tions are provided by the Federal Reserve as

part of its telegraphic securities transfer system.

The various Federal Reserve Banks will wire

transfer most government securities between the

book-entry safekeeping accounts of the seller

and buyer. The Federal Reserve’s systems also

are used to facilitate security borrowings, loans,

and pledges. Hence, the securities ﬁrm will need

to use the services of a clearing bank.

3240.0.6.4 Short Sales

Another area of U.S. government security activ-

ity involves short-sale transactions. A short sale

is the sale and delivery of a security that the

seller does not own. It is accomplished by bor-

rowing the security for delivery. The borrowed

securityis collateralized byan appropriateamount

of a similar security. Short sales are conducted

to accommodate customer orders, to obtain funds

by leveraging existing assets, to hedge the mar-

ket risk of other assets, or with the expectation

that the market price of the sold security will

decline sufﬁciently to allow the bank to com-

plete the transaction by purchasing an equiva-

lent security at a later date and a lower price.

3240.0.6.5 Arbitrage

Arbitrage is the coordinated purchase and sale

of two securities or of a security and a futures or

options contract in which there is a relative

market imbalance. The objective of such activ-

ity is to obtain earnings by taking advantage of

changing yield spreads. Arbitrage opportunities

take many forms and can exist whenever seg-

ments of the securities markets are subject to a

yield variance.

Exposure on arbitrage and/or short sales should

be closely monitored for compliance with prede-

termined objectives. Risk should be controlled

by point-spread limits coordinated with stop-

loss buy provisions or sell provisions and by

guidelines on the length of time a short position

can remain uncovered.

3240.0.7 MONEY MARKET TRADING

Aside from short-term securities, banks custom-

arily trade a substantial volume of other money

market instruments such as banker’s accep-

tances. It should be noted that the Supreme

Court has opined that commercial paper is a

Glass-Steagall security.

3240.0.7.1 Banker’s Acceptances

Banker’s acceptances are an obligation of the

acceptor bank and an indirect obligation of the

drawer. They are normally secured by rights to

the goods being ﬁnanced and are available in a

wide variety of principal amounts. Maturities

are generally less than nine months. Accep-

tances are priced like Treasury bills, with a

discount ﬁgured for the actual number of days

to maturity based on a 360-day year.

3240.0.7.2 Certiﬁcates of Deposit

Negotiable certiﬁcates of deposit (CDs) issued

by money-center banks are actively traded in

denominations of $100,000 to $1 million. Inter-

est generally is calculated on a 360-day year and

paid at maturity. Secondary market prices are

computed based on current yield, net of accrued

interest due the seller. Eurodollar CDs trade like

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domestic CDs except their yields are usually

higher and their maturities often longer.

Money market instruments trade with the

same-day or one-day settlement. Publicly quoted

yields or dollar prices are usually based on

round lot trades of $1 million, except for com-

mercial paper, which trades in round lots of

$250,000. Odd-lot prices may vary, but because

of the large dollar volume of most trades, the

percentage spread between the acquisition cost

and sale price is characteristically modest.

Management should attempt to minimize mar-

ket risk by establishing a maximum holding

limit for each class of money market instrument.

Policy guidelines also should establish concen-

tration limits for money market instruments

issued by a single obligor. Such limits should

include commitments.

A sound money market trading policy recog-

nizes the need for a qualitative analysis of the

issuers of instruments. Credit approvals should

be obtained before trading in CDs and accep-

tances, and reviews should be conducted on a

regular schedule.

Banks dealing in money market instruments

are subject to a number of legal restrictions. The

sale of federal funds by a member bank to a

bank afﬁliate is limited under section 23A (12

U.S.C. 371(c)) and subject to the restrictions of

section 23B of the Federal Reserve Act (12

U.S.C. 371(c-1)). The acquisition, as principal,

of a certiﬁcate of deposit issued by an afﬁliate

bank also is subject to section 23A limitations

and section 23B restrictions. These restrictions

do not apply to transactions between bank sub-

sidiaries that are 80 percent or more commonly

owned by a bank holding company. These trans-

actions must be conducted on terms that are

consistent with safe and sound banking practices.

3240.0.8 REPURCHASE

AGREEMENTS AND SECURITIES

LENDING

The overwhelming majority of a government

security dealer’s inventory is ﬁnanced by repur-

chase agreements. In addition, many dealers

operate a ‘‘matched book’’ repo operation

whereby they ﬁnance the acquisition or carrying

of securities by customers through reverse

repurchase agreements and contemporaneously

obtain funding for such transactions through the

sale of the same or similar securities under a

repurchase agreement. In addition, securities

dealers often lend or borrow speciﬁc issues to

effect delivery against short positions or because

of failure to receive securities required to be

delivered. For prudential guidelines that have

been issued to ﬁnancial institutions in connec-

tion with repurchase agreements and securities

lending, see the FFIEC supervisory policy

statements at sections 2140.0 and 2150.0,

which have been adopted by the Federal Reserve

Board.

Firms enter into ‘‘reverse repos’’ to ﬁnance

the U.S. government securities inventory of

other dealers or mortgage bankers who have

originated pools of mortgages to back federal

housing agency securities. Repos are sold to

customers in lieu of certiﬁcates of deposit. Cus-

tomers ﬁnd them attractive because interest can

be paid on repos having maturities of less than

seven days and because customer funds are col-

lateralized by the security underlying the repur-

chase transaction.

The rate of interest received and paid is gen-

erally dictated by prevailing market rates. Prof-

its are based on a modest positive spread between

interest earned and interest paid. A dealer may

attempt to improve that modest proﬁt by

increasing the volume of such transactions, using

the proceeds to ﬁnance or pyramid the acquisi-

tion of reverse repos or securities to be used in

additional repo arrangements.

A common dealer strategy is to vary resale

and repurchase maturities in anticipation of

interest-rate movements. If an upward rate trend

is expected, the dealer will attempt to lock in a

cheaper source of funds at the current low rate

by negotiating longer maturities for repos and

shorter maturities for reverse repos. Conversely,

if interest rates are expected to decline, the

dealer attempts to negotiate longer-maturity

reverse repos to ensure continuing higher earn-

ings, while negotiating shorter-maturity repos to

take advantage of cheaper future sources of

funds. Care should be taken to limit exposure by

instituting policy guidelines that—

1. limit the aggregate amounts of reverse repo

and repo positions,

2. specify acceptable amounts of funds for

unmatched or extended maturity transactions,

3. determine maximum time gaps for unmatched

maturity transactions and minimally accept-

able interest-rate spreads for various matu-

rity agreements, and

4. follow the prudentialguidelines in the FFIEC’s

policy statement on repurchase agreements

and securities lending. (See sections 2140.0

and 2150.0.)

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3240.0.9 POLICY SUMMARY

The legal responsibilities of directors require

that they ensure that dealer activities are con-

ducted on a sound and legal basis that can only

be accomplished if the directors endorse a writ-

ten trading policy that addresses each area of

market and legal risk. Written policy guidelines

should be distributed to each individual engaged

in trading activities.

3240.0.10 SCOPE OF THE

INSPECTION

The scope of inspection will vary depending on

the types of securities or money market instru-

ment underwriting, dealing, and brokerage

activities conducted by the subsidiary. Examin-

ers may encounter situations in which a securi-

ties subsidiary is an SEC-registered broker-

dealer because the subsidiary also executes

transactions in municipal securities.

Registered broker-dealers are required to

become members of the NASD or some other

‘‘self-regulatory organization.’’ To avoid unnec-

essary regulatory overlap, examiners can rely on

the NASD’s complianceexaminationwith respect

to investor protection, including compliance with

rules of the SEC, NASD, and Municipal Securi-

ties Rulemaking Board (MSRB), and the Board’s

Regulation T governing securities credit (if appli-

cable). Consequently, in commencing such an

inspection, examiners should begin by request-

ing and reviewing the NASD’s most recent

examination letter to the broker-dealer and seri-

ous violations that could endanger the banking

organization (for example, fraudulent activities

that could subject the organization to losses or

lawsuits). Signiﬁcant violations that have not

yet been corrected should be noted in the bank

holding company report.

Federal Reserve examiners retain responsibil-

ity for inspecting certain areas of registered

broker-dealer operations regardless of whether

the NASD reviews them. Speciﬁcally, System

examiners should still evaluate management,

ﬁnancial results, and safety-and-soundness con-

siderations, including internal controls. In addi-

tion, examiners still need to verify that regis-

tered broker-dealer subsidiaries comply with

the provisions of Regulation Y, sec-

tion 225.28(b)(8)(i), or speciﬁc Board orders

pertaining to the ﬁrm under inspection. Finally,

the examiner should be prepared to review

in-depth any activities or money market instru-

ments that are not securities that might not have

been reviewed by the NASD because the activi-

ties are outside their scope of examination.

3240.0.11 INSPECTION OBJECTIVES

1. To determine if the policies, practices, proce-

dures, and internal controls regarding dealer

activities are adequate.

2. To determine if ofﬁcers are operating in con-

formance with the established guidelines.

3. To evaluate the trading portfolio for credit

quality and marketability.

4. To determine the scope and adequacy of the

audit-compliance functions.

5. To determine compliance with applicable

laws and regulations, including 12 C.F.R.

225.28(b)(8)(i).

6. To ensure investor protection.

7. To initiate corrective action when policies,

practices, procedures, or internal controls are

deﬁcient or when violations of law or regula-

tion have been noted.

3240.0.12 INSPECTION PROCEDURES

1. Review the adequacy of the dealer’s inter-

nal controls. (See section 3240.0.13.)

2. Based on the evaluation of internal controls

and the work performed by internal/

external auditors, determine the scope of

the inspection.

3. Test for compliance with policies, practices,

procedures, and internal controls in con-

junction with performing the remaining pro-

cedures. Also, obtain a listing of any deﬁ-

ciencies noted in the latest review done by

internal/external auditors from the exam-

iner assigned ‘‘Internal and External Audits,’’

and determine if corrections have been

accomplished.

4. Obtain a copy of the latest letter received

from the self-regulatory organization

responsible (if applicable) for examining

broker-dealer activities of this subsidiary.

5. Request that the ﬁrm provide the following

schedules:

a. aged schedule of securities that have

been acquired as a result of underwriting

activities

b. aged schedule of trading-account securi-

ties and money market instruments held

for trading or arbitrage purposes, which

should reﬂect commitments to purchase

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and sell securities and all joint-account

interests

c. schedule of short-sale transactions

d. aged schedule of due bills

e. list of bonds borrowed

f. aged schedule of ‘‘fails’’ to receive or

deliver securities on unsettled contracts

g. schedule of approved securities borrow-

ers and approved limits

h. schedule of loaned securities

i. schedule detailing account names

and/or account numbers of the—

• afﬁliated banks’ permanent portfolio

accounts;

• personal accounts maintained at the

ﬁrm by its employees;

• accounts of brokers or other dealers;

and

• personal accounts of employees of other

brokers, dealers, or municipal securi-

ties dealers

j. list of all joint accounts entered into

since the last examination

k. list of underwriting since the last exami-

nation and whether such securities were

acquired by negotiation or competitive

bid

l. list of all ﬁnancial advisory relationships

6. Compare balances of appropriate schedules

to the general ledger and review reconciling

items for reasonableness.

7. Determine the extent and effectiveness of

trading-policy supervision by—

a. reviewing the abstracted minutes of meet-

ings of the board of directors and/or of

any appropriate committee,

b. determining that proper authorization for

the trading ofﬁcer or committee has been

made,

c. ascertaining the limitations or restric-

tions on delegated authorities,

d. evaluating the sufﬁciency of analytical

data used in the most recent board or

committee trading-department review,

e. reviewing the methods of reporting by

department supervisors and internal

auditors to ensure compliance with

established policy and law, and

f. reaching a conclusion about the effec-

tiveness of director supervision of the

trading policy. Prepare a memo for the

examiner assigned ‘‘Duties and Respon-

sibilities of Directors’’ stating your con-

clusions. All conclusions should be sup-

ported by factual documentation.

(Before continuing, refer to steps 14 and 15.

They should be performed in conjunction with

the remaining examination steps.)

8. Ascertain the general character of under-

writing and direct-placement activities and

ascertain the effectiveness of department

management by reviewing underwriter ﬁles

and ledgers, committee reports, and offer-

ing statements to determine—

a. the signiﬁcance of underwriting activi-

ties and direct placements of securities

as reﬂected by the volume of sales and

proﬁt or loss on operations (compare

current data to comparable prior periods);

b. whether there is a recognizable pattern

in—

• the extent of analysis of material infor-

mation relating to the ability of the

issuer to service the obligation,

• rated quality of offerings,

• point spread of proﬁt margin for

unrated issues,

• geographic distribution of issuers, and

• syndicate participants, and

c. the volume of outstanding bids. Com-

pare current data to comparable prior

periods.

9. Determine the general character of trading-

account activities and whether the activities

are in conformance with stated policy by

reviewing departmental reports, budgets,

and position records for various categories

of trading activity and determining—

a. the signiﬁcance of present sales volume

compared to comparable prior periods

and departmental budgets;

b. whether the ﬁrm’s objectives are com-

patible with the volume of trading activity;

c. signiﬁcant inventory positions taken since

the prior examination and determining

if—

• the quality and maturity of the inven-

tory position was compatible with pru-

dent practices, and

• the size of the position was within

prescribed limits and compatible with

a sound trading strategy

d. the exposure on offsetting repurchase

transactions by—

• reviewing the maturities of offsetting

‘‘repo’’ and ‘‘reverse repo’’ agree-

ments to ascertain the existence, dura-

tion, amounts, and strategy used to

manage unmatched maturity ‘‘gaps’’

and extended (over 30 days) maturities;

• reviewing records since the last

inspection to determine the aggregate

amounts of—

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— matchedrepurchase transactions and

— ‘‘reverse repo’’ ﬁnancing extended

to one or related ﬁrms(s); and

• performing credit analyses of signiﬁ-

cant concentrations with any single or

related entities.

10. Determine the extent of risk inherent in

trading-account securities which have been

in inventory in excess of 30 days.

a. Determine the dollar volume in extended

holdings.

b. Determine the amounts of identiﬁable

positions with regard to issue, issuer,

yield, credit rating, and maturity.

c. Determine the current market value for

individual issues which show an internal

valuation markdown of 10 percent or

more.

d. Perform credit analyses on the issuers of

nonrated holdings identiﬁed as signiﬁ-

cant positions.

e. Perform credit analyses on those issues

with valuation writedowns considered

signiﬁcant relative to the scope of trad-

ing operations.

f. Discuss plans for disposal of slow-

moving inventories with management and

determine the reasonableness of those

plans in light of current and projected

market trends.

11. Using an appropriate technique, select issues

from the schedule of trading-account

inventory. Test valuation procedures by—

a. reviewing operating procedures and sup-

porting workpapers and determining if

prescribed valuation procedures are being

followed;

b. comparing dealer-prepared market prices,

as of the most recent valuation date, to

an independent pricing source (use trade

date ‘‘bid’’ prices); and

c. investigating any price differences noted.

12. Using an appropriate technique, select trans-

actions from the schedule of short sales and

determine—

a. the degree of speculation reﬂected by

basis-point spreads,

b. present exposure shown by computing

the cost to cover short sales, and

c. if transactions are reversed in a reason-

able period of time.

13. Analyze the effectiveness of operational

controls by reviewing recent cancellations

and fail items (fail to receive securities and

fail to deliver securities) that are a week or

more beyond settlement date and

determine—

a. the amount of extended fails,

b. the planned disposition of extended fails,

c. if the control system allows a timely,

productive follow-up on unresolved fails,

d. the reasons for cancellations, and

e. the planned disposition of securities that

have been inventoried before the recog-

nition of a fail or a cancellation.

14. Determine compliance with applicable laws,

rulings, and regulations by performing the

following:

a. 12 C.F.R. 1.3—eligible securities.

• Review inventory schedules of under-

writing and trading accounts and deter-

mine if issues whose par value is in

excess of 10 percent of the afﬁliated

lead bank’s capital and unimpaired

surplus are type I securities.

• Determine that the total par value of

type II investments does not exceed

10 percent of the afﬁliated lead bank’s

capital and unimpaired surplus, based

on the combination of holdings and

permanent portfolio positions in the

same securities.

• Elicit management’s comments and

review underwriting records on direct

placement of type II securities and

determine if the broker-dealer is deal-

ing or engaging in impermissible direct

placement of type III securities.

b. Sections 23A and 23B of the Federal

Reserve Act (12 U.S.C. 371(c) and 375)—

preferential treatment. Obtain a list of

domestic afﬁliate relationships and a list

of directors and principal ofﬁcers and

their business interests from appropriate

examiners and determine whether

transactions, including securities-

clearance services, involving afﬁliates,

insiders, or their interests are on terms

less favorable to the bank than those

transactions involving unrelated parties.

15. Test for unsafe and unsound practices and

possible violations of theSecurities Exchange

Act of 1934 by—

a. reviewing transactions, including U.S.

government tender-offer subscription

ﬁles, involving employees and directors

of dealer or other banks, and determin-

ing if the funds used in the transactions

were misused bank funds or the proceeds

of reciprocal or preferential loans,

b. reviewing sales to afﬁliated companies

to determine that the sold securities were

not subsequently repurchased at an addi-

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tional markup and that gains were not

recognized a second time,

c. reviewing securities position records and

customer ledgers with respect to large-

volume repetitive purchase and sales

transactions and—

• independently testing market prices of

signiﬁcant transactions which involve

the purchase and resale of the same

security to the same or related parties,

and

• investigating the purchase of large

blocks of securities from dealer ﬁrms

just prior to month-end and their sub-

sequent resale to the same ﬁrm just

after the beginning of the next month

d. reviewing customer-complaint ﬁles and

determining the reasons for such

complaints.

16. Discuss with an appropriate ofﬁcer and pre-

pare report comments concerning—

a. the soundness of trading objectives, poli-

cies, and practices;

b. the degree of legal and market risk

assumed by trading operations;

c. the effectiveness of analytical, reporting,

and control systems;

d. violations of law;

e. internal control deﬁciencies;

f. apparent or potential conﬂicts of interest;

and

g. other matters of signiﬁcance.

17. Reach a conclusion regarding the quality of

department management and state your con-

clusions on the appropriate inspection report

pages.

18. Update workpapers with any information

that will facilitate future inspections.

3240.0.13 REVIEW OF INTERNAL

CONTROLS

As a part of carrying out the inspection proce-

dures for this activity, the examiner is expected

to review the dealer’s system of internal con-

trols. The examiner should concentrate the inter-

nal controls review on the policies, practices,

and procedures of the ﬁrm.

The system should be documented in a com-

plete, concise manner and should include, where

appropriate, narrative descriptions, ﬂow charts,

copies of forms used, and other pertinent infor-

mation. Items marked with asterisks require sub-

stantiation by observation or testing.

3240.0.13.1 Securities Underwriting

Trading Policies

1. Has the board of directors, consistent with its

duties and responsibilities, adopted written

securities underwriting/trading policies that—

a. outline objectives?

b. establish limits and/or guidelines for the

following:

• price markups?

• quality of issues?

• maturity of issues?

• inventory positions (including when-

issued (WI) positions)?

• amounts of unrealized loss on inventory

positions?

• length of time an issue will be carried in

inventory?

• amounts of individual trades or under-

writer interests?

• acceptability of brokers and syndicate

partners?

c. recognize possible conﬂicts of interest and

establish appropriate procedures

regarding—

• deposit and service relationships with

municipalities whose issues have under-

writing links to the trading department?

• deposit relationshipswith securities ﬁrms

handling signiﬁcant volumes of agency

transactions or syndicate participations?

• transfers made between trading-account

inventory and afﬁliated investment

portfolio(s)?

• the afﬁliated bank’s trust department

acting as trustee, paying agent, and trans-

fer agent for issues which have an under-

writing relationship with the trading

department?

d. state procedures for periodic, monthly or

quarterly, valuation of trading inventories

to market value?

e. state procedures for periodic independent

veriﬁcation of valuations of the trading

inventories?

f. outline methods of internal review and

reporting by department supervisors and

internal auditors to ensure compliance with

established policy?

g. identify permissible types of securities?

2. Are the underwriting/trading policiesreviewed

at least quarterly by the board of directors to

determine their adequacy in light of chang-

ing conditions?

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3. Is there a periodic review by the board to

ensure that the underwriting/trading depart-

ment is in compliance with its policies?

3240.0.13.2 Offsetting Resale and

Repurchase Transactions

1. Has the board of directors, consistent with its

duties and responsibilities, adopted written

offsetting repurchase transaction policies

that—

a. limit the aggregate amount of offsetting

repurchase transactions?

b. limit the amounts in unmatched or extended

(over 30 days) maturity transactions?

c. determine maximum time gaps for

unmatched maturity transactions?

d. determine minimally acceptable interest-

rate spreads for various maturity

transactions?

e. determine the maximum amount of funds

to be extended to any single or related

ﬁrms through ‘‘reverse repo’’ transactions

involving unsold (through forward sales)

securities?

f. require ﬁrms involved in reverse repo

transactions to submit corporate resolu-

tions stating the names and limits of indi-

viduals who are authorized to commit the

ﬁrm?

g. require submission of current ﬁnancial

information by ﬁrms involved in reverse

repo transactions?

h. provide for periodic credit reviews and

approvals for ﬁrms involved in reverse

repo transactions?

i. specify types of acceptable offsetting repur-

chase transaction collateral?

j. require receipt of assurance letters that

unregulated securities dealers comply with

the Federal Reserve Bank of New York’s

‘‘Capital Adequacy Guideline for U.S.

Government Securities Dealers?’’

2. Are written collateral-control procedures

designed so that—

a. collateral assignment forms are used?

b. collateral assignments of registered

securities are accompanied by powers of

attorney signed by the registered owner,

and are registered securities registered in

the dealer or dealer’s nominee name when

they are assigned as collateral for extended

maturity (over 30 days) reverse repo

transactions?

c. funds are not disbursed until reverse repo

collateral is delivered into the physical

custody of the dealer or an independent

safekeeping agent?

d. funds are only advanced against pre-

determined collateralmarginsor discounts?

e. collateral margins or discounts are predi-

cated upon the following:

• the type of security pledged as

collateral?

• maturity of collateral?

• historic and anticipated price volatility

of the collateral?

• creditworthiness of the counterparty?

• maturity of the reverse repo

agreements?

• accrued interest?

f. maintenance agreements are required to

support predetermined collateral margin

or discount by daily mark to market of

repurchase agreement securities?

g. maintenance agreements are structured to

allow for obtaining additional securities

or cash calls in the event of collateral

price declines?

h. collateral market value is frequently

checked to determine compliance with

margin and maintenance requirements?

3240.0.13.3 Custody and Movement of

Securities

*1. Are the dealer’s procedures such that per-

sons do not have sole custody of securities

in that—

a. they do not have sole physical access to

securities?

b. they do not prepare disposal docu-

ments that are not also approved by

authorized persons?

c. for the security custodian, supporting

disposal documents are examined or

adequately tested by a second custodian?

d. no person authorizes more than one of

the following transactions: execution of

trades, receipt and delivery of securi-

ties, and collection or disbursement of

payment?

2. Are securities physically safeguarded to

prevent loss, unauthorized disposal, or use?

a. Are negotiable securities kept under

dual control?

b. Are securities counted frequently on a

surprise basis and reconciled to the

securities record? Are the results of

such counts reported to management?

c. Does the dealer periodically test for

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BHC Supervision Manual June 2003

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compliance with provisions of its insur-

ance policies regarding custody of

securities?

d. For securities in the custody of others—

• are custody statements agreed peri-

odically to position ledgers, and any

differences followed up to a

conclusion?

• are statements received from brokers

and other dealers reconciled promptly,

and any differences followed up to a

conclusion?

• are positions for which no statements

are received conﬁrmed periodically,

and stale items followed up to a

conclusion?

3. Are trading-account securities segregated

from other dealer-owned securities or

securitiesheldin safekeepingforcustomers?

*4. Is access to the trading-securities vault

restricted to authorized employees?

5. Do withdrawal authorizations require

countersignature to indicate security count

veriﬁcations?

6. Is registered mail used for mailing securi-

ties, and are adequate receipt ﬁles main-

tained for such mailings (if registered mail

is used for some but not all mailings,

indicate criteria and reasons)?

7. Are prenumbered forms used to control

securities trades, movements, and

payments?

8. If so, is numerical control of prenumbered

forms accounted for periodically by per-

sons independent of those activities?

9. Do alterations to forms governing the trade,

movement, and payment of securities

require—

*a. signature of the authorizing party?

b. use of a change-of-instruction form?

10. With respect to negotiability of registered

securities—

a. are securities kept in non-negotiable

form whenever possible?

b. are all securities received and not

immediately delivered transferred to

the name of the dealer or its nominee

and kept in non-negotiable form when-

ever possible?

c. are securities received checked for

negotiability (endorsements, signa-

ture, guarantee, legal opinion, etc.)

and for completeness (coupons, war-

rants, etc.) before they are placed in

the vault?

3240.0.13.4 Purchase and Sales

Transactions

1. Are all transactions promptly conﬁrmed in

writing to the actual customers or dealers?

2. Are conﬁrmations compared or adequately

tested to purchase and sales memoranda and

reports of execution of orders, and any differ-

ences investigated and corrected (including

approval by a designated responsible

employee)? Are conﬁrmations and purchase

and sale memoranda checked or adequately

tested for computation and terms by a second

individual?

3. Are comparisons received from other dealers

or brokers compared with conﬁrmations, and

any differences promptly investigated? Are

comparisons approved by a designated

individual?

3240.0.13.5 Customer and Dealer

Accounts

1. Do account bookkeepers periodically trans-

fer to different account sections or otherwise

rotate posting assignments?

2. Are letters mailed to customers requesting

conﬁrmation of changes of address?

3. Are separate customer-account ledgers main-

tained for—

a. employees?

b. afﬁliates?

c. afﬁliated bank’s trust accounts?

4. Are customerinquiriesandcomplaints handled

exclusively by designated individuals who

have no incompatible duties?

3240.0.13.6 Other

1. Are the preparation, additions, and posting of

subsidiary records performed and/or

adequately reviewed by persons who do not

also have sole custody of securities?

2. Are subsidiary records reconciled, at least

monthly, to the appropriate general-ledger

accounts, and are reconciling items adequately

investigated by persons who do not also have

sole custody of securities?

3. Are fails to receive and deliver under a sepa-

rate general-ledger control?

a. Are fail accounts periodically reconciled

to the general ledger, and any differences

followed up to a conclusion?

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b. Are periodic aging schedules prepared?

c. Are stale fail items conﬁrmed and fol-

lowed up to a conclusion?

d. Are stale items valued periodically, and, if

any potential loss is indicated, is a particu-

lar effort made to clear such items or to

protect the bank from loss by other means?

4. With respect to securities loaned and bor-

rowed positions—

a. are details periodically reconciled to the

general ledger, and any differences fol-

lowed up to a conclusion?

b. are positions conﬁrmed periodically?

c. are all policies and procedures in confor-

mance with the FFIEC policy on securi-

ties lending contained section 2140.0?

4(c)(8)—Underwriting & Dealing in U.S. Obligations, Municipal Securities, & Money Market Instruments

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3240.0.14 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Authorization for state

member banks of the Federal

Reserve System to underwrite

and deal in obligations of the

United States, various states,

and political subdivisions and

other authorized obligations

for state member banks

24 (7),

335

250.120

250.121

250.122

250.123

250.142

3–414.94 3–414.95

3–414.96

3–414.97

3–415.2

2–425.11

Initial October 19, 1976, order

stating that the activity of

underwriting and dealing in

certain government and

municipal securities was

closely related to banking

41 Federal

47083 (1976)

Order approving application to

engage de novo in

underwriting and dealing in

municipal securities

1978 FRB 222

Order approving application of

a BHC that would permit it to

retain shares in a government

and municipal securities

dealer to engage in

underwriting government

securities

1978 FRB 222

1978 FRB 223

Order approving application of

a BHC to acquire a company

that would engage de novo in

underwriting and dealing in

government and municipal

securities and providing

investment portfolio advice to

associations, state and local

governments, and ﬁnancial

institutions (‘‘nonbank

entities’’), and to

unafﬁliated banks

1979 FRB 363

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Subject Laws

Regulations

Interpretations

Orders

Order approving an

application of a BHC to form

an incorporated securities

company that would engage

de novo in the activities of

underwriting and dealing in,

purchasing, and selling U.S.

government and municipal

obligations, and money market

instruments such as banker’s

acceptances and certiﬁcates

of deposit. Securities

company limited to

permissible BHC activities.

1982 FRB 249

Adding of the activity to the

list of permissible activities per

Regulation Y

225.28(b)(8)(i) 1984 FRB 121

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

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BHC Supervision Manual June 2003

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4(c)(8)—Agency Transactional Services

(Futures Commission Merchants and Futures Brokerage)

Section 3250.0

A futures commission merchant (FCM) is an

entity referred to in the Commodity Exchange

Act to denote a registered ﬁrm that is in the busi-

ness of soliciting or accepting orders, as broker,

for the purchase or sale of any exchange-traded

futures contract and options thereon. For the

purposes of this examiner guidance, the term

‘‘FCM activities’’ is used in a broad context and

refers to all futures brokerage activities, opera-

tions, and their associated risks that are subject

to the Federal Reserve System’s supervision. In

connection with these activities, banking organi-

zations may hold customer funds, assets, or

property and may be members of futures

exchanges and their associated clearinghouses.

They may also offer related advisory services as

registered commodity trading advisers (CTAs).

The guidance addresses the expanding scope of

futures activities conducted by different types of

banking organizations worldwide and imple-

ments supervisory initiatives to effect more risk-

focused and burden-sensitive approaches to the

supervision of FCM activities. The guidance is

designed to help examiners (1) assess how well

a consolidated ﬁnancial organization manages

one or more discrete futures brokerage opera-

tions and (2) make a broader assessment of the

organization’s overall risk management.

The guidance pertains to FCM subsidiaries of

bank holding companies (BHCs), but it is also

applicable to FCM subsidiaries of state member

banks, Edge Act corporations, and foreign bank-

ing organizations. It addresses the broader scope

of permissible futures brokerage activities

articulated within Regulation Y

and, by exten-

sion,in RegulationK, and focuseson the adequacy

of management and the management processes

used to control the credit, market, liquidity,

reputation, and operations risks entailed in these

activities, including brokerage, clearing, funds

management, and advisory services.

The guidance takes a global line-of-business

supervisory approach to the inspection of FCM

activities rather than using the traditional full-

scope inspections of individual FCM subsidi-

aries, many of which are primarily supervised

by functional regulators. Reviews and reports of

functional regulators should be used to the full-

est extent when planning and conducting inspec-

tions of FCM activities of bank holding compa-

nies and other banking organizations to avoid

duplication and minimize supervisory burdens.

However, in conducting an inspection of various

aspects of an FCM’s activities, a review of

various functions, derived from a sample of the

organization’s FCM subsidiaries, may be neces-

sary and appropriate to determine the extent of

the risks these operations pose to the banking

organization and to determine whether manage-

ment of those risks is satisfactory. The examiner

should pay particular attention to activities con-

ducted in FCM subsidiaries that have not been

subject to a regular inspection by their func-

tional regulator and to FCM activities of foreign

afﬁliates in which there is uncertainty concern-

ing the level of local supervision.

BHC subsidiaries, banks (generally through

operating subsidiaries), Edge Act corporations,

and foreign banking organizations (FBOs) oper-

ating in the United States may operate futures

brokerage and clearing services involving a

myriad of ﬁnancial and nonﬁnancial futures

contracts and options on futures. These activi-

ties can involve futures exchanges and clearing-

houses throughout the world. In general, most

organizations conduct these activities as FCMs.

The Federal Reserve has a supervisory inter-

est in ensuring that the banking organizations

subject to its oversight conduct their futures

brokerage activities in a safe and sound manner

consistent with Regulations Y and K (and with

any terms and conditions in Board orders for a

particular organization). Accordingly, a review

of futures brokerage activities is an important

element for inspections of BHCs, examinations

of state member banks, and reviews of FBO

1. The Board broadened the scope of permissible FCM

nonbanking activities for a bank holding company with the

revision of Regulation Y, effective April 21, 1997. For exam-

ple, the following activities are permissible:

• Derivative contracts can be executed and cleared on a broad

range of nonﬁnancial commodities.

• Derivative contracts can be cleared without simultaneously

providing execution services. Likewise, execution ser-

vices can be provided without also providing clearing

services.

• Foreign-exchange transactional services can be provided in

the same FCM subsidiary that provides advice regarding

foreign exchange.

• Bank holding companies can engage in FCM activities

through a section 20 subsidiary.

• An FCM nonbanking subsidiary can trade for its own

account.

• An FCM nonbanking subsidiary may act on exchange-

traded futures contracts and on options on futures contracts

based on a ﬁnancial or nonﬁnancial commodity.

• A bank holding company may combine FCM activities and

incidental activities. For example, FCM activities may be

combined with futures-related ﬁnancing to customers, such

as ﬁnancing to cover margin obligations (note: such ﬁnanc-

ing may be prohibited by some exchanges).

BHC Supervision Manual January 2010

Page 1

operations. The following guidance on evaluat-

ing the futures brokerage activities of bank hold-

ing company subsidiaries, branches and agen-

cies of foreign banks operating in the United

States, or any operating subsidiaries of state

member banks provides a list of procedures that

may be used to tailor the scope of an inspection

of these activities.

3250.0.1 SCOPE OF GUIDANCE

Examiners are to use a risk-based inspection

approach to evaluating FCM activities—

including brokerage, clearing, funds manage-

ment, and advisory activities. Signiﬁcant

emphasis should be placed on evaluating the

adequacy of management and the management

processes used to control the credit, market,

liquidity, legal, reputation, and operations risks

entailed in these operations. Both the adequacy

of risk management and the quantitative level of

risk exposures should be assessed, as appropri-

ate to the scope of the FCM’s activities. The

objectives of a particular inspection should dic-

tate the FCM activities to be reviewed and set

the scope of the inspection.

Examiners are to use a functional-regulatory

approach (consistent with section III of the

Gramm-Leach-Bliley Act) to minimize duplica-

tive inspection and supervisory burdens. Reviews

and reports of functional regulators should be

used to their fullest extent. For the examination

authority and limitations on the examination of

a functionally regulated subsidiary, see section

1040.0 and 12 U.S.C. 1844(c).

When futures brokerage occurs in more than

one domestic or foreign afﬁliate, examiners

should assess, using a functional-regulatory

approach (consistent with section III of the

Gramm-Leach-Bliley Act), the adequacy of the

management of the futures brokerage activities

of the consolidated ﬁnancial organization to

ensure that the parent organization recognizes

and effectively manages the risks posed by its

various futures brokerage subsidiaries. Accord-

ingly, in reviewing futures brokerage opera-

tions, examiners should identify all bank hold-

ing company, bank operating, or FBO subsidiaries

that engage in FCM activities and the scope of

those activities. Not all subsidiaries may need to

be reviewed to assess the risk management of

the consolidated organization. Selection of the

particular FCM subsidiariesto be reviewedshould

be based on an assessment of the risks their

activities pose to the consolidated organization.

This guidance primarily addresses the assess-

ment of activities associated with futures broker-

age operations. Any proprietary trading that

occurs at an FCM should be assessed in connec-

tion with the review of proprietary trading

activities of the consolidated ﬁnancial organiza-

tion, using the appropriate guidance in the Fed-

eral Reserve’s Trading and Capital-Markets

Activities Manual. Similarly, when a review of

futures advisory activities is planned, examiners

should refer to investment, ﬁnancial, and futures

advisory inspection guidance in this manual

(sections 3130.0 and 3130.4), as appropriate.

3250.0.2 EVALUATION OF FCM RISK

MANAGEMENT

Consistent with existing Federal Reserve poli-

cies, examiners should evaluate the risk-

management practices of FCM operations and

ensure that this evaluation is incorporated appro-

priately in the rating of risk management under

the bank CAMELS, BHC RFI/C(D), or FBO

ROCA rating systems. Accordingly, examiners

should place primary consideration on ﬁndings

related to the adequacy of (1) board and senior

management oversight; (2) policies, procedures,

and limits used to control risks; (3) systems for

measuring, monitoring, and reporting risk; and

(4) internal controls and audit programs.

3250.0.2.1 Board and Senior

Management Oversight

The board of directors has the ultimate responsi-

bility for the level of risks taken by the organiza-

tion. Accordingly, the board, a designated sub-

committee of the board, or a high level of senior

management should approve overall business

strategies and signiﬁcant policies that govern

risk-taking in the organization’s FCM activities.

In particular, the board or a committee thereof

should approve policies that identify authorized

activities and managerial oversight and should

articulate risk tolerances and exposure limits of

FCM activities. The board should also actively

monitor the performance and risk proﬁle of its

FCM activities. Directors and senior manage-

ment should periodically review information

that is sufﬁciently detailed and timely to allow

them to understand and assess the various risks

involved in these activities. In addition, the

board or a delegated committee should periodi-

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

3250.0

BHC Supervision Manual January 2010

Page 2

cally reevaluate the business strategies and major

risk-management policies and procedures,

emphasizing the organization’s ﬁnancial objec-

tives and risk tolerances.

The FCM’s senior management is responsible

for ensuring that policies and procedures for

conducting FCM activities on both a long-range

and day-to-day basis are adequate. Senior man-

agement or a designated subcommittee of the

board should review and approve these policies

and procedures annually. The consistency of

these policies with parent company limits or

other directions pertaining to the FCM’s activi-

ties should be conﬁrmed. Management must

also maintain (1) clear lines of authority and

responsibility for managing operations and the

risks involved, (2) appropriate limits on risk-

taking, (3) adequate systems and standards for

measuring and tracking risk exposures and mea-

suring ﬁnancial performance, (4) effective inter-

nal controls, and (5) a comprehensive risk-

reporting and risk-management review process.

To provide adequate oversight, management

should fully understand the risk proﬁle of FCM

activities. Examiners should review reports given

to senior management and evaluate whether

they consist of good summary information and

sufﬁcient detail that will enable management to

assess and manage the FCM’s risk. As part of

its oversight responsibilities, senior manage-

ment should periodically review the organiza-

tion’s risk-management procedures to ensure

that they remain appropriate and sound.

Management should also ensure that activi-

ties are conducted by competent staff whose

technical knowledge and experience are consis-

tent with the nature and scope of the organiza-

tion’s activities. There should be sufﬁcient depth

in staff resources to manage these activities if

key personnel are not available. Management

should also ensure that back-ofﬁce and ﬁnancial-

control resources are sufﬁcient to effectively

manage and control risks. Functions for measur-

ing, monitoring, and controlling risk should

have clearly deﬁned duties. There should be

adequate separation of duties in key elements of

the risk-management process to avoid potential

conﬂicts of interest. The nature and scope of

these safeguards should be in accordance with

the scope of the FCM’s activities.

3250.0.2.2 Policies, Procedures, and

Limits

FCMs should maintain written policies and pro-

cedures that clearly outline their approach for

managing futures brokerage and related activi-

ties. Such policies should be consistent with the

organization’s broader business strategies, capi-

tal adequacy, technical expertise, and general

willingness to take risk. Policies, procedures,

and limits should address the relevant credit,

market, liquidity, reputation, and operations risks

in light of the scope and complexity of the

FCM’s activities. Policies and procedures should

establish a logical framework for limiting the

various risks involved in an FCM’s activities

and should clearly delineate lines of responsibil-

ity and authority over these activities. They

should also address the approval of new product

lines, strategies, and other activities; conﬂicts of

interest, including transactions by employees;

and compliance with all applicable legal

requirements. Procedures should incorporate and

implement the parent company’s relevant poli-

cies and should be consistent with applicable

statutes, Federal Reserve Board regulations,

interpretations, Board orders, and supervisory

policies and guidance.

A sound system of integrated limits and risk-

taking guidelines is an essential component of

the risk-management process. Such a system

should set boundaries for organizational risk-

taking and ensure that positions that exceed

certain predetermined levels receive prompt man-

agement attention so they can be either reduced

or prudently addressed.

3250.0.2.3 Risk Measurement,

Monitoring, and Reporting

An FCM’s system for measuring the credit,

market, liquidity, and other risks involved in its

activities should be as comprehensive and accu-

rate as practicable and should be commensurate

with the nature of its activities. Risk exposures

should be aggregated across customers, prod-

ucts, and activities to the fullest extent possible.

Examiners should evaluate whether the risk

measures and the risk-measurement process are

sufﬁciently robust to accurately reﬂect the dif-

ferent types of risks facing the organization.

Clear standards for measuring risk exposures

and ﬁnancial performance should be established.

The standards should provide a common frame-

work for limiting and monitoring risks and

should be understood by all relevant personnel.

An accurate, informative, and timely manage-

ment information system is essential to the pru-

dent operation of an FCM. Accordingly, the

examiner’s assessment of the quality of the

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BHC Supervision Manual July 2005

Page 3

management information system is an important

factor in the overall evaluation of the risk-

management process. Appropriate mechanisms

should exist for reporting risk exposures and the

ﬁnancial performance of the FCM to its board

and parent company, as well as for internal

management purposes. FCMs must establish

management-reporting policies to apprise their

boards of directors and senior management of

material developments, the adequacy of risk

management, operating and ﬁnancial perfor-

mance, and material deﬁciencies identiﬁed dur-

ing reviews by regulators and by internal or

external audits. The FCM should also provide

reports to the parent company (or in the case of

foreign-owned FCMs, to its U.S. parent organi-

zation, if any) on ﬁnancial performance; adher-

ence to risk parameters and other limits and

controls established by the parent for the FCM;

and any material developments, including ﬁnd-

ings of material deﬁciencies by regulators.

Examiners should determine the adequacy of an

FCM’s monitoring and reporting of its risk

exposure and ﬁnancial performance to appropri-

ate levels of senior management and to the

board of directors.

3250.0.2.4 Internal Controls

An FCM’s internal control structure is critical to

its safe and sound functioning in general and to

its risk-management system in particular. Estab-

lishing and maintaining an effective system of

controls, including the enforcement of ofﬁcial

lines of authority and appropriate separation of

duties—such as trading, custodial, and back

ofﬁce—is one of management’s more important

responsibilities. Appropriately segregating duties

is a fundamental and essential element of a

sound risk-management and internal control sys-

tem. Failure to implement and maintain an

adequate separation of duties can constitute an

unsafe and unsound practice, possibly leading to

serious losses or otherwise compromising the

ﬁnancial integrity of the FCM.

When properly structured, a system of inter-

nal controls promotes effective operations and

reliable ﬁnancial and regulatory reporting; safe-

guards assets; and helps to ensure compliance

with relevant laws, regulations, and organiza-

tional policies. Ideally, internal controls are

tested by an independent internal auditor who

reports directly to either the entity’s board of

directors or its designated committee. Personnel

who perform these reviews should generally be

independent of the function they are assigned to

review. Given the importance of appropriate

internal controls to banking organizations of all

sizes and risk proﬁles, the results of audits or

reviews, whether conducted by an internal audi-

tor or by other personnel, should be adequately

documented, as should management’s responses

to them. In addition, communication channels

should exist that will allow negative or sensitive

ﬁndings to be reported directly to the board of

directors or the relevant board committee (for

example, a board audit committee).

3250.0.3 FUTURES EXCHANGES,

CLEARINGHOUSES, AND FCMs

Futures exchanges provide auction markets for

standardized futures and options on futures con-

tracts. In the United States and most other coun-

tries, futures exchanges and FCMs are regulated

by a governmental agency. Futures exchanges

are membership organizations and impose ﬁnan-

cial and other regulatory requirements on mem-

bers, particularly those that do business for cus-

tomers as brokers. In the United States and most

other countries, futures exchanges also have

quasi-governmental (self-regulatory) responsi-

bilities to monitor trading and prevent fraud,

with the authority to discipline or sanction mem-

bers that violate exchange rules. FCMs may be

members of the exchange on which they effect

customers’ trades. When they are not members,

FCMs must use other ﬁrms that are exchange

members to execute customer trades.

Each futures exchange has an afﬁliated clear-

inghouse responsible for clearing and settling

trades on the exchange and for managing associ-

ated risks. When a clearinghouse accepts trans-

action information from its clearing members, it

generally guarantees the performance of the

transaction to each member and becomes the

counterparty to the trade (that is, the buyer to

every seller and the seller to every buyer). Daily

cash settlements are paid or collected by clear-

ing members through the clearinghouse. The

cash transfers represent the difference between

the original trade price and the daily ofﬁcial

closing settlement price for each commodity

futures contract. The two members settle their

sides of the transaction with the clearinghouse,

2. A ﬁrm or trading company that maintains only a propri-

etary business may become a member of an exchange without

registering as an FCM.

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usually by closing out the position before deliv-

ery of the futures contract or the expiration of

the option on the futures contract.

An exchange member that wishes to clear or

settle transactions for itself, customers, other

FCMs, or commodity professionals (locals or

market makers) may become a member of the

afﬁliated clearinghouse (clearing member) if it

is able to meet the clearinghouse’s ﬁnancial-

eligibility requirements. In general, these

requirements are more stringent than those

required for exchange membership. For exam-

ple, a clearing member usually is required to

maintain a speciﬁed amount of net capital in

excess of the regulatory required minimum and

to make a guaranty deposit as part of the ﬁnan-

cial safeguards of the clearinghouse. The size of

the deposit is related to the scale of the clearing

member’s activity. If it is not a member of the

clearinghouse for the exchange on which a con-

tract is executed, an FCM must arrange for

another FCM that is a clearing member to clear

and settle its transactions.

Margin requirements are an important risk-

management tool for maintaining the ﬁnancial

integrity of clearinghouses and their afﬁliated

exchanges. Clearinghouses require that their

members post initial margin (performance bond)

on a new position to cover potential credit expo-

sures borne by the clearinghouse. The clearing

ﬁrm, in turn, requires its customers to post mar-

gin. At the end of each day, and on some

exchanges on an intraday basis, all positions are

marked to the market. Clearing members with

positions that have declined in value pay the

amount of the decline in cash to the clearing-

house, which then pays the clearing members

holding positions that have increased in value

on that day. This process of transferring gains

and losses among clearing-member ﬁrms, known

as collecting variation margin, is intended to

periodically eliminate credit-risk exposure from

the clearinghouse.

In volatile markets, a clear-

inghouse may call for additional variation mar-

gin during the trading day, sometimes with only

one hour’s notice, and failure to meet a variation

(or initial) margin call is treated as a default to

the clearinghouse.

Some clearinghouses also require that their

members be prepared to pay loss-sharing assess-

ments to cover losses sustained by the clearing-

house in meeting the settlement obligations of a

clearing member that has defaulted on its (or its

customers’) obligations. Such assessments arise

when losses exceed the resources of defaulting

members, the guaranty fund, and other surplus

funds of the clearinghouse. Each clearinghouse

has its own unique loss-sharing rules.

At least

one U.S. and one foreign exchange have unlim-

ited loss-sharing requirements. Most U.S. clear-

inghouses relate loss-sharing requirements to

the size of a member’s business at the clearing-

house. Given the potential drain on a banking

organization’s ﬁnancial resources, the exposure

to loss-sharing agreements should be a signiﬁ-

cant consideration in the decision to become a

clearing member. A parent bank holding com-

pany may not provide a guarantee or become

liable to an exchange or clearing association

other than for trades conducted by the subsidi-

ary for its own account or for the account of any

afﬁliate. (See section 225.28(b)(6)(iv) of Regu-

lation Y.)

3250.0.4 COMMODITY EXCHANGE

ACT, COMMODITY FUTURES

TRADING COMMISSION, AND

SELF-REGULATORY

ORGANIZATIONS

In the United States, the primary regulator of

exchange-traded futures activities is the Com-

modity Futures Trading Commission (CFTC),

which was created by and derives its authority

from the Commodity Exchange Act (CEA). The

CFTC has adopted registration,

ﬁnancial

responsibility, antifraud, disclosure, and other

rules for FCMs and CTAs, and has general

enforcement authority over commodities ﬁrms

and professionals that buy or sell exchange-

traded futures contracts.

3. The nonmember FCM opens an account, usually on an

omnibus basis, with the clearing-member FCM. Separate om-

nibus accounts have to be maintained for customer and non-

customer or proprietary trading activity. If the FCM does not

carry customer accounts by holding customer funds and main-

taining account records, the clearing member will carry the

customer’s account on a fully disclosed basis and issue conﬁr-

mations, account statements, and margin calls directly to the

customer on behalf of the introducing FCM. In such cases, the

introducing FCM operates as an introducing broker (IB) and

could have registered with the Commodity Futures Trading

Commission as such.

4. Some foreign exchanges do not allow the withdrawal of

unrealized proﬁts as mark-to-market variation.

5. Clearinghouses usually (1) retain the right to use assets

owned by clearing members, but under the control of the

clearinghouse (for example, proprietary margin); (2) require

additional contributions of funds or assets or require the

member to purchase additional shares of the clearinghouse; or

(3) perfect a claim against the member for its share of the loss.

6. Many FCMs also are SEC-registered as broker-dealers

and are subject to SEC and CFTC ﬁnancial-responsibility

rules.

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The futures exchanges, in addition to provid-

ing a marketplace for futures contracts, are

deemed to be self-regulatory organizations

(SROs) under the CEA. For example, a number

of SROs have adopted detailed uniform practice

rules for FCMs, including ‘‘know your cus-

tomer’’ recordkeeping rules and other formal

customer-disclosure requirements. The National

Futures Association (NFA) also is an SRO,

although it does not sponsor a futures exchange

or other marketplace. The NFA has adopted

sales-practice rules applicable to members who

do business with customers. All FCMs that wish

to accept orders and hold customer funds and

assets must be members of the NFA.

The CEA and rules of the CFTC require the

SROs to establish and maintain enforcement

and surveillance programs for their markets and

to oversee the ﬁnancial responsibility of their

members.

The CFTC has approved an arrange-

ment under which a designated SRO (DSRO) is

responsible for performing on-site audits and

reviewing periodic reports of a member FCM

that is a member of more than one futures

exchange. The NFA is the DSRO for FCMs that

are not members of any futures exchange.

Oversight of FCMs is accomplished through

annual audits by the DSRO and the ﬁling of

periodic ﬁnancial statements and early warning

reports by FCMs, in compliance with CFTC and

SRO rules. In summary, this oversight encom-

passes the following three elements:

1. Full-scope audits at least once every other

year of each FCM that carries customer

accounts. Audit procedures conform to a

Uniform Audit Guide developed jointly by

the SROs. The full-scope audit focuses on

the ﬁrm’s net capital computations, segrega-

tion of customer funds and property, ﬁnan-

cial reporting, recordkeeping, and opera-

tions.

The audit also reviews sales practices

(including customer records, disclosures,

advertisements, and customer complaints)

and the adequacy of employee supervision.

The audit’s scope should reﬂect the FCM’s

prior compliance history as well as the exam-

iner’s on-site evaluation of the ﬁrm’s internal

controls. During the off-year, the DSROs per-

form limited-scope audits of member FCMs.

This audit is limited to ﬁnancial matters such

as a review of the FCM’s net capital compu-

tations, segregation of customer funds, and

its books and records.

2. FCM quarterly ﬁnancial reporting require-

ments. FCMs are required to ﬁle quarterly

ﬁnancial statements (form 1-FR-FCM) with

their DSROs. The fourth-quarter statement

must be ﬁled as of the close of the FCM’s

ﬁscal year and must be certiﬁed by an inde-

pendent public accountant. The ﬁlings gener-

ally include statements regarding changes in

ownership equity, current ﬁnancial condi-

tion, changes in liabilities subordinated to

claims of general creditors, computation of

minimum net capital, segregation require-

ments and funds segregated for customers,

secured amounts and funds held in separate

accounts, and any other material information

relevant to the ﬁrm’s ﬁnancial condition. The

certiﬁed year-end ﬁnancial report also must

contain statements of income and cash ﬂows.

3. Early warning reports. FCMs are required to

notify the CFTC and the SROs when certain

ﬁnancial weaknesses are experienced.

For

example, if an FCM’s net capital falls to a

speciﬁed warning level, it must ﬁle a written

notice within ﬁve business days and ﬁle

monthly ﬁnancial reports (form 1-FR-FCM)

until its net capital meets or exceeds the

warning level for a full three months. If an

FCM’s net capital falls below the minimum

required, it must cease doing business and

give telegraphic notice to the CFTC and any

commodities or securities SRO of which it is

a member. Similar notices must be given by

a clearing organization or carrying FCM

when it determines that a position of an FCM

must be liquidated for failure to meet a mar-

gin call or other required deposit.

3250.0.5 FEDERAL RESERVE

REGULATION OF FCMs AND CTAs

Bank holding companies are permitted, under

Regulation Y (section225.28(b)(7)(iv)),to engage

7. CFTC Rule 1.51, contract market program for enforce-

ment, requires that SROs monitor market activity and trading

practices in their respective markets, perform on-site examina-

tions (audits) of members’ books and records, review periodic

ﬁnancial reports ﬁled by members, and bring disciplinary and

corrective actions against members for violations of the CEA

and CFTC and SRO rules.

8. If an FCM is also a broker-dealer, the DSRO is not

required to examine the FCM for compliance with net capital

requirements if the DSRO confers with the broker-dealer’s

examining authority at least annually to determine that the

FCM is in compliance with the broker-dealer’s net capital

requirements and receives the DSRO copies of all examinations.

9. CFTC Rule 1.12 requires the maintenance of minimum

ﬁnancial requirements by FCMs and introducing brokers.

These requirements are similar to those applicable to broker-

dealers under SEC rules.

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in FCM and CTA activities on both domestic

and foreign futures exchanges through sepa-

rately incorporated nonbank subsidiaries. As a

general matter, the nonbank subsidiaries of bank

holding companies (and some foreign banks)

provide services to unafﬁliated customers in the

United States under section 4(c)(8) of the Bank

Holding Company Act (BHC Act) and to unaf-

ﬁliated customers outside the United States under

Regulation K.

Banks and the operating subsid-

iaries of banks usually provide futures-related

services to unafﬁliated parties in the United

States under the general powers of the bank and

to unafﬁliated parties outside the United States

under Regulation K. These various subsidiaries

may provide services to afﬁliates under section

4(c)(1)(C) of the BHC Act.

Regulation Y permits a bank holding com-

pany subsidiary that acts as an FCM to engage

in other activities in the subsidiary, including

futures advisory services and trading, as well as

other permissible securities and derivative

activities as deﬁned in sections 225.28(b)(6)

(ﬁnancial and investment advisory activities)

and 225.28(b)(7) (agency transactional services

for customer investments). Section 225.28(b)(7)

speciﬁcally authorizes FCMs to provide agency

services for unafﬁliated persons in execution,

clearance, or execution and clearance of any

futures contract and option on a futures contract

traded on an exchange in the United States and

abroad. It also includes the authority to engage

in other agency-type transactions (for example,

riskless principal) involving a forward contract,

an option, a future, an option on a future, and

similar instruments. Furthermore, this section

codiﬁes the long-standing prohibition against a

parent bank holding company’s issuing any

guarantees or otherwise becoming liable to an

exchange or clearinghouse for transactions

effected through an FCM, except for the propri-

etary trades of the FCM and those of afﬁliates.

A well-capitalized and well-managed bank

holding company, as deﬁned in section 225.2(r)

and (s) of Regulation Y, respectively, may com-

mence activities as an FCM or a CTA by ﬁling a

notice prescribed under section 225.23(a) of

Regulation Y. Bank holding companies that are

not eligible to ﬁle notices or that wish to act in a

capacity other than as an FCM or CTA, such as

a commodity pool operator (CPO), must follow

the speciﬁc application process for these activi-

ties. Examiners should ensure that all of these

activities are conducted in accordance with the

Board’s approval order.

A bank holding company, bank, or FBO par-

ent company of an FCM is expected to establish

speciﬁc risk parameters and other limits and

controls on the brokerage operation. These lim-

its and controls should be designed to manage

ﬁnancial risk to the consolidated organization

and should be consistent with its business objec-

tives and overall willingness to assume risk.

3250.0.6 PARTICIPATION IN

FOREIGN MARKETS

FCMs frequently transact business on foreign

exchanges as either exchange or clearinghouse

members or through third-party brokers that are

members of the foreign exchange. The risks of

doing business in foreign markets generally par-

allel those in U.S. markets; however, some unique

issues of doing business on foreign futures

exchanges must be addressed by the FCM and

its parent company to ensure that the activity

does not pose undue risks to the consolidated

ﬁnancial organization.

Before doing business on a foreign exchange,

an FCM should understand the legal and opera-

tional differences between the foreign exchange

and U.S. exchanges. For example, the FCM

should know about local business practices and

legal precedents that pertain to business in the

foreign market. In addition, the FCM should

know how the foreign exchange is regulated and

how it manages risk, and should develop poli-

cies and the appropriate operational infrastruc-

ture of controls, procedures, and personnel to

manage these risks. Accordingly, examiners

should conﬁrm that, in considering whether and

how to participate in a foreign market, an FCM

performs due diligence on relevant legal and

regulatory issues, as well as on local business

practices. Foreign-exchange risks should be

understood and authorized by the FCM’s parent

company, and any limits set by the parent com-

pany or FCM management should be carefully

monitored. The FCM and its parent company

also should assess the regulatory and ﬁnancial

risks associated with exchange and clearing-

house membership in a foreign market, includ-

ing an understanding of the extent to which the

10. Those nonbank subsidiaries that operate in the United

States may open ofﬁces outside the United States if (1) the

bank holding company’s authority under Regulation Y is not

limited geographically, (2) the foreign ofﬁce is not a sepa-

rately incorporated entity, and (3) the activities conducted by

the foreign ofﬁce are within the scope of the bank holding

company’s authority under Regulation Y. In addition, a bank

holding company may operate a limited foreign-based busi-

ness in the United States under Regulation K. (See 12 C.F.R.

211.6.)

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foreign clearinghouse monitors and controls day-

to-day credit risk and its loss-sharing

requirements.

3250.0.7 SPECIFIC RISKS AND

THEIR RISK-MANAGEMENT

CONSIDERATIONS

In general, FCMs face ﬁve basic categories of

risk—credit risk, market risk, liquidity risk,

reputation risk, and operations risk. The follow-

ing discussions highlight speciﬁc considerations

in evaluating the key elements of sound risk

management as they relate to these risks. The

compliance and internal-controls functions pro-

vide the foundation for managing the risks of an

FCM.

3250.0.7.1 Credit Risk

FCMs encounter a number of different types of

credit risks. The following discussions identify

some of these risks and discuss sound risk-

management practices applicable to each.

3250.0.7.1.1 Customer Credit Risk

Customer credit risk is the potential that a cus-

tomer will fail to meet its variation-margin calls

or its payment or delivery obligations. An FCM

should establish a credit-review process for new

customers that is independent of the marketing

and sales function. It is not unusual for the

FCM’s parent company (or banking afﬁliate) to

perform the credit evaluation and provide the

necessary internal approvals for the FCM to

execute and clear futures contracts for particular

customers. In some situations, however, the

FCM may have the authority to perform the

credit review internally. Examiners should deter-

mine how customers are approved and conﬁrm

that documentation in the customer’s credit ﬁles

is adequate even when the approval is per-

formed by the parent. Customer credit ﬁles

should indicate the scope of the credit review

and contain approval of the customer’s account

and credit limits. For example, customer credit

ﬁles may contain recent ﬁnancial statements,

sources of liquidity, trading objectives, and any

other pertinent information used to support the

credit limits established for the customer. In

addition, customer credit ﬁles should be updated

periodically.

FCM procedures should describe how cus-

tomer credit exposures will be identiﬁed and

controlled. For example, an FCM could monitor

a customer’s transactions, margin settlements,

or open positions as a means of managing the

customer’s credit risk. Moreover, procedures

should be in place to handle situations in which

the customer has exceeded credit limits. These

procedures should give senior managers who

are independent of the sales and marketing func-

tion the authority to approve limit exceptions

and require that such exceptions be documented.

3250.0.7.1.2 Customer-Financing Risk

Several exchanges, particularly in New York

and overseas, allow FCMs to ﬁnance customer

positions. These exchanges allow an FCM to

lend initial and variation margin to customers

subject to taking the capital charges under the

CFTC’s (or SEC’s) capital rules if the charges

are not repaid within three business days. In

addition, some exchanges allow FCMs to ﬁnance

customer deliveries, again subject to a capital

charge.

An FCM providing customer-ﬁnancing ser-

vices should adopt ﬁnancing policies and proce-

dures that identify customer-credit standards.

The ﬁnancing policies should be approved by

the parent company and should be consistent

with the FCM’s risk tolerance. In addition, an

FCM should establish overall lending limits for

each customer based on a credit review that is

analogous to that performed by a bank with

similar lending services. The process should be

independent of the FCM’s marketing, sales, and

ﬁnancing functions, but it may be performed by

the FCM’s banking afﬁliate. Examiners should

determine how customer-ﬁnancing decisions are

made and conﬁrm that documentation is adequate,

even when an afﬁliate approves the ﬁnancing. In

addition, the FCM should review ﬁnancial infor-

mation on its customers periodically and adjust

lending limits when appropriate.

3250.0.7.1.3 Clearing-Only Risk

FCMs often enter into agreements to clear, but

not execute, trades for customers. Under a

‘‘clearing-only’’ arrangement, the customer gives

its order directly to an executing FCM. The

executing FCM then gives the executed transac-

tion to the clearing FCM, which is responsible

for accepting and settling the transaction. Cus-

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tomers often prefer this arrangement because it

provides the beneﬁts of centralized clearing

(recordkeeping and margin payments) with the

ﬂexibility of using a number of specialized bro-

kers to execute transactions.

FCMs entering into clearing-only arrange-

ments execute written give-up agreements, which

are triparty contracts that set forth the responsi-

bilities of the clearing FCM, the executing FCM,

and the customer. Most FCMs use the ‘‘uniform

give-up agreement’’ prepared by the Futures

Industry Association, although some FCMs still

use their own give-up contracts. The uniform

give-up agreement permits a clearing FCM,

upon giving prior notice to the customer and the

executing FCM, to place limits or conditions on

the transactions it will accept to clear or termi-

nate the arrangement. If an executed transaction

exceeds speciﬁed limits, the FCM may decline

to clear the transaction unless it is acting as the

qualifying or primary clearing FCM for the cus-

tomer and has not given prior notice of

termination.

Clearing-only arrangements can present sig-

niﬁcant credit risks for an FCM. An FCM’s

risk-management policies and procedures for

clearing-only activities should address the quali-

ﬁcations required of clearing-only customers

and their volume of trading, the extent to which

customer-trading activities can be monitored by

the clearing-FCM at particular exchanges, and

how aggregate risk will be measured and

managed.

The FCM should establish trading limits for

each of its clearing-only customers and have

procedures in place to monitor their intraday

trading exposures. The FCM should take appro-

priate action to limit its liability either by review-

ing and approving a limit exception or by reject-

ing the trade if a clearing-only customer has

exceeded acceptable trading limits. Examiners

should conﬁrm that the FCM formally advises

(usually in the give-up agreement) its customers

and their executing FCMs of the trading param-

eters established for the customer. Examiners

should also conﬁrm that the FCM personnel

responsible for accepting or rejecting an executed

trade for clearance have sufﬁcient current infor-

mation to determine whether the trade is consis-

tent with the customer’s trading limits. Prudent

give-up agreements (or other relevant docu-

ments such as the customer account agreement)

should permit the FCM to adjust the customer’s

transaction limits when appropriate in light of

market conditions or changes in the customer’s

ﬁnancial condition.

Some FCMs act as the primary clearing ﬁrm

(also referred to as the sponsoring or qualifying

ﬁrm) for customers.

A primary clearing ﬁrm

guarantees to the clearinghouse that it will accept

and clear all trades submitted by the customer or

executing FCM, even if the trade is outside the

agreed-on limits. Because an FCM is obligated

to accept and clear all trades submitted by its

primary clearing customers, the FCM must be

able to monitor its customers’ trading activities

on an intraday basis for compliance with

agreed-on trading limits. Monitoring is espe-

cially important during times of market stress.

The FCM should be ready and able to take

immediate steps to address any unacceptable

risks that arise, for example, by contacting the

customer to obtain additional margin or other

assurances, approving a limit exception, taking

steps to liquidate open customer positions, or

giving appropriate notice of termination of the

clearing arrangement to enable the FCM to

reject future transactions.

Intraday monitoring techniques will vary

depending on the technology available at the

particular exchange. A number of the larger,

more automated U.S. exchanges have developed

technologies that permit multiple intraday col-

lection, matching, and reporting of trades—

although the frequency of such reconciliations

varies. On exchanges that are less automated,

the primary clearing FCM must develop proce-

dures for monitoring clearing-only risks. For

example, the FCM could maintain a signiﬁcant

physical presence on the trading ﬂoor to moni-

tor customer trading activities and promote more

frequent collection (and tallying) of trade infor-

mation from clearing-only customers. The

resources necessary for such monitoring obvi-

ously will depend on the physical layout of the

exchange—the size of the trading ﬂoor and the

number of trading pits, the ﬂoor population and

daily trading volumes, and the level of familiar-

ity the FCM has with the trading practices and

objectives of its primary clearing customers.

The FCM should be able to increase its ﬂoor

presence in times of market stress.

3250.0.7.1.4 Carrying-Broker Risk

An FCM may enter into an agreement with

another FCM to execute and clear transactions

11. Primary clearing customers include institutions and

individuals, as well as other nonclearing futures professionals

(locals or ﬂoor traders), who execute their own trades on the

exchange and other nonclearing FCMs that execute trades for

unafﬁliated customers.

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on behalf of the ﬁrst FCM (typically, when the

ﬁrst FCM is not an exchange or clearing mem-

ber of an exchange). In such cases, the FCM

seeking another or carrying FCM to execute its

transactions should have procedures for review-

ing the creditworthiness of the carrying FCM. If

the FCM reasonably expects that the carrying

FCM will use yet another FCM to clear its

transactions (for example, if the carrying FCM

enters into its own carrying-broker relationship

with another ﬁrm for purposes of executing or

clearing transactions on another exchange), the

ﬁrst FCM should try to obtain an indemniﬁca-

tion from the carrying FCM for any losses

incurred on these transactions.

When carrying

transactions occur on a foreign exchange, an

FCM should know about the legal ramiﬁcations

of the carrying relationship under the rules of

the exchange and the laws of the host country.

Moreover, it may be appropriate for an FCM to

reach an agreement with its customers that

addresses liabilities relative to transactions

effected on a non-U.S. exchange by a carrying

broker.

3250.0.7.1.5 Executing-FCM Risk

When an FCM uses an unafﬁliated FCM to

execute customer transactions under a give-up

arrangement, the clearing ﬁrm that sponsors the

executing FCM guarantees its performance.

Therefore, the ﬁrst FCM should review the sub-

contracting risk of its executing FCMs and their

sponsoring clearing ﬁrms. However, unlike the

clearing risk inherent in a carrying-broker rela-

tionship, the subcontracting risk for an FCM

using an executing FCM is limited to transac-

tion risk (execution errors). An FCM’s manage-

ment should approve each executing broker it

uses, considering the broker’s reputation for

obtaining timely executions and the ﬁnancial

condition of its sponsoring clearing ﬁrm.

3250.0.7.1.6 Pit-Broker Risk

Usually, FCMs will subcontract the execution of

their orders to unafﬁliated pit brokers who accept

and execute transactions for numerous FCMs

during the trading day. The risk associated with

using a pit broker is similar to that of using an

executing broker: the risk is limited to the bro-

ker’s performance in completing the transac-

tion. If the pit broker fails, then the primary

clearing ﬁrm is responsible for completing the

transaction. Therefore, an FCM should approve

each pit broker it uses, considering the pit bro-

ker’s reputation for obtaining timely executions

and the resources of its sponsoring clearing firm.

3250.0.7.1.7 Clearinghouse Risk

Clearinghouse risk is the potential that a clear-

inghouse will require a member to meet loss-

sharing assessments caused by another clearing

member’s failure. Before authorizing member-

ship in an exchange or clearinghouse, an FCM’s

board of directors and its parent company must

fully understand the initial and ongoing regula-

tory and ﬁnancial requirements for members.

The FCM’s board of directors should approve

membership in a clearinghouse only after a thor-

ough consideration of the ﬁnancial condition,

settlement and default procedures, and loss-

sharing requirements of the clearinghouse.

Particularly when it is considering member-

ship in a foreign exchange or clearinghouse, an

FCM’s board should examine any regulatory

and legal precedents related to how the exchange,

clearinghouse, or host country views loss-

sharing arrangements. As in the United States,

some foreign clearinghouses have unlimited loss-

sharing requirements, and some have ‘‘limited’’

requirements that are set at very high percent-

ages. However, the loss-sharing provisions of

some of the foreign clearinghouses have not yet

been applied, which means that there are no

legal and regulatory precedents for applying the

stated requirements. In addition, the board should

be apprised of any differences in how foreign

accounts are viewed, for example, whether cus-

tomer funds are considered separate from those

of the FCM, whether the relationship between

an FCM and its customer is viewed as an agency

rather than a principal relationship, and whether

there are material differences in the way futures

activities are regulated.

The board also should be apprised of any

material changes in the ﬁnancial condition of

every clearinghouse of which the FCM is a

member. Senior management should monitor

the ﬁnancial condition of its clearinghouses as

part of its risk-management function.

12. The CFTC takes the position that an FCM is respon-

sible to its customers for losses arising from the failure of the

performance of a carrying broker. The industry disagrees with

this position, and the issue has not been resolved by the

courts.

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3250.0.7.1.8 Guarantees

FCM parent companies often are asked to pro-

vide assurances to customers and clearinghouses

that warrant the FCM’s performance. These

arrangements may take the form of formal guar-

antees or less formal letters of comfort.

Under Regulation Y (section 225.28(b)

(7)(iv)(B)), a bank holding company may not

provide a guarantee to a clearinghouse for the

performance of the FCM’s customer obliga-

tions. A bank holding company may provide a

letter of comfort or other agreement to the

FCM’s customers that states the parent (or afﬁli-

ate) will reimburse the customers’ funds on

deposit with the FCM if they are lost as a result

of the FCM’s failure or default. Customers may

seek this assurance to avoid losses that could

arise from credit exposure created by another

customer of the FCM, since the clearinghouse

may use some or all of the FCM’s customer-

segregated funds in the event of a default by the

FCM stemming from a failing customer’s obli-

gations.

Examiners should note any permis-

sible guarantees for purposes of the consoli-

dated report of the parent bank holding company,

as they are relevant to calculating the consoli-

dated risk-based capital of the bank holding

company.

3250.0.7.2 Market Risk

When an FCM acts as a broker on behalf of

customers, it generally is only subject to market

risk if it executes customers’ transactions in

error. In this regard, operational problems can

expose the FCM to market ﬂuctuations in con-

tract values. However, when an FCM engages in

proprietary trading, such as market making and

other position-taking, it will be directly exposed

to market risk. Potential market-risk exposure

should be addressed appropriately in an FCM’s

policies and procedures.

An FCM that engages in proprietary trading

should establish market-risk and trading param-

eters approved by its parent company. The FCM’s

senior management should establish an indepen-

dent risk-management function to control and

monitor proprietary trading activities. Finally,

the FCM should institute procedures to control

potential conﬂicts of interest between its broker-

age and proprietary trading activities.

3250.0.7.3 Liquidity Risk

Liquidity risk is the risk that the FCM will not

be able to meet its ﬁnancial commitments (end-

of-day and intraday margin calls) to its clearing

FCM or clearinghouse. Clearing FCMs are

required to establish an account at one of the

settlement banks used by the clearinghouse for

its accounts and the accounts of its clearing

members. In some foreign jurisdictions, the cen-

tral bank fulﬁlls this settlement function. An

FCM should establish and monitor daily settle-

ment limits for its customers and should ensure

that there are back-up liquidity facilities to meet

any unexpected shortfalls in same-day funds. To

ensure the safety of its funds and assets, an

FCM should also monitor the ﬁnancial condi-

tion of the settlement bank it has chosen and

should be prepared to transfer its funds and

assetsto another settlement bank, when necessary.

To control other types of liquidity risks, an

FCM should adopt contingency plans for liquid-

ity demands that may arise from dramatic mar-

ket changes. An FCM, to the extent possible,

should monitor the markets it trades in to iden-

tify undue concentrations by others that could

create an illiquid market, thereby creating a risk

that the FCM could not liquidate its positions.

Most U.S. clearinghouses monitor concentra-

tions and will contact an FCM that holds more

than a certain percentage of the open interest in

a product. In some situations, the exchange

could sanction or discipline the FCM if it ﬁnds

that the FCM, by holding the undue concentra-

tion, was attempting to manipulate the market.

These prudential safeguards may not be in place

on foreign exchanges; consequently, an FCM

will have to establish procedures to monitor its

liquidity risk on those exchanges.

3250.0.7.4 Reputation Risk

FCMs should have reporting procedures in place

to ensure that any material events that harm its

reputation, and the reputations of its bank afﬁli-

ates, are brought to the attention of senior man-

agement; the FCM’s board of directors; and,

when appropriate, its parent company. Reports

of potentially damaging events should be sent to

senior management at the parent bank holding

company, who will evaluate their effect on the

FCM to determine what, if any, steps should be

taken to mitigate the impact of the event on the

whole organization.

13. The letter of comfort would protect customers whose

funds were used to cover other customer losses by the clear-

inghouse. U.S. clearinghouses also have guarantee funds that

can be used to reimburse customers at the clearinghouse’s

discretion.

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3250.0.7.4.1 Commodity Trading Adviser

Acting as a commodity trading adviser (includ-

ing providing discretionary investment advice to

retail and institutional customers or commodity

pools) may pose reputation and litigation risks

to a CTA or an FCM, particularly when retail

customers are involved. Accordingly, the FCM’s

board should adopt policies and procedures

addressing compliance with CFTC and NFA

sales-practice rules (including compliance with

the ‘‘know your customer’’ recordkeeping rules).

3250.0.7.5 Operations Risk, Internal

Controls, Internal Audits, and Compliance

3250.0.7.5.1 Operations Risk

Operations risk is the potential that deﬁciencies

in information systems or internal controls will

result in unexpected loss. Some speciﬁc sources

of operating risk at FCMs include inadequate

procedures, human error, system failure, or fraud.

For FCMs, failure to assess or control operating

risks accurately can be a likely source of prob-

lems. Back-ofﬁce or transaction-processing

operations are an important source of operations-

risk exposures. In conducting reviews of back-

ofﬁce operations, examiners should consult the

appropriate chapters of the Trading and Capital-

Markets Activities Manual for further guidance.

Operations risk also includes potential losses

from computer and communication systems that

are unable to handle the volume of FCM trans-

actions, particularly in periods of market stress.

FCMs should have procedures that address the

operations risks of these systems, including con-

tingency plans to handle systems failures and

back-up facilities for critical parts of risk-

management, communications, and accounting

systems.

When FCMs execute or clear transactions in

nonﬁnancial commodities, they may have to

take delivery of a commodity because a cus-

tomer is unable or unwilling to make or take

delivery on its contract. To address this situa-

tion, the FCM should have in place the proce-

dures it will follow to terminate its position and

avoid dealing in physical commodities.

3250.0.7.5.2 Internal Controls

Adequate internal controls are the ﬁrst line of

defense in controlling the operations risks

involved in FCM activities. Internal controls

that ensure the separation of duties involving

account acceptance, order receipt, execution,

conﬁrmation, margin processing, and account-

ing are particularly important. Internal controls

should also be established to record, track, and

resolve errors and discrepancies with customers

and other parties.

FCMs should have approved policies that

specify documentation requirements for transac-

tions and formal procedures for saving and safe-

guarding important documents, consistent with

legal requirements and internal policies. Rel-

evant personnel should fully understand docu-

mentation requirements. Examiners should also

consider the extent to which entities evaluate

and control operations risks through internal

audits, contingency planning, and other manage-

rial and analytical techniques.

3250.0.7.6 Internal Audits and Their

Review

An FCM should be subject to regular internal

audits to conﬁrm that it complies with its poli-

cies and procedures and is managed in a safe

and sound manner. In addition, the internal audit

function should review any signiﬁcant issues

raised by compliance personnel to ensure that

they are resolved. Other staff within the FCM

(i.e., compliance personnel) should be able to

reach internal audit staff to discuss any serious

concerns they might have. Internal audit reports

should be forwarded to the FCM’s senior man-

agement. Material ﬁndings and management’s

plan to resolve the audit issues should be reported

to the FCM’s board of directors, the parent

company, and any designated board committee

(for example, an audit committee). Frequently,

the internal audit function is located at the par-

ent company, and audit reports are routinely

sent to senior management at the parent com-

pany and to the audit committee designated by

the board of directors.

3250.0.8 INSPECTION GUIDANCE

The review of an FCM’s functions should take a

functional-regulatory approach, using the ﬁnd-

ings of the FCM’s primary regulators as much

as possible. Examiners should especially focus

on the signiﬁcant risks that the FCM poses to

the parent company and afﬁliated banks. These

risks should be assessed by reviewing the

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adequacy of the FCM’s policies and procedures,

internal controls, and risk-management func-

tions. Compliance with policies and procedures,

and with any conditions on the FCM’s activities

imposed by regulatory authorities (including the

FederalReserve Board), should be fully reviewed.

Bank holding companies, banks, and FBOs

may have more than one subsidiary that acts as

an FCM in the United States or that engages in

futures transactions for customers in foreign

markets. To ensure that the FCM/CTA activities

of a banking organization are evaluated on a

consolidated basis, a cross-section of afﬁliated

futures brokerage and advisory ﬁrms should be

reviewed periodically—particularly those that

present the greatest risk to the consolidated

ﬁnancial organization. Relevant factors to con-

sider when identifying ﬁrms for review include

(1) the volume of business; (2) whether the

FCM has unafﬁliated customers; (3) the number

of customers; (4) whether the ﬁrm provides

customer ﬁnancing; (5) the number of brokers

effecting transactions; (6) whether exchange or

clearinghouse memberships are involved;

(7) whether the FCM provides clearing-only

services; and (8) the date and scope of the last

review conducted by the Federal Reserve, SRO,

or other regulator.

The scope of any review to be conducted

depends on the size of the FCM and the scope of

its activities. The draft ﬁrst-day letter should

provide an overview of an FCM’s authorized

activities and conditions, as well as a descrip-

tion of the actual scope of its business. Examin-

ers should review the most recent summary of

management points or other inspection results

issued by the FCM’s SRO or other regulator, as

well as any correspondence between the FCM

and any federal agency or SRO. If examiners

have any questions about the ﬁndings of an

SRO’s or a regulator’s results, they should con-

tact the organization to determine whether the

matter is material and relevant to the current

inspection. The status of any matters left open

after the SRO’s or regulator’s review should

also be inquired about.

An important factor in determining the scope

of the inspection is whether the FCM has unaf-

ﬁliated customers or conducts transactions solely

for afﬁliates. Other factors include whether

(1) the FCM is a clearing member of an exchange,

particularly of a non-U.S. exchange; (2) it acts

as a carrying broker on behalf of other FCMs;

(3) it has omnibus accounts with other brokers

in markets in which it is not a member (U.S. or

foreign); (4) it provides advisory or portfolio

management services, including discretionary

accounts, or has been authorized to act as a

commodity pool operator (CPO); (5) it provides

clearing services to locals or market-makers;

and (6) it provides ﬁnancing services to

customers.

Examiners are not expected to routinely per-

form a front- or back-ofﬁce inspection unless

(1) the FCM’s primary regulator found material

deﬁciencies in either ofﬁce during its most recent

examination or (2) if front- or back-ofﬁce opera-

tions have not been examined by the primary

regulator within the last two years. However,

examiners may still choose to review a small

sample of accounts and transactions to conﬁrm

that appropriate controls are in place. In addi-

tion, net capital computations of U.S. FCMs do

not need to be reviewed; they are reviewed by

the FCM’s DSRO, and the FCM is subject to

reporting requirements if capital falls below

warning levels. Examiners should perform a

front- and back-ofﬁce review of the FCM’s

operations outside of the United States.

Review of audit function. Examiners may rely

on well-documented internal audit reports and

workpapers to verify the adequacy of risk man-

agement at the FCM. Examiners should review

the internal audit reports and workpapers to

determine the adequacy of their scope and thor-

oughness in complying with FCM policies and

procedures. If an examiner ﬁnds that an internal

audit adequately documents the FCM’s compli-

ance with a policy or procedure pertaining to the

management of the various risk assessments

required by the current inspection, that fact

should be documented in the workpapers, and

inspection procedures should be completed in

any area not adequately addressed by the inter-

nal audit report. Examiners should periodically

spot check areas covered by internal audits to

ensure the ongoing integrity of the audit pro-

cess. Finally, examiners should ensure that inter-

nal auditors have adequate training to evaluate

14. If the FCM engages in proprietary trading for its own

account, particularly for purposes other than hedging (market

making or position taking), or if the FCM acts as an interme-

diary in any over-the-counter futures or other derivative

activities, the examiner should advise the examiner in charge

of the inspection so that the ﬁrm’s proprietary trading can be

evaluated in connection with similar activities of the consoli-

dated ﬁnancial organization.

15. The inspection procedures for reviewing front- and

back-ofﬁce operations may be found in sections 2050.3 and

2060.3, respectively, of the Trading and Capital-Markets

Activities Manual.

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the FCM’s compliance with its policies and

procedures and with applicable laws and regula-

tions (both inside and, if applicable, outside the

United States).

If an examiner has determined that it is not

necessary to perform a routine back-ofﬁce review,

he or she should conﬁrm that the FCM has

addressed operations risks in its policies and

procedures. Examiners also should review the

internal controls of an FCM to ensure that the

ﬁrm is operated safely and soundly according to

industry standards and that it complies with any

Board regulations or conditions placed on the

FCM’s activities. Examiners should be alert to

any ‘‘red ﬂags’’ that might indicate inadequate

internal controls. An FCM must be organized so

that its sales, operations, and compliance func-

tions are separate and managed independently.

If an FCM engages in proprietary trading, exam-

iners should conﬁrm that the ﬁrm has proce-

dures that protect against conﬂicts of interest in

the handling of customer orders (examples of

these conﬂicts of interest include front-running

or ex-pit transactions). To make an overall

assessment of the FCM’s future business, the

results of any review should be consolidated

with the results of reviews by other FCMs

inspected during this cycle.

3250.0.9 INSPECTION OBJECTIVES

1. To identify the potential and extent of vari-

ous risks associated with the FCM’s activi-

ties, including credit, market, liquidity, and

reputation risks.

2. To evaluate the adequacy of the audit func-

tionand reviewsigniﬁcant ﬁndings,themethod

of follow-up, and management’s response to

correct any deﬁciencies.

3. To assess the adequacy of the risk-

management function at the FCM.

4. To assess the adequacy of and compliance

with the FCM’s policies and procedures and

the adequacy of the internal control function.

5. To evaluate and determine the FCM’s level

of compliance with relevant statutes, Board

regulations, interpretations, orders, and

policies.

6. To assess the adequacy of risk management

of afﬁliated FCMs on a consolidated basis.

3250.0.10 INSPECTION PROCEDURES

3250.0.10.1 Structural Organization and

Activity Analysis

3250.0.10.1.1 General

1. Identify all bank holding company subsidi-

aries that engage in FCM- or CTA-type

activities in the United States or abroad or

identify U.S. FCM/CTA subsidiaries of FBOs.

Determine which ﬁrms should be inspected

to provide a global view of the adequacy of

management of these activities on a consoli-

dated basis, based on the scope of activities

and the degree of supervision by other regu-

lators. Complete applicable procedures below

for ﬁrms selected for inspection.

2. Review ﬁrst-day-letter documents, notices

ﬁled under Regulation Y, Board orders and

letters authorizing activities, previous inspec-

tion reports and workpapers, previous audit

reports by futures regulators (CFTC, DSRO,

National Futures Association, foreign futures

regulator) and correspondence exchangedwith

those regulatory entities, and reports by

internal or external auditors or consultants.

3. Note the scope of the FCM’s activities,

including—

a. execution and clearing;

b. execution only for afﬁliates and third

parties;

c. clearing-only for afﬁliates, third parties,

professional ﬂoor traders (locals);

d. pit brokerage;

e. advisory;

f. discretionary portfolio management;

g. commodities or commodity pool operator

(in FCM or in afﬁliate);

h. margin ﬁnancing;

i proprietary trading;

j. exchange market maker or specialist;

k. types of instruments (for example, ﬁnan-

cial, agricultural, precious metals,

petroleum);

l. contractmarketswhere business is directed;

m. other derivatives products (should be iden-

tiﬁed, for example, interest-rate swaps and

related derivative contracts, foreign-

exchange derivative contracts, foreign gov-

ernment securities, other);

n. other futures-related activities, including

off-exchange transactions;

o. riskless-principal transactions; and

p. registered broker-dealers.

4. Note exchange and clearinghouse member-

ships here and abroad, noting any ﬁnancial

commitments and any guarantees by the FCM

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or its parent

to the exchange or clearing-

house with respect to proprietary, afﬁliate, or

customer transactions.

5. Note any new lines of business or activities

occurring at the FCM or any changes to

exchange and clearing memberships since

the last inspection.

6. Note the percentage of business conducted

for—

a. afﬁliate banks,

b. nonbank afﬁliates,

c. customers (note the breakdown between

institutional and retail customers and if

there is any guarantee or letter of comfort

to customers in which the parent company

provides that it will reimburse customers

for loss as a result of the FCM’s failure or

other default),

d. proprietary accounts (hedging, position-

taking), and

e. professional ﬂoor traders (locals, market

makers).

3250.0.10.1.2 Audit Program

Determine the quality of the internal audit pro-

gram. Assess the scope, frequency, and quality

of the audit program for the FCM and related

activities. Consider spot checking areas covered

by internal audits.

1. Review the most recent audit report, noting

any exceptions and their resolution.

2. Determine whether internal auditors have

adequate training to evaluate the FCM’s com-

pliance with its policies and procedures and

with applicable laws and regulations.

3. Verify that audit ﬁndings have been commu-

nicated to senior management and material

ﬁndings have been reported to the FCM’s

board of directors and parent company.

4. Identify any areas covered by these proce-

dures that are not adequately addressed by

the internal audit report.

5. Identify areas of the internal audit report that

should be veriﬁed as part of the current

inspection.

3250.0.10.1.3 Operational Activities

Determine the scope of review that is appropri-

ate to activities and allocate examiner resources,

considering the adequacy of internal audit

workpapers.

1. Complete the appropriate front- and/or back-

ofﬁce inspection procedures when—

a. front- and back-ofﬁce operations have not

been examined by the DSRO within the

last two years,

b. material deﬁciencies in front- or back-

ofﬁce operations were found by the DSRO

during the most recent audit, or

c. the primary regulator for the FCM is not a

U.S. entity.

2. Advise the examiner in charge of the inspec-

tion of the parent company if the FCM engages

in proprietary trading or over-the-counter

futures or derivatives business as principal or

agent.

3250.0.10.2 Board and Senior

Management Oversight

1. Review the background and experience of

the FCM’s board of directors and senior

management, noting prior banking and futures

brokerage experience.

2. Determine if the board of directors of the

FCM has approved written policies summa-

rizing the ﬁrm’s activities listed below, and

addressing oversight by the board or a board-

designated committee:

a. the risk appropriate for the FCM, includ-

ing credit, market, liquidity, operation,

reputation, and legal risk (see SR-95-51)

b. the monitoring of compliance with risk

parameters

c. the exchange and clearinghouse

memberships

d. the internal audit function

3. Determine if senior management of the FCM

has adopted procedures implementing the

board’s policies for—

a. approval of new-product lines and other

activities;

b. transactions with afﬁliates;

c. transactions by employees;

d. compliance with applicable regulations

and policies and procedures;

e. management information reports;

f. the separation of sales, operations, back-

ofﬁce, and compliance functions; and

g. reports to the FCM boards of directors on

material ﬁndings of the complaint or audit

16. The parent bank holding company cannot provide a

guarantee or otherwise become liable to an exchange or

clearing association other than for those trades conducted by

the FCM subsidiary for its own account or for the account of

any afﬁliate. See Regulation Y, section 225.28(b)(7)(iv)(B).

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functions and on material deﬁciencies iden-

tiﬁed during the course of regulatory audits

or inspections.

4. Determine that policies and procedures are

periodically reviewed by the board of direc-

tors or senior management, as appropriate,

and ensure that they comply with existing

regulatory and supervisory standards and ad-

dress all of the FCM’s activities.

5. Review management information reporting

systems and determine whether the board of

directors of the parent company (or a desig-

nated committee of the parent’s board) is

apprised of—

a. material developments at the FCM,

b. the ﬁnancial position of the ﬁrm including

signiﬁcant credit exposures,

c. the adequacy of risk management,

d. material ﬁndings of the audit or compli-

ance functions, and

e. material deﬁciencies identiﬁed during the

course of regulatory reviews or inspections.

6. Review the FCM’s strategic plan.

a. Assess whether there are material incon-

sistencies between the stated plans and the

FCM’s stated risk tolerances.

b. Verify that the strategic plan is reviewed

and periodically updated.

3250.0.10.3 Risk Management

3250.0.10.3.1 Credit Risk

1. Review credit-risk policies and procedures.

a. Verify the independence of credit-review

approval from the limit-exceptions

approval.

b. Verify that the procedures designate a

senior ofﬁcer with the responsibility to

monitor and approve limit-exception

approvals.

2. Determine whether the FCM has authority

to open customer accounts without parent

company approval.

3. Review the customer base (afﬁliates, third

parties) for credit quality in terms of afﬁlia-

tion and business activity (afﬁliates, corpo-

rate, retail, managed funds, ﬂoor traders,

etc.).

4. Evaluate the process for customer-credit

review and approval. Determine whether

the customer-credit review identiﬁes credit

risks associated with the volume of transac-

tions executed or cleared for the customer.

5. Evaluate the adequacy of credit-risk-

management policies. Determine if they—

a. establish and require adequately docu-

mented credit limits for each customer

that reﬂect their respective ﬁnancial

strengths, liquidity, trading objectives,

and potential market risk associated with

the products traded;

b. require periodic updates of such credit

limits in light of changes in the ﬁnancial

condition of each customer and market

conditions; and

c. do not permit the FCM to waive impor-

tant broker safeguards, such as the right

to liquidate customer positions upon

default or late payment of margin.

6. Consider verifying the above information

by sampling customer-credit ﬁles.

7. Verify that up-to-date customer-credit ﬁles

are maintained on site or are available for

review during the inspection. If the customer-

credit approval was performed by the par-

ent company or an afﬁliate bank, verify that

the FCM’s ﬁles contain information indicat-

ing the scope of the credit review, the

approval, and credit limits.

8. Review notiﬁcations and approval of limit

exceptions for compliance with FCM

procedures.

9. Determine whether the FCM has adopted

procedures identifying when the FCM should

take steps to limit its customer-credit expo-

sure (for example, when to refuse a trade,

grant a limit exception, transfer positions to

another FCM, or liquidate customer

positions).

10. Evaluate the adequacy of risk management

of customer-ﬁnancing activities.

11. Determine that the credit-review process is

independent from the marketing, sales, and

ﬁnancing function.

a. Verify that the FCM has policies that

identify customer-credit standards and

that it establishes overall lending limits

for each customer.

b. Assess the adequacy of the credit-review

process and documentation, even when

credit review is performed by an afﬁliate.

12. Review the instances when the FCM has

lent margin to customers on an unsecured

basis. If the FCM does not engage in

margin ﬁnancing as a business line, verify

that extensions are short-term and with-

in the operational threshold set for the

customer.

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3250.0.10.3.2 Clearing-Only Risk

1. Determine whether each clearing arrange-

ment is in writing and that it—

a. identiﬁes the customer and executing bro-

kers, and deﬁnes and adequately docu-

ments the respective rights and obliga-

tions of each party;

b. establishes overall limits and trading

parameters for the customer that are based

on the customer’s creditworthiness and

trading objectives; and

c. permits transaction limits to be adjusted

to accommodate market conditions or

changes in the customer’s ﬁnancial

condition.

2. When the FCM has entered into a clearing-

only agreement with a customer, verify that

it has reviewed the creditworthiness of each

executing broker or its qualifying clearing

ﬁrm identiﬁed in the agreement.

3. If the FCM acts as the primary clearing ﬁrm

for locals or other customers, conﬁrm that

the ﬁrm has adopted procedures for monitor-

ing and controlling exposure. Note whether

the ﬁrm monitors customer positions through-

out the trading day and how this monitoring

is accomplished.

3250.0.10.3.3 Carrying Brokers,

Executing Brokers, and Pit Brokers

1. If the FCM uses other brokers to execute

and/or clear transactions, either on an omni-

bus or a fully disclosed basis, determine that

it has adequately reviewed the creditworthi-

ness and approved the use of the other bro-

kers. If the FCM uses nonafﬁliated executing

brokers, conﬁrm that it also has considered

the reputation of the broker’s primary clear-

ing ﬁrm. If the other broker is likely to use

another broker, determine whether the broker

has given the FCM an indemniﬁcation against

any loss that results from the performance or

failure of the other broker.

2. If the FCM uses other brokers to execute or

clear transactions in non-U.S. markets, deter-

mine whether senior management under-

stands the legal risks pertinent to doing busi-

ness in those markets and has adopted policies

for managing those risks.

3. When the FCM uses third-party ‘‘pit bro-

kers’’ to execute transactions, verify that the

FCM has reviewed and approved each bro-

ker after considering the reputation of the pit

broker’s primary clearing ﬁrm.

3250.0.10.3.4 Exchange and

Clearinghouse Membership

1. Verify that the FCM completes a due-

diligence study of each exchange and clear-

inghouse before applying for membership in

the organization.

a. Determine whether board minutes approv-

ing membership demonstrate a thorough

understanding of the loss-assessment pro-

visions and other obligations of member-

ship for each exchange and clearinghouse,

as well as a general understanding of the

regulatory scheme.

b. Determine whether, in approving mem-

bership in a non-U.S. exchange or clear-

inghouse, the board’s minutes indicate a

discussion of the regulatory environment

and any relevant credit, liquidity, and legal

risks associated with doing business in the

particular jurisdiction. The minutes should

also reﬂect discussion of any material dif-

ferences from U.S. precedent in how for-

eign accounts are viewed, for example,

whether customer funds held in an omni-

bus account are considered separate (seg-

regated) from those of the FCM or whether

the relationship between the FCM and its

customers is viewed as an agency or prin-

cipal relationship in the host country.

2. Verify that the FCM has apprised its parent

company of the results of its study of the

exchange or clearinghouse and that it has

written authorization by senior management

of its parent company to applyfor membership.

3. Verify that the FCM monitors the ﬁnancial

condition of each exchange and clearing

organization for which it is a member.

4. Review all guarantees, letters of comfort, or

other forms of potential contingent liability.

Verify that the parent company has not pro-

vided a guarantee to the clearinghouse for

the performance of the FCM’s customer obli-

gations.

Note any guarantees against the

parent losses incurred from the failure of an

FCM and advise the examiner in charge of

the parent company’s inspection, who can

conﬁrm that guarantees are included in the

17. The parent bank holding company cannot provide a

guarantee or otherwise become liable to an exchange or

clearing association other than for those trades conducted by

the FCM subsidiary for its own account or for the account of

any afﬁliate. See Regulation Y, section 225.28(b)(7)(iv)(B).

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bank holding company’s calculation of con-

solidated risk-based capital.

3250.0.10.3.5 Market Risk

1. If an FCM engages in proprietary trading,

determine whether policies and procedures

are in place to control potential conﬂicts of

interest between its brokerage business and

trading activities.

2. When an FCM plans to enter (or has entered

into) a foreign market, determine if the FCM

performed due-diligence reviews of relevant

legal and regulatory issues, as well as on

local business practices.

3250.0.10.3.6 Liquidity Risk

1. Verify that the FCM has established and

monitors daily settlement limits for each cus-

tomer to ensure that liquidity is sufﬁcient to

meet clearinghouse obligations.

2. Determine whether the FCM has established

back-up liquidity facilities to meet unex-

pected shortfalls.

3. Verify that the FCM monitors by product the

amount of open interest (concentrations) that

it holds at each exchange, either directly or

indirectly through other brokers. If positions

are held on foreign exchanges and concentra-

tions are not monitored, verify that the FCM

is able to monitor its positions and manage

its potential liquidity risks arising from that

market.

4. Review liquidity contingency plans for deal-

ing with dramatic market changes.

3250.0.10.3.7 Reputation Risk

1. Review management information reporting

systems and determine whether—

a. the FCM is able to assess the extent of

any material exposure to legal or reputa-

tion risk arising from its activities, and

b. the parent company receives sufﬁcient

information from the FCM to assess the

extent of any material exposure to litiga-

tion or reputation risk arising from the

FCM’s activities.

2. If the FCM provides investment advice to

customers or commodity pools, determine

whether it has procedures designed to mini-

mize the risks associated with advisory

activities. Such procedures might address the

delivery of risk disclosures to customers, the

types of transactions and trading strategies

that could be recommended or effected for

retail customers, compliance with the ‘‘know

your customer’’ recordkeeping and other sales

practice rules of the SROs, and conformance

to any trading objectives established by the

customer or fund.

3. If the FCM acts as a CPO, verify that it has

obtained prior Board approval and is in com-

pliance with any conditions in the Board

order.

3250.0.10.4 Operations, Internal Controls,

and Compliance

1. Determine the extent to which operating

risk is evaluated and controlled through the

use of internal audits, contingency plan-

ning, and other managerial and analytical

techniques.

2. Review the most recent summary of man-

agement points or similar document and

also respective correspondence issued by

the FCM’s DSRO or other primary futures

regulator. Discuss any criticism with FCM

management and conﬁrm that corrective

action has been taken.

3. Consider reviewing a small sample of

accounts and transactions to conﬁrm that

appropriate controls are used and that the

FCM has incorporated operations risks into

its policies and procedures.

4. Review the organizational structure and

reporting lines within the FCM and verify

separation of sales, trading, operations, com-

pliance, and audit functions.

5. Determine that the FCM’s policies and pro-

cedures address the booking of transactions

by afﬁliates and employees and other poten-

tial conﬂicts of interest.

6. If the FCM is authorized to act as a CPO,

review the most recent NFA or other pri-

mary futures regulator’s audit, including

any informal ﬁndings by examiners. Dis-

cuss any criticism with the FCM manage-

ment and conﬁrm that corrective action has

been taken.

7. If the FCM executes and clears nonﬁnancial

futures, verify that the FCM has procedures

to avoid taking physical possession of the

nonﬁnancial product when effecting

‘‘exchange for physical transactions’’ for

customers.

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8. When the FCM takes physical delivery of

commodities due to failure or unwillingness

of a customer to make or take delivery of its

contracts, determine whether the FCM has

and follows procedures to close out its posi-

tion. Note if the FCM frequently takes

delivery of physical commodities.

9. Assess the adequacy of customer-complaint

review by reviewing the complaint ﬁle and

how complaints are resolved. Note if the

FCM receives repeat or multiple complaints

involving one or more of its activities or

employees.

10. Determine whether the FCM has developed

contingency plans that describe actions to

be taken in times of market disruptions and

whether such plans address management

responsibilities, including communications

with its parent bank holding company,

liquidity, the effect on customer-credit qual-

ity, and communications with customers.

3250.0.10.5 Conclusions

1. Prepare inspection ﬁndings and draw conclu-

sions as to the adequacy of the FCM’s risk-

management, compliance, operations, inter-

nal controls, and audit functions.

2. Present ﬁndings to FCM management and

submit inspection ﬁndings to the examiner in

charge of the parent company inspection.

3250.0.11 FCM Supplemental Checklist Questionnaire

Yes No

3250.0.11.1 General Questions

1. Is the FCM a separately incorporated subsidiary of the bank holding company

as required by Regulation Y, 12 C.F.R. 225.28(b)(6)(iv)?

2. Has the parent bank holding company provided a guarantee or otherwise

become liable to an exchange or clearing association other than for those trades

conducted by a subsidiary for its own account or for the account of any afﬁliate

(prohibited by Regulation Y (see 12 C.F.R. 225.28(b)(6)(iv))?

3. How long has the FCM been in operation? yrs.

4. Approximately how many customers does the FCM have?

5. What degree of market participation does the FCM have

(mark (x) for the highest level of involvement)?

a. FCM, nonmember of futures exchange.

Must execute trades through exchange members and is

subject to NFA rules.

b. Exchange member. Holds membership on one or

more futures exchanges entitling FCM to execute trades on the

exchange(s) and subjecting FCM to the rules of exchange(s).

c. Clearinghouse member. Holds membership in an

exchange’s clearinghouse as well as exchange membership,

thus enabling FCM to execute and clear its own transactions.

Such FCM is subject to exchange and clearinghouse rules.

6. If FCM is an exchange member, on which exchange(s) (domestic

and foreign) does the FCM have membership(s)?

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Yes No

7. If FCM is a clearing member, list below the clearinghouse(s) of

which it is a member.

8. Does the FCM periodically make an adjusted net capital computation to verify

that it maintains capitalization fully adequate to meet its own commitments

and those of its customers, including afﬁliates?

(NOTE: Under the CFTC’s net capital computations, there have

been no capital requirements for ‘‘hedge’’ transactions by FCM

afﬁliate banks. It may be necessary to request that an adjusted net

capital computation be made to determine the amount of adjusted

net capital required when afﬁliate trades are treated as third-party

transactions.)

9. Does a review of the FCM’s correspondence from its designated

self-regulatory organization reveal that the FCM meets CFTC

requirements with respect to capital rules, segregation of customer

assets, and risk disclosure?

10. If an FCM will receive services from an afﬁliate (e.g., the lead bank

assesses FCM customer-credit risk or monitors customer positions

and margin accounts), have the FCM and afﬁliate entered into a

formal service agreement on an explicit fee basis?

3250.0.11.2 Management

1. Does the FCM’s management have expertise and previous

experience as a broker, dealer, or participant in cash, futures, or

forward markets related to those in which the FCM executes

transactions?

2. Does the FCM’s management have prior banking experience?

3. Does it appear that management has the expertise necessary to

evaluate the viability of various hedging strategies?

4. Does it appear that FCM management has the ability to recognize

imprudent or unsafe customer activity that could endanger the

FCM?

5. Does the board of directors have written policies that summarize the ﬁrm’s

activities and its oversight function (certain functions may be designated to a

board audit or other committee) with respect to—

a. risk appropriate for the FCM?

b. compliance monitoring and risk parameters?

3250.0.11.3 Controls of Risk Exposure with Customers

1. Does the FCM have a system for assessing and periodically

re-evaluating customer-credit risk?

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Yes No

2. Does the FCM take customer-credit risk into consideration and establish for

each customer—

a. position limits for each contract the customer wishes to trade?

b. an aggregate position limit for outstanding contracts held by each

customer?

3. Does the FCM have a system for monitoring customer positions to ensure

positions are within the limits imposed by the FCM?

4. Does the FCM have an adequate system in place to monitor its overall risk

exposure, primarily customer-default risk, on a daily basis?

5. Do customer agreements and internal procedures enable the FCM to—

a. limit the types of trades a customer engages in?

b. refuse, when appropriate, to execute any trades except those resulting in

liquidation of existing positions?

3250.0.11.4 Margin Requirements

1. Does the FCM have a system for daily monitoring of margin accounts to

ensure that margin calls are promptly issued and satisﬁed?

2. Does the customer agreement permit and has the FCM adopted procedures for

liquidating a customer’s position if margin calls are not promptly satisﬁed?

3. Do customer-account agreements authorize the FCM to require higher initial

and variation margin levels than those set by the exchanges?

4. Does the FCM have a system in place for obtaining higher customer margins in

instances when the FCM determines—

a. a customer’s futures position or deteriorating ﬁnancial condition necessi-

tates a greater amount of margin to protect the FCM?

b. volatile market conditions justify higher levels of margin than those

required by an exchange?

3250.0.11.5 Credit Risk

1. Is the credit-review approval independent from the limit-exceptions approval?

2. Does a senior ofﬁcer monitor and approve limit-exception approvals?

3. Does the customer-credit review identify credit risks associated with the

volume of transactions executed or cleared for the customer?

4. Is adequate documentation required and maintained of credit limits for each

customer that reﬂect customers’ respective ﬁnancial strengths and liquidity,

trading objectives, and the potential market risk associated with the products

traded?

5. Has the FCM adopted procedures identifying when the FCM should take steps

to limit its customer-credit exposure (e.g., when to refuse a trade, grant a limit

exception, transfer positions to another FCM, or liquidate customer positions)?

6. Is the credit-review process independent from the marketing/sales function and

the ﬁnancing function?

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Yes No

3250.0.11.6 Clearing-Only Risk

1. Is each arrangement in writing and does it—

a. identify the customer, executing brokers, and deﬁne and adequately docu-

ment the respective rights and obligations of each party?

b. establish overall limits and trading parameters for the customer that are

based on the customer’s creditworthiness and trading objectives?

c. permit transaction limits to be adjusted to accommodate market conditions

or changes in the customer’s ﬁnancial condition?

2. Has the FCM or its qualifying clearing ﬁrm veriﬁed that it has reviewed the

creditworthiness of each executing broker?

3. If the FCM acts as the primary clearing ﬁrm for locals or other customers, has

the ﬁrm adopted procedures for monitoring and controlling exposure through-

out the trading day?

3250.0.11.7 Carrying Brokers, Executing Brokers, and Pit Brokers

1. If the FCM uses other brokers to execute and/or clear transactions, either on an

omnibus or fully disclosed basis, has it adequately reviewed the creditworthi-

ness and approved the use of the other brokers?

2. Has the FCM been given an indemniﬁcation against any loss that results from

the performance or failure of the other broker?

3. If the FCM uses nonafﬁliated executing brokers, has it considered the reputa-

tion of the broker’s primary clearing ﬁrm?

3250.0.11.8 Exchange and Clearinghouse Membership

1. Does the FCM complete a due-diligence study of each exchange and clearing-

house before applying for membership in such organization?

2. Do the board minutes approving such memberships demonstrate a thorough

understanding of the loss-assessment provisions and other obligations of

membership for each exchange and clearinghouse, as well as a general under-

standing of the regulatory scheme?

3. In approving membership in a non-U.S. exchange or clearinghouse, do the

board minutes evidence a discussion of the regulatory environment and any

relevant credit, liquidity, and legal risks associated with doing business in a

particular jurisdiction?

4. Does the FCM monitor the ﬁnancial condition of each exchange and clearing

organization for which it is a member?

3250.0.11.9 Market Risk

1. If an FCM engages in proprietary trading, are policies and procedures in place

to control potential conﬂicts of interest between its brokerage business and

trading activities?

2. If an FCM has entered or plans to enter a foreign market, has the FCM

performed due-diligence reviews of relevant legal and regulatory issues, as

well as on local business practices?

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Yes No

3250.0.11.10 Liquidity Risk

1. Has the FCM established and does it monitor daily settlement limits for each

customer to ensure liquidity sufﬁcient to meet clearinghouse obligations?

2. Has the FCM established back-up liquidity facilities to meet unexpected

shortfalls?

3. Does the FCM monitor the amount of open interest (concentrations) by

product that it holds, directly or indirectly, at each exchange?

3250.0.11.11 Reputation Risk

1. Is the FCM able to assess the extent of any material exposure to legal or

reputation risk arising from its activities?

2. Does the parent company receive sufﬁcient information from the FCM’s

information systems to assess the extent of any material exposure to litigation

or reputation risk arising from the FCM’s activities?

3. If the FCM provides investment advice to customers or commodity pools, does

it have procedures designed to minimize the risks associated with advisory

activities?

4. If the FCM acts as a CPO, has it obtained prior Board approval and is it in

compliance with any conditions in the Board order?

3250.0.11.12 Internal Controls

1. Does the FCM have written procedures pertaining to the following:

a. the types of futures and options on futures contracts which the FCM will

execute?

b. individuals authorized to effect transactions and sign contracts and conﬁr-

mations?

c. the ﬁrms or individuals with whom FCM employees may conduct business?

2. Does the FCM obtain written authorization from customers specifying the

individuals who are authorized to execute trades on behalf of the customers?

3. Does the FCM have written procedures governing—

a. the solicitation and acceptance of customers?

b. the execution of purchases and sales?

c. processing transactions?

d. accounting for transactions?

e. clearing of transactions?

f. safekeeping of customer margin deposits or securities deposited as margin?

4. Does the FCM have written contracts with all ﬁrms or individuals who may

conduct business on behalf of the FCM?

5. Does the FCM have proper segregation of duties to ensure that individuals

involved in executing transactions are not able to make accounting entries?

6. Does the FCM have a numbered and controlled system of order tickets and

conﬁrmations to prevent unauthorized trading and to verify the accuracy of

records and enable reconciliation throughout the system?

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Yes No

7. Does the FCM have procedures to time stamp receipt of all orders at least to

the nearest minute and execute all orders strictly in chronological sequence (to

the extent consistent with the customers’ speciﬁcations)?

8. Does the FCM have a system for routing incoming conﬁrmations to an

operating unit separate from the unit that executes transactions?

9. Does the FCM have a system for comparing internal and external conﬁrma-

tions to ensure that the FCM will not accept or deliver securities and/or margin

payments without proper authorization and documentation?

10. Does the FCM have procedures to ensure that someone outside the trading unit

is responsible for resolution of trades in which incoming and outgoing conﬁr-

mations do not match?

11. With respect to transactions cleared by others, are procedures in place for

verifying and agreeing clearing FCM open position and margin deposit

reports?

12. Does the FCM review daily outstanding contracts, customer positions, and

margin balances?

13. Does FCM management regularly review all adjustments affecting futures

positions or income recognition to verify that such adjustments were proper

and approved?

14. Are subsidiary ledgers regularly reconciled to the general ledger?

15. Has the FCM adopted written supervisory procedures for supervising brokers

and others to ensure that they follow written policies and procedures?

16. Are there written procedures containing criteria for selecting and training

competent personnel?

17. Does the FCM have a comprehensive reporting system for providing manage-

ment with all the information necessary to effectively manage the FCM’s

operations?

18. Are procedures in place to ensure that any futures advisory services (invest-

ment advice) furnished—

a. reﬂect the views of persons authorized to supervise advisory activities?

b. are authorized under Regulation Y or by Board order?

19. Is there a formal and comprehensive internal audit program pertaining to FCM

activities?

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3250.0.12 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Brokerage of gold and silver bul-

lion and coins (provided subse-

quent basis for FCM execution and

clearance of futures contracts)

38 Federal

(1973)

FCMs for the execution of futures

contracts for gold, silver, platinum

bullion, and coins

1990 FRB 552

1985 FRB 467

1977 FRB 951

FCMs for the execution and clear-

ance of futures contracts

1982 FRB 651

1982 FRB 514

Engage in FCM activities: U.S. gov-

ernment securities, negotiable

money market instruments, foreign

exchange

1983 FRB 729

1983 FRB 216

FCM engaged in the execution and

clearance of options

1983 FRB 733

Inclusion into Regulation Y per-

missible nonbanking activities

(1984 and 1987)

225.28(b)(7)(iv) 1984 FRB 53

1984 FRB 591

Execution and clearing of futures

contracts on a municipal bond index

and to provide futures advisory

services

1986 FRB 144

1985 FRB 803

1985 FRB 651

1985 FRB 111

Execute, purchase, and sale of gold

and silver bullion and coins for the

account of customers

1985 FRB 467

1985 FRB 251

1985 FRB 111

Advisory services for futures con-

tracts on stock indexes and options

thereon

1987 FRB 220

Advice on certain futures and

options on futures

1988 FRB 820

Execution and clearance of futures

contracts on stock indexes, options

thereon, and futures contracts on a

municipal bond index

1985 FRB 970

Execution and clearing futures con-

tracts on stock indexes

1985 FRB 801

Providing investment advice on

ﬁnancial futures and options on

futures

225.28(b)(6)(iv)

(Regulation Y)

1997 FRB 275

1986 FRB 833

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Subject Laws

Regulations

Interpretations

Orders

Providing investment advice on

tradingfutures contractsandoptions

on futures contracts in nonﬁnan-

cial commodities

1991 FRB 126

Executing-only and clearing-only

trades

1993 FRB 728

1993 FRB 723

Discretionary portfolio manage-

ment services on futures and options

on futures on ﬁnancial commodities

1995 FRB 386

Discretionary portfolio manage-

ment services on futures and options

on futures on nonﬁnancial

commodities

1995 FRB 803

FCM executing and clearing, and

clearing without execution, futures

and options on futures on nonﬁ-

nancial commodities

1993 FRB 1049

Trading for one’s own account in

futures, options, and options on

futures contracts based on certiﬁ-

cates of deposit or other money

market instruments

1995 FRB 190

Commodity and index swap

transactions—originator, principal,

agent, broker, or adviser

1995 FRB 191

1995 FRB 190

Tradingin futures options on futures

contracts based on commodities or

on stock, bond, or commodity

indexes for one’s own account

1995 FRB 185

Discretionary portfolio manage-

ment services on futures and options

on futures on ﬁnancial commodities

1995 FRB 386

1994 FRB 151

FCM execution, clearance, and

advisory services for contracts on

ﬁnancial and nonﬁnancial com-

modities for noninstitutional

customers

1995 FRB 880

Serving as a commodity pool

operator

1996 FRB 569

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Subject Laws

Regulations

Interpretations

Orders

Primary clearing ﬁrm for a limited

number of ﬂoor traders and broker-

age services for forward contracts

on ﬁnancial and nonﬁnancial

commodities

1997 FRB 138

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

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4(c)(8)—Agency Transactional Services (Futures Commission

Merchant Board Orders) Section 3251.0

This section serves as a prelude to the futures

commission merchant activities (FCM) that are

provided as examples of previous Board FCM

decisions. Sections 3251.0.1 through 3251.0.13

provide brief historical summaries of Board

decisions that may have led to the authoriza-

tions that have been incorporated into the April

1997 revision of Regulation Y for this activity.

The summaries provide the reader with some

historical perspective as to how and why the

current provisions of Regulation Y evolved for

FCMs. Certain conditions and commitments

within these orders may no longer apply to the

current provisions of Regulation Y. Therefore,

reference must be made to the current Regula-

tion Y, section 225.28(b)(7)(iv).

3251.0.1 FCM BROKERAGE OF

FUTURES CONTRACTS ON A

MUNICIPAL BOND INDEX

A bank holding company applied pursuant to

section 4(c)(8) of the BHC Act and section

225.23(a)(3) of Regulation Y to engage de novo,

through a wholly owned subsidiary located in

the state of New York, to execute and clear

futures contracts on a municipal bond index.

The applicant also proposed to offer futures

advisory services for a separate fee or as an

integrated package of services to futures com-

mission merchant customers through the

subsidiary.

The Board had previously approved by regu-

lation the activity of executing and clearing

futures contracts on bullion, foreign exchange,

U.S. government securities, and money market

instruments, primarily on the basis that banks

may hold and deal in the underlying cash items.

The proposed futures contract on a municipal

bond index was based on an index of general

obligation bonds selected by the The Bond Buyer.

The Bond Buyer Municipal Index is composed

of 50 tax-exempt municipal revenue and general

obligation bonds chosen on the basis of criteria

that favor recently issued and actively traded

bonds. The index is intended to be an accurate

indicator of trends and changes in the municipal

bond market. The offering of futures contracts

based on the bond index (broad spectrum of

municipal securities) could provide FCM cus-

tomers with a more effective tool for hedging

against the price risk associated with a portfolio

of municipal bonds than any of the existing

interest-rate futures contracts.

Banks are permitted to hold and deal in gen-

eral obligation bonds, and they are active par-

ticipants in the cash markets for those bonds.

Based on these facts, the Board determined that

the applicant’s proposal was substantially simi-

lar to proposals to broker other ﬁnancial futures

previously approved by the Board, and was thus

closely related to banking.

With regard to the proposed advisory activi-

ties, the Board had previously approved by order

the provision of advisory services relating to

approved FCM activities (1984 FRB 780). The

applicant proposed to provide advisory services

either for a separate fee or as an integral pack-

age of services to FCM customers. The services

would include written or oral presentations on

the historical relationship between the cash

and futures markets, a demonstration of exam-

ples of ﬁnancial futures uses for hedging, and

assistance in structuring a hedging strategy.

The applicant would provide these services

only to major corporations and other ﬁnancial

institutions.

Based on all the facts provided, the Board

concluded that—

1. the proposed activities by the applicant could

reasonably be expected to produce beneﬁts

to the public;

2. the proposed FCM activities would entail

risks or conﬂicts of interests different than

those considered and addressed by the Board

in its approvals of other FCM activities; and

3. the balance of the public-interest factors was

favorable.

The Board noted, however, that trading of the

futures contract involved in the application had

not been approved by the Commodity Futures

Trading Commission (CFTC). It therefore con-

ditioned its December 21, 1984, approval of the

application on the CFTC’s approval of the con-

tract (1985 FRB 111).

3251.0.2 FCM BROKERAGE OF

CERTAIN FUTURES CONTRACTS ON

STOCK INDEXES INCLUDING

OPTIONS

A bank holding company applied, under section

4(c)(8) of the BHC Act and section 225.21(a) of

Regulation Y, to engage, de novo through its

BHC Supervision Manual December 1998

Page 1

wholly owned futures corporation, in executing

and clearing, on major commodity exchanges,

futures contracts on stock indexes and options

on such futures contracts. The subsidiary would

execute and clear—

1. the Standard & Poor’s 100 Stock Price Index

futures contract;

2. the Standard & Poor’s 500 Stock Price Index

futures contract (S&P 500);

3. options on the S&P 500, all of which are

traded on the Index and Option Division of

the Chicago Mercantile Exchange;

4. the Major Market Index futures contract, cur-

rently traded on the Chicago Board of Trade;

and

5. the FT-SE 100 Equity Index futures contract,

currently traded on the London International

Financed Futures Exchange.

The execution and clearance of stock index

futures and options traded on major commodity

exchanges appeared to be functionally and oper-

ationally similar to securities brokerage, permit-

ted for bank holding companies under section

225.28(b)(6)(i) of Regulation Y. Like municipal

bond index futures (an activity proposed by an

applicant which was previously approved by

Board order), these futures contracts are settled

in cash and are designed to allow customers to

hedge the market risk associated with holding

ﬁnancial assets, in this instance, corporate equity

securities. The equities represented by the listed

indexes were chosen on the basis of criteria that

favor a combination of securities that would

accurately reﬂect ﬂuctuations in the stock

market.

The Board approved the application on

February 4, 1985, based on the above analysis

and on the fact that national banks have been

permitted to execute and clear stock index futures,

and options thereon, for the account of custom-

ers, through their FCM operations subsidiaries

(1985 FRB 251). It also took into consideration

the fact that trust departments of banks have

begun to use stock index futures contracts and

options on such contracts to hedge the market

risk facing diversiﬁed stock portfolios.

3251.0.3 LIMITED FCM

CLEARING-ONLY AND

EXECUTING-ONLY TRADES

A bank holding company (the applicant) applied

for the Board’s permission under section 4(c)(8)

of the BHC Act and section 225.23(a)(3) of

Regulation Y to engage de novo in various

FCM activities. The activities were to be con-

ducted through its wholly owned FCM subsidi-

ary (the company). The FCM activities con-

sisted of—

1. executing and clearing, executing without

clearing, and clearing without executing, as

agent for institutional customers, the futures

contracts and options on futures contracts

listed in appendix A of the order;

2. executing and clearing as agent for institu-

tional customers, through omnibus trading

accounts with unafﬁliated FCMs, the futures

contracts and options on futures contracts

listed in appendix B of the order; and

3. providing relatedinvestment advisory services.

The applicant proposed to conduct the activities

throughout the United States.

The applicant requested authority to conduct,

through the company, both execution and

clearing activities on the Chicago Mercantile

Exchange (CME) and the Chicago Board of

Trade (CBOT). The company also planned to

conduct FCM activities through omnibus cus-

tomer trading accounts established in its own

name with clearing members of the exchanges

on which the company would not be a member.

The applicant also sought authority for the

company to clear trades on the CME and the

CBOT that had been executed by unafﬁliated

brokers pursuant to ‘‘give-upagreements.’’ Under

the applicant’s proposal, the company would

not be the primary clearing member for any

nonclearing member on the CBOT and would

not qualify any nonclearing member on the

CME. The company also planned to execute

trades that would be given up for clearance, at

the customer’s request, to an unafﬁliated FCM.

The Board had previously determined, by

regulation and order, that acting as an FCM in

executing and clearing all of the proposed ﬁnan-

cial futures contracts and options on futures

contracts, and providing investment advisory

services with respect to such contracts, are

activities closely related to banking under sec-

1. An omnibus account is an arrangement between a mem-

ber clearing ﬁrm of an exchange and a nonmember FCM that

seeks to conduct business on that exchange. Using this

arrangement, the member clearing ﬁrm executes and clears

transactions for the nonmember FCM and its customers. The

omnibus account reﬂects all positions of the FCM’s custom-

ers but is divided into separate segments for each customer for

the purposes of calculating margin requirements, reporting

current holdings, and other matters.

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Page 2

tion 4(c)(8) of the BHC Act with two excep-

tions.

See section 225.28(b)(7)(iv) and (b)(6)(iv)

of Regulation Y and the Board orders found at

1992 FRB 953, 1991 FRB 64, 1990 FRB 881,

and 1990 FRB 554.

On January 9, 1991, the Board denied a bank

holding company’s application to engage,

through a nonbanking subsidiary, in clearing-

only activities related to securities options and

other ﬁnancial instruments. The applicant in that

case had proposed that its subsidiary primarily

clear, but not execute, trades for professional

ﬂoor traders (primarily market makers and spe-

cialists) trading for their own accounts on major

securities and commodities exchanges. (See sec-

tion 3700.12 and 1991 FRB 189.)

In the 1991 case, the Board was concerned

that, by not engaging in both the execution and

clearance of a trade, the nonbanking subsidiary

could not decline transactions that posed unac-

ceptable risk. It would have been obligated to

settle each trade entered into by one of its cus-

tomers, even if the customer did not have the

ﬁnancial resources to honor the obligation. No

mechanism existed by which the nonbanking

subsidiary could contemporaneously monitor

the intra-day trading activities of the ﬂoor trad-

ers, its primary customers. The Board decided

that the proposed nonbanking activity exposed

the parent bank holding company to substantial

credit risk. This decision was based on (1) the

subsidiary’s inability to monitor and control the

risks to be undertaken and (2) the fact that

clearing agents had to guarantee the ﬁnancial

performance of their customers to the clearing-

houses of the exchanges on which they operate.

The public-beneﬁt considerations therefore pre-

cluded approval of that application under sec-

tion 4(c)(8) of the BHC Act.

The applicant’s proposal differed from the

1991 case in several respects. Under the pro-

posal, the company would not serve as the pri-

mary or qualifying clearing ﬁrm for any unafﬁli-

ated customers. Also, the company would clear

only those trades that it executed, or that other

executing brokers executed and the company

accepted for clearance pursuant to a customer’s

give-up agreement. The executing brokers would

be independent from the customers and would

have the opportunity to evaluate the trade before

it was executed.

All of the company’s clearing-only activities

would be conducted pursuant to give-up agree-

ments. Under these give-up agreements and

other customer agreements, the company would

have the right to refuse to accept for clearance

any customer trade that it deemed unsuitable.

The refusal could stem, for example, from con-

sideration of market conditions or the custom-

er’s ﬁnancial situation or objectives. Also, the

applicant represented that it would be able to

restrict the number and types of positions to be

held by a customer as it deemed reasonable. The

company could then refuse to accept trades that

posed unacceptable risks.

The company established a framework for

limiting risk from the clearing-only activities.

It would review the creditworthiness of each

potential customer and, based on the review,

approve or reject the customer and establish

appropriate limits concerning trading, margin,

credit, and exposure limits. The company had

controls in place to monitor the intra-day trad-

ing activities and risk exposure of its customers.

The Board determined that the credit and

other risk considerations associated with the

proposed clearing-only activities on the CME

and CBOT were consistent with previous

approvals. The decision was based on (1) the

framework for limiting risk from clearing-only

activities, (2) the commitments made by the

applicant, and (3) the other facts of record. After

reviewing other required considerations, the

Board approved the application on May 6, 1993

(1993 FRB 723). Approval was subject to the

commitments made by the applicant and the

terms and conditions set forth in the order as

well as in other Board orders related to the

proposed activities.

3251.0.4 FCM CLEARING

TRANSACTIONS BY PREAPPROVED

EXECUTION GROUPS

A foreign banking organization (the applicant)

subject to the provisions of the BHC Act applied

for the Board’s permission under section 4(c)(8)

of the BHC Act and section 225.23(a) of Regu-

lation Y to engage de novo in clearing trades of

sophisticated institutional investors relating to

contracts on futures and options on futures.

Trades would be cleared through the applicant’s

majority-owned clearing subsidiary (the com-

2. The two exceptions are the Deutsche Aktienindex 30

Stock Index futures and the German Government Bond Index

futures contracts traded on the Deutsche Terminborse GmbH.

These two contracts had been approved as FCM activities

pursuant to Regulation K. The Board also noted that these

contracts served the same functions as the futures contracts

for which FCM activities had previously been approved under

section 4(c)(8) of the BHC Act.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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Page 3

pany) on the Chicago Mercantile Exchange

(CME) and the Board of Trade of the City of

Chicago (CBOT) and executed by nonafﬁliated

ﬂoor brokers.

In particular, the applicant proposed to accept

for clearance customer orders that are executed

by preapproved execution groups pursuant to

‘‘give-up agreements.’’

The applicant expected

that the company would initially provide only

limited execution services. The company would

not be the primary clearing ﬁrm for any non-

clearing member of the CBOT, and would not

qualify any nonclearing member of the CME.

The applicant also sought approval to engage

in other FCM and data processing and transmis-

sion activities. The applicant committed that the

company would conduct these activities accord-

ing to the provisions and subject to the limita-

tions of Regulation Y (section 225.28(b)(7)(iv)

and (b)(14)).

The company also planned to

engage in certain other activities that the appli-

cant maintained were incidental to its FCM ser-

vices. These activities included the management

of institutional-customer funds under its control.

The incidental activities would also include pro-

viding to institutional customers, on request,

general advice about (1) sources of information,

(2) the selection and arrangement of an appro-

priate execution group, (3) the availability of

computer software relating to futures and options

on futures, (4) order-placement alternatives, and

(5) cost-reduction methods in the use of futures

and options on futures for hedging purposes.

The company committed that it would not pro-

vide investment advice relating to futures and

options on futures or on any other matter not

authorized by the order.

The Board previously denied a proposal in

which a nonbanking subsidiary of a BHC would

have cleared, but not executed, trades for profes-

sional ﬂoor traders (primarily market makers

and specialists) trading for their own account on

major securities and commodity exchanges. (See

1991 FRB 189 and section 3700.12.) In that

order, the Board was concerned that, by not

engaging in both the execution and clearance of

a trade, the FCM nonbanking subsidiary could

not decline transactions that posed unacceptable

risk. It would have been obligated to settle each

trade entered into by one of its customers, even

if the customerdid not have the ﬁnancial resources

to honor the obligation. No mechanism existed

by which the FCM nonbanking subsidiary could

contemporaneously monitor the intra-day trad-

ing activities of the ﬂoor traders, its primary

customers. The Board decided that the proposed

nonbanking activity exposed the parent bank

holding company to substantial credit risk. This

decision was based on (1) the FCM’s inability

to monitor and control the risks to be under-

taken and (2) the fact that the clearing agents

had to guarantee the ﬁnancial performance of

their customers to the clearinghouses of the

exchanges on which they operate. The public-

beneﬁt considerations therefore precluded

approval of that application under section 4(c)(8)

of the BHC Act.

The applicant’s proposal differed from the

above-mentioned denied application in various

respects. In the applicant’s case, the company

would not serve as the primary or qualifying

clearing ﬁrm for any broker that executes its

clearing-only trades or for any nonafﬁliated cus-

tomer. The company would clear only trades

that it executes, or that other executing brokers

execute and the company accepts for clearance

pursuant to the customer’s give-up agreement.

The applicant represented that, under the

give-up agreements, the company would have

the contractual right to refuse a customer’s trade

that exceeded established trading limits that

were documented in the give-up agreement for

that particular customer. The company would

have a period of time within which it could

determine if the executed trade was properly

authorized according to established limits, and

could decide to reject the trade.

The company’s customer base would consist

of sophisticated institutional investors. The com-

pany would review the creditworthiness and

other characteristics of each potential customer.

Based on that review, it would approve or reject

the customer and establish appropriate trading,

credit, margin, and exposure limits for the cus-

tomer. It would accept for clearance only trades

that had been executed by preapproved execu-

tion groups trading on the CBOT and CME.

Company would approve an execution group

only if the ﬂoor brokers, and their primary or

qualifying clearing ﬁrms, satisﬁed the com-

3. Under a give-up agreement, the executing ﬂoor broker

(or give-in broker), pursuant to a customer’s instructions,

gives up an executed order for clearance to a clearing member

other than the executing broker’s primary clearing member

(or qualifying member). Such agreements are used primarily

to allow institutional customers to select a broker who has

superior expertise and execution skills with respect to speciﬁc

contracts or types of orders, while maintaining their accounts

and positions with a clearing ﬁrm in which they have ﬁnancial

conﬁdence.

4. Company would not trade for its own account except

(1) to hedge a cash position in the related ﬁnancial instrument

or (2) to offset or liquidate a clearing error arising in the

normal course of business.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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Page 4

pany’s ﬁnancial, managerial, and operational

standards.

The Board decided that the credit and the

other risk considerations associated with the

proposed nonbanking activities were consistent

with requirements for approval. The decision

was based on (1) the framework described in the

order; (2) the fact that the company would not

be the primary or qualifying clearing ﬁrm for

any broker that executed the company’s clearing-

only trades, or for any nonafﬁliated customer;

(3) the other contractual and operational distinc-

tions noted between this proposal and the previ-

ous denied application (1991 FRB 189); and

(4) the other facts of record.

The Board noted that it had recently approved

applications by two bank-afﬁliated FCMs to

engage in clearing-only activities, also on the

CBOT and the CME (1993 FRB 723 and 1993

FRB 728). For a brief summary of the initial

order, see section 3251.0.3.

The Board approved the application on

August 2, 1993 (1993 FRB 961). The approval

was subject to the facts of record, all the com-

mitments made by the applicant, and the limita-

tions and conditions stated in the order.

3251.0.5 FCM—EXECUTING AND

CLEARING, AND CLEARING

WITHOUT EXECUTING, FUTURES

AND OPTIONS ON FUTURES ON

NONFINANCIAL COMMODITIES

A bank holding company (the applicant, a BHC

within the meaning of the BHC Act) applied for

the Board’s permission under section 4(c)(8) of

the BHC Act and section 225.3 of the Board’s

Regulation Y to act, through a wholly owned

subsidiary (the company), as a futures commis-

sion merchant (FCM) for unafﬁliated customers

in executing and clearing, and clearing without

executing, futures and options on futures on

nonﬁnancial commodities. Initially, the appli-

cant proposed to conduct these activities in

futures and options on futures on heating oil,

crude oil, corn, wheat, soybeans, cattle, and

hogs. The applicant must give at least 20 days’

written notice to the Federal Reserve before it

engages in FCM activities with respect to addi-

tional contracts linked to other physical com-

modities, unless other contracts are approved

for any other bank holding company under the

BHC Act.

The company is engaged in executing and

clearing on major commodities exchanges futures

and options on futures on ﬁnancial commodi-

ties and certain broad-based and widely traded

stock and bond indices.

The company proposed

to engage in its proposed activities on the CBOT,

CME, and New York Mercantile Exchange

(NYMEX).

The company will not trade in the proposed

derivative instruments for its own account. How-

ever, when a customer defaults on a contract

after the termination of futures trading and the

company is required to make or take delivery of

the underlying commodity, or when it exercises

its right to liquidate a customer’s account, the

company is permitted to take the necessary

actions to mitigate its damages. These actions

include acting for its own account in retendering

or redelivering the commodity, entering into an

exchange-for-physical transaction, or entering

into an offsetting transaction in the cash market,

provided these and other appropriate actions are

taken as soon as practicable.

The company will limit its proposed services

only to institutional customers and will not pro-

vide such services to retain brokerage custom-

ers, locals, or market makers. Approximately

10 percent of its business will be conducted on

behalf of managed commodity funds (regulated

by the Commodity Futures Trading Commis-

sion (CFTC) and the National Futures Commis-

sion). None of the managed funds would be

owned, sponsored, advised by, or otherwise

afﬁliated with the applicant. The company will

not act as a commodity trading advisor,

otherwise provide investment advice on the pro-

posed instruments.

The Board had not previously approved

the execution and clearance by bank holding

companies of futures and options on futures on

nonﬁnancial commodities. The Board’s approval

had been limited to acting as an FCM in the

execution and clearance on major commodities

exchanges of futures and options on futures on a

variety of ﬁnancial commodities, such as gold

5. See 1985 FRB 970. The company already engages in

FCM activities on the Chicago Mercantile Exchange (CME),

Chicago Board of Trade (CBOT), Commodity Exchange,

London International Financial Futures and Options Exchange,

Marche a Terme International de France, and Singapore Inter-

national Monetary Exchange.

6. As deﬁned in the Commodities Exchange Act, a com-

modity trading advisor includes, with certain exceptions, ‘‘any

person who, for compensation or proﬁt, engages in the busi-

ness of advising others, either directly or through publications

or writings, as to the value of commodities or as to the

advisability of trading in any commodity for future delivery

on or subject to the rules of any contract market, or who for

compensation or proﬁt, and as part of the regular busi-

ness, issues or promulgates analyses or reports concerning

commodities.’’ (7 U.S.C. 2)

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 5

and silver bullion and coins, foreign exchange,

government securities, certiﬁcates of deposit

and money market instruments that banks may

buy and sell for their own accounts, and stock

and bond indices.

3251.0.5.1 BHC’s Execution and

Clearance of Futures and Options on

Futures on Nonﬁnancial Commodities

National banks engage in a broad range of FCM

activities involving all types of exchange-traded

futures and option contracts consisting of ﬁnan-

cial and nonﬁnancial commodities for the

accountsof customers,and for their own accounts,

for hedging purposes. The Ofﬁce of the Comp-

troller of the Currency (OCC) reasoned that the

clearing process for any futures contract or

option on a futures contract involves essentially

an extension of credit because, upon receiving

an executed order from a customer, the clearing

broker supplies its own credit in an order on

behalf of the customer and then sends the order

to the exchange clearing organization for settle-

ment. The OCC also determined that the execu-

tion, clearance, and advisory services provided

by an FCM to its customers are essentially the

same whether or not the underlying commodi-

ties are ﬁnancial or nonﬁnancial.

Some national banks act as an FCM in the

execution and clearance of futures and options

on futures on a broad array of ﬁnancial and

nonﬁnancial commodities. The state of

New York Banking Department has also permit-

ted several New York–chartered banks to engage,

to a limited extent, in FCM activities involv-

ing derivative instruments on nonﬁnancial

commodities.

The Board has previously authorized bank

holding companies to conduct FCM activities

involving numerous instruments based on ﬁnan-

cial commodities. The Board determined that

acting as an FCM in connection with contracts

involving nonﬁnancial commodities is opera-

tionally and functionally similar to conducting

FCM activities with respect to derivative con-

tracts involving ﬁnancial commodities. In both

instances, the FCM monitors customer credit

risk and trading exposure; assesses and collects

initial and maintenance margins from custom-

ers; and brokers, executes, and clears trades.

Acting as an FCM for derivative instruments

involves functions, skills, risks, and expertise

that are substantially similar to those associated

with the execution and clearance of ﬁnancial

futures and option contracts that the Board pre-

viously approved. The mechanics of executing

and clearing trades are operationally the same

whether the commodity underlying the exchange-

traded derivative instrument is ﬁnancial or non-

ﬁnancial. The rules and regulations of the CFTC,

as well as the rules, procedures, practices, capi-

tal requirements, and safeguards of the various

commodities exchanges, govern both the execu-

tion and clearance of nonﬁnancial futures and

options and the execution and clearance of ﬁnan-

cial futures and options.

In 1991, the Board permitted bank holding

companies to provide investment advice on trad-

ing futures contracts and options on futures con-

tracts in nonﬁnancial commodities, such as agri-

cultural and energy commodities. (See 1991

FRB 126.) It concluded that (1) providing invest-

ment advice on investing in futures and options

on nonﬁnancial commodities appeared to be

the functional equivalent of providing advice on

futures and options on futures on ﬁnancial com-

modities and (2) exchange-traded futures and

options on futures involving nonﬁnancial com-

modities were essentially ﬁnancial instruments.

The Board concluded, based on an analysis of

the range of FCM activities currently existing in

banking (as summarized above and cited in the

order), that the activity of acting as an FCM in

the execution and clearance of futures and options

on futures on nonﬁnancial commodities, as pro-

posed by the applicant, is an activity that is

closely related to banking for the purposes of

the BHC Act.

3251.0.5.2 FCM’s Execution and

Clearance of Futures and Options on

Futures on Nonﬁnancial Commodities

The Board noted that both the company and the

commodities exchanges on which the proposed

FCM activities would be conducted are subject

to regulatory oversight by the CFTC. The com-

pany’s trading and clearance activities would

also be subject to regulation and review by the

CFTC and the commodities exchanges. The

7. See section 225.28(b)(7)(iv) of Regulation Y (12 C.F.R.

225). See also 1985 FRB 251, 1985 FRB 111, 1977 FRB 951,

and 38 Federal Register 27,552 (1973). The applicant’s pro-

posed clearing without execution activities were approved in

1993 (FRB 723–728). The company proposed to conduct its

clearing-only activities subject to the same conditions and

limitations set forth in these Board orders, including the use of

the ‘‘give-up agreement’’ by and among the company, its

customers, and the nonafﬁliated executing FCM that allows

the company to refuse to clear trades that exceed speciﬁed

risk parameters.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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Page 6

applicant committed to conduct the proposed

activities subject to the same rules and proce-

dures the Board imposed on FCM activities in

derivatives of ﬁnancial commodities, including

prohibitions on extending credit to customers

for the purpose of meeting margin requirements.

The applicant committed to take several further

steps in the event that one of the company’s

customers has an open position in a contract

after futures trading is ceased, and the customer

is not willing or is unable to make or take

delivery. Based on the commitments made by

the applicant for conducting the proposed activi-

ties, the limitations on the activities cited in the

order, and all the facts on record, the Board

approved the application on September 28, 1993,

subject to all the terms and conditions set forth

in the order and the noted Board regulations and

orders that relate to the proposed activities. (See

1993 FRB 1049.)

3251.0.6 FCM AND RELATED

ADVISORY SERVICES FOR OPTIONS

ON EUROTOP 100 INDEX FUTURES

AND THE ONE-MONTH CANADIAN

BANKER’S ACCEPTANCE FUTURES

A foreign bank (the applicant) subject to the

provisions of the BHC Act applied for the

Board’s permission under section 4(c)(8) of the

BHC Act and section 225.23 of Regulation Y

for its section 20 subsidiary (the company) to

act as an FCM for and provide advisory services

to nonafﬁliated persons, in connection with the

purchase and sale of futures and options on

futures contracts that are based on bonds or

other debt instruments; certain commodities; or

stock, bond, or commodity indices. The appli-

cant proposed contracts that were not previously

considered by the Federal Reserve System:

options on Eurotop 100 Index futures, to be

traded on the Commodity Exchange, Inc. (Euro-

top contracts), and the one-month Canadian

Banker’s Acceptance Futures, to be traded on

the Montreal Exchange (banker’s acceptance

futures). These contracts are based on a ﬁnan-

cial instrument or a broad-based ﬁnancial index

and are comparable to contracts previously con-

sidered by the Federal Reserve System. They

have essentially the same terms and serve the

same functions as futures and options contracts

for which FCM and related advisory services

have been approved by the Board under section

4(c)(8) of the BHC Act. The Board concluded

that the skills necessary to engage in providing

FCM and futures advisory services are the same

as those used to provide such services with

regard to previously approved contracts. The

Board thus approved the applicant’s provision

of these FCM and related advisory services for

these contracts by the company, concluding that

the activity is closely related to banking within

the meaning of section 4(c)(8) of the BHC Act.

(See 1995 FRB 188–189.)

3251.0.7 FCM TRADING FOR ITS

OWN ACCOUNT IN FUTURES,

OPTIONS, AND OPTIONS ON

FUTURES CONTRACTS BASED ON

CERTIFICATES OF DEPOSIT OR

OTHER MONEY MARKET

INSTRUMENTS

A foreign bank (the applicant) subject to the

provisions of the BHC Act applied for the

Board’s permission under section 4(c)(8) of the

BHC Act and section 225.23 of Regulation Y

for its section 20 subsidiary (the company) to

trade as an FCM in all futures, options, and

options on futures contracts based on certiﬁcates

of deposit or other money market instruments

that are permissible investments for national

banks. The Board had previously authorized

company to trade for its own account, for pur-

poses other than hedging, in futures, options,

and options on futures contracts based on U.S.

government securities that are permissible invest-

ments for national banks and in similar con-

tracts based on certain money market instru-

ments. (See 1991 FRB 759.) In that order, the

Board noted that trading in these contracts would

require a market judgment on interest rates. It

was noted that banks, through their core lending

and funding activities, had developed expertise

in judging interest-rate and price movements.

For those reasons, and because that proposal

would not authorize company to trade in deriva-

tive contracts based on securities or instruments

that a state member bank could not purchase for

its own account, the Board determined the trad-

ing activity to be closely related to banking

under section 4(c)(8) of the BHC Act.

The Board concluded that its reasoning in the

1991 order could be applied currently to this

expanded 1994 proposal. The Board noted that

the Ofﬁce of the Comptroller of the Currency

had determined that trading in futures and options

contracts based on bank-eligible securities or

instruments is an activity that is within the

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 7

legally authorized powers of national banks

(OCC Interpretive Letter No. 494 (December

20, 1989)). The Board thus concluded that the

proposed trading activity is conducted by banks

and is so operationally and functionally similar

to activities conducted by banks that banks are

particularly well-equipped to engage in the

activity. It therefore concluded that trading for

one’s own account, for purposes other than

hedging, in futures, options, and options on

futures contracts based on certiﬁcates of deposit

or other money market instruments that are per-

missible investments for national banks is an

activity that is closely related to banking within

the meaning of section 4(c)(8) of the BHC Act.

(See 1995 FRB 190.)

3251.0.8 FCM ENGAGING IN

COMMODITY AND INDEX SWAP

TRANSACTIONS AS AN

ORIGINATOR, PRINCIPAL, AGENT,

BROKER, OR ADVISOR

A foreign bank (the applicant) subject to the

provisions of the BHC Act applied for the

Board’s permission under section 4(c)(8) of the

BHC Act and section 225.23 of Regulation Y

for its section 20 subsidiary (the company) to

engage in FCM activities and in acting as an

originator, principal, agent, broker, or advisor

with respect to swaps and swap-derivative prod-

ucts and over-the-counter option transactions

based on certain commodities; stock, bond, or

commodity indices; or a hybrid of interest rates

and these commodities or indices (commodity

and index swap transactions).

Except for cer-

tain advisory services, the Board had not deter-

mined whether these proposed activities are

closely related to banking under section 4(c)(8)

of the BHC Act. The Board had determined, by

order or regulation, that acting as an originator,

principal, broker, agent, or advisor with respect

to interest-rate and currency swaps and swap-

derivative products relating thereto (ﬁnancial

swap transactions) are activities closely related

to banking and are thus permissible for bank

holding companies. (See Regulation Y, section

225.28(b)(6) and 1993 FRB 345.)

The applicant anticipates that the section

20 subsidiary’s swap transactions will be based

on a variety of stock and bond indices, similar

to those previously approved in connection with

proposed FCM activities (or to a specially

tailored basket of securities selected by the

parties) (index transactions), or they could be

based on precious metals and energy products

or related commodity indices (commodity

transactions). They also could include hybrid

transactions that are based on a combina-

tion of interest rates and such indices or

commodities.

Commodity and index swap transactions are

operationally, structurally, and functionally simi-

lar to ﬁnancial swap transactions. Both types of

swapsinvolveprivatelynegotiatedﬁnancialtrans-

actions. The parties involved in the transaction

agree to exchange speciﬁed payment streams

over a speciﬁc period of time, based on a prede-

termined formula. For an interest-rate swap, the

basic structure is an exchange between two

counterparties of the payment streams that arise

out of different interest payment obligations,

calculated on the basis of an agreed-upon

notional principal amount. With the commodity

or index swap transaction, the parties exchange

payment streams based on a notional principal

amount and the prices of certain commodities or

the value of or returns on certain securities or

indices of securities, or on a combination of

these and other measures such as interest rates.

For both types of swap transactions, the parties

enter into these contracts to meet various com-

mon investment objectives, including taking

positions in the market for the underlying assets

for investment purposes, limiting one’s expo-

sure to market uncertainties and future price

ﬂuctuations, and preserving principal while par-

ticipating in the potential returns of a particular

ﬁnancial market or economic sector. Since a

swap transaction is negotiated between parties,

the economic terms of the transaction (including

the duration of the contract; notional principal

amount; method of calculating and frequency of

payments; and underlying assets, rates, or indi-

ces upon which the payments are to be deter-

mined) can be individually tailored to meet spe-

ciﬁc ﬁnancial goals and risk sensitivities of the

counterparty.

National banks have been authorized by the

OCC to engage in activities that involve matched

and unmatched commodity and index swap

transactions (including related swap-derivative

products and over-the-counter options). The New

York State Banking Department also approved

these activities for state-chartered banks under

its jurisdiction. In addition, the Board permits

8. The proposed activities are subject to the same commit-

ments relating to interest-rate and currency swap transactions

and related swap-derivative products. (See 1993 FRB 345.)

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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statememberbanksto enterintoperfectly matched

commodity and index swap transactions, pro-

vided the transactions are consistent with their

state charters. Further, the Federal Reserve Bank

of New York, acting under delegated authority,

has approved proposals by state member banks

to engage in such activities on an unmatched

basis. (See 12 C.F.R. 208.128.)

For the foregoing reasons and based on the

facts of record, the Board determined that

engaging in commodity and index swap trans-

actions is an activity conducted by banks. The

Board also considered the similarities between

these transactions and the ﬁnancial swap trans-

actions noted above, as well as the fact that

banks and other intermediaries play a similar

role in ﬁnancial swap transactions and commod-

ity and index swap transactions. It was noted

that all of these contracts represent forms of

ﬁnancial intermediation that banks have histori-

cally engaged in. Based on all the facts on

record, the Board concluded that these proposed

activities are closely related to banking under

section 4(c)(8) of the BHC Act.

As noted previously, the company also pro-

poses to provide advisory, agency, and broker-

age services with respect to commodity and

index swap transactions. The Board believes

that the authority of banks to conduct these

activities could be implicit in or incidental to

their authority to engage in the transactions as

principal. In its analysis, the Board noted that

banks can develop a familiarity and expertise as

to the structure and economic effects of these

transactions, which should well equip them to

provide the intended advisory, agency, and bro-

kerage services. National banks have been

expressly authorized to provide advisory, execu-

tion, and other services with respect to exchange-

traded futures and options on futures contracts

based on ﬁnancial and nonﬁnancial commodi-

ties. (See OCC Interpretive Letter No. 494.) The

exchange-traded transactions are used for pur-

poses similar to the over-the-counter transac-

tions for which the applicant proposes that the

company render advisory, agency, and broker-

age services. The pricing bases for, economic

effects of, and risk presented by the two types of

transactions are also similar in important

respects.

Based on the facts on record, the Board deter-

mined that the proposed advisory, agency, and

brokerage services are activities conducted by

banks or are operationally and functionally simi-

lar to such activities. Thus, they are closely

related to banking under section 4(c)(8) of the

BHC Act. (See 1995 FRB 190–191.)

3251.0.9 FCM TRADING IN FUTURES,

OPTIONS, AND OPTIONS ON

FUTURES CONTRACTS BASED ON

COMMODITIES OR ON STOCK,

BOND, OR COMMODITY INDICES

FOR ITS OWN ACCOUNT

A foreign bank (the applicant) subject to the

provisions of the BHC Act applied for the

Board’s permission under section 4(c)(8) of the

BHC Act and section 225.23 of Regulation Y

for its section 20 subsidiary (the company) to

engage in trading for its own account for pur-

poses other than hedging in futures, options, and

options on futures contracts based on certain

commodities or on stock, bond, or commodity

indices—transactionsthat have not been expressly

authorized for banks. The instruments to be

traded are generally the same as those previ-

ously approved by the Board in considering

FCM and futures advisory activities of bank

holding company subsidiaries, such as crude oil

futures, Standard & Poor’s 500 Stock Price

Index futures, and municipal bond index futures.

(See 1993 FRB 1,049 and 1994 FRB 151 and

also SR-93-27 (refer to Appendix A).) The

applicant proposes to engage in FCM activities

and go beyond furnishing those FCM and related

advisory services and seeks the Board’s permis-

sion for the company to trade these instruments

for its own account. Such activities include arbi-

trage operations, market making for customer-

accommodation purposes, and proprietary trad-

ing (taking positions for investment purposes),

as well as hedging transactions.

The proposed activities could consist of

exchange-traded instruments that could be based

on commodities such as crude oil, providing

for delivery of the underlying commodity upon

expiration of the contract. The applicant con-

ﬁrmed that it does not intend to take delivery

of such commodities but plans to take several

actions to avoid delivery of commodities other

than precious metals. These actions include

closing positions in expiring contracts during

trading periods and engaging in exchange-for-

physical transactions after trading closes. The

Board stipulated, as a condition of approval,

that the applicant could not take delivery of the

commodities, except in unusual circumstances.

Whenever delivery is taken, the applicant is

required to notify the Federal Reserve System

and divest itself of the commodity promptly.

The Board views the contracts as ﬁnancial

instruments, despite the possibility that trading

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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Page 9

in such contracts can result in the delivery and

ownership of commodities that banking organi-

zations are generally not permitted to hold. The

Board also noted, with respect to the proposed

exchange-traded transactions that are based on

an index of securities or commodities, that

(1) the transactions would be settled in cash and

(2) they would not provide for the delivery of

the underlying securities or commodities.

The Board had not previously approved this

trading activity, with respect to the instruments

proposed, for bank holding companies or their

subsidiaries under section 4(c)(8) of the BHC

Act. The Board has, however, authorized acting

as an FCM and providing advisory services

with respect to the instruments to be traded. The

Board also approved similar trading with respect

to instruments based on U.S. government securi-

ties and money market instruments. (See 1991

FRB 759.) With respect to section 20 nonbank

subsidiaries, the Board has recognized the util-

ity of trading in these instruments to hedge

market exposure resulting from other trading

activities, indicating that these bank holding

company subsidiaries may engage in such risk-

management transactions as a necessary inci-

dent to their underwriting and dealing activities.

(See 1994 FRB 449.) No federal bank regula-

tory authority had expressly permitted banks to

trade in the proposed instruments for their own

accounts for purposes other than hedging.

The Board believes that the proposed trading

activities are closely related to banking. It noted

that banks engage in activities with respect to

the instruments in question that are similar to or

related to the proposed trading activities and

that they engage in trading activities for the

same purposes with respect to similar instru-

ments,includingexchange-tradedcontracts based

on bank-eligible securities and instruments and

over-the-counter transactions based on com-

modities and various indices.

The Board further noted that banking organi-

zations have substantial experience with

exchange-traded derivative transactions based

on commodities or on commodity or securities

indices. It also noted important similarities

between the proposed instruments and transac-

tions that have been authorized for banks for

nonhedging purposes. Moreover, the Board

believes that the risks inherent in the proposed

trading activities are similar to those that are

experienced by banks that engage in swaps and

other permissible transactions; hence, the pro-

posed transactions require analytical skills; risk-

management policies, procedures, and tech-

niques; and computer and operations systems

similar to those used by banks for engaging in

those permissible transactions. Based on this

reasoning, the Board determined the proposed

activity to be closely related to banking under

section 4(c)(8) of the BHC Act. The Board’s

December 23, 1994, approval is subject to all

the facts of record, all the commitments made in

connection with the application, and the condi-

tions cited in the order. (See 1995 FRB 185.)

These include adhering to future supervisory or

examination policies and guidance issued by the

Board for a banking organization’s derivatives

business, including policies or guidance with

respect to customer transactions, trading and

marketing practices and policies, and related

systems and controls.

3251.0.10 APPENDIX A—

PREVIOUS PRIOR-APPROVAL

REQUIREMENTS FOR BANK

HOLDING COMPANIES PROPOSING

TO ENGAGE IN FCM ACTIVITIES

In May 1993, the Board reduced the prior-

approval requirements for bank holding compa-

nies proposing to engage in certain futures

commission merchant (FCM) activities. (See

SR-93- 27.) First, the Board delegated to Reserve

Banks its authority to approve proposals by

bank holding companies to act as an FCM in

executing and clearing any futures contract on a

ﬁnancial commodity or stock or bond index that

the Board has previously approved, on any

Board-approved exchange. The Board also del-

egated to Reserve Banks its authority to approve

proposals by bank holding companies to act as

an FCM or commodity trading advisor in pro-

viding investment advisory services for previ-

ously approved ﬁnancial instruments.

In addition, the Board modiﬁed and, in cer-

tain cases, eliminated the prior-approval require-

ment for bank holding companies seeking to act

as an FCM for additional ﬁnancial instruments

or to act as an FCM on additional exchanges in

which the bank holding company already has

Federal Reserve System approval to engage

generally in FCM activities. Any bank holding

company that had previously received approval

to act as an FCM under either Board order or the

former sections 225.25(b)(18) and (b)(19) of

Regulation Y could act as an FCM subject to

certain limitations and conditions. These

requirements were replaced by the April 1997

Regulation Y revision at section 225.28(b)(7)(iv).

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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3251.0.11 PROVIDING

DISCRETIONARY PORTFOLIO

MANAGEMENT SERVICES ON

FUTURES AND OPTIONS ON

FUTURES ON FINANCIAL

COMMODITIES

A foreign bank (the applicant), a bank holding

company within the meaning of the BHC Act,

applied under section 4(c)(8) of the act to engage

through company in providing discretionary port-

folio management services with respect to

exchange-traded futures and options on futures

on ﬁnancial commodities.

The provision of dis-

cretionary portfolio management services, with

respect to futures and options on futures on

ﬁnancial commodities, had not been previously

considered by the Board as to whether it is

closely related to banking under section 4(c)(8)

of the act.

In providing discretionary management ser-

vices, company would manage customers’

accounts and purchase and sell in its sole dis-

cretion exchange-traded futures and options

on futures on ﬁnancial commodities for such

accounts. Company would provide discretion-

ary management services in combination with

providing futures commission merchant (FCM)

transactional services and would only provide

such services to institutional customers.

Com-

pany would not act as a counterparty on cus-

tomer transactions or trade these instruments for

its own account. In addition, company would

not purchase or sell over-the-counter contracts

for accounts over which it exercises discretion.

The Board has permitted bank holding com-

pany FCMs and commodity trading advisors to

provide investment advice with respect to

futures and options on futures on ﬁnancial and

nonﬁnancial commodities. (See Regulation Y,

section 225.28(b)(6) and 1994 FRB 151.) The

bank holding company argued that discretionary

management is a normal manner of providing

investment advice to institutional customers.

Indeed, the Board permits bank holding compa-

nies to act as discretionary portfolio managers

as part of providing investment advisory and

full-service brokerage services with respect to

securities. (See Regulation Y, section225.28(b)(6)

and (b)(7)(i).) In addition, the Ofﬁce of the

Comptroller of the Currency permits national

banks to engage in discretionary funds manage-

ment with respect to futures and options on

futures.

The applicant also indicated that company

would provide the proposed futures-related dis-

cretionary portfolio management services in

accordance with the limitations and conditions

that would be imposed if company were provid-

ing portfolio management services in the securi-

ties context. In this regard, the applicant com-

mitted that company would only provide the

proposed discretionary portfolio management

services to institutional customers and only at

the request of such customers.

The applicant also indicated that it would

have a ﬁduciary relationship with all customers

to whom it provides the proposed discretionary

management services and has committed that

company would comply with applicable law,

including ﬁduciary principles. As one method of

meeting its ﬁduciary obligations, the bank hold-

ing company committed that company would

obtain the consent of customers before engag-

ing, as principal or agent, in a transaction in

which any afﬁliate of company acts as principal

in futures or options on futures transactions on

the customer’s behalf. Company and its afﬁli-

ates also agreed not to share any conﬁdential

information concerning their respective custom-

ers without the consent of the customer. In addi-

tion, the applicant stated that company would

exercise its discretionary management authority

only in purchasing and selling exchange-traded

instruments. Therefore, concerns surrounding

over-the-counter instruments, such as the poten-

tial for abuses due to the lack of price transpar-

ency, were not presented by the proposal.

For these reasons, the Board concluded that

providing discretionary portfolio management

services with respect to futures and options on

futures on ﬁnancial commodities is closely related

to banking and a proper incident to banking for

purposes of section 4(c)(8). The application was

approved by the Board on February 9, 1995.

(See 1995 FRB 386.)

9. The bank holding company also proposed to engage in a

variety of data processing, securities, futures, and foreign

exchange–related activities through company and another sub-

sidiary. The Board previously has determined by order or

regulation that these activities are closely related to banking.

The bank holding company committed to conduct these activi-

ties in accordance with the conditions established by the

Board in Regulation Y and prior orders.

10. Company would provide these services to commodity

pools but would not become a commodity pool operator.

11. See OCC Interpretive Letter No. 494 (December 20,

1989).

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

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3251.0.12 FCM EXECUTION,

CLEARANCE, AND ADVISORY

SERVICES FOR CONTRACTS ON

FINANCIAL AND NONFINANCIAL

COMMODITIES FOR

NONINSTITUTIONAL CUSTOMERS

A foreign banking organization (the notiﬁcant)

subject to the provisions of the Bank Holding

Company Act (BHC Act) provided notice under

section 4(c)(8) of the BHC Act (12 U.S.C.

1843(c)(8)) and section 225.23 of the Board’s

Regulation Y (12 C.F.R. 225.23) of its proposal

that its indirect U.S. subsidiary (the indirect

subsidiary)

acquire certain assets and assume

certain liabilities of a company.

The notiﬁcant

would engage indirectly in FCM execution,

clearance, and advisory activities with respect to

futures and options on futures on ﬁnancial and

nonﬁnancial commodities

and in buying and

selling foreign exchange in the spot, forward,

and over-the-counter options markets on the

order of investors as riskless principal.

The

Board had previously determined by order and

regulation that the above proposed activities are

closely related to banking within the meaning of

section 4 of the BHC Act.

3251.0.12.1 Providing FCM Services to

Certain Sophisticated Noninstitutional

Customers

First, the notiﬁcant proposed that the indirect

subsidiary would provide FCM execution, clear-

ance, and advisory services with respect to con-

tracts on both ﬁnancial and nonﬁnancial com-

modities to persons that do not qualify as

institutional customers but who trade futures

and options on futures solely to hedge risks

arising from their business activities (noninstitu-

tional commercial hedger customers), such as

farmers. The Board has limited bank hold-

ing companies to providing nonﬁnancial

commodities–related FCM services only to in-

stitutional customers. Similarly, with respect to

contracts on ﬁnancial commodities, the Board

12. The indirect subsidiary is wholly owned by the notiﬁ-

cant. The indirect subsidiary engages in various futures com-

mission merchant, foreign-exchange, and securities-related

activities. See 1994 FRB 646 and 649.

13. The acquired ﬁrm was a clearing member of certain

ﬁnancial and nonﬁnancial commodities exchanges. The FBO

stated that the indirect subsidiary would become a clearing

member of those exchanges. In addition, that subsidiary would

provide FCM services with respect to two exchange-traded

contracts that had not previously been approved by the Board

(heating oil crack-spread options and gasoline crack-spread

options) and would purchase and sell through the use of

omnibus account arrangements certain futures and options on

futures on nonﬁnancial commodities traded on two other

exchanges.

14. These activities include providing execution-only and

clearing-only services to customers. See 1993 FRB 723 and

1994 FRB 151.

15. The indirect subsidiary would provide the proposed

riskless-principal services only to institutional customers,

except that it would provide such services to certain noninsti-

tutional customers when they direct it to convert funds from

one currency to another to trade futures and options on futures

contracts. Foreign exchange–related advisory services would

not be provided to these noninstitutional customers.

16. See 12 C.F.R. 225.28(b)(7)(iv) and 225.28(b)(6) and

1990 FRB 649 (1990).

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual June 2002

Page 12

has not permitted bank holding companies to

provide execution-only or clearing-only ser-

vices to noninstitutional customers and only per-

mits bank holding companies to provide advi-

sory services to ﬁnancially sophisticated

customers that have signiﬁcant dealings in the

underlying commodities.

The indirect subsidiary’s noninstitutional com-

mercial hedger customers would be engaged or

would be afﬁliated with a commercial enterprise

that is engaged in producing, manufacturing,

processing, or merchandising products or in pro-

viding services that are related to the com-

modities underlying the futures and options on

futures contracts in which the customers would

trade. The noninstitutional commercial hedger-

customers would not be engaged in executing

their own trades on the ﬂoor of any commodi-

ties exchanges. The notiﬁcant stated that the

indirect subsidiary would require noninstitu-

tional commercial hedger customers to state in

writing that they would only engage in ‘‘bona

ﬁde hedging transactions,’’ as deﬁned by the

Commodity Futures Trading Commission

(CFTC).

In addition, an initial credit-review

process will be established to determine whether

a noninstitutional commercial hedger custom-

er’s proposed hedging activities are appropriate

in light of the customer’s net worth and business

activities. The indirect subsidiary will not per-

mit noninstitutional commercial hedger custom-

ers to trade in any commodities other than those

that the customer would trade to hedge risks

from its commercial activities, and it would

establish a system to detect any unauthorized

trading activities.

By limiting transactional services and advice

to areas in which the customer has special

expertise, the proposed limitations address the

concern that the customer would rely unduly

on the bank holding company’s advice or that

the customer would be unable to detect conﬂicts

of interest or advice that is motivated by the

bank holding company’s self-interest. More-

over, the notiﬁcant will abide by all the other

limitations designed to more speciﬁcally address

the potential risks that may result from provid-

ing clearing-only and execution-only services to

these customers.

3251.0.12.2 Foreign-Exchange Activities

Second, in connection with the proposal that the

indirect subsidiary will buy and sell foreign

exchange on the order of customers as riskless

principal, the notiﬁcant proposed that the indi-

rect subsidiary be permitted to purchase and sell

foreign exchange for its own account for limited

purposes while also providing foreign-exchange-

related execution and advisory services.

several limited circumstances, the Board has

permitted a bank holding company to provide

foreign-exchange-related transactional and advi-

sory services in a subsidiary that purchases and

sells foreign exchange for its own account.

For example, the Board has permitted bank

holding companies to provide foreign-exchange-

related advice and transactional services through

a subsidiary engaged in purchasing and selling

foreign exchange for its own account to hedge

positions in permissible interest-rate or currency-

swap transactions or to hedge risks arising from

the permissible securities underwriting and deal-

ing activities of the subsidiary.

The indirect subsidiary will take positions in

foreign exchange only as a means to hedge

ﬁnancial-statement translations of income for its

foreign parent and as necessary for the payment

of invoices denominated in foreign currencies.

It would not enter into a foreign-exchange trans-

action for its own account with a customer if the

customer is receiving foreign-exchange services

relating to such transaction from this subsidiary.

The notiﬁcant committed that the indirect sub-

sidiary will observe the standards of care and

conduct applicable to ﬁduciaries with respect to

its foreign-exchange-related advisory activities

and will provide foreign-exchange-related

execution and advisory services only to institu-

17. See 1993 FRB 1049 and 12 C.F.R. 225.25(b)(19) (con-

tracts on ﬁnancial commodities). These limitations address

concerns that, in futures transactions, unsophisticated custom-

ers may place undue reliance on investment advice received

from a banking organization and may not be able to detect

investment advice that is motivated by the advisor’s self-

interest. Similarly, in cases involving clearing-only transac-

tions, the limitation helps address the added risk to the bank

holding company that results from its more limited ability to

review and reject trades that have been executed through

another FCM.

18. See 17 C.F.R. 1.3(z).

19. The indirect subsidiary currently provides foreign-

exchange-related execution and advisory services to its cus-

tomers. In permitting bank holding companies to provide

foreign-exchange execution and advisory services on a com-

bined basis, the Board has relied on the representation that the

subsidiary providing the foreign-exchange-related services

would not purchase or sell foreign exchange for its own

account.

20. The Board also previously has noted that in conducting

foreign-exchange operations, commercial banks combine the

functions of giving advice, executing transactions, and taking

positions in foreign exchange.

21. See 1994 FRB 157 and 1993 FRB 892.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 13

tional customers. The notiﬁcant also committed

that the indirect subsidiary’s personnel engaged

in purchasing and selling foreign exchange for

its own account will not have access to informa-

tion about the foreign-exchange trading activi-

ties of customers and that customer representa-

tives will not have access to information about

the foreign-exchange activities of personnel

engaged in purchasing and selling foreign

exchange for the indirect subsidiary’s own

account.

3251.0.12.3 Board’s Decision on the

Proposed FCM Activities

Based on the foregoing and all the facts of

record, the Board approved the notiﬁcation sub-

ject to all the terms and conditions set forth in

the order and in the above-noted Board regula-

tions and orders that relate to these activities.

The Board’s determination is subject to all the

terms and conditions set forth in the Board’s

Regulation Y, including those in sections 225.7

and 225.23(b). The Board’s decision is speciﬁ-

cally conditioned on compliance with all the

commitments made. The notice was approved

on July 14, 1995 (see 1995 FRB 880).

3251.0.13 FCM SERVING AS A

PRIMARY CLEARING FIRM FOR A

LIMITED NUMBER OF FLOOR

TRADERS AND BROKERAGE

SERVICES FOR FORWARD

CONTRACTS ON FINANCIAL AND

NONFINANCIAL COMMODITIES

A foreign banking organization and its parent

holding companies (the notiﬁcants), bank hold-

ing companies within the meaning of the Bank

Holding Company Act, requested the Board’s

approval under section 4(c)(8) of the BHC Act

(12 U.S.C. 1843(c)(8)) and section 225.23 of the

Board’s Regulation Y (12 C.F.R. 225.23) to

acquire all the voting securities of a company

(the company) and thereby engage in a wide

range of nonbanking activities, including

securities- and derivatives-related activities. The

company and its principal subsidiary (the sub-

company) engage worldwide in a wide range of

investment advisory, securities underwriting, and

futures-related activities. The notiﬁcants pro-

posed to merge the subcompany and the com-

pany into the notiﬁcants’ existing nonbank sec-

tion 20 company (the section 20 company). The

section 20 company would continue as a regis-

tered broker-dealer with the Securities and

Exchange Commission under the Securities

Exchange Act of 1934 and as a member of the

National Association of Securities Dealers. The

section 20 company would also become regis-

tered as a futures commission merchant (FCM)

and a commodity trading advisor (CTA).

The notiﬁcants proposed to engage in a vari-

ety of FCM-related activities the Board previ-

ously had determined, by regulation or order,

were so closely related to banking as to be

proper incidents thereto within the meaning of

section 4(c)(8) of the BHC Act. The proposed

activities included engaging in execution-only,

clearing-only, and omnibus account activities

with respect to futures and options on futures

based on ﬁnancial and nonﬁnancial commodi-

ties, and providing discretionary portfolio man-

agement services with respect to futures and

options on futures on ﬁnancial and nonﬁnancial

commodities.

(See 1997 FRB 138–142.) The

section 20 company committed to providing

these futures-related execution-only, clearing-

only, and discretionary portfolio management

services only to institutional customers and cer-

tain sophisticated noninstitutional commercial

hedger customers.

3251.0.13.1 Primary Clearing Firm for a

Limited Number of Professional Floor

Traders

The notiﬁcants also proposed that the section 20

22. To address potential conﬂicts of interest in connection

with providing the proposed foreign-exchange riskless-

principal services, the notiﬁcant committed that the indirect

subsidiary will disclose to each customer that receives advice

relating to over-the-counter transactions in the foreign-

exchange market that it may have an interest as a counterparty

principal in the course of action ultimately chosen by the

customer. Also, in any case in which the indirect subsidiary

has an interest in a speciﬁc over-the-counter foreign-exchange

transaction as counterparty principal, it will advise its cus-

tomer of that fact before recommending participation in that

transaction.

23. The subcompany was already registered as an FCM

and CTA.

24. The notiﬁcants committed that the section 20 company

would provide these services in accordance with the limita-

tions previously established by the Board. See 1993 FRB 723,

1993 FRB 1049, and 1994 FRB 151.

25. The notiﬁcants stated that all noninstitutional commer-

cial hedger customers would meet the requirements previ-

ously reviewed by the Board. See 1995 FRB 880.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 14

company provide clearing-only services to, and

serve as the primary clearing ﬁrm for, certain

professional ﬂoor traders on two exchanges with

respect to the futures contracts and options on

futures contracts traded on such exchanges.

The Board previously has determined that pro-

viding clearing services with respect to exchange-

traded securities, options, futures, and options

on futures contracts is closely related to banking

within the meaning of section 4(c)(8) of the

BHC Act. In 1991, however, the Board denied

an application by the notiﬁcants to engage de

novo in providing the proposed services to an

unlimited number of market makers and other

professional ﬂoor traders dealing for their own

accounts.

In the 1991 order, the Board recognized that a

company serving as the primary clearing ﬁrm

for professional ﬂoor traders may be exposed to

signiﬁcant ﬁnancial risks because the company

generally would not have the ability to reject an

executed trade presented to it for clearance,

even when the company believes the trade pre-

sents unacceptable risks in light of market con-

ditions or the traders’ ﬁnancial position. The

Board also noted that, at the time of the 1991

application, the applicants lacked appropriate

operational systems to track and manage the

intraday risks arising from the trading activities

of the ﬂoor traders. This lack of a mechanism to

monitor intraday trading activities presented the

possibility that a professional ﬂoor trader could

incur substantial losses through the trading of

options or futures contracts, which the appli-

cants would be obligated to clear and guarantee,

before the applicants could act to mitigate their

credit-risk exposure.

It was noted that since 1991, the Board and

bank holding companies have gained substantial

experience with the conduct, methods, proce-

dures, and regulation of clearing-only activities.

Also, since 1991, the Board had authorized bank

holding companies to provide clearing-only ser-

vices with respect to futures contracts and options

on futures contracts for customers other than

professional ﬂoor traders, subject to certain con-

ditions designed to ensure that the bank holding

companies have the ability to manage the atten-

dant ﬁnancial risks.

The Board concluded that the facts of record

indicated that the subcompany had and the sec-

tion 20 company would have sufﬁcient risk-

management policies, procedures, and systems

to permit the notiﬁcants and the section 20

company to adequately monitor and control the

risks, including the intraday risks, associated

with the section 20 company’s proposal to serve

as the primary clearing ﬁrm for a limited num-

ber of professional ﬂoor traders on the two

exchanges. Speciﬁcally, the section 20 company

would use the subcompany’s established trad-

ing, credit, margin, and exposure limits for each

professional ﬂoor trader for which the sec-

tion 20 company serves as the primary clearing

ﬁrm. Adherence to these limits is monitored on

an intraday basis by experienced personnel who

are physically present on the ﬂoor of the two

exchanges. These personnel visually monitor

the trading activities of ﬂoor traders on the

exchanges and review trades submitted by the

ﬂoor traders for clearance.

If an employee of

the section 20 company determines that a ﬂoor

trader is exceeding the limits it has established,

or is otherwise engaged in questionable trading

activities, the employee would have the ability

26. A primary clearing ﬁrm is obligated to accept and clear

all trades submitted by a professional ﬂoor trader, even if the

trade was initially presented to, and rejected by, another

clearing ﬁrm. Once a primary clearing ﬁrm clears a trade for a

professional ﬂoor trader, the ﬁrm becomes obligated to settle

the trade in the event of a default by the professional ﬂoor

trader. The company served as the primary clearing ﬁrm for

professional ﬂoor traders on the two exchanges. The notiﬁ-

cants requested authority for the section 20 company to act as

the primary clearing ﬁrm for up to 20 professional ﬂoor

traders on one exchange and 40 professional ﬂoor traders on

the other.

27. See 1991 FRB 189.

28. In particular, the bank holding companies agreed to

provide the clearing-only services pursuant to ‘‘give-up’’

agreements, which provide the bank holding companies with

the right to refuse to accept for clearance any customer trade

that the bank holding company deems unsuitable in light of

market conditions or the customer’s ﬁnancial situation or

objective. In addition, the bank holding companies agreed to

establish procedures to monitor the intraday trading activities

and risk exposure of their clearing-only customers.

29. The Board recognizes that trades on the two relevant

exchanges are not electronically submitted to the clearing ﬁrm

or the exchange. Instead, trading cards for each trade are

submitted by each professional ﬂoor trader to its clearing ﬁrm,

which enters the trade into the exchange’s clearing system.

Both exchanges require that the subcompany collect the trad-

ing cards from each ﬂoor trader at least once during each

half-hour period, thereby providing the subcompany person-

nel with an opportunity to review the intraday trading activi-

ties of ﬂoor traders. The rules of one exchange also require

thatthesubcompany enterall collectedtradesinto theexchange’s

on-line clearing system within 45 minutes of the end of the

half-hour period during which the trades were collected. That

exchange’s on-line clearing system also permits the subcom-

pany to monitor the trading activities of ﬂoor traders, both

individually and in the aggregate, on an intraday basis, and

allows the subcompany to identify any potentially unmatched

trades. Although the other exchange does not operate an

on-line clearing system, the subcompany personnel maintain

tally sheets that are updated every 30 minutes and reﬂect all

trades submitted by each professional ﬂoor trader throughout

the day.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 15

to limit or halt the ﬂoor trader’s activities,

require the ﬂoor trader to post additional mar-

gin, partially or entirely liquidate the ﬂoor trad-

er’s positions, or immediately revoke the ﬂoor

traders membership on the exchange.

The

notiﬁcants’ operations managers on the two

exchanges also would personally guarantee the

section 20 company against any losses that it

may incur from serving as the primary clearing

ﬁrm for ﬂoor traders on the exchanges, thereby

providing such personnel with an incentive to

closely monitor the trading activities of the ﬂoor

traders. The notiﬁcants also stated that the sec-

tion 20 company would install an on-line risk-

management system that would provide its per-

sonnel with intraday data on the trading activities

of the professional ﬂoor traders, and the ability

to analyze its exposure to such trading activities

on an intraday basis.

The Board noted that the type of risk-

management systems necessary to appropriately

manage the risks arising from a particular activ-

ity necessarily depends on the scope and nature

of the proposed activity. In this regard, the

Board noted that the section 20 company pro-

posed to serve as the primary clearing ﬁrm for

only a limited number of professional ﬂoor trad-

ers on two exchanges. These exchanges have

relatively small trading areas and volumes, which

permit personnel on the ﬂoors of the exchanges

to monitor trading activity. The Board noted that

the Federal Reserve Bank had conducted an

on-site operational and managerial infrastruc-

ture review used by the subcompany to monitor

and control the ﬁnancial risks associated with its

primary clearing activities on the two exchanges.

Based on that review and other facts of record,

the Board concluded that the subcompany had

the managerial and operational resources and

systems to adequately monitor and control the

ﬁnancial risks arising from its role as primary

clearing ﬁrm on the two exchanges.

The Board also noted that approval of the

proposal could reasonably be expected to pro-

duce public beneﬁts. Speciﬁcally, the Board

noted that the subcompany served as the pri-

mary clearing ﬁrm for a signiﬁcant percentage

of the professional ﬂoor traders on the two

exchanges and that the notiﬁcants’ proposal

would permit the section 20 company to con-

tinue providing primary clearing services to

such professional ﬂoor traders.

In light of all the facts of record, including

the limited nature of the section 20 company’s

proposed clearing-only activities for profes-

sional ﬂoor traders, the commitments provided

by the notiﬁcants, and the operational and mana-

gerial systems that the section 20 company will

have in place to monitor and control the risks

arising from the proposed activities, the Board

concluded that the credit and other risk consid-

erations associated with the proposed clearing-

only activities for professional ﬂoor traders on

the two exchanges are consistent with approval

of this notice and that, therefore, the proposed

activity is a proper incident to banking within

the meaning of section 4(c)(8) of the BHC Act.

3251.0.13.2 Brokerage Services with

Respect to Forward Contracts Based on

Certain Financial and Nonﬁnancial

Commodities

The notiﬁcants also proposed that the section 20

company act as broker with respect to forward

contracts based on certain ﬁnancial and nonﬁ-

nancial commodities. In this capacity, the com-

pany would assist customers in arranging for-

ward contracts with third parties pursuant to

which the customers would make (or receive)

delivery of ﬁnancial and nonﬁnancial commodi-

ties on a future date.

The section 20 company

would act as a broker only with respect to

forward contracts that are based on those ﬁnan-

cial and nonﬁnancial commodities that also serve

as the basis for an exchange-traded futures con-

tract.

The Board recognized that banking regu-

lators had not expressly permitted banks to

engage in the proposed activity.

Bank holding companies are permitted to act

as a broker in the execution and clearance of

futures contracts and options on futures con-

tracts based on ﬁnancial and nonﬁnancial com-

modities.

As noted above, the forward con-

tracts that the section 20 company proposed to

broker would be based on the same ﬁnancial

and nonﬁnancial commodities that underlie

futures contracts that bank holding companies

30. The subcompany’s risk-management personnel also

electronically receive trade information from the two exchanges

up to four times a day. Reports based on such data are

prepared by risk-management personnel and reviewed daily.

31. Because the section 20 company will act only as a

broker, the section 20 company will not itself be required

to take physical delivery of the nonﬁnancial commodities

underlying the forward contracts that it arranges under any

circumstances.

32. Exchange-traded futures contracts may be based on a

wide variety of commodities, including precious metals, oil,

cocoa, or wool.

33. See 1993 FRB 1049.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 16

are permitted to broker as an FCM. Bank hold-

ing companies also are permitted to broker for-

ward contracts on foreign exchanges and arrange

swap transactions that are based on nonﬁnancial

commodities or indices of nonﬁnancial com-

modities.

Accordingly, based on these and

other facts of record, the Board concluded that

acting as a broker for forward contracts based

on those ﬁnancial and nonﬁnancial commodities

that underlie an exchange-traded futures con-

tract is a permissible activity for bank holding

companies under section 4(c)(8) of the BHC

Act.

3251.0.13.3 Conclusion

Based on all the facts of record, the Board

approved the notice subject to all the terms and

conditions discussed in the order and in the

section 20 orders, as modiﬁed by the modiﬁca-

tion orders. (See 1997 FRB 138.)

34. See 1995 FRB 185.

4(c)(8)—Agency Transactional Services (FCM Board Orders) 3251.0

BHC Supervision Manual December 1998

Page 17

Section 4(c)(8) of the BHC Act—Agency Transactional Services for

Customer Investments (Other Transactional Services)

Section 3255.0

With the adoption of the April 1997 revision to

Regulation Y, the Board authorized certain types

of other transactional services in section

225.28(b)(7)(v). Bank holding companies can

provide to customers as agent transactional ser-

vices with respect to swaps and similar

transactions—

1. any transaction that is described in section

225.28(b)(8) of the regulation;

2. any transaction that is permissible for a state

member bank; and

3. any other transaction involving a forward

contract, option, futures, option on a futures

or similar contract (whether traded on an

exchange or not) relating to a commodity

that is traded on an exchange.

Under this provision of the current rule, a

bank holding company can provide transac-

tional services for customers involving any

derivative or foreign-exchange transaction that

the bank holding company is permitted to con-

duct for its own account (item 1 above). A bank

holding company may also act as a broker with

respect to forward contracts based on a ﬁnancial

or nonﬁnancial commodity that also serves as

the basis for an exchange-traded futures con-

tract. This permits a bank holding company to

act as agent in a forward contract that involves

the same commodities and assessment of risk

that underlie the permissible FCM activities of

bank holding companies. This authority is not

extended to forward contracts for the delayed

sale of commercial products (such as automo-

biles, consumer products, etc.) or real estate.

Before the incorporation of the above transac-

tions into the authority of Regulation Y, such

activities had been previously approved indi-

vidually by Board order. This section provides,

as historical examples, summaries of such

activities that were previously approved by Board

order. Such orders led to the incorporation of the

nonbanking activity into the April 1997 Regula-

tionY ‘‘laundrylist.’’Thereaderoftheseexamples

should only consider the current provisions for

‘‘other transactional services’’ as found in sec-

tion 225.28(b)(7)(v) of Regulation Y. There

should be no reliance on previous Board order

commitments, supervisory policies, and inter-

pretations that relate to this nonbanking activity

that were in existence before April 21, 1997,

unless such provisions remain. Certain former

provisions or commitments may no longer be

applicable.

3255.0.1 BROKERING OPTIONS ON

SECURITIES ISSUED OR

GUARANTEED BY THE U.S.

GOVERNMENT AND ITS AGENCIES

AND OPTIONS ON U.S. AND

FOREIGN MONEY-MARKET

INSTRUMENTS

A bank holding company applied for the Board’s

approval under section 4(c)(8) and section

225.21(a) of the Board’s Regulation Y to engage

de novo, through a wholly owned indirect sub-

sidiary, in certain futures commission merchant

and broker-dealer activities. One of the activi-

ties proposed for Board approval consisted of

engaging in brokerage activities with respect to

options on certain physicals, that is, securities

issued or guaranteed by the U.S. government

and its agencies and U.S. and foreign money-

market instruments. The Board concluded that

an option on a physical appears to serve the

same function as other instruments in that it

offers the investor a means to hedge portfolio

risk. The Board had previously approved appli-

cations to engage in discount securities broker-

age for retail customers with respect to corpo-

rate securities, and had added discount securities

brokerage to the list of permissible nonbanking

activities for bank holding companies generally.

As a broker for options on physicals, it was

stated that the indirect subsidiary would act

solely as agent on behalf of nonafﬁliated per-

sons for the purchase and sale of options.

The

services performed by a broker of options on the

proposed securities appeared to be similar to

those of other brokers. The Board thus con-

cluded on December 8, 1983, that the proposal

was closely related to banking (1984 FRB 238).

3255.0.2 BROKERING OPTIONS IN

FOREIGN CURRENCY ON

EXCHANGES REGULATED

BY THE SEC

A BHC applied for the Board’s approval under

section 4(c)(8) of the BHC Act and section

225.21(a) of the Board’s Regulation Y to engage

1. A broker of options on U.S. government and agency

securities and options on money market instruments is a

securities broker under the securities laws.

BHC Supervision Manual December 1998

Page 1

de novo, through a wholly owned subsidiary, in

executing and clearing options in foreign cur-

rency. The Board referenced its approval to a

previous order regarding the brokering of options

on certain ﬁnancial physicals (see subsec-

tion 3255.0.1 above). The Board concluded that

its rationale for this prior action was equally

applicable to the brokerage of options in foreign

exchange. The Board noted that the applicant

had been active in the cash and forward markets

for foreign currency and had the expertise to

provide the proposed services to customers. The

Board concluded on March 19, 1984, that, in the

manner proposed, the applicant’s proposal to

broker options in foreign currency was closely

related to banking (1984 FRB 368).

In considering the potential for adverse effects,

the Board took into account and relied on the

regulatory framework established pursuant to

law by the SEC for the trading of options. In

addition, the Board noted that the applicant

would not trade any of the options involved for

its own account.

3255.0.3 EXECUTING AND

CLEARING CFTC-REGULATED

OPTIONS ON BULLION AND

FOREIGN EXCHANGE ON

AUTHORIZED COMMODITY

EXCHANGES

A BHC applied for the Board’s approval under

section 4(c)(8) of the BHC Act and section

225.21(a) of the Board’s Regulation Y to engage

de novo through its wholly owned subsidiary in

executing and clearing options. As part of that

request, the BHC requested the Board to approve

the executing and clearing of CFTC-regulated

options on bullion and foreign exchange on

authorized commodity exchanges. In making a

determination that the activity was closely related

to banking, the Board noted—

1. that it previously determined the brokering

of futures and options on futures in bullion

and foreign exchange to be a permissible

nonbanking activity under the former section

225.25(b)(18) of Regulation Y (currently sec-

tion 225.28(b)(7)(iv));

2. that options on physicals serve essentially

the same function as futures and options on

futures; and

3. that the brokering of options on certain physi-

cals,that is, U.S. government securities,money

market instruments, and options on foreign

currency regulated by the SEC, is closely

related to banking (1984 FRB 368, see sub-

section 3255.0.2, above).

TheBoarddetermined thatthe proposedCFTC-

regulated options on physicals are functionally

and operationally comparable devices for hedg-

ing investment-portfolio risk. The Board also

determined that the applicant’s proposal was

substantially similar to proposals to engage in

options activities previously approved by the

Board. It noted that the applicant had been

active in the cash and forward markets for bul-

lion and foreign currency and that it possessed

the expertise to provide the proposed services to

customers. The Board therefore concluded the

activity to be closely related to banking and

approved the application on June 5, 1984, in the

manner proposed (1984 FRB 591).

4(c)(8)—Agency Transactional Services for Customer Investments (Other Transactional Services)

3255.0

BHC Supervision Manual December 1998

Page 2

Section 4(c)(8) of the BHC Act—Investment Transactions

as Principal Section 3260.0

Under Regulation Y, a bank holding company

may engage in—

1. underwriting and dealing in government obli-

gations and money market instruments (see

section 3260.0.1),

2. certain investing and trading activities as

principal, and

3. buying and selling bullion and related

activities.

A bank holding company may engage or trade

as principal in the following:

1. foreign exchange

2. forward contracts, options, futures, options

on futures, swaps, and similar contracts,

whether traded on exchanges or not, based

on any rate, price, ﬁnancial asset (including

gold, silver, platinum, palladium, copper, or

any other metal approved by the Board),

nonﬁnancial asset, or group of assets, other

than a bank-ineligible security,

if—

a. a state member bank is authorized to

invest in the asset underlying the contract;

b. the contract requires cash settlement;

c. the contract allows for assignment, termi-

nation, or offset prior to delivery or expi-

ration, and the company—

(1) makes every reasonable effort to avoid

taking or making delivery of the asset

underlying the contract; or

(2) receives and instantaneously transfers

title to the underlying asset, by opera-

tion of contract and without taking or

making physical delivery of the asset;

d. the contract does not allow for assign-

ment, termination, or offset prior to deliv-

ery or expiration and is based on an asset

for which futures contracts or options on

futures contracts have been approved for

trading on a U.S. contract market by the

Commodity Futures Trading Commission,

and the company—

(1) makes every reasonable effort to avoid

taking or making delivery of the asset

underlying the contract; or

(2) receives and instantaneously transfers

title to the underlying asset, by opera-

tion of contract and without taking or

making physical delivery of the asset

3. forward contracts, options,

futures, options

on futures, swaps, and similar contracts,

whether traded on exchanges or not, based

on an index of a rate, a price, or the value of

any ﬁnancial asset, nonﬁnancial asset, or

group of assets, if the contract requires cash

settlement

Before the incorporation of these activities

involving investment transactions as principal

into the authority of Regulation Y, certain of the

activities had been approved individually by

Board order. Following the Board’s adoption of

the April 1997 revised Regulation Y, a bank

holding company can continue to trade in for-

eign exchange and bank-eligible securities. Bank

holding companies, however, are no longer

required to have a separate subsidiary to provide

advice to customers when engaging in trading

activities as principal.

This section provides, as historical examples,

summaries of such activities that were previ-

ously approved by Board order. Such orders

may have led to the incorporation of the non-

banking activity into the April 1997 Regulation

Y ‘‘laundry list.’’ The reader of these examples

should only consider the current regulatory pro-

visions as currently found in section 225.28(b)(8)

of Regulation Y. Only minimum reliance should

be placed on previous Board order commit-

ments, supervisory policies, and interpretations

that relate to this nonbanking activity that were

in existence before April 21, 1997, unless such

provisions remain currently. Certain former

provisions or commitments may no longer be

applicable.

3260.0.1 UNDERWRITING AND

DEALING IN GOVERNMENT

OBLIGATIONS AND MONEY

MARKET INSTRUMENTS

A bank holding company may engage in under-

writing and dealing in obligations of the United

States, general obligations of states and their

1. A bank holding company is authorized to buy, sell, and

store gold, silver, copper, platinum, and palladium bullion,

coins, bars, and rounds, and any other metal approved by the

Board.

2. See sections 3260.0.4.6 and 3920.0.

3. This does not include acting as a dealer in options based

on indexes of bank-ineligible securities when the options are

traded on securities exchanges. These options are securities

for purposes of the federal securities laws.

BHC Supervision Manual December 2003

Page 1

political subdivisions, and other obligations that

state member banks of the Federal Reserve Sys-

tem may be authorized to underwrite and deal in

under 12 U.S.C. 24 and 355. This activity includes

banker’s acceptances and certiﬁcates of deposit,

under the same limitations as would be applica-

ble if the activity were performed by the bank

holding company’s subsidiary member banks or

its subsidiary nonmember banks as if they were

member banks. See Regulation Y, section

225.28(b)(8)(i) and section 3240.0.

3260.0.2 FOREIGN EXCHANGE

A bank holding company may engage as princi-

pal in foreign exchange. See Regulation Y, sec-

tion 225.28(b)(8)(ii)(A).

3260.0.3 DEALING IN GOLD, SILVER,

PLATINUM, AND PALLADIUM

BULLION AND COINS

On September 27, 1973, the Board approved a

foreign banking organization’s request to acquire

30 percent of the voting shares of a domestic

company engaged in the trading and arbitrage of

gold and silver bullion on various exchanges

and in the open market. The subsidiary is enabled

to participate in the domestic gold bullion mar-

ket under 12 U.S.C. 24 (para. 7), which speciﬁ-

cally authorized national banks to deal in bullion.

The Board found that buying and selling gold

and silver bullion and silver coin, dealing in

exchange and silver futures, and arbitraging

gold and silver in markets throughout the world

are activities closely related to banking or man-

aging or controlling banks. Thus, in approving

the application, the Board maintained its basic

position that it will beneﬁt the public to allow

foreign banks to engage in U.S. activities on a

nondiscriminatory basis. (See 1973 FRB 775.)

In another case, a BHC applied for the Board’s

permission to engage in certain activities related

to dealing in gold and silver bullion. The activi-

ties consisted of (1) buying and selling gold and

silver bullion, bars, rounds, and bullion coins

for its own account and the account of others;

(2) ﬁnancing the production, reﬁning, and fabri-

cation of gold and silver, including lending and

borrowing gold and silver in connection with

such ﬁnancing; (3) arbitraging gold and silver in

markets throughout the world; and (4) providing

various incidental services for customers, such

as arranging for the safe custody, assaying, and

shipment of gold and silver.

The Board determined previously that many

of the proposed activities are permissible for

BHCs. A BHC may engage in the purchase and

sale of gold and silver for its own account and

for the account of others.

The Board believed

the assaying and arranging for transport to be

part of this activity.

Financing activities for the

production and fabrication of gold and silver are

permissible activities. (See section 225.28(b)(1)

of Regulation Y—Extending credit and servic-

ing loans.) The Board approved the application

by order on November 24, 1986 (1987 FRB 61).

(See SR-87-7.)

In a subsequent case, a foreign banking orga-

nization presented its application to the Board,

pursuant to section 4(c)(8) of the BHC Act,

requesting permission to engage in the activity,

through its wholly owned subsidiary, of pur-

chasing and selling platinum coins issued by the

Canadian and Australian governments as legal

tender. The subsidiary would acquire the plati-

num coins issued by the Canadian and Austra-

lian governments solely for the purpose of

effecting distribution. It would maintain an inven-

tory of the coins. However, it would not pur-

chase the coins for investment or speculation for

its own account or offer its customers invest-

ment advice regarding their purchase and sale. It

would enter into forward contracts with its cus-

tomers. In considering the BHC’s application,

the Board noted that the Ofﬁce of the Comptrol-

ler of the Currency had authorized national

banks to purchase and sell platinum coins and

that the proposed activities were operationally

and functionally similar to purchasing and sell-

ing gold and silver coins. The Board found the

purchasing and selling of platinum coins that

function as legal tender to be closely related to

banking. The related application was approved

on June 25, 1990 (1990 FRB 681).

In a more recent case, a foreign bank subject

to the provisions of the BHC Act applied for the

4. The applicant further notiﬁed the Board of its intention

to purchase and sell for its own account options, futures, and

options on futures on gold and silver bullion. The applicant

committed to take positions in these investments only as a

means of hedging its position in the underlying commodity,

that is, gold and silver. The activity was thus permissible

under section 4(c)(1)(C) of the BHC Act, which allows BHCs

to furnish services to or perform services for such BHCs or its

banking subsidiaries.

5. See 1986 FRB 345, 1986 FRB 146, 1985 FRB 467, and

1981 FRB 635.

6. The Board allowed another BHC to provide storage

facilities, weighing, coin-counting, and transportation services

for bullion and coin. (See 38 Fed. Reg. 27,552 (1973).)

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 2

Board’s permission under section 4(c)(8) of the

act and section 225.23 of Regulation Y for its

section 20 subsidiary to trade platinum coin and

bullion for its own account. The Ofﬁce of the

Comptroller of the Currency has determined

that a national bank may engage in this activity.

(See OCC Interpretive Letter No. 553, May 2,

1991, relying, in part, on the fact that several

countrieshad recently introducedplatinumcoins.)

The Board had not previously determined that

this activity was closely related to banking

under section 4(c)(8) of the act. As stated previ-

ously, it had determined that the purchase and

sale of platinum coins that function as legal

tender is an activity that is closely related to

banking. (See 1994 FRB 346 and 1990 FRB

681.) The Board had also approved as a non-

banking activity, under Regulation K, trading in

platinum by bank holding company subsidiaries

located abroad (1994 FRB 177 and 1990 FRB

552). On the basis of these decisions, the Board

concluded that the proposed activity is closely

related to banking. (See 1995 FRB 190.)

With respect to palladium, a bank holding

company applied for the Board’s approval under

section 4(c)(8) of the act and section 225.23 of

the Board’s Regulation Y (12 C.F.R. 225.23) to

engage de novo through a wholly owned asset-

management subsidiary that will be established

to serve as the general partner of limited partner-

ships (the partnerships) for investing in a wide

variety of commodities and exchange-traded and

over-the-counter instruments, including trading

in precious metals. The partnerships would trade

and invest in coin and bullion consisting of such

precious metals as palladium, platinum, gold,

and silver.

The Board has previously determined that it

is closely related to banking under the act for

bank holding companies to trade in all the

instruments and commodities it proposed for the

partnerships, except palladium.

Banks currently

are permitted to engage in palladium trading.

Therefore, the Board concluded that trading pal-

ladium coin and bullion is closely related to

banking within the meaning of section 4(c)(8)

of the act.

3260.0.4 ENGAGING AS PRINCIPAL

IN DERIVATIVES INVOLVING

FINANCIAL ASSETS AND

NONFINANCIAL ASSETS OR

GROUPS OF ASSETS

A bank holding company may engage as princi-

pal in forward contracts, options, futures, options

on futures, swaps, and similar contracts, whether

traded on exchanges or not, based on any rate,

price, ﬁnancial asset, nonﬁnancial asset, or group

of assets, other than a bank-ineligible security.

A ﬁnancial asset includes gold, silver, platinum,

palladium, copper, and any other metal approved

by the Board. See Regulation Y, section

225.28(b)(8)(ii)(B).

3260.0.4.1 Trading for a Company’s

Own Account in Futures, Options, and

Options on Futures Based on U.S.

Government Securities and Certain

Money Market Instruments

A foreign bank, subject to the provisions of the

BHC Act, applied to the Board under section

4(c)(8) and section 225.23 of the Board’s Regu-

lation Y to engage through a wholly owned

subsidiaryin trading activities for its own account.

The trading included futures, options, and options

on futures based on U.S. government securities

that are permissible investments for national

banks(bank-eligible securities) andcertain money

market instruments.

The Board had previously determined that

BHCs could purchase derivative instruments

based on government securities for the purpose

of reducing interest-rate exposure. (See 12 C.F.R.

225.142, Statement of Policy Concerning Bank

Holding Companies Engaging in Futures, For-

ward, and Option Contracts on U.S. Govern-

ment and Agency Securities and Money Market

Instruments.) Previously, the Board approved

applications to trade in derivative instruments

based on foreign exchange for the company’s

own account for other than hedging purposes.

(See 1989 FRB 217.) Section 225.28(b)(7)(iv)

and 225.28(b)(6)(iv) of Regulation Y detail a

BHC’s ability to act as futures commission mer-

chant and to offer advice with regard to futures

7. See 12 C.F.R. 225.28(b)(6)(iv), 1987 FRB 61 (trading

gold and silver bullion and coin), and 1995 FRB 190 (trading

platinum coin and bullion for a BHC’s own account).

8. See OCC Interpretive Letters Nos. 683 (1995) and 553

(1991).

9. See 1991 FRB 759 for a listing of the derivative instru-

ments to be traded, which are listed in appendix A. The

subsidiary would hedge its positions in these instruments with

the instruments listed in appendix B of the order.

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 3

and options on futures on bank-eligible securi-

ties, respectively.

The purchasing and selling of derivative

instruments that represent the right to purchase

and sell bank-eligible securities is considered by

the Board to be closely related to banking.

The

experience gained by banks in dealing with the

securities underlying these instruments would

equip the banks to trade in instruments based on

these securities. In addition, the derivative

instruments based on money market instruments

require a market judgment on interest rates.

Banks have developed an expertise in such judg-

ments through their lending and funding activi-

ties. The Board thus concluded on July 12,

1991, the activity of trading for a company’s

own account in derivative instruments based on

bank-eligible securities and certain money mar-

ket instruments to be closely related to banking.

(See 1991 FRB 759).

3260.0.4.2 Dealing as a Registered

Options Trader on Foreign-Exchange

Options

A foreign bank subject to the BHC Act applied

under section 4(c)(8) of the act to deal, through

its wholly owned U.S. subsidiary, as a registered

options trader (trader) on foreign-exchange

options. As a trader, the subsidiary would act as

dealer and market maker in such options to

assist in the maintenance of a ‘‘fair and orderly’’

market on the designated exchange. A trader

deals for its own account in order to maintain a

‘‘fair and orderly’’ market in certain options

when a lack of price continuity or temporary

disparity exists on options for which the trader

makes a market. The subsidiary would be obliged

to make a market in the proposed foreign-

currency options, or bid and offer, for all traders

who approach it on the designated exchange.

The subsidiary would not be obliged in any way

as to the price and quantity it bids and offers. A

trader is permitted to ‘‘leave the ﬂoor,’’ that is,

not trade, if it meets minimum trading levels

each quarter.

The Board previously recognized that foreign-

exchange activities have traditionally been con-

ducted at banks and are permissible activities

under the BHC Act.

The Board noted that the

Ofﬁce of the Comptroller of the Currency autho-

rized national banks to deal in foreign-currency

options as a trader on a securities exchange. It

also noted that through bank participation in the

interbank market for foreign-currency options,

banks developed experience in dealing, market

making, and risk management, which are deemed

essential elements of the activities proposed.

For these reasons and the facts presented in the

BHC’s application, the Board approved the non-

banking activity as being closely related to

banking. The application was approved by the

Board on July 30, 1990 (1990 FRB 776).

3260.0.4.3 Acting as a Specialist in

Options on Foreign Exchange

A foreign bank subject to the BHC Act applied

for the Board’s approval under section 4(c)(8)

of the act (12 U.S.C. 1843(c)(8)) and section

225.21(a) of the Board’s Regulation Y (12 C.F.R.

225.21(a)) for its wholly owned subsidiary (the

company) to act as the sole specialist in deut-

sche mark options on a speciﬁed exchange (the

exchange). As a specialist, the subsidiary would

act as a dealer and market maker in these

options for the purpose of assisting in the main-

tenance of a fair and orderly market on the

exchange.

The Board found the activity of engaging as a

specialist in foreign-currency options on the

exchange to be closely related to banking for

purposes of section 4(c)(8) of the BHC Act.

Banks provide services that are operationally

similar to the activities proposed. The Board

deemed banking organizations to be particularly

well equipped to provide the proposed activi-

ties. The Board believes that banks possess sub-

stantial experience in dealing in foreign exchange

and related services that are similar to the func-

tions involved in the BHC’s proposed specialist

activity. Foreign-exchange activities were noted

as having been traditionally conducted by banks

that are major participants in all aspects of the

foreign-exchange markets. Banks act as market

makers in various currencies. Banks trade for

their own account as well as for their customers

in virtually all foreign-exchange markets and

instruments, including trading in foreign-

currency options on regulated exchanges, as

proposed by this BHC applicant.

The Board believes the ﬁnancial risk in this

case to be sufﬁciently minimized since (1) the

rules of the exchange allow the specialist to set

10. The applicant was not authorized to purchase deriva-

tive instruments based on securities or instruments that a state

member bank may not purchase for its own account.

11. See 1989 FRB 217, 308, and 580.

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 4

the price and quantity that it will buy and sell in

order to limit its risk in an adverse or volatile

market; (2) the specialist is prohibited from

speculating; and (3) the BHC has committed not

to write unhedged options, having developed

substantial experience with hedging from its

existing foreign-currency and options business.

The company will be a registered broker-dealer

with the Securities and Exchange Commission

(SEC) and will thus be subject to the SEC’s net

capital rule. The Board expects that the com-

pany will maintain capital adequate to support

its activity and to cover reasonable expenses

and losses at all times.

The Board considered its earlier decision

(1986 FRB 141) to deny a proposal to act as a

specialistin French franc optionson the exchange,

summarizedinsection3700.8. The Boardbelieves

that the facts and circumstances in this case

were different in several signiﬁcant respects

from the current situation. The current proposal

did not raise the issues relating to potential

conﬂicts of interest and risk raised by the earlier

decision (1986 FRB 141). The markets for deut-

sche marks and deutsche mark options are more

liquid than they were for French francs at that

time. Further, the market for foreign-currency

options has broadened signiﬁcantly on the

exchange, and the involvement of commercial

banks in that market has become more wide-

spread. The Board approved the BHC’s applica-

tion by order on June 22, 1989. (See 1989 FRB

580.)

3260.0.4.4 Acting as a Dealer, Broker

with Respect to Interest-Rate and

Currency Swaps and Related Transactions

A bank holding company applied pursuant to

section 4(c)(8) of the BHC Act and section

225.23(a) of the Board’s Regulation Y for its

wholly owned subsidiary to engage de novo

in—

1. intermediating in the international swap mar-

kets by acting as originator and principal

in interest-rate swap and currency-swap

transactions;

2. acting as an originator and principal with

respect to certain risk-management products

such as caps, ﬂoors, and collars, as well as

options on swaps, caps, ﬂoors, and collars

(swap-derivative products);

3. acting as a broker or agent with respect to the

foregoing transactions and instruments; and

4. acting as an adviser to institutional custom-

ers regarding ﬁnancial strategies involving

interest-rate and currency swaps and swap-

derivative products.

The Board has permitted bank holding com-

panies under section 4(c)(8) of the act to pro-

vide advice in connection with interest-rate and

currency swaps, interest-rate caps, and similar

transactions.

(See 1987 FRB 59 and 1989 FRB

308.) However, the Board had not previously

approved the remaining activities proposed under

section 4(c)(8) of the act. The Board determined

that the remaining activities proposed are closely

related to banking for the reasons summarized

below.

Intermediating in the International Swap Mar-

ket; Acting as an Originator and Principal with

Respect to Certain Risk-Management Products—

Caps, Floors, Collars, and Options on Swaps,

Caps, Floors, and Collars

1. Banks, in particular, the money center banks,

do conduct the proposed intermediation

12. Swap terminology:

Interest-rate swap. An exchange between two counterpar-

ties of different payment streams arising out of ﬁxed-rate

and ﬂoating-rate payment obligations. The exchange is made

using the same currency and is calculated by reference to a

mutually agreed-upon ‘‘notional’’ principal amount.

Currency swap. An exchange between two counterparties

of a ﬁxed-rate interest obligation in one currency for a ﬁxed-

rate interest obligation in another currency. Currency swaps

may involve an initial physical exchange of principal at an

agreed-upon current exchange rate or an exchange of interest

payments in different currencies on an agreed-upon notional

amount with no actual transfer of principal. In either case,

there will be periodic exchange of ﬁxed-rate interest payments

over the course of the swap. Upon maturity, there would be a

re-exchange of the original principal amounts.

Cap. An agreement under which one party purchases from

the other a promise to pay, at predetermined future times, the

excess, if any, of a speciﬁed ﬂoating interest rate over a ﬁxed

per annum rate. Caps may be sold separately or packaged with

an interest-rate swap.

Floor. An agreement under which one party purchases a

promise by another to pay the amount, if any, by which a

speciﬁed ﬂoating interest rate is lower than a ﬁxed per annum

rate at speciﬁed times during the life of the agreement. Floors

may be sold separately or packaged with an interest-rate

swap.

Collar. The simultaneous sale of a cap and purchase of a

ﬂoor, or purchase of a cap and sale of a ﬂoor.

Agent or broker in swap market. An agent or broker in the

swap market locates, for a fee, a suitable counterparty for a

party seeking to enter into a swap agreement.

Intermediary in swap market. A party that is willing to step

between the two parties of a swap agreement and act as a

principal counterparty with each of the other participants, thus

taking on the credit risk of each of the participants. Upon

entering into a swap with one counterparty, the intermediary

enters into an equivalent and offsetting swap with another

counterparty.

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 5

activitieswithin the international swap market.

2. Banks have participated in the swap markets

for several years as end-users, entering into

swaps and purchasing swap-derivative prod-

ucts in order to hedge other business risks or

to match assets and liabilities.

Acting as a Broker or Agent with Respect to

These Transactions and Instruments

1. Banks provide services that are operationally

similar to the proposed activities.

2. The Board had previously determined that

acting as a broker with respect to foreign-

exchange forward transactions is closely

related to banking since banks have histori-

cally engaged in the provision of assistance

with respect to foreign exchange. (See 1983

FRB 221.) Currency swaps are very similar

to foreign-exchange forward transactions. The

primary difference is the exchange of interest

rates in connection with currency swaps.

Interest-rate swaps are similar to currency

swaps in that they involve agreements to

exchange different payment streams that arise

out of a prescribed principal amount. Simi-

larly, caps, ﬂoors, and collars involve agree-

ments to pay an amount by reference to a

prescribed interest rate.

The Board approved the application on June

26, 1989 (see 1989 FRB 582), subject to the

commitments included in the order to minimize

the potential risk (that is, credit, price, basis,

portfolio, and operations risk) and the possible

conﬂicts of interest.

3260.0.4.5 Currency Swaps for Hedging

a BHC’s Own Position in Foreign

Currency

A foreign bank, subject to section 4 of the BHC

Act, applied for the Board’spermission to acquire,

through its wholly owned subsidiary, all the

shares of a company located in New York, New

York. The acquired company would engage in

several nonbanking activities. One of the activi-

ties, not previously approved by the Board for

BHCs, consisted of entering into currency-swap

transactions for hedging the BHC’s own posi-

tion in foreign currency. The Board previously

found that banks engage in this activity and thus

concluded that the activity is closely related to

banking.

In conducting this activity, the appli-

cant is to use the same policies, quantitative

limitations, and internal controls and audit pro-

grams applicable to its trading in futures, options,

and options on futures and similar contracts

used for hedging, including the guidelines in the

Board’s policy statement.

The application was

approved on August 15, 1990 (1990 FRB 860).

3260.0.4.6 Derivative Transactions as

Principal (Commodities Underlying

Derivative Contracts)

On June 27, 2003, the Board amended section

225.28 of Regulation Y (12 C.F.R. 225.

28(b)(8)(ii)(B)), effective August 4, 2003, to

permit bank holding companies (BHCs) to enter

into commodity derivative contracts (commod-

ity contracts) that are settled by the BHC receiv-

ing and transferring title to the underlying com-

modity instantaneously, by operation of contract,

without taking physical possession of the com-

modity. The Board also modiﬁed the existing

condition in Regulation Y that generally pre-

vented BHCs from engaging as principal in a

physically settled commodity contract unless the

contract speciﬁcally provides for assignment,

termination, or offset before delivery (the con-

tractual offset requirement).

The restrictions in Regulation Y that were

effective before August 4, 2003, were designed

to reduce the potential that BHCs would become

involved in and bear the risks of physical pos-

session, transport, storage, delivery, and sale of

bank-ineligible commodities. These restrictions

ensured that the commodity derivatives business

of a BHC was largely limited to acting as a

ﬁnancial intermediary that facilitates transac-

tions for customers who use or produce com-

modities or are otherwise exposed to commodity-

price risk as part of their regular business.

The former Regulation Y derivatives restric-

tions, however, impeded the ability of BHCs to

participate substantially in certain derivatives

markets. Notably, in some over-the-counter

(OTC) forward markets (U.S. energy markets,

for example), the physically settled derivative

contracts traded by market participants do not

speciﬁcally provide for assignment, termination,

or offset prior to delivery and, thus, did not

conform to the contractual offset requirement of

13. See 1989 FRB 582.

14. Statement of Policy Concerning Bank Holding Compa-

nies Engaging in Futures, Forward and Options Contracts on

U.S. Government and Agency Securities and Money Market

Instruments. See 12 C.F.R. 225.142 (establishing guidelines

for trading in forward, futures, and option contracts on ﬁnan-

cial instruments).

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 6

Regulation Y. Moreover, participants in these

markets generally settle contracts by tempo-

rarily taking and making delivery of title to the

underlying commodities and, thus, did not com-

ply with the requirement in Regulation Y that

the BHC make every reasonable effort to avoid

taking or making delivery of the asset under-

lying the contract (the delivery avoidance

requirement).

Financial intermediary participants in these

markets generally enter into back-to-back

derivative contracts with third parties that effec-

tively offset each other. That is, ﬁnancial inter-

mediaries in these markets that enter into a

contract to buy, for example, a certain number

of barrels of oil from a certain counterparty in a

certain future month generally also will enter

into another contract, before the expiration of

the original contract, to sell the same number of

barrels of oil to another counterparty in the

same future month on substantially identical

delivery terms. These market practices typically

result in the creation of a chain of contractual

relationships that begins with a commodity pro-

ducer, passes through a number of intermediar-

ies who have entered into matched contracts

both to buy and sell the same commodity at the

same future time, and ends with a purchaser that

intends to take physical delivery of the com-

modity. On the maturity date of the derivative

contracts, the producer will be responsible for

making physical delivery, and the ultimate buyer

will be responsible for accepting physical deliv-

ery, while each intermediate participant in the

chain will be deemed, by operation of contract,

to have instantaneously received and transferred

legal title to the commodity.

The Board believes that a BHC that takes title

to a commodity on an instantaneous, pass-

through basis takes no risk that is greater than or

different in kind from the risk that the BHC has

as a holder of a commodity derivative contract

that met the former requirements of Regulation

Y. Instantaneous receipt and transfer of title to

(but not physical possession of) commodities

does not appear to involve the usual activities

relating to, or risks attendant on, commodity

ownership. Instead, such transactions involve

theroutine operations functions ofpassing notices,

documents, and payments—functions that BHCs

regularly perform in their role as ﬁnancial inter-

mediaries in other markets. Moreover, although

BHCs that receive and transfer title to commodi-

ties on an instantaneous, pass-through basis face

default risks, they are not signiﬁcantly different

than the default risks associated with cash-

settled derivative contracts or derivative con-

tracts that include the assignment, termination,

or offset provisions previously required by Regu-

lation Y. In addition, banking organizations that

engage in derivatives activities, including the

modiﬁed Regulation Y commodity derivatives

activities, will remain subject to the general

securities, commodities, and energy laws and

the rules and regulations of the Securities and

Exchange Commission, the Commodity Futures

Trading Commission (CFTC), and the Federal

Energy Regulatory Commission.

For the above reasons, the Board modiﬁed

Regulation Y by changing the delivery avoid-

ance requirement to allow BHCs to take or

make delivery of title to commodities under-

lying commodity derivative transactions on an

instantaneous, pass-through basis. A BHC takes

and makes delivery of title to a commodity on

an instantaneous, pass-through basis for pur-

poses of Regulation Y only if the BHC takes

delivery of title to the commodity from a seller

and immediately thereafter makes delivery of

title to the commodity to a buyer. Accordingly,

the revised delivery avoidance requirement does

not provide authority for a BHC to take physical

delivery of commodities for use or investment

or to make physical delivery of commodities out

of the inventory of the BHC. In other words, the

BHC must not be the original seller of the

commodity in the initial position in the delivery

chain or the ultimate buyer of the commodity in

the last position in the delivery chain.

The Board’s modiﬁcation of Regulation Y

also changed the contractual offset requirement

to permit BHCs to participate in physically

settled derivative markets in which the standard

industry documentation does not allow for

assignment, termination, or offset. In particular,

the modiﬁed Regulation Y allows BHCs to enter

into commodity contracts that do not require

cash settlement or speciﬁcally provide for

assignment, termination, or offset before deliv-

ery so long as the contracts involve commodi-

ties for which futures contracts have been

approved for trading on a U.S. futures exchange

by the CFTC (and the BHC complies with the

revised delivery avoidance requirement).

15. The CFTC publishes annually a list of the CFTC-

approved commodity contracts. See, for example, Commodity

Futures Trading Commission, FY 2001 Annual Report to

Congress 126. With respect to granularity, the Board intends

this requirement to include all types of a listed commodity.

For example, any type of coal or coal derivative contract

would satisfy this requirement, even though the CFTC list

speciﬁcally approves only Central Appalachian coal.

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 7

The Board’s modiﬁcations of the derivatives

provisions in Regulation Y are effective for all

BHCs. (See 2003 FRB 385.)

3260.0.5 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Investment transactions as

principal

225.25(b)(8)

Investing and trading activities—

engaging as principal

1843(c)(8)—

section 4(c)(8)

of the BHC

Act

225.28(b)(8)(ii)

BHCs can (1) take and make

delivery of title to commodities

underlying commodity deriva-

tives contracts on an instanta-

neous, pass-through basis and

(2) enter certain commodity

derivative contracts that do not

require cash settlement or

speciﬁcally provide for assign-

ment, termination, or offset prior

to delivery

225.28(b)(8)(ii)(B) 2003 FRB 385

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act—Investment Transactions as Principal 3260.0

BHC Supervision Manual December 2003

Page 8

Section 4(c)(8) of the BHC Act (Real Estate

and Personal Property Appraising) Section 3270.0

Effective December 31, 1980, the Board amended

section 225.28(b) of Regulation Y (12 C.F.R.

225.28(b)(2)(i)) to include the performance of

real estate appraisals in the list of activities

permissiblefor bank holding companies to engage

in. The Board concluded that banks perform real

estate appraisals either in connection with exten-

sions of credit involving real estate lending or as

a discrete activity. In addition, such an appraisal

activity calls upon the necessary skills and

resources often possessed by banking organiza-

tions. The Board thus determined that the activ-

ity of performing appraisals of real estate is

closely related to banking and that its perfor-

mance by bank holding companies will yield net

beneﬁts to the public.

In addition to authorizing the appraisals of

real estate as a nonbanking activity, the Board

has previously determined by order that the

appraisal of certain types of personal property,

both tangible and intangible, is closely related to

banking (1985 FRB 118). Providing personal

property appraisals was added to the list of

permissible nonbanking activities in Regulation

Y. It was combined with the already-approved

activity of providing real estate appraisals (12

C.F.R. 225.28(b)(2)(i)). The action was approved

by the Board on October 31, 1986, effective

December 15, 1986, without any conditions. In

permitting bank holding companies to engage in

the activity of providing valuations of compa-

nies, the Board noted that the commercial lend-

ing and trust departments of banks commonly

make valuations of a broad range of tangible

and intangible property, including the securities

of closely held companies. Providing valuations

of companies necessarily involves the appraisal

of various types of intangible personal property,

such as securities of closely held corporations,

as well as any tangible personal property that a

company might possess.

Banks currently engage in the appraisal of

personal property through their trust depart-

ments. Trust departments value private business

interests for their own trust accounts and other

types of personal property in a customer’s estate

for probate and tax purposes. Banks engage in

property appraisal activities in connection with

secured lending activities and routinely appraise

property which they take as collateral on loans,

includingperishable commodities,durablegoods,

computer software, crops, livestock, machinery,

and equipment.

Banks also engage in appraisal activities in

connection with their leasing activities. With

regard to leasing, banks determine the residual

value of leased property, such as vehicles and

equipment, in order to establish the terms of a

lease. Some money-center banks have appraised

aircraft and locomotives, in connection with

their leasing or lending transactions. Finally,

banks may become involved in personal prop-

erty appraising when they appraise real prop-

erty, since certain types of real property, such as

factories or apartment buildings, contain ﬁx-

tures or other personal property that must be

evaluated separately to determine the value of

the real property.

3270.0.1 SCOPE OF INSPECTION

As noted within the subsequent inspection pro-

cedures, a sampling of real estate and personal

property appraisals is to be reviewed to deter-

mine whether the appraised value of the prop-

erty is reasonable and the documentation sup-

ports the appraisal.

Regulatory appraisal standards for federally

related transactions are discussed below and

must be considered in determining the scope of

the inspection. The types, components, and pro-

cedures that should be used in evaluating real

estate appraisals are included in section 2231.0,

which contains guidelines for use by bank hold-

ing companies and subsidiaries for real estate

appraisal and evaluationprograms. Personalprop-

erty appraisal involves estimating or determin-

ing the value of property other than real property.

3270.0.2 APPRAISAL STANDARDS

FOR FEDERALLY RELATED

TRANSACTIONS

The Board approved, on June 27, 1990, Appraisal

Standards for Federally Related Transactions

that represent amendments to Regulation H (12

C.F.R. 208) and Regulation Y (12 C.F.R. 225)

that are designed to protect federal ﬁnancial and

public policy interests in real estate transactions

requiring the services of an appraiser. The regu-

lations are intended to supplement the Board’s

appraisal guidelines currently in effect. Section

1. ‘‘Federally related transaction’’ refers to any real estate–

related ﬁnancial transaction entered into on or after August 9,

1990, that (1) the Board or any regulated institution engages

in or contracts for and (2) requires the services of an indepen-

dent appraiser.

BHC Supervision Manual December 2000

Page 1

208.50 of Regulation H refers to the appraisal

standards forfederallyrelated transactions entered

into by state member banks. The appraisal stan-

dards for federally related transactions are found

in subpart G, section 225 of Regulation Y. The

amendments were the result of implementing

provisions of title XI of the Financial Institu-

tions Reform, Recovery, and Enforcement Act

of 1989 (FIRREA) regarding real estate apprais-

als. The Regulation Y amendments identify

which transactions require an appraiser (section

225.63),

set forth minimum standards for per-

forming appraisals (section 225.64), and distin-

guish those appraisals requiring the services of a

state-certiﬁed appraiser from those requiring a

state-licensed appraiser (section 225.63). The

effective dates are August 9, 1990, for the

appraisal standards and July 1, 1991, for the

appraiser certiﬁcation and licensing require-

ments. Other provisions address appraiser inde-

pendence (section 225.65), professional associa-

tion membership, and competency.

3270.0.3 APPRAISER’S

QUALIFICATIONS

With respect to an institution’s selection of

appraisers, examiners need to consider the

following:

1. The professional certiﬁcation, license, or other

recognition of the competence of the appraiser.

For real estate appraisals, the appraiser must

have the proper state certiﬁcation or license

required by section 225.63 of Regulation Y.

Examiners should also consider the Septem-

ber 1992 Guidelines for Real Estate Appraisal

and Evaluation Programs. For personal prop-

erty appraisals, the appraiser’s qualiﬁcations

might be evidenced by certiﬁcation from a

nationally recognized personal property

appraisal organization or they may be sup-

ported by license or other recognition of the

competence of the appraiser.

2. The reputation and standing of the specialist

in the view of his peers and others familiar

with the person’s capability of performance.

3. The relationship, if any, of the appraiser to

the bank holding company in order to deter-

mine independence and objectivity.

4. The appraiser’s documented accomplish-

ments (for example, the appraiser’s personal

‘‘qualiﬁcations statement’’ or job history

resume).

5. Whethertheappraiser’sexperienceandknowl-

edge or expertise relates to the property

appraised.

6. Whether the appraiser meets continuing-

education requirements for licensing or

certiﬁcation. Membership or the absence of

membership in any particular appraisal orga-

nization should not be accepted as prima

facie evidence of an appraiser’s qualiﬁcations.

3270.0.4 KEY COMPONENTS OF A

PERSONAL PROPERTY APPRAISAL

REPORT

When reviewing personal property appraisals,

the appraisal should describe the following:

1. the kind of value being determined, such as

fair market value, liquidation value,

replacement/reproduction value, etc.

2. the property being valued

3. the detailed procedures used to estimate the

values, such as—

a. analysis of comparable sales,

b. estimation and analysis of income, and

c. the appraised values as of a speciﬁc date

4. the name of the individual who made the

appraisal and who is responsible for its valid-

ity and objectivity (to the person receiving

the appraisal, to third parties, and to the

public)

5. the personal qualiﬁcations data of the

appraiser

3270.0.5 APPRAISAL OF

CONSTRUCTION AND

CONSTRUCTION-ANALYSIS

SERVICES

The activity of providing construction-analysis

services, including appraisal of construction

projects at various stages of development and

disbursement of construction loan funds in

accordance with the terms of the loan agree-

ment, is included within the permissible activi-

ties of real estate appraising and loan servicing.

2. The Appraisal Standards for Federally Related Transac-

tions that are found in Regulation Y were amended, effective

December 28, 1998, to exclude from the Board’s appraisal

requirements transactions involving the underwriting of or

dealing in mortgage-backed securities. The amendment per-

mits bank holding company subsidiaries engaged in the under-

writing of and dealing in securities to underwrite and deal in

mortgage-backed securities without demonstrating that the

loans underlying the securities are supported by appraisals

that meet the Board’ s appraisal requirements.

Section 4(c)(8) of the BHC Act (Real Estate and Personal Property Appraising) 3270.0

BHC Supervision Manual December 2000

Page 2

3270.0.6 INSPECTION OBJECTIVES

1. To determine what ﬁnancial effect the activity

has on the parent holding company and the

bank subsidiaries.

2. To determine whether the company has for-

mal written policies and procedures. For real

estate appraisals, the policies and procedures

should be consistent with the Guidelines for

Real Estate Appraisal and evaluation pro-

grams in section 2231.0.

3. To determine if there is compliance with the

appraisal standards for federally related trans-

actions detailed in the Board’s Regulations H

and Y.

4. To determine whether the appraisals were

performed on an independent basis.

5. To determine whether the individuals per-

forming the appraisals are qualiﬁed and that

the appraisals are reasonable.

6. To determine whether the appraisals are cur-

rent, complete, and reasonably accurate.

7. To determine if real estate appraisals are

performed by state-licensed or state-certiﬁed

appraisers.

3270.0.7 INSPECTION PROCEDURES

1. Review the company’s ﬁnancial statements

and determine if there are any factors or

trends that could have an adverse impact on

the parent holding company or the bank

subsidiaries.

2. Review the company’s policies and proce-

dures to determine that the following are

present:

a. Adequate minutes are prepared of the

board and board committee meetings.

b. Professional liability insurance and

blanket bond coverage, if appropriate,

are in place and the coverage appears

sufﬁcient.

c. Only qualiﬁed individuals are authorized

to perform appraisals.

3. Review a sampling of the real estate and

personal property appraisals to determine

how a value is derived and whether this

value is adequately substantiated.

4. For the appraisals reviewed in procedure 3,

determine the reason for each appraisal. If it

is for the purpose of valuing collateral for a

loan extended by or to a bank afﬁliate, does

the value appear realistic in relation to the

loan amount?

5. Check for compliance with section 106(b) of

the 1970 Amendments of the BHC Act (pro-

hibition against tie-in arrangements). (See

section 3500.0.)

3270.0.8 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Real estate appraisal

activity approval

225.28(b)(2)(i) 1980 FRB 962

and 984

1997 FRB 275

Acquisition of a nonbanking

subsidiary that performs

valuations of companies

and of large blocks of stock

for a variety of purposes

1985 FRB 118

Personal property appraisal

activity approval

225.28(b)(2)(i) 1986 FRB 833

1997 FRB 275

Appraisal standards for

federally related

transactions

225 subpart G,

225.61–

225.67

4–053 1990 FRB 639

1999 FRB 50

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Real Estate and Personal Property Appraising) 3270.0

BHC Supervision Manual June 1999

Page 3

Section 4(c)(8) of the BHC Act

(Check-Guaranty and Check-Veriﬁcation Services)

Section 3320.0

The activities of check-guaranty and check-

veriﬁcation services permit bank holding com-

panies to authorize the acceptance by subscrib-

ing merchants of certain personal checks tendered

by the merchant’s customers in exchange for

goods and services, and to purchase validly

authorized checks from merchants in the event

the checks are subsequently dishonored.

The Board determined, previously, that check-

guaranty services were closely related to bank-

ing, and had approved applications by bank

holding companies on a case-by-case basis to

engage in the activity (1979 FRB 263 and 1981

FRB 740). See also 1999 FRB 582, 1996 FRB

348 (fraud-detection services), 1994 FRB 1107,

and 1995 FRB 492 (ATM network services).

The Board noted the potential for unfair com-

petition or conﬂicts of interest with respect to

the authorization of checks not drawn on afﬁli-

ated banks. To minimize this possibility, the

Board has maintained a condition in Regulation

Y, noted in previous orders, stating that the

check guarantor cannot discriminate against

checks drawn on unafﬁliated banks.

3320.0.1 INSPECTION OBJECTIVES

1. To determine the extent of exposure to guar-

anteed bad-check losses.

2. To determine whether management is quali-

ﬁed and effective in controlling losses.

3. To determine whether administrative and

operating procedures and check-guaranty and

check-veriﬁcation transactions are processed

in accordance with established Board or Board

committee authorization policies and proce-

dures, including adequate internal control

procedures.

4. To determine whether recordkeeping and data

processing are adequate and current to avoid

losses resulting from outdated or inaccurate

information.

5. To determine whether any signiﬁcant contin-

gent liabilities exist.

6. To determine whether the ﬁnancial condition

of the nonbanking subsidiary will have an

adverse inﬂuence on the ﬁnancial condition

of the consolidated corporation.

3320.0.2 INSPECTION PROCEDURES

1. Review ﬁnancial statements to determine the

ﬁnancial condition of the company and past

and current operating trends. Test the accu-

racy of those records against the ﬁnancial

statements for each material asset, liability,

and equity account.

2. Review the minutes of the board of directors

and executive committees and correspon-

dence exchanged with the company’s legal

counsel.

3. Review authorization records for check-

guaranty and check-veriﬁcation services for

adequacy to determine whether check clear-

ance is veriﬁed and whether the company has

an accurate record of its contingent liability

for guaranteed checks.

4. Review collection records to determine

whether follow-up procedures on purchased

guaranteed bad checks are adequate and

whether they evidence timely collection con-

tacts and successful recoveries.

5. Determine whether collection-problemchecks

are turned over to attorneys or collec-

tion agencies for appropriate collective or

legal action on a timely basis.

6. Review the company’s history of bad-check

losses and the current status of uncollected

bad checks, and determine whether adequate

reserves have been set aside for those losses.

7. Determine whether fee calculations and bill-

ing procedures ensure accuracy and propriety.

BHC Supervision Manual December 1999

Page 1

3320.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Engage de novo

through a new nonbank

subsidiary in the activity

of check veriﬁcation

1979 FRB 263

Retail check-authorization

and check-guaranty

activities

1981 FRB 740

1999 FRB 582

Fraud-detection services 1996 FRB 348

(see footnote 15)

Amendment of

Regulation Y adding

check veriﬁcation as a

permissible activity

225.28(b)(2)(iii) 1986 FRB 833

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Check-Guaranty and Check-Veriﬁcation Services 3320.0

BHC Supervision Manual December 1999

Page 2

Section 4(c)(8) of the BHC Act

(Operating a Collection Agency) Section 3330.0

The Board authorized the addition of operating

a collection agency to the list of approved activi-

ties. A collection-agency subsidiary seeks to

collect payment on the overdue bills of debtors,

charging the party submitting the claim a ﬂat

dollar amount or a speciﬁed percentage commis-

sion contingent on the amount collected. The

Board determined that operating a collection

agency is closely related to banking as banks

engage in debt-collection activities for loans

they originate and service, including overdue

credit-card accounts.

The Board recognized the potential for unfair

competition and conﬂicts of interest through the

operation of a collection agency. Accordingly,

the Board established the following conditions

on operating a collection agency:

1. The collection agency shall not obtain the

names of customers of competing collection

agencies from an afﬁliated depository institu-

tion that maintains trust accounts for those

agencies

2. The collection agency shall not provide pref-

erential treatment to an afﬁliate or a customer

of such afﬁliate seeking collection of an out-

standing debt.

3330.0.1 INSPECTION OBJECTIVES

1. To determine whether the collection agency

is obtaining the names of customers of com-

peting collection agencies from an afﬁliated

depository institution that maintains trust

accounts for those agencies.

2. To determine whether the collection agency

provides preferential treatment to an afﬁliate

or a customer of such afﬁliate seeking collec-

tion of an outstanding debt.

3. To determine what effect the activity has on

the parent company, its subsidiaries, and the

overallconsolidatedorganization,and whether

the company or activity evidences a going

concern.

4. To determine whether the company has for-

mal written policies and operating and inter-

nal control procedures to successfully admin-

ister the activity.

5. To determine the extent of management

expertise, experience, and involvement with

the administration of the activity.

6. To determine the extent of compliance with

laws, regulations, and interpretations associ-

ated with the activity, including the Fair

Credit Reporting Act, Fair Debt Collection

Practices Act, and Right to Financial Privacy

Act.

7. To determine whether the company adminis-

ters formal training programs which include

proper operating and compliance methods.

8. To determine whether any signiﬁcant

contingent liabilities exist and whether those

liabilities resulted from the failure of the

bank holding company or its nonbanking

subsidiary to fulﬁll its responsibilities as an

agent for its customers.

3330.0.2 INSPECTION PROCEDURES

1. Review ﬁnancial statements to determine the

ﬁnancial condition of the company and past

and current operating trends. Test the accu-

racy of the ﬁnancial statements against the

company’s ﬁnancial records and other sup-

portive corroborating evidence.

2. Review the minutes of the board of directors

and executive committees, and correspon-

dence exchanged with the company’s legal

counsel with regard to possible contingency

losses.

3. Review collection records for adequacy, and

determine whether the amount of payments

received is independently veriﬁed.

4. Review collection records—tickler ﬁles—to

determine whether follow-up procedures on

acquired accounts are adequate and whether

they evidence timely collection contacts and

successful recovery rates.

5. Determine whether appropriate legal action

is used and authorized by customers on a

timely basis.

6. Determine whether fee calculations and bill-

ing procedures ensure accuracy and propriety.

7. Review parent company and subsidiary

administrative and operating policies, and

determine whether the collection agency is

prohibited from obtaining the names of cus-

tomers of competing collection agencies from

an afﬁliated depository institution that main-

tains trust accounts for those agencies.

8. Review customer lists and billings and any

prioritized collection schedules, and deter-

mine whether the collection agency is pro-

viding any preferential treatment to an afﬁli-

ate or a customer of such afﬁliate seeking

collection of an outstanding debt.

BHC Supervision Manual June 1998

Page 1

3330.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Amendment of Regulation Y

adding collection-agency

services as a permissible

activity

225.28(b)(2)(iv) 1986 FRB 833

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

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

BHC Supervision Manual June 1998

Page 2

Section 4(c)(8) of the BHC Act

(Operating a Credit Bureau) Section 3340.0

A bank holding company that engages in the

activity of operating a credit bureau gathers,

stores, and disseminates factual information

relating to the identity and paying habits of

consumers. Credit bureaus then provide this

information for a fee to credit grantors, such as

retailers, banks, and ﬁnance companies, to enable

the institutions to arrive at prudent credit-

granting decisions. The Board concluded that

the activity is closely related to banking as

banks maintain credit ﬁles and analyze credit

information as part of their consumer-lending

function.

The Board recognized that possible adverse

effects could result from a potential conﬂict of

interest when a bank holding company performs

credit bureau activities. For example, under the

Fair Credit Reporting Act, a credit bureau is

required to investigate the accuracy of any item

of information disputed by a consumer (15

U.S.C. 1681(i)). A bank holding company credit

bureau may not conduct an impartial investiga-

tion if the disputed information originates with

an afﬁliate. The Board thus imposed the condi-

tion that a credit bureau could not provide pref-

erential treatment to a customer of an afﬁliated

ﬁnancial institution.

Regulation Y allows bank holding companies

to engage only in consumer-credit-reporting

activities rather than credit-reporting activities

concerning large commercial institutions.

3340.0.1 Inspection Objectives

1. To determine whether the activity is limited

to only consumer-credit-reporting activities.

2. To determine whether the bank holding com-

pany gives preferential treatment to a cus-

tomer of an afﬁliated ﬁnancial institution.

3. To determine the adequacy of internal poli-

cies and operating and internal control

procedures.

4. To determine whether any signiﬁcant contin-

gent liabilities exist which arose from the

failure of the holding company and its non-

banking subsidiary to fulﬁll their responsi-

bilities as an agent for their customers.

5. To determine whether appropriate steps have

been taken to ensure compliance with the

Fair Credit Reporting Act, Equal Credit

Opportunity Act, and Right to Financial Pri-

vacy Act.

6. To determine whether adequate controls exist

to prevent unauthorized access into any com-

puterized credit bureau credit ﬁles to pre-

serve the conﬁdentiality of the information

stored for customers’ use.

3340.0.2 INSPECTION PROCEDURES

1. Review the company’s ﬁnancial statements

for accuracy, and determine if there are any

factors or trends that could have an adverse

impact on the parent company or its banking

or nonbanking subsidiaries.

2. Review recordkeeping practices, and deter-

mine whether such management information

systems are adequate to service customers

and limit the risk of loss resulting from weak

recordkeeping activities.

3. Review customer logs or client lists, and

determine whether the activity is limited to

only consumer-credit-reporting activities.

4. Review the activity and billings for a cus-

tomer of an afﬁliated ﬁnancial institution,

and compare those ﬁndings to the activities

and billings of other customers. Determine

whether the bank holding company is giving

preferential treatment to a customer(s) of an

afﬁliated ﬁnancial institution.

5. Review the company’s policies and operat-

ing and internal control procedures for the

activity, and determine whether they have

been documented and whether they are being

tested for compliance as part of the compa-

ny’s internal/external audits.

6. Review correspondence with legal counsel,

and determine whether any signiﬁcant con-

tingent liabilities exist due to the failure of

the holding company and its nonbanking sub-

sidiary to fulﬁll their responsibilities as an

agent for their customers.

7. Determine whether internal control proce-

dures and compliance audits test for compli-

ance with the Fair Credit Reporting Act,

Equal Credit Opportunity Act, and Right to

Financial Privacy Act.

8. Determine what steps have been taken to

prevent unauthorized access to any comput-

erized credit bureau credit ﬁles to preserve

the conﬁdentiality of the information stored

for customers’ use.

BHC Supervision Manual June 1998

Page 1

3340.0.3 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Denial of a BHC’s

proposal to engage in

providing credit ratings

for large businesses

1985 FRB 118

Activity is closely related

to banking and a

permissible nonbanking

activity for consumer-

credit reporting only

225.28(b)(2)(v) 1986 FRB 833

1997 FRB 275

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(8) of the BHC Act (Operating a Credit Bureau) 3340.0

BHC Supervision Manual June 1998

Page 2

Prohibitions Against Tying Arrangements

Section 3500.0

3500.0.1 INTRODUCTION

Among other things, section 106 of the Bank

Holding Company Act amendments of 1970

(section 106) prohibits a bank from condition-

ing the availability or price of one product on a

requirement that the customer also obtain another

product from the bank or an afﬁliate of the

bank.

The statute is intended to prevent banks

from using their ability to offer bank products in

a coercive manner to gain a competitive advan-

tage in markets for other products and services.

Tying arrangements that are prohibited by sec-

tion 106 may be addressed by the bank’s appro-

priate federal banking agency through an en-

forcement action, by the Department of Justice

through a request for an injunction, or by a

customer or other person injured by the tying

arrangement through a request for an injunction

or a legal action against the bank for damages.

Although section 106 prohibits banks from

imposing certain types of tying arrangements on

their customers, the statute also expressly per-

mits banks to engage in other forms of tying and

authorizes the Board to grant additional excep-

tions to the statute’s prohibitions by regulation

or order.

3500.0.2 PROHIBITIONS UNDER

SECTION 106

Section 106 prohibits a bank from extending

credit, leasing or selling property, furnishing

any service, or ﬁxing or varying the consider-

ation for any of the foregoing on the condition

or requirement that a customer

• obtain some additional credit, property, or ser-

vice from the bank or its afﬁliates other than a

loan, discount, deposit, or trust service;

• provide some additional credit, property, or

service to the bank or its afﬁliates, other than

those related to and usually provided in con-

nection with a loan, discount, deposit, or trust

service; or

• not obtain some additional credit, property, or

service from a competitor of the bank or of an

afﬁliate of the bank unless the condition is

reasonably imposed in a credit transaction to

assure the soundness of the credit.

The most common types of tying arrange-

ments are those where a bank product or consid-

eration for a bank product to a customer is

conditioned upon the customer obtaining another

product from the bank or an afﬁliate. There are

two elements necessary to establish a tying ar-

rangement under these circumstances: (1) the

arrangement must involve two or more separate

products, and (2) the customer is, in fact, re-

quired to buy a tied product in order to get a

tying product.

3500.0.3 APPLICABILITY OF

SECTION 106

Section 106 applies only to tying arrangements

that are imposed by a bank, whether or not they

are subsidiaries of holding companies. The stat-

ute does not apply to tying arrangements im-

posed by afﬁliates of the bank. However, an

examination of the facts and circumstances of a

tying arrangement imposed by a bank afﬁliate

that involves a bank product could reveal that

the arrangement essentially is a tying arrange-

ment set forth by the bank, but structured to

appear as though it is required by the bank

afﬁliate. These arrangements may constitute pro-

hibited tying arrangements.

Section 106 speciﬁcally allows a bank to

engage in a tying arrangement if the tied prod-

uct is a “loan, discount, deposit, or trust service”

(a “traditional bank product”) provided to a

customer.

The Board has not clariﬁed the scope

of this exception.

A parallel provision, codiﬁed in section 5(q)

of the Home Owners’ Loan Act of 1933, applies

to savings associations and is also administered

by the Board.

1. 12 U.S.C. 1972. Although part of the Bank Holding

Company Act amendments of 1970, section 106 applies to a

bank whether or not the bank is owned or controlled by a bank

holding company.

2. Banks and their afﬁliates, including nonbank afﬁliates,

are also subject to the tying restrictions contained in the

federal antitrust laws (the Sherman and Clayton Acts).

15 U.S.C. 1 et seq.; 15 U.S.C. 12 et seq.

3. 12 U.S.C. 1972, 1973, 1975, and 1976.

4. 12 U.S.C. 1972(1).

5. 12 U.S.C. 1972(1)(A). Products or services in the form

of a “loan, discount, deposit, or trust service” are considered

to be traditional bank products.

6. 12 U.S.C. 1464(q).

BHC Supervision Manual November 2021

Page 1

3500.0.4 EXCEPTIONS TO

SECTION 106

Section 106 expressly permits a bank to condi-

tion the availability or price of a product on a

requirement that the customer also obtain a loan,

discount, deposit or trust service from the bank.

The statute also expressly permits a bank to

condition the availability or price of a product

on a requirement that the customer provide the

bank with some additional product that is re-

lated to and usually provided in connection with

a loan, discount, deposit, or trust service. Mixed-

productarrangements—or arrangementswhereby

bank customers can receive a discount if they

choose several products among a larger menu of

products—may or may not violate section 106

depending on the facts and circumstances.

In addition to the statutory exceptions set

forth in section 106, additional regulatory ex-

ceptions can be found in the Board’s Regula-

tion Y (12 CFR 225.7). These exceptions include

(1) situations where the tied product is a tradi-

tional bank product offered by an afﬁliate of the

bank, (2) combined-balance discount packages,

and (3) bank transactions with foreign persons.

The Board is also authorized, in consultation

with the Ofﬁce of the Comptroller of the Cur-

rency and the Federal Deposit Insurance Corpo-

ration, to grant additional exceptions to the stat-

ute’s prohibitions by regulation or order.

3500.0.5 INTERNAL CONTROLS TO

PROMOTE COMPLIANCE WITH

PROHIBITIONS OF SECTION 106

Banks should have policies, procedures, and

systems in place that are reasonably designed to

promote bank compliance with the tying prohi-

bitions of section 106. The types of policies,

procedures, and systems appropriate for a par-

ticular bank depend on the bank’s size and the

nature, scope, and complexity of its activities.

Banks should review and update their policies,

procedures, and systems periodically to ensure

that they reﬂect any changes in the nature,

scope, or complexity of their activities or appli-

cable statutes, regulations, or supervisory guid-

ance.

Banks should also ensure that appropriate

bank personnel receive education and training

concerning the provisions of section 106. A

bank’s internal audit function should periodi-

cally review and test its tying policies, proce-

dures, and systems in order to conﬁrm that they

are working effectively and in the manner in-

tended.

3500.0.6 SUPERVISORY

CONSIDERATIONS

Depending on the facts and circumstances, it

may be appropriate to assess compliance with

section 106 at the holding company or the state

member bank. Examiners should focus on the

holding company’s responsibility to oversee and

safeguard against prohibited tying arrangements

by its bank subsidiaries and afﬁliates. In addi-

tion, examiners may conduct more targeted ex-

aminations of the marketing programs, training

materials, internal reports and internal tying in-

vestigations of a bank. Examiners should be

aware that the principal objective of section 106

is to eliminate any potential for “arm twisting”

customers into buying some other product to get

the product they desire. In assessing tying ar-

rangements, examiners should focus their review

on the bank’s policies, procedures, and internal

controls as well as training and audit programs

covering compliance with section 106. As part

of this supervisory review, examiners should

consider the inspection objectives and proce-

dures in subsections

3500.0.7 and 3500.0.8.

Examiners should assess the adequacy of the

bank’s audit and compliance programs related

to tying arrangements. If the audit program fo-

cused on tying arrangements is infrequent or

inadequate, examiners may consider reviewing

a sample of pertinent extensions of credit (for

example, loans, lines of credit, and letters of

credit) that may be susceptible to improper ty-

ing arrangements.

The determination of whether a violation of

section 106 has occurred often requires a careful

review of the speciﬁc facts and circumstances

associated with the relevant transaction between

the bank and the customer. If there is an appar-

ent violation of law at the bank, examiners

generally should communicate the ﬁndings in

the report of examination or supervisory letter,

which includes the name of the applicable law

(section 106 of the Bank Holding Company Act

amendments of 1970 (12 U.S.C. 1972)) or regu-

lation (Regulation Y, 12 CFR 225.7), a brief

description of the scope of the relevant law, the

requirements of the regulation or statute, and a

discussion of how or why the violation oc-

curred. The discussion in the report of examina-

tion should also describe any plans or recom-

mendations for corrective action.

Prohibitions Against Tying Arrangements 3500.0

BHC Supervision Manual November 2021

Page 2

3500.0.7 INSPECTION OBJECTIVES

1. To assess the adequacy of the institution’s

policies and procedures related to tying ar-

rangements.

2. To determine whether the institution has

established internal controls and procedures

for complying with section 106.

3. To determine whether the institution appro-

priately monitors internal loan reviews of

pertinent bank extensions of credit to bor-

rowers whose credit facilities or services

may be susceptible to improper tying ar-

rangements in violation of section 106 or

the Board’s regulations.

4. To determine whether training is provided

to management and employees who are re-

sponsible for compliance with tying prohi-

bitions.

3500.0.8 INSPECTION PROCEDURES

Preliminary Review

1. Determine whether the institution engages

in any activities that present an increased

opportunity to inappropriately tie its ser-

vices or credit facilities to other services or

facilities.

Policies

2. Determine whether there is a holding-

company-wide policy or if the holding com-

pany’s banking subsidiaries have their own

policies related to tying arrangements.

3. Ascertain whether the institution’s policy

incorporates safeguards to prevent viola-

tions of relevant statutes and regulations.

Consider whether the policy

a. indicates that certain tying arrangements

are prohibited by statute and regulations;

b. provides speciﬁc examples of impermis-

sible practices relevant to the product

lines; and

c. contains procedures for employees to

follow if questions arise concerning the

application of the prohibitions against

tying arrangements.

4. Assess whether the policy requires periodic

review of servicing contracts between the

bank and its afﬁliates, as well as expectations

for reviewing the substance of transactions,

to determine—

a. the capacity in which the bank and its

tied afﬁliate are acting (for example, is it

acting as principal on its own behalf or

as an agent for the afﬁliate bank?);

b. the nature of all services provided; and

c. billing arrangements for service fees, the

frequency of billing, the method of com-

putation, and the basis for such fees.

5. Determine whether the policy related to ty-

ing arrangements provides expectations for

employee training, and whether management

and its internal auditors have periodically

conﬁrmed that there is compliance with such

an internal policy.

6. Determine whether the policy is periodically

reviewed by appropriate risk-management

staff and updated to accurately reﬂect the

products and services offered by the holding

company and its subsidiaries.

Monitoring and Internal Controls

7. Assess the holding company’s program to

monitor the internal loan reviews of subsidi-

ary banks and their afﬁliates. Such reviews

should include

a. the inspection of credit ﬁles for loan

agreements and other documentation that

place conditions or restrictions on bor-

rowers that indicate a possible tying ar-

rangement.

b. internal loan reviews of ﬁles for insur-

ance applications, particularly if an in-

surance subsidiary maintains a consis-

tently high penetration rate on credits

granted by bank afﬁliates, which could

indicate the presence of improper tying

arrangements.

8. While reviewing credit and collateral ﬁles

(especially loan agreements) as well as the

accounts receivable area, consider whether

any extension of credit—or terms for an ex-

tension of credit—are conditioned upon the

customer—

a. obtaining additional credit, property, or

services from the bank, other than a loan,

discount, deposit, or trust service;

b. obtaining additional credit, property, or

service from the bank’s parent holding

company or the parent’s other subsidi-

aries;

c. providing an additional credit, property,

or service to the bank, other than those

related to and usually provided in con-

nection with a loan, discount, deposit, or

trust service;

d. providing additional credit, property, or

service to the bank’s parent holding com-

Prohibitions Against Tying Arrangements 3500.0

BHC Supervision Manual November 2021

Page 3

pany or any of the parent’s other subsid-

iaries; or

e. not obtaining other credit, property, or

service from a competitor of the bank,

the bank’s parent holding company, or

the parent’s other subsidiaries, except

that the lending bank may impose condi-

tions and requirements in a credit trans-

action to ensure the soundness of the

credit.

9. Review the holding company’s internal con-

trols that are intended to prevent prohibited

tying arrangements by its bank subsidiaries

and afﬁliates.

10. Review incentives that may encourage ty-

ing arrangements by bank employees, such

as commission structures and fee-splitting

arrangements between departments.

Audit

11. Determine whether the audit function as-

sesses the institution’s compliance with the

prohibitions on tying arrangements.

12. Identify whether the institution’s legal coun-

sel or other competent experts review trans-

actions in the appropriate areas of the hold-

ing company, its bank subsidiaries, and

afﬁliates to ensure compliance with the pro-

hibitions against tying arrangements. If yes,

determine whether they identiﬁed any com-

pliance weaknesses or are aware of cus-

tomer allegations of prohibited tying ar-

rangements.

Training

13. Assess the appropriateness of training pro-

grams aimed to instruct employees on tying

arrangements. Consider whether

a. employees are aware of the prohibitions

against tying arrangements;

b. participation in a training program is re-

quired for new employees; and

c. training programs concerning the tying

requirements are updated to reﬂect new

activities at the institution.

Prohibitions Against Tying Arrangements 3500.0

BHC Supervision Manual November 2021

Page 4

Sections 4(c)(9) and 2(h) of the BHC Act (Nonbanking

Activities of Foreign Banking Organizations) Section 3510.0

A foreign bank that operates in the United States

through a branch, agency, or commercial lend-

ing company subsidiary, or that owns or con-

trols a U.S. bank or Edge corporation, must

conform to the nonbanking restrictions of the

BHC Act.

The BHC Act also provides exemptions that

permit a foreign bank with U.S. banking opera-

tions to engage in certain nonbanking activities.

As with domestic bank holding companies, pur-

suant to section 4(c)(8), a foreign bank may own

shares of any company that the Board has

determined to be so closely related to banking

or managing or controlling banks as to be a

proper incident thereto. As described below, a

foreign bank may also qualify for additional

exemptions pursuant to sections 4(c)(9) and

2(h). These latter exemptions apply only to for-

eign banking institutions and seek to limit the

extraterritorial application of federal banking

law while preserving national treatment of these

institutions’ domestic counterparts.

3510.0.1 REGULATION K

Regulation K implements the nonbanking

restrictions of section 4 of the BHC Act by

applying the limits to any foreign banking orga-

nization (FBO). An FBO is (1) any foreign bank

that either operates a branch, agency, or com-

mercial lending company subsidiary in the United

States, or that controls a U.S. bank, and (2) any

company that owns or controls a foreign bank

described in (1). (See 12 C.F.R. 211.21(o) to

apply these limits.) Regulation K requires any

FBO that engages in activities in the United

States to conform those activities to the non-

banking restrictions by either limiting the activi-

ties or obtaining an exemption. (See 12 C.F.R.

211.23(n).)

Regulation K implements statutory exemp-

tions from the BHC Act for certain activities of

foreign banks. Sections 4(c)(9) and 2(h) of the

BHC Act provide exemptions that are available

to ‘‘qualifying foreign banking organizations’’

(QFBOs).

Section 2(h) allows a foreign company that is

principally engaged in banking business outside

the United States to own foreign afﬁliates that

engage in impermissible nonﬁnancial activities

in the United States, subject to certain require-

ments. These include requirements that the for-

eign afﬁliate must derive most of its business

from outside the United States and that it may

engage in the United States in only the same

lines of business it conducts outside the United

States.

Section 4(c)(9) allows the Board to exempt

foreign companies from the nonbank activity

restrictions of the BHC Act when the exemption

would not be substantially at variance with the

BHC Act and would be in the public interest.

Under this authority, the Board has exempted,

among other things, all foreign activities of

QFBOs from the nonbanking prohibitions of the

BHC Act.

To qualify as a QFBO (and, hence, to be

eligible for the 4(c)(9) and 2(h) exemptions), an

FBO must chieﬂy engage in banking activities

worldwide; that is, it must demonstrate that

more than half of its business is banking and

that more than half of its banking business is

outside the United States. Regulation K sets

forth a multistep test for determining when an

FBO primarily engages in banking activities

worldwide. This so-called QFBO test is met if

‘‘disregarding [the FBO’s] U.S. banking busi-

ness, more than half of [the FBO’s] worldwide

business is banking; and more than half of its

banking business is outside the United States.’’

(See 12 C.F.R. 211.23(a).)

Under the QFBO test, an FBO must satisfy at

least two of the following criteria:

1. the banking assets held outside the United

States must exceed total worldwide nonbank-

ing assets;

2. revenues derived from the business of bank-

ing outside the United States must exceed

total revenues derived from its worldwide

nonbanking business; or

3. net income derived from the business of

banking outside the United States must exceed

total net income derived from its worldwide

nonbanking business.

In addition, the FBO must meet at least two of

the following criteria:

1. the banking assets held outside the United

States must exceed the banking assets held in

the United States;

2. revenues derived from the business of bank-

ing outside the United States must exceed the

revenues derived from the business of bank-

ing in the United States; or

3. net income derived from the business of

banking outside the United States must exceed

BHC Supervision Manual June 2002

Page 1

net income from the business of banking in

the United States.

Regulation K provides rules on how to calcu-

late the assets, revenues, and net income of the

FBO and its foreign subsidiaries.

In calculating

assets, revenues, or net income held or derived

from the business of banking ‘‘outside the United

States,’’ the FBO may not include assets, rev-

enues, or net income, whether held or derived

directly or indirectly, of a subsidiary bank, a

branch, an agency, a commercial lending com-

pany, or another company engaged in the busi-

ness of banking in the United States, including

any territory of the United States, Puerto Rico,

Guam, American Samoa, or the Virgin Islands.

Regulation K provides a broader deﬁnition of

‘‘banking’’ for use in the QFBO test. A QFBO

may include assets, revenues, and income from

any activity that a U.S. bank holding company

may perform abroad pursuant to section 211.10

of Regulation K, if the activity is conducted by

the foreign bank itself or by a subsidiary. Thus,

for example, an FBO may treat certain insur-

ance and securities activities as banking activi-

ties for determining QFBO status. (See 12 C.F.R.

211.23(b)(2) and 211.10.) However, this broader

deﬁnition of banking applies to the QFBO test

only. It does not deﬁne the types of permissible

banking activities that a QFBO may perform in

the United States.

An FBO may be unable to satisfy the QFBO

test because a substantial part of its ﬁnancial

activities is conducted outside of the foreign

bank itself. This might occur, for example, when

an FBO conducts substantial life insurance

activities through a parent or sister company of

the foreign bank. Such an FBO may neverthe-

less be eligible for some more limited exemp-

tive relief if it meets a modiﬁed test. Under this

modiﬁed test, when calculating assets, revenues,

or net income for the prong of the QFBO test

that measures whether more than half of an

FBO’s business is banking, the FBO may count

banking activities conducted outside the foreign

banking chain. For the other prong of the test,

which determines whether more than half of an

FBO’s banking business is outside the United

States, the banking-chain requirement would

still apply. An FBO that meets this modiﬁed test

will be eligible for all of the exemptions other

than the exemption for limited commercial and

industrial activities provided under section 2(h)

(as implemented by 12 C.F.R. 211.23(f)(5)).

However, any foreign banks within the FBO

that independently meet the QFBO test would

be eligible for all of the exemptions available to

QFBOs. The modiﬁed test is intended to limit

the extraterritorial effect of the BHC Act on

foreign ﬁrms and to avoid penalizing a consoli-

dated group that engages mostly in activities

permissible for a U.S. banking organization.

An FBO that does not qualify, or that ceased

to qualify for two consecutive years (as reported

in the Annual Report of Foreign Banking Orga-

nizations, Form FR Y-7, that the FBO ﬁled with

the Board), is not eligible for the exemptions

afforded by sections 2(h) and 4(c)(9). An FBO

that does not qualify for these exemptions may

only engage in activities in the United States

that are permissible for a domestic bank holding

company. An FBO that no longer qualiﬁes under

the QFBO test may seek a determination of

continued eligibility from the Board. Otherwise,

the FBO may only continue to engage in activi-

ties begun, or retain investments acquired, before

the end of the ﬁrst ﬁscal year in which it failed

to qualify. Other activities or investments must

cease or be divested within three months of the

ﬁling of the second FR Y-7, which demonstrates

that the foreign bank no longer qualiﬁes for the

exemptions. The Board also has the authority to

grant exemptive relief under Regulation K to

foreign organizations that do not include foreign

banks. (See 12 C.F.R. 211.23(e).)

3510.0.2 NONBANKING

EXEMPTIONS FROM THE BHC ACT

FOR QFBOs UNDER SECTIONS

4(C)(9) AND 2(H)

Sections 2(h) and 4(c)(9) of the BHC Act are

exemptive provisions that seek to limit the

extraterritorial impact of federal banking law.

While there is considerable overlap in these two

sections (for example, only a QFBO is eligible

for both kinds of exemptions), they also have

signiﬁcant differences (for example, section 2(h)

only exempts certain types of activities, whereas

1. A subsidiary is any company that either (1) has 25 per-

cent or more of its voting shares directly or indirectly owned,

controlled, or held with the power to vote by a company,

including a foreign bank or a foreign banking organization, or

(2) is otherwise controlled or capable of being controlled by a

foreign bank or foreign banking organization. See 12 C.F.R.

211.21(z).

2. Any FBO that qualiﬁes as a ﬁnancial holding company

(FHC) would be able to make merchant banking investments

and investments in connection with its insurance business in

the United States to the extent permitted for an FHC. The lack

of eligibility for the exemption in section 211.23(f)(5) would

not negate or otherwise affect such authority.

Sections 4(c)(9) and 2(h) (Nonbanking Activities of FBOs) 3510.0

BHC Supervision Manual June 2002

Page 2

section 4(c)(9) may also exempt speciﬁc activi-

ties or investments upon Board order).

3510.0.2.1 Section 4(c)(9) of the

BHC Act

Section 4(c)(9) of the BHC Act authorizes the

Board to exempt the U.S. activities of a QFBO,

through order or regulation, if the exemption

‘‘would not be substantially at variance with the

purposes of [the BHC Act] and would be in the

public interest.’’ The Board has implemented

this provision in Regulation K to permit a QFBO

to engage directly or indirectly in any activity

outside of the United States; hold the shares of

any company that engages in activities in the

United States that are ‘‘incidental’’ to foreign

business; hold a noncontrolling interest in any

chieﬂy foreign company that engages in any

activity in the United States, if the foreign com-

pany derives more than half its assets and rev-

enues from outside the United States; or own or

control voting shares of any company acquired

in good faith in a ﬁduciary capacity as permitted

by section 4(c)(4) of the BHC Act. An FBO is

not permitted to own more than 10 percent of

the shares of a foreign company that directly or

indirectly engages in underwriting, selling, or

distributing securities to an extent not permitted

for bank holding companies.

(See 12 C.F.R.

211.23(f)(1), (2), (3), (4), and 5(i) and (ii).)

The provision that permits a QFBO to own

shares of a foreign company that engages in

incidental, international activities in the United

States has been deﬁned by interpretation. That

is, an activity is ‘‘incidental’’ to a foreign com-

pany’s activities outside of the United States

only if it is an activity that an Edge or agree-

ment corporation may perform in the United

States. Section 211.6 of Regulation K deﬁnes

the permissible activities of an Edge or agree-

ment corporation.

An application to the Federal

Reserve is not required before a QFBO engages

in an activity that is incidental to international

business under this exemption.

A QFBO may also request a speciﬁc exemp-

tion from the BHC Act under section 4(c)(9) to

perform otherwise impermissible activities in

the United States. The Board considers these

requests on a case-by-case basis.

3510.0.2.2 Section 2(h) of the BHC Act

Section 2(h) of the BHC Act permits a QFBO to

own or control the voting shares of a foreign

company that is principally engaged in business

outside of the United States and that engages

directly or indirectly in activities in the United

States that are the same as or related to the

company’s lines of business abroad.

Section 2(h) is designed to allow a QFBO

that has foreign commercial or industrial afﬁli-

ates to continue to hold those afﬁliates, even if

the afﬁliate engages in activities in the United

States that would ordinarily be prohibited by

section 4 of the BHC Act. The U.S. activities

must be the same kind of activity the afﬁliate

conducts outside the United States and the for-

eign afﬁliate must be chieﬂy foreign, that is, it

must derive more than half of its assets and

revenues from outside the United States. The

U.S. branches and agencies of a QFBO may not

lend to an afﬁliate held under section 2(h)

except on an arm’s-length basis.

A QFBO may not engage in ﬁnancial activi-

ties in the United States on the basis of section

2(h). Regulation K provides a list of activities

that are considered ‘‘ﬁnancial.’’ These activities

should be referenced to Division H (Finance,

Insurance, and Real Estate) of the Standard

Industrial Classiﬁcations (SIC), as well as to

selected activities in other divisions of the SIC

that are considered ﬁnancial in nature.

3. Speciﬁcally, Regulation K permits a QFBO to (1) engage

in activities of any kind outside the United States; (2) engage

directly in activities in the United States that are incidental to

its activities outside the United States; (3) own or control

voting shares of any company that is not engaged, directly or

indirectly, in any activities in the United States other than

those that are incidental to the international or foreign busi-

ness of such company; and (4) own or control voting shares of

any company in a ﬁduciary capacity under circumstances that

would entitle such shareholding to an exemption under sec-

tion 4(c)(4) of the BHC Act if the shares were held or

acquired by a bank.

4. Generally, these activities must have an international

nexus and may consist of receiving deposits from foreign

governments and persons; receiving deposits from other per-

sons under certain conditions; holding or investing liquid

funds in certain forms or instruments; engaging in certain

credit activities or borrowing funds; receiving or collecting

payments under certain conditions; performing foreign-

exchange activities; acting as a ﬁduciary, an investment ad-

viser, or a broker or performing other activities related to

investing under certain conditions; providing banking services

for employees; and engaging in other activities with prior

Board approval. See 12 C.F.R. 211.6(a).

5. The North American Industry Classiﬁcation System

(NAIS) replaces the use of SIC codes. The NAICS codes

differ from the SIC codes. To evaluate compliance with sec-

tion 2(h) of the BHC Act, examiners should consult Regula-

tion K directly when determining whether particular activities

are permissible. Regulation K refers to NAICS codes.

Sections 4(c)(9) and 2(h) (Nonbanking Activities of FBOs) 3510.0

BHC Supervision Manual June 2003

Page 3

Section 2(h) is implemented in Regulation K

as follows: A QFBO may own or control voting

shares of a foreign company that is engaged

directly or indirectly in business in the United

States other than that which is incidental to its

international or foreign business, subject to the

following limitations:

1. More than 50 percent of the foreign compa-

ny’s consolidated assets shall be located,

and consolidated revenues derived from, out-

side the United States.

(See 12 C.F.R.

211.23(f)(5)(i).)

2. The foreign company shall not directly under-

write, sell, or distribute, nor directly own or

control more than 10 percent of the voting

shares of a company that underwrites, sells,

or distributes, securities in the United States

except to the extent permitted bank holding

companies. (See 12 C.F.R. 211.23(f)(5)(ii),

12 C.F.R. 225.124, and section 3510.0.2.3.)

Regulation K places additional restrictions on

the 2(h) exemption when a QFBO owns a for-

eign company that is a subsidiary. Speciﬁcally,

the foreign company must be, or must control,

an operating company. Its direct or indirect

activities in the United States are subject to the

following limitations:

1. The foreign company’s activities in the United

States shall be the same kind of activities or

related to the activities engaged in directly or

indirectly by the foreign company abroad, as

measured by the ‘‘establishment’’ categories

of the SIC. An activity in the United States

shall be considered related to an activity

outside the United States if it consists of

supply, distribution, or sales in further-

ance of the activity. (See 12 C.F.R.

211.23(f)(5)(iii)(A).)

2. The foreign company may engage in activi-

ties in the United States that consist of bank-

ing securities, insurance or other ﬁnancial

operations, or types of activities permitted by

regulation or order under section 4(c)(8) of

the BHC Act only under regulations of the

Board or with the prior approval of the

Board, subject to the following:

a. Activities within Division H (Finance,

Insurance, and Real Estate) of the SIC

shall be considered banking or ﬁnancial

operations for this purpose, with the

exception of acting as operators of non-

residential buildings (SIC 6512), opera-

tors of apartment buildings (SIC 6513),

operators of dwellings other than apart-

ment buildings (SIC 6514), operators of

residential mobile home sites (SIC 6515),

and operating title abstract ofﬁces (SIC

6541).

b. The following activities shall be consid-

ered ﬁnancialactivitiesand may be engaged

in only with the approval of the Board

under section 211.23(g) of Regulation K:

credit reporting services (SIC 7323); com-

puter and data processing services (SIC

7371 to 7379); armored car services (SIC

7381); management consulting (SIC 8732,

8741, 8742, and 8748); certain rental and

leasing activities (SIC 4741, 7352, 7353,

7359, 7513, 7514, 7515, and 7519);

accounting, auditing, and bookkeeping ser-

vices (SIC 8721); courier services (SIC

4215 and 4513); and arrangement of pas-

senger transportation (SIC 4724, 4725,

and 4729).

The restriction in paragraph 2b. above reﬂects

the fact that section 2(h) is not the source of

authority for a QFBO to engage in banking,

securities, or other ﬁnancial activities in the

United States through a subsidiary.

The section 2(h) exemption only applies to

the nonﬁnancial, nonbanking activities of an

FBO. To preserve competitive equity, the

exemption does not permit an FBO to control a

foreign nonbanking company that engages in, or

that holds more than 5 percent of the voting

shares of another company that engages in,

banking, securities, insurance, real estate, or

other ﬁnancial activities in the United States.

These activities may be performed only with

Federal Reserve approval under section 4(c)(8)

or 4(c)(9) of the BHC Act.

3510.0.2.3 Foreign Banks’ Underwriting

of Securities

A number of foreign banks, which are subject to

6. If the foreign company fails to meet the requirements of

paragraph (f)(5)(i) (12 C.F.R. 211.23) for two consecutive

years (as reﬂected in annual reports (FR Y-7) the FBO ﬁled

with the Board), the foreign company must be divested or its

activities must be terminated within one year of the ﬁling of

the second consecutive annual report that reﬂects nonconfor-

mance with the requirements of paragraph (f)(5)(i), unless the

Board grants consent to retain the investment under 12 C.F.R.

211.23(g).

7. Section 211.23(g) of Regulation K permits a foreign

banking organization to request a case-by-case exemption

from the nonbanking restrictions to engage in otherwise

impermissible activities pursuant to section 4(c)(9) of the

BHC Act.

Sections 4(c)(9) and 2(h) (Nonbanking Activities of FBOs) 3510.0

BHC Supervision Manual June 2003

Page 4

the BHC Act, had participated as co-managers

in the underwriting of securities that were dis-

tributed in the United States. These banks did

not have the authority to engage in securities

underwriting activity in the United States. The

U.S. ofﬁces of afﬁliates of the foreign banks

were used to engage in activities conducted in

support of the underwriting transactions, for

which these U.S. ofﬁces were compensated by

the foreign bank. The foreign bank became a

member of the underwriting syndicate but it did

not distribute any of the securities in the United

States or elsewhere. The foreign banks took the

position that they were not engaged in under-

writing in the United States because any under-

writing obligation was booked outside the United

States.

A foreign bank that is subject to the BHC Act

may engage in underwriting activities in the

United States only if it has been authorized

under section 4 of that act. Section 225.124 of

the Board’s Regulation Y states that a foreign

bank will not be considered to be engaged in the

activity of underwriting in the United States if

the shares to be underwritten are distributed

outside the United States. In the transactions in

question, all of the securities were distributed in

the United States.

In 1985, the Board amended Regulation K in

section 211.23(f)(5)(ii) to provide clariﬁcation

that a foreign banking organization shall not

‘‘directly underwrite, sell, or distribute, nor own

or control more than 10 percent of the voting

shares of a company that underwrites, sells, or

distributes securities in the United States, except

to the extent permitted bank holding compa-

nies.’’ When proposing this provision, the Board

stated ‘‘...that no part of the prohibited under-

writing process may take place in the United

States and that the prohibition on the activity

does not depend on the activity being conducted

through an ofﬁce or subsidiary in the United

States.’’

Regulation K deﬁnes ‘‘engaged in business’’

and ‘‘engaged in activities’’ to mean conducting

an activity through an ofﬁce or subsidiary in the

United States. The Regulation K deﬁnition of

‘‘engaged in business,’’ adopted in 1979, how-

ever, does not authorize foreign banking organi-

zations to evade regulatory restrictions on secu-

rities activities in the United States by using

U.S. ofﬁces and afﬁliates to facilitate the prohib-

ited activity. Also, the framework of the Gramm-

Leach-Bliley Act (the GLB Act) requires that

banking organizations meet certain ﬁnancial and

managerial requirements of the GLB Act and

the Board’s Regulation K to engage in these

activities in the United States.

The Board therefore issued an interpretation

on February 7, 2003 (effective February 19,

2003), clarifying that the underwriting by for-

eign banks of securities to be distributed in the

United States is an activity conducted in the

United States, regardless of the location at which

the underwriting risk is assumed and the under-

writing fees are booked. Consequently, any bank-

ing organization that wishes to engage in such

activity must either be a ﬁnancial holding com-

pany under the GLB Act or have authority to

engage in underwriting activity under section

4(c)(8) of the BHC Act (so-called section 20

authority). Revenue generated by underwriting

bank-ineligible securities in such transactions

should be attributed to the section 20 company

for those foreign banks that operate under sec-

tion 20 authority. (See 12 C.F.R. 211.605.)

3510.0.3 GRANDFATHER RIGHTS

Section 8 of the International Banking Act (IBA)

provides grandfather rights to foreign banks that

operated a branch, agency, or subsidiary com-

mercial lending company at the time of enact-

ment of the IBA.

Section 8(c) of the IBA permanently grand-

fathers activities engaged in directly or through

an afﬁliate on or before July 26, 1978, or for

which an application to engage in such activities

had been ﬁled on or before that date.

Grand-

fathered nonbanking activities may not be

expanded through the acquisition of any interest

in or the assets of a going concern engaged in

the same activities. The Board may, subject to

opportunity for hearing, terminate these grand-

father rights where it is necessary to prevent

undue concentration of resources, decreased or

unfair competition, conﬂicts of interest, or

unsound banking practices in the United States.

A foreign bank that is required to terminate its

indirect grandfathered activity may retain own-

ership of the shares of the grandfathered com-

pany for a period of two years from the date of

the Board’s action.

Grandfather rights conferred under section

8(c) of the IBA shall terminate immediately

upon the ﬁling of an FHC declaration by the

foreign bank or foreign company. With respect

to a foreign bank or foreign company that did

8. The term ‘‘afﬁliate’’ means any company that controls,

is controlled by, or is under common control with the foreign

bank or the parent of the foreign bank.

Sections 4(c)(9) and 2(h) (Nonbanking Activities of FBOs) 3510.0

BHC Supervision Manual June 2003

Page 5

not ﬁle an FHC declaration by November 12,

2001, the Board has the authority, giving due

regard to the principle of national treatment and

equality of competitive opportunity, to impose

such restrictions and requirements on the con-

duct of any grandfathered activities as are com-

parable to those imposed on a U.S. FHC, includ-

ing a requirement to conduct such activities in

compliance with any prudential safeguards

established under 12 U.S.C. 1828a.

3510.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Foreign banking

organizations

1841(h)

1843(c)(9)

3106

211.23(f)(5)

Underwriting of securities

in the United States

is an activity conducted

in the United States

211.605 3–693

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Sections 4(c)(9) and 2(h) (Nonbanking Activities of FBOs) 3510.0

BHC Supervision Manual June 2003

Page 6

Section 4(c)(10) of the BHC Act (Exemption from Section 4 for

BHCs That Are Banks) Section 3520.0

This manual section explains the “grandfather”

or legacy exemption from the general prohibi-

tions of section 4(c)(10) of the Bank Holding

Company (BHC) Act for a small group of BHCs

that were themselves banks. For such BHCs and

their wholly owned subsidiaries, the exemption

provided for continued ownership of nonbank

shares that were lawfully acquired and owned

directly or indirectly prior to enactment of the

BHC Act (May 9, 1956). At the time of its

enactment, the exemption accommodated only

three BHCs. While these BHCs no longer exist,

this manual section provides historical back-

ground about this exemption from the BHC Act.

Section 4(c)(10) limited its exemption to

“wholly owned subsidiaries.” To have been eli-

gible for the exemption in section 4(c)(10), the

holding company must have continuously held

the shares of the wholly owned subsidiary since

May 9, 1956. This interpretation aligned with

the Federal Reserve Board’s interpretations of

other sections of the BHC Act.

BHC Supervision Manual February 2023

Page 1

Section 4(c)(11) (Authorization for BHCs to Reorganize Share Ownership

Held on the Basis of Any Section 4 Exemption)

Section 3530.0

Section 4(c)(11) was adopted to authorize bank

holding companies to reorganize share owner-

ship held on the basis of any section 4 exemp-

tion. Reorganization is permitted with respect to

section 4(a)(2) grandfathered activities engaged

in prior to June 30, 1968, retaining indeﬁnite

grandfather authority. Shares held pursuant to

Board approval under section 4(c)(8) or any

other section 4 exemption also come within

section 4(c)(11)’s reorganization authority.

Under section 4(c)(11), a bank holding com-

pany is authorized to reorganize its share owner-

ships, shift its activities among its various enti-

ties and form new subsidiaries without Board

approval as long as there is no change in the

activities of the bank holding company system.

Congress also felt it entirely appropriate for

these companies to expand their activities so

long as such expansion did not produce anti-

competitive or other adverse effects. Accord-

ingly, internal expansion of the grandfathered

activities was permitted but the provision was

added that this section does not authorize the

grandfathered companies to acquire, either

directly or indirectly, any interest in or the assets

of any going concern outside the holding com-

pany system (unless the acquisition is pursuant

to a contract entered into before June 30, 1968).

Congress reasoned that purchasing a going con-

cern engaged in the grandfathered activities of a

holding company would tend to have an anti-

competitive effect in that it would reduce the

number of ﬁrms competing against each other in

a given activity.

BHC Supervision Manual December 1992

Page 1

Section 4(c)(12) of the BHC Act (Ten Year Exemption

from Section 4 of the BHC Act) Section 3540.0

This section provided an exemption from the

general prohibitions of section 4 for shares held

or activities which became subject to the Act by

the 1970 amendments.

Section 4(c)(12) provided not only for contin-

ued ownership of shares or performance of

activities so held or performed as of December

31, 1970, but also for others permitted afterward

by the Board. As stated in subparagraphs (A)

and (B) of section 4(c)(12), the 10-year exemp-

tion applied if such bank holding companies:

(A)(i) ceased to be bank holding companies by

December 31, 1980; or (A)(ii) ceased to retain

direct or indirect ownership of the nonbank

shares or engage in the nonbank activities by

December 31, 1980; or (B) complied with such

other condition as the Board may prescribe.

A company was required to ﬁle an irrevoca-

ble declaration that it would cease to be a bank

holding company by January 1, 1981, unless the

Board granted it hardship exemption under sec-

tion 4(d) of the Act. Such a company could then

expand its nonbanking activities de novo with-

out notiﬁcation to the Board and could acquire a

going concern nonbank company 45 days after

informing the appropriate Reserve Bank of the

proposed acquisition unless notiﬁed otherwise

within that time. If an irrevocable declaration

was not ﬁled, then no acquisition could have

been made or activities commenced under sec-

tion 4(c)(12) except with prior Board approval.

These limitations did not apply to acquisitions

made pursuant to a binding commitment entered

into before March 23, 1971.

Few bank holding companies have claimed

an exemption under section 4(c)(12). It is unlikely

that many situations involving section 4(c)(12)

will be encountered by inspection personnel.

However, if a 4(c)(12) company has committed

to cease the nonbanking activities examiners

must ensure that the divestiture has occurred.

3540.0.1 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Divestitures 225.138

Successor rights 1977 FRB 946

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

BHC Supervision Manual December 1992

Page 1

Section 4(c)(13) of the BHC Act (International

Activities of Bank Holding Companies) Section 3550.0

Section 4(c)(13) of the BHC Act governs the

international activities of bank holding compa-

nies. In general, the act authorizes the Board to

permit domestic bank holding companies to

invest in companies that do no business in the

United States except what is incidental to inter-

national or foreign business. Bank holding com-

panies may invest in the same companies as

Edge corporations.

3550.0.1 INVESTMENTS AND

ACTIVITIES ABROAD

The investment provisions of Regulation K (sec-

tions 211.8, 211.9, and 211.10) implement sec-

tion 4(c)(13) of the BHC Act. In general, an

‘‘investor’’ under Regulation K may invest,

directly or indirectly, in a subsidiary or joint

venture or may make portfolio investments, sub-

ject to the limits in section 211.8 and the general

provisions in section 211.9(a). (See SR-02-03

and SR-02-02.)

Bank holding companies may invest in the

same types of entities as Edge and agreement

corporations. However,member banks may invest

directly in only foreign banks; domestic or for-

eign organizations formed for the sole purpose

of holding shares of a foreign bank; foreign

organizations formed for the sole purpose of

performing nominee, ﬁduciary, or other banking

services incidental to the activities of a foreign

branch or foreign bank afﬁliate of the member

bank; and subsidiaries established pursuant to

section 211.4(a)(8) of Regulation K (that is, a

company that engages solely in activities in

which the member bank is permitted to engage

or that are incidental to the activities of the

member bank’s foreign branch). (See all sec-

tions of Regulation K for any other activity or

investment authorizations, limitations, require-

ments, or prohibitions not discussed in this

section.)

In general, the Board has limited the types of

activities that a bank holding company may

engage in through the ownership of foreign

companies to banking or ﬁnancially related

activities, and to those that are necessary to

carry on such activities. These include all of the

activities permitted under section 211.10 of

Regulation K and section 4(c)(8) of the BHC

Act, including equity securities underwriting

and management consulting. Many of the activi-

ties permitted abroad are not subject to the same

limits as those imposed domestically under sec-

tion 4(c)(8) (for example, brokerage of all types

of insurance is permitted abroad).

Activities abroad, whether conducted directly

or indirectly, are to be conﬁned to activities of a

banking or ﬁnancial nature and to those that are

necessary to carry on such activities. At all

times, investors

must act in accordance with

high standards of banking or ﬁnancial prudence,

having due regard for diversiﬁcation of risks,

suitable liquidity, and adequacy of capital. The

Board follows the policy of allowing activities

abroad to be organized and operated as best

meets corporate policies. The following pro-

vides a limited discussion of general investment

activities under Regulation K. The regulation

should be referred to for more speciﬁc require-

ments and limitations.

In general, an investor may make (1) an

investment in a subsidiary, (2) an investment in

a joint venture, or (3) a portfolio investment in

an organization. With regard to an investment in

a subsidiary, the subsidiary must engage in

activities authorized under section 211.10 of

Regulation K, or in other activities that the

Board has determined to be permissible (for a

particular case). In the acquisition of a going

concern, existing activities that are not other-

wise permissible for a subsidiary may account

for not more than 5 percent of either the acquired

organization’s consolidated assets or consoli-

dated revenues. For an investment in a joint

venture, no more than 10 percent of the joint

venture’s consolidated assets or consolidated

revenues can be attributable to activities that are

not listed in section 211.10.

For portfolio investments in an organization,

the investor and its afﬁliates’ total direct and

indirect portfolio investments in an organization

that is engaged in activities not permissible for

joint ventures, when combined with all other

shares in the organization (held under any other

authority), cannot exceed—

1. 40 percent of the total equity of the organiza-

tion, or

2. 19.9 percent of the organization’s voting

shares.

In addition to the individual investment limits,

these portfolio investments are subject to an

1. For purposes of sections 211.8, 211.9, and 211.10 of

Regulation K, a direct subsidiary of a member bank is deemed

to be an investor.

BHC Supervision Manual June 2002

Page 1

aggregate equity limit. (See section 211.10(a)(15)

of Regulation K.) For investments in organiza-

tions engaged in activities that are not permis-

sible for joint ventures, when combined with

shares held directly and indirectly by the inves-

tor and its afﬁliates under the equity dealing

provisions of Regulation K, the investments

cannot exceed—

1. 25 percent of the bank holding company’s

tier 1 capital, where the investor is a bank

holding company;

2. 20 percent of the investor’s tier 1 capital,

where the investor is a member bank;

and

3. the lesser of 20 percent of any parent insured

bank’s tier 1 capital or 100 percent of

the investor’s tier 1 capital, for any other

investor.

3550.0.2 INVESTMENT PROCEDURES

Except as the Board may otherwise determine,

direct and indirect investments must be made in

accordance with the general-consent, limited-

general-consent, prior-notice, or speciﬁc-

consent procedures of section 211.9 of Regula-

tion K. The investment procedures of section

211.9(a) include the following requirements:

1. Minimum capital adequacy standards. The

investor, the bank holding company, and the

member bank must be in compliance with

applicable minimum standards for capital

adequacy set out in the capital adequacy

guidelines. If the investor is an Edge or

agreement corporation, the minimum capital

required is total and tier 1 capital ratios of

8 percent and 4 percent, respectively.

2. Composite rating. For an investor to make

investments under the general-consent or

limited-general-consent procedures of sec-

tions 211.9(b) and (c), the investor and any

parent insured bank must have received a

composite rating of at least 2 at the most

recent examination.

3. Modiﬁcation or suspension of procedures.

The Board may, at any time upon notice,

modify or suspend the investment proce-

dures for any investor or for the acquisition

of shares of organizations engaged in particu-

lar kinds of activities.

4. Long-range investment plan. Any investor

may submit a long-range investment plan to

the Board for its speciﬁc consent. If approved

by the Board, the plan shall be subject to the

other procedures of section 211.9 only to the

extent the Board determines is necessary to

ensure the safety and soundness of the opera-

tions of the investor and its afﬁliates.

5. Prior speciﬁc consent for initial investment.

For its initial investment in its ﬁrst subsidiary

or joint venture under subpart A of Regula-

tion K, an investor must apply for and receive

the prior speciﬁc consent of the Board, unless

an afﬁliate previously has received approval

to make such an investment.

6. Expiration of investment authority. Authority

to make investments that was granted under

prior-notice or speciﬁc-consent procedures

shall expire one year from the earliest date

on which the authority could have been exer-

cised, unless the Board determines a longer

period shall apply.

7. Conditional approval; access to information.

The Board may impose such conditions on

investment authority granted under section

211.9 as it deems necessary. The Board may

also require termination of any activities con-

ducted under subpart A of Regulation K, if

an investor is unable to provide information

on its activities or those of its afﬁliates that

the Board deems necessary to determine and

enforce compliance with U.S. banking laws.

3550.0.3 GENERAL CONSENT FOR

WELL-CAPITALIZED AND

WELL-MANAGED INVESTORS

The Board has granted its limited general con-

sent to make investments by well-capitalized

and well-managed investors. For these general-

consent provisions to apply, the investor, any

parent-insured bank, and any parent bank hold-

ing company must be well capitalized and well

managed both before and immediately after the

proposed investment. The investments are sub-

ject to the limitations discussed below.

3550.0.3.1 Individual Limit for

Investment in a Subsidiary

The Board grants its general consent for invest-

ments by well-capitalized and well-managed

investors, subject to certain investment limita-

tions. For an investment in a subsidiary, the total

amount that may be invested directly or indi-

rectly (in one transaction or a series of transac-

2. For this purpose, a direct subsidiary of a member bank is

deemed to be an investor.

Section 4(c)(13) of the BHC Act (International Activities of BHCs) 3550.0

BHC Supervision Manual June 2002

Page 2

tions) may not exceed 10 percent of the inves-

tor’s tier 1 capital, where the investor is a bank

holding company; 2 percent of the investor’s

tier 1 capital, where the investor is a member

bank; or the lesser of 2 percent of the tier 1

capital of any parent-insured bank or 10 percent

of the investor’s tier 1 capital, for any other

investor.

3550.0.3.2 Individual Limit for

Investments in a Joint Venture

For individual investments in a joint venture,

the total amount invested directly or indirectly

(in one transaction or a series of transactions)

may not exceed 5 percent of the investor’s tier 1

capital, where the investor is a bank holding

company; 1 percent of the investor’s tier 1 capi-

tal, where the investor is a member bank; or the

lesser of 1 percent of the tier 1 capital of any

parent-insured bank or 5 percent of investor’s

tier 1 capital, for any other investor.

3550.0.3.3 Individual Limit for Portfolio

Investment

For a portfolio investment, the total amount

invested directly or indirectly (in one transac-

tion or a series of transactions) in such com-

pany, general partnership, or unlimited-liability

company cannot exceed the lesser of $25 mil-

lion or—

1. 5 percent of the investor’s tier 1 capital, in

the case of a bank holding company or its

subsidiary or an Edge corporation engaged in

banking; or

2. 25 percent of the investor’s tier 1 capital, in

the case of an Edge corporation not engaged

in banking.

3550.0.3.4 Aggregate Investment Limits

The amount of all investments made, directly or

indirectly, during the previous 12-month period

under section 211.9, when aggregated with the

proposed investment, shall not exceed 20 per-

cent of the investor’s tier 1 capital, where the

investor is a bank holding company; 10 percent

of the investor’s tier 1 capital, where the inves-

tor is a member bank; or the lesser of 10 percent

of the tier 1 capital of any parent-insured bank

or 50 percent of the tier 1 capital of the investor,

for any other investor.

3550.0.4 LIMITED GENERAL

CONSENT FOR AN INVESTOR THAT

IS NOT WELL CAPITALIZED OR

WELL MANAGED

3550.0.4.1 Individual Limit

For investors that are not well capitalized and

well managed, the Board has granted limited

general consent for an investor to make an

investment in a subsidiary or joint venture, or to

make a portfolio investment. The total amount

invested, directly or indirectly (in one transac-

tion or a series of transactions), cannot exceed

the lesser of $25 million or 5 percent of the

investor’s tier 1 capital, where the investor is a

bank holding company; 1 percent of the inves-

tor’s tier 1 capital, where the investor is a mem-

ber bank; or the lesser of 1 percent of any parent

insured bank’s tier 1 capital or 5 percent of the

investor’s tier 1 capital, for any other investor.

3550.0.4.2 Aggregate Limit

The amount of limited-general-consent invest-

ments made by such an investor directly or

indirectly during the previous 12-month period,

when aggregated with the proposed investment,

cannot exceed 10 percent of the investor’s tier 1

capital, where the investor is a bank holding

company; 5 percent of the investor’s tier 1 capi-

tal, where the investor is a member bank; and

the lesser of 5 percent of any parent insured

bank’s tier 1 capital or 25 percent of the inves-

tor’s tier 1 capital, for any other investor.

3550.0.5 CALCULATING

COMPLIANCE WITH THE

INDIVIDUAL AND AGGREGATE

GENERAL-CONSENT LIMITS

When determining compliance with the indi-

vidual and aggregate general-consent limits, an

investment by an investor in a subsidiary can

only be counted once, notwithstanding that the

subsidiary may, within 12 months of making the

investment, downstream all or any part of the

investment to another subsidiary. Also, when

determining compliance with these limits, an

investor is not required to combine the value of

all shares of an organization held in trading or

dealing accounts under section 211.10(a)(15) of

Section 4(c)(13) of the BHC Act (International Activities of BHCs) 3550.0

BHC Supervision Manual June 2002

Page 3

Regulation K with investments in the same

organization.

3550.0.6 OTHER ELIGIBLE

INVESTMENTS UNDER GENERAL

CONSENT

In addition to the general-consent authority

already discussed, the Board has granted its

general consent for any investor to make the

following investments: any investment in an

organization in an amount equal to cash divi-

dends received from that organization during

the preceding 12 calendar months, and any

investment that is acquired from an afﬁliate at

net asset value or though a contribution of

shares.

3550.0.7 INVESTMENT INELIGIBLE

FOR GENERAL CONSENT

An investment in a foreign bank is ineligible for

general consent if (1) after the investment, the

foreign bank would be an afﬁliate of a member

bank, and (2) the foreign bank is located in a

country in which the member bank and its afﬁli-

ates have no existing banking presence.

3550.0.8 INVESTMENTS MADE WITH

PRIOR NOTICE TO OR THE SPECIFIC

CONSENT OF THE BOARD

An investment that does not qualify for general

consent under section 211.9(b), (c), or (d) of

Regulation K may be made after the investor

has provided the Board with 30 days’ prior

written notice. The notice period commences at

the time the notice is received. However—

1. the Board may waive the 30-day period if it

ﬁnds the full period is not required for con-

sideration of the proposed investment, or that

the circumstances presented require immedi-

ate action, and

2. the Board may suspend the 30-day period or

act on the investment under its speciﬁc-

consent procedures.

Any investment that does not qualify for either

the general-consent or the prior-notice proce-

dure cannot be consummated without the spe-

ciﬁc consent (that is, express approval) of the

Board.

3550.0.9 EXAMINATION OF FOREIGN

SUBSIDIARIES OF BHCs

The procedures involved in examining foreign

subsidiaries of domestic bank holding compa-

nies are generally the same as those used in

examining domestic subsidiaries engaged in simi-

lar activities. The on-site examination of foreign

subsidiaries is, however, necessarily limited. In

most cases, examiners should try to implement

asset-appraisal procedures by using records at

the location of the U.S. parent or bank. Overseas

examinations are intended primarily to appraise

the ﬁrm’s internal-control systems and the sufﬁ-

ciency of the ﬁrm’s reporting to its parent com-

pany. For examination objectives and proce-

dures for foreign subsidiaries, see the instructions

for similar section 4(c)(8) investments in other

sections of this manual.

3550.0.10 INVESTMENTS BY BANK

HOLDING COMPANIES, EDGE

CORPORATIONS, AND MEMBER

BANKS IN FOREIGN COMPANIES

Subject to the limitations within subpart A of

Regulation K, the Board allows, with its speciﬁc

consent, banking organizations to acquire and

hold investments in foreign companies that do

business in the United States subject to the

following conditions:

1. The activities abroad, whether conducted

directly or indirectly, must be conﬁned to

activities of a banking or ﬁnancial nature and

those that are necessary to carry out such

activities. When engaging in these activities,

the investors are to act in accordance with

high standards of banking and ﬁnancial pru-

dence, having due regard for diversiﬁcation

of risks, suitable liquidity, and adequacy of

capital.

2. The activities are either those that the Board

has determined to be usual in connection

with the transaction of banking or other

ﬁnancial operations abroad as listed in sec-

tion 211.10 of Regulation K, including those

activities authorized with the Board’s spe-

ciﬁc approval, and those that have been deter-

mined to be usual in connection with the

transaction of the business of banking or

other ﬁnancial operations abroad, consistent

with the Federal Reserve Act or the BHC

Act.

Section 4(c)(13) of the BHC Act (International Activities of BHCs) 3550.0

BHC Supervision Manual June 2002

Page 4

3550.0.11 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Investment and activities abroad 211.8

Investment procedures 211.9

Use of foreign subsidiaries to sell

long-term debt obligations in

foreign markets

3–706

Investment by U.S. banking organi-

zations in foreign companies that

transact business in the United States

211.602 3–715

Investment by U.S. banking organi-

zations in futures commission

merchant activities overseas

1982 FRB 671

Investment by U.S. banking organi-

zation in general life insurance

underwriting overseas

1984 FRB 168

1985 FRB 269

Investment by U.S. banking organi-

zation in property and casualty

insurance underwriting overseas

1985 FRB 267

1985 FRB 808

Investment by U.S. banking organi-

zation in physical commodities

brokered overseas

1981 FRB 369

Investment in Edge Act corporation 611–632

Investment in foreign banking

corporation

601–604/

611–618

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Section 4(c)(13) of the BHC Act (International Activities of BHCs) 3550.0

BHC Supervision Manual June 2002

Page 5

Section 4(c)(14) of the BHC Act

(Export Trading Companies) Section 3560.0

In 1982 the Bank Holding Company Act of

1956 was amended by the Bank Export Services

Act (BESA). The Bank Export Services Act

provided an exemption to the prohibitions of

Section 4 of the BHC Act for a bank holding

company’s investment in the shares of any com-

pany that is an export trading company. The

(BESA) was designed to increase U.S. exports

by encouraging investments and participation in

export trading companies by bank holding com-

panies and the speciﬁed investors.

An export trading company is a company that

is exclusively engaged in activities related to

international trade and, by engaging in one or

more export trade services:

1. derives at least one-third of its revenues in

each consecutive four-year period (excluding a

two-year start up period) from the export of

goods and services produced in the United States

by persons other than the export trading com-

pany or its subsidiaries; and

2. derives revenues from the export, or facili-

tating the export, of goods or services produced

in the United States and those revenues exceed

revenues from the import, or facilitating the

import into the United States, of goods or ser-

vices produced outside the United States.

A bank holding company’s direct and indirect

investment in export trading companies may not

exceed 5 percent of the bank holding company’s

consolidatedcapitaland surplus. The total amount

of extensions of credit by a bank holding com-

pany and its subsidiaries to its afﬁliated export

trading company may not exceed 10 percent of

the bank holding company’s consolidated capi-

tal and surplus.

A bank holding company may not invest in

an export trading company, unless the Board has

been given sixty days prior written notice of the

proposed investment. The Board may disap-

prove any proposed investment only if:

1. Such disapproval is necessary to prevent

unsafe or unsound banking practices, undue

concentration of resources, decreased or unfair

competition, or conﬂicts of interest; or

2. It ﬁnds that such investment would affect

the ﬁnancial or managerial resources of a bank

holding company to an extent that is likely to

have a materially adverse effect on the safety

and soundness of any subsidiary bank of such

bank holding company; or

3. The bank holding company fails to furnish

the information required by the Board.

An Edge Act or agreement corporation that is

a subsidiary of a bank holding company may

invest directly or indirectly in the aggregate up

to 5 percent (25 percent in the case of a corpora-

tion not engaged in banking) of the voting stock

or other evidences of ownership in one or more

export trading companies.

Sections 23A and 23B of the Federal Reserve

Act applies to transactions between an export

trading company and its afﬁliated banks. Regu-

lation K, however, grants relief from sec-

tion 23A’s collateral requirements where a bank

issues a letter of credit or advances funds to an

afﬁliated export trading company solely to ﬁnance

the purchase of goods for which: (1) the export

trading company has a bona ﬁde contract for the

subsequent sale of the goods; and (2) the bank

has a security interest in the goods or in the

proceeds from their sale at least equal in value

to the letter of credit or the advance. All other

‘‘covered transactions’’ between a bank and an

afﬁliated export trading company should con-

form to sections 23A and 23B of the Federal

Reserve Act.

3560.0.1 INSPECTION PROCEDURES

Export Trading Companies are generally subsid-

iaries of bank holding companies. Regulations

applicable to them are contained in Section

211.31–4 of Regulation K. Inspections of Export

Trading Companies will usually be conducted

by international examiners or examiners having

specialized training. Examiners conducting in-

spections of Export Trading Companies should

be familiar with these sections as well as Sec-

tion 4(c)(14) of the BHC Act.

There is no standardized inspection report

form for inspections of Export Trading Compa-

nies. However, as a minimum, the report is to

include the following items:

BHC Supervision Manual December 1992

Page 1

Page Description

— Cover

Name of organization

Location

Name of parent

Location of parent

Date inspection commenced

Date of ﬁnancial statements

i Table of Contents

Same information as cover

1 Examiner’s comments

Scope of inspection

Summary of condition

Violations

Operating results

Adequacy of accounting records,

internal controls, and audit

2 Comparative balance sheets

3 Comparative income statements

4 Classiﬁed Assets

CONFIDENTIAL

A Ofﬁcers

B Directors

C Conﬁdential comments

Assessment of management

1. Same information in tabular form as in Edge report.

Inspection procedures should follow the Export

Trading Company Questionnaire, illustrated

herein. The questionnaire will be part of a

special inspection report, prepared separately,

or in conjunction with, a holding company

inspection.

A copy of the Export Trading Company report

as well as a copy of the Export Trading Com-

pany Questionnaire will be retained and included

in the workpapers for the BHC inspection. Sig-

niﬁcant ﬁndings will be incorporated into the

‘‘Examiner’s Comments’’ page, or the Analysis

of Financial Factors page, when appropriate.

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 2

3560.0.1.1 Export Trading Company Questionnaire

Yes No NA Comments

( )1. Is the Bank Holding Company (BHC) or

banking Edge Corporation investment in the

Export Trading Company (ETC) limited to

5% of its consolidated capital and surplus?

Reference: BESA, Section 203; BHC Act,

Section 4(c); Regulation K, Section

211.33(a)

( )2. Is the investment in the ETC by an Edge

Corporation not engaged in banking limited to

25% of its consolidated capital and surplus?

Reference: Same as question 1.

( )3. Did the BHC or Edge Corporation furnish the

Federal Reserve Board through the local FRB

written notice of its proposed investment

in the ETC at least 60 days prior to its

investment in the ETC?

Reference: BESA, Section 203; BHC Act,

Section 4(c); Regulation K, Section 211.34

( )4. Do the direct and indirect outstanding credit

extensions to the ETC by the investor and its

subsidiaries exceed 10% of the investor’s

consolidated capital and surplus?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(B); Regulation K,

Section 211.33(b)

5. If the BHC or its subsidiary has extended

credit to an afﬁliated ETC or to any of the

ETC’s customers:

( )a. are the terms of the credit any more

favorable than those afforded to similar

borrowers in similar circumstances;

( )b. does the credit involve more than normal

risk of repayment; and

( )c. does the credit present any unfavorable

features?

Reference: Regulation K, Section 211.33(b)(2)

6. If the BHC or its subsidiary has extended credit

to another investor with at least 10% interest in

the ETC, or to an afﬁliate of the investor:

( )a. are the terms of the credit any more favorable

than those afforded to similar borrowers in

similar circumstances;

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 3

Yes No NA Comments

( )b. does the credit involve more than normal

risk of repayment; and,

( )c. does the credit present any unfavorable

features?

Reference: Same as question 5.

( )7. Do covered transactions (under Sections 23A

and 23B of the Federal Reserve Act) between

a bank and an afﬁliated ETC meet the collateral

requirements of Section 23A unless exempted

because the bank has extended a letter of credit

or advance to the afﬁliated ETC solely for the

purchase of goods for which:

a. the ETC has a bona ﬁde sales contract; and

b. the bank has a security interest in the goods,

or in the proceeds from their sale at least

equal in value to the letter of credit or

advance?

Reference: Regulation K, Section 211.33(b)(3)

( )8. Has the ETC received an export trade

Certiﬁcate of Review which exempts it from

antitrust laws?

Reference: BESA, Section 301

( )9. Has the ETC Certiﬁcate holder submitted an

annual report to the Secretary of Commerce

as required?

Reference: BESA, Section 308

( )10. Is the ETC exclusively engaged in activities

related to international trade?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(F) Regulation K, Sec-

tion 211.32(a)

( )11. Is the ETC operated principally for the

purposes of exporting goods or services

produced in the U.S., or for purposes of

facilitating the exportation of goods or ser-

vices produced in the U.S. by unafﬁliated

persons by providing one or more export

trade services?

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 4

Yes No NA Comments

The term ‘‘export trade services’’ includes,

but is not limited to, consulting, international

market research, advertising, marketing,

insurance other than acting as principal,

agent or broker in the sale of insurance on

risks resident or located, or activities per-

formed, in the United States, except for

insurance covering transportation of cargo

from any point of origin in the U.S. to point

of origin in the U.S. to a point of ﬁnal desti-

nation outside the U.S., product research and

design, legal assistance, transportation,

including trade documentation and freight

forwarding, communication and processing

of foreign orders to and for exporters and

foreign purchasers, warehousing, foreign

exchange, ﬁnancing, and taking title to

goods in order to facilitate U.S. exports. An

ETC may engage in importing, barter, and

third-party trades only if these activities fur-

ther U.S. exports and only if the preponder-

ance of ETC activities do not involve

importing and the revenues from export

activities exceed revenues from import

activities.

Reference: Same as question 10.

( )12. If the ETC has expanded its activities signiﬁ-

cantly beyond those in the original notice to

the Board, such as to taking title to goods,

product research and design, product modiﬁ-

cation, or activities not speciﬁcally covered

in the BHC Act, has the investor given a 60

day notice in advance to the Board?

Reference: Regulation K, Section 211.34

( )13. If the ETC has been in operation more than

six years, is more than one-third of the

ETC’s revenue in the last consecutive four-

year period derived from exports or

facilitating exports of U.S. goods and ser-

vices produced in the U.S. by persons other

than the ETC or its subsidiaries?

Revenue includes net sales revenue from the

trading of goods by the ETC for its own

account and gross revenue from all other

activities of the ETC.

Reference: Regulation K, Section 211.32(a)

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 5

Yes No NA Comments

( )14. Does the ETC engage in agricultural produc-

tion, manufacturing or product modiﬁcation

of goods, e.g., repackaging, reassembly, or

extracting by-products other than incidental

product modiﬁcation as necessary to con-

form to the requirements of foreign countries

for sale of the goods in the foreign

countries?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(c)

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(c)

( )15. Does the ETC take title to goods for which it

has received no ﬁrm purchase order or

commitment?

Reference: BESA, Section 103(a)(3)

16. What period of time do the goods on which

the ETC has taken title remain in the inven-

tory of the ETC?

( )Does this activity appear unduly speculative?

Reference: Same as question 15.

( )17. Do the nature and terms of sale of goods

retained by the ETC appear to be in line with

proper ETC business operations, i.e., not

unduly speculative and related to authorized

activities?

Reference: Same as question 15.

( )18. If the ETC acts as a principal, agent, or

broker in the sale of insurance, does such

activity exclude the sale of insurance on

risks or activities located or performed

in the U.S.

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(F)

( )19. If the ETC engages in, or holds shares of a

company engaged in underwriting, selling or

distributing securities in the U.S., are such

activities limited to the same extent as for

BHC’s under applicable Federal and State

banking laws and regulations?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(C), 12 USC, Section

1843(c)(14)(C)(i)

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 6

Yes No NA Comments

( )20. Does the ETC take positions in commodities,

commodity contracts, securities or foreign

exchange other than as may be necessary in

the course of the ETC’s authorized business

transactions?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(D)

( )21. Are activities of the ETC Certiﬁcate holder

in compliance with the Certiﬁcate of

Review? (If not, the ETC could be subject to

antitrust laws.)

Reference: BESA, Section 306

( )22. Does the ETC capital base appear to ad-

equately support the strength of the ETC and

its ability to withstand unexpected adverse

developments so as not to affect the ﬁnancial

resources of the parent or the safety and

soundness of afﬁliated banks?

Reference: 43 Federal Register,

26,448(1983).

( )23. Is there any evidence of adverse effect of the

investment in the ETC on the investment in

the ETC on the ﬁnancial or managerial

resources of the BHC or Edge Corporation

investor, or on the safety and soundness of

any subsidiary bank of a BHC investor?

Reference: BESA, Section 203; BHC Act,

Section 4(c)(14)(A)(iv)(11)

( )24. Has the ETC’s capital to asset ratio remained

at all times at or above the minimum estab-

lished in the original notice to the Board?

( )25. Is the ETC in compliance with operational

policies, including maximum ﬁnancial lever-

age per transaction, as established in the

original notice to the Board?

( ) = Exception

Export Trading Company

Bank Holding Company Investor

Examination Date

Prepared by:

Date:

Section 4(c)(14) of the BHC Act (Export Trading Companies) 3560.0

BHC Supervision Manual December 1992

Page 7

Permissible Activities by Board Order

(Section 4(c)(8) of the BHC Act) Section 3600.0

As a general rule, a bank holding company must

provide 60 days’ prior written notice to its

Reserve Bank to engage in any nonbanking

activity, or to acquire or retain the shares of a

company engaged in an activity based on sec-

tion 4(c)(8) or 4(a)(2). When a bank holding

company gives notice to a Reserve Bank for

approval to engage in, or retain or acquire shares

in a company engaged in, a nonbank activity,

the BHC must be of the opinion that the activity

is closely related to banking and, assuming this

test is met, that the activitiy is a proper incident

thereto. In addition, a BHC that also is an FHC

must provide 60 days’ prior written notice to its

Reserve Bank to engage in an activity that is

complementary to a ﬁnancial activity under sec-

tion 4(k)(1)(B). In considering such a notice, the

Board must determine whether performance of

the activity can reasonably be expected to pro-

duce beneﬁts to the public, such as greater con-

venience, increased competition, or gains in efﬁ-

ciency, that outweigh possible adverse effects,

such as undue concentration of resources,

decreased or unfair competition, conﬂicts of

interest, or unsound banking practices.

As an exception to the general rule, no prior

notice is required for a bank holding company

that is qualiﬁed under section 4(j)(4) of the

BHC Act to engage de novo, directly or through

a subsidiary, in an activity that the Board permit-

ted under section 225.28 of Regulation Y before

November 12, 1999. After passage of the Gramm-

Leach-Bliley Act of 1999, this list of activities

cannot be expanded. For all bank holding com-

panies that are not qualiﬁed under section 4(j)(4),

for all other nonbanking activities based on sec-

tion 4(c)(8) or section 4(a)(2), and for all activi-

ties that are complementary to a ﬁnancial activ-

ity under section 4(k)(1)(B), the bank holding

company must provide the appropriate prior

written notice of its proposal to its Reserve

Bank.

The Board must review the notice with-

out disapproving it each time the bank holding

company wishes to engage in a proposed activ-

ity. The inspection objective and procedures set

forth below can be implemented for each of the

activities summarized in subsequent sections.

3600.0.1 INSPECTION OBJECTIVE

1. To determine what ﬁnancial effect nonbank-

ing activities have on the parent and the bank

subsidiaries, and if there is any degree of

exposure in the activities because of a lack of

appropriate audit systems and controls.

3600.0.2 INSPECTION PROCEDURES

1. Review the company’s ﬁnancial statements

for accuracy and determine if any factors or

trends could have an adverse impact on the

parent holding company or the bank

subsidiaries.

2. Review the adequacy of the company’s poli-

cies, procedures, practices, internal controls,

and audit coverage regarding nonbanking

activities, and whether they are adhered to.

1. A bank holding company that is qualiﬁed under section

4(j)(4) of the BHC Act may provide 12 calendar days’ prior

written notice before engaging by acquisition in an activity

permitted under section 225.28 or engaging in an activity

based on section 4(c)(8) and approved by the Board by order.

BHC Supervision Manual June 2000

Page 1

Permissible Activities by Board Order

(Operating a “Pool Reserve Plan”) Section 3600.1

Two bank holding companies (Company A) and

(Company B) had requested the Board to deter-

mine whether their planned nonbank subsidiary

activities were of the kind described in Section

4(c)(8) of the BHC Act. The applications had

been ﬁled prior to the passage of the Bank

Holding Company Act Amendments of 1970.

The applicants proposed to expand their activi-

ties under a ‘‘pool reserve plan’’ to include

correspondent banks. Such activities were lim-

ited to subsidiary banks.

The ‘‘pool reserve plan’’ was described as a

method of pooling of loss reserves with respect

to term loans to small businesses and the estab-

lishment of uniform credit standards in that

regard. The ‘‘pool reserve plan’’ permitted banks

to adopt a uniform and liberal credit policy in

extending credit and the usual method of

exchanging participations between the banks.

The General Counsel of the Board of Gover-

nors determined, on October 14, 1971, pursuant

to delegated authority, that the proposed activi-

ties would be ‘‘so closely related to banking or

managing or controlling banks as to be a proper

incident thereto’’ in accordance with Section

4(c)(8) of the BHC Act, as amended by the

BHC Act Amendments of 1970. The approval

(1971 FRB 1037) included the following condi-

tions that:

1. The subsidiary was to amend its charter so

that the charter would authorize it to perform its

functions, and make its services available to

banks, but not to lenders other than banks, and

to amend its proposed contracts with correspon-

dent banks;

2. Any correspondent banks could terminate

their contract with the subsidiary respecting

future transactions upon 90-day prior written

notice, and that;

3. The subsidiary be subject to the same lim-

itations with the respect to the ownership of any

collateral acquired in the course of the conduct

of its proposed activities as were its parents,

(Company A and Company B).

BHC Supervision Manual December 1992

Page 1

Permissible Activities by Board Order (Engaging in

Banking Activities via Foreign Branches) Section 3600.5

3600.5.1 NEW YORK INVESTMENT

COMPANY

On May 10, 1977, the Board approved an appli-

cation of a foreign-owned domestic bank to

form a holding company, and, at the same time,

for that holding company to acquire substan-

tially all of the voting shares of an investment

company organized and operating under article

XII of the New York State Banking Law (a New

York investment company).

The investment company at that time was

engaged in providing lending and international

banking services, including letters of credit,

acceptances, and other ﬁnancing facilities in

connection with exports and imports, interna-

tional transfers of funds, and foreign-exchange

services; investments and foreign-exchange trans-

actions for its own account; leasing improved

real estate and data processing equipment; and

maintenance of credit balances incidental to or

related to the foregoing activities. Although the

holding company believed that certain of the

activities of the New York investment company

had already been determined by the Board to be

permissible for bank holding companies, it

requested approval of its application on the basis

that all the activities that a New York invest-

ment company is permitted to engage in under

New York law are closely related to banking. A

New York investment company had not previ-

ously been determined by the Board to be an

activity permissible for bank holding companies.

The Board noted that the structural and com-

petitive circumstances under which a New York

investment company operates are unique to New

York and have served in the past as a means for

foreign-bank entry into New York in cases where

entry through a direct branch or agency was

either unavailable or undesirable for the pur-

poses sought. Most of the lending and banking

services offered by these companies are also

offered by commercial banks generally and, in

this connection, compete with foreign banking

organizations and domestic commercial banks

and their Edge corporation subsidiaries. How-

ever, under article XII of the New York State

Banking Law, a New York investment company

is permitted to engage in various other activities

which the Board does not consider to be closely

related to banking.

Based on the foregoing, the Board’s approval

in this case was limited to and contingent upon

the New York investment company’s (1) con-

tinuing to engage principally in transactions

involving international or foreign commerce,

and not accept demand deposits; (2) complying

with all Board or legislatively imposed reserve

and interest-rate requirements; (3) divesting of

ofﬁces in another state within two years; (4) con-

ﬁning activities of its foreign branch to those

permitted in the Board’s order; and (5) not

engaging in the activities of underwriting, sell-

ing, or distributing securities; buying or selling

coin and bullion; or acting as a ﬁnancial agent

of the U.S. government or as a depositary of

public moneys of the United States, or in any

new activity which New York investment com-

panies by subsequent enactment may be permit-

ted to engage in, without the prior approval of

the Board. (See 1977 FRB 595.)

3600.5.2 ENGAGING IN BANKING

ACTIVITIES THROUGH FOREIGN

BRANCHES OF A NONBANK

COMPANY

A bank holding company applied for the Board’s

approval to retain direct or indirect ownership

of a subsidiary, ‘‘CBC,’’ a Delaware-chartered

corporation, after it established branches in

Nassau and Luxembourg, to engage in certain

commercial banking activities. The activities

included accepting funds in U.S. dollars or for-

eign currency in wholesale money markets in

amounts over $100,000, making commercial

loans in amounts over $100,000, placing funds

with and making loans and advances to subsidi-

ary and afﬁliated organizations, engaging in

foreign-exchange transactions, and other activi-

ties constituting commercial banking outside the

United States. CBC held the shares of a number

of nonbanking subsidiaries of the BHC pursuant

to section 4(c)(1)(C) of the BHC Act, which

permits a subsidiary of a bank holding company

to perform services for its parent company.

The purpose of the proposal was to provide

the BHC with increased ﬂexibility in funding its

domestic operations by allowing CBC to gain

access to the offshore wholesale money market.

The proposed foreign branches of CBC, by

obtaining banking licenses, would give direct

access to Eurocurrency interbank markets, and

the activities of the proposed branches were

expected to be viewed as an integral part of a

large U.S.–headquartered entity, making the

branches competitive in the offshore interbank

markets.

BHC Supervision Manual December 1998

Page 1

The Board decided that the lending and bank-

ing services that the proposed branches would

offer were generally offered by commercial banks,

and thus are permissible activities of foreign

branches of domestic banks and foreign subsidi-

aries of bank holding companies. The proposed

activities of CBC’s branches were substantially

similar to activities that the Board had previ-

ously approved under section 4(c)(8) of the

BHC Act for the foreign branches of the New

York investment company, incorporated under

article XII of the New York Banking Law (see

1977 FRB 595 and 1979 FRB 667). CBC did

not propose to engage in any activity that would

not be permitted for a separately incorporated

foreign subsidiary of a bank holding company.

The Board, therefore, ruled that the proposed

activities of CBC were closely related to bank-

ing (1982 FRB 251).

CBC proposed to engage in no banking

activities in the United States, stating that its

only U.S. activities would consist of its indirect

nonbanking activities through subsidiaries. The

subsidiaries would be funded through funds

raised by the proposed foreign branches. In this

connection, the BHC committed to accepting no

placement of or deposits from,

or extending no

credit to (other than a subsidiary or afﬁliated

organization) a United States resident.

The BHC

committed that the liabilities to CBC of any

person, other than an afﬁliate, would not exceed

10 percent of the capital and surplus of CBC.

The Board felt that these prudential conditions

were adequate to meet any supervisory concerns

to which the proposal might give rise and thus

approved the application, subject to the obtain-

ing of the necessary licensing requirements of

the countries involved.

1. A placement or deposit received from a foreign branch,

ofﬁce, subsidiary, afﬁliate, or other foreign establishment

(‘‘foreign afﬁliate’’) controlled by one or more domestic cor-

porations is not regarded as a placement or deposit received

from a U.S. resident if such funds are used in its foreign

branches or that of other foreign afﬁliates of the controlling

domestic corporation(s).

2. Credit extended to a foreign afﬁliate, controlled by one

or more domestic corporations, is not regarded as credit

extended to a U.S. resident if the proceeds will be used in its

foreign business or that of other foreign afﬁliates of the

controlling domestic corporation(s).

Permissible Activities by Board Order (Engaging in Banking Activities via Foreign Branches)

3600.5

BHC Supervision Manual December 1998

Page 2

Permissible Activities by Board Order

(Operating a Securities Exchange) Section 3600.6

A domestic bank holding company (the BHC)

and a foreign banking organization (the FBO),

subject to the BHC Act, applied for the Board’s

permission to engage in operating a securities

exchange under the authority of section 4(c)(8)

of the BHC Act and section 225.24 of Regula-

tion Y. The BHC proposed to control approxi-

mately 17 percent of the voting shares of group

(the group), and the FBO planned to control

approximately another 11 percent of the voting

shares of the group. The group owned about

54.1 percent of a ﬁnancial network subsidiary

(FNS), which operated an electronic securities

exchange (the exchange) for the secondary trad-

ing of equity and equity-related securities listed

on the London Stock Exchange (LSE). The

BHC and FBO indicated that the group planned

to establish an ofﬁce in the United States. In

anticipation of the establishment of this ofﬁce,

the BHC and FBO requested the Board’s approval

to acquire their interests in the group. A BHC

must obtain the Board’s approval if a foreign

company held by the BHC seeks to engage in

business in the United States.

The exchange is a screen-based electronic

market that provides securities trade matching,

trade execution, and related services to U.S. and

foreign market makers, broker-dealers, and

institutional investors that become members of

the exchange. Members may access the exchange

and enter bid and ask quotations using elec-

tronic terminals that are linked to designated

ﬁnancial networks (for example, a Bloomberg

terminal) or through a personal computer linked

directly to the exchange. The exchange can be

accessed from terminals located anywhere in the

world. Trading, however, may occur only dur-

ing the operating hours of the LSE. Orders

entered in the exchange’s system appear on

separate electronic order books for each secu-

rity, which display the best bid and ask quotes

for the security in descending order. The exchange

automatically and continuously matches equal

bid and ask offers for each listed security on a

ﬁrst-come, ﬁrst-served basis.

FNS does not take a principal position in

securities, clear or settle the securities transac-

tions executed on the exchange, or assume any

principal risk for securities trades executed on

the exchange. FNS and its shareholders are not

obligated to guarantee any member’s trades.

Each member of the exchange must be a mem-

ber of the London Clearing House, or must

appoint a member of the London Clearing House

to clear the member’s trades on the exchange.

Trades matched by the exchange are registered

at the end of each business day with the London

Clearing House in the name of the appropriate

clearing member. London Clearing House then

becomes the counterparty to each side of the

trade until the trade is settled. The trade is

settled through a designated system operated by

a corporation established by the Bank of England

to settle uncertiﬁcated U.K. equities.

The exchange is a recognized investment

exchange under section 37(3) of the U.K. Finan-

cial Services Act of 1986, and is regulated and

supervisedby the U.K.Financial ServicesAuthor-

ity (FSA), under the securities laws of the United

Kingdom. While FNS makes its services avail-

able to customers in the United States, the SEC

has granted it a limited volume exception from

the registration requirements of the Securities

Exchange Act of 1934. The SEC exemptive

order permits FNS to operate in the United

States without registering as a securities exchange

provided (1) the exchange’s average daily vol-

ume of trades involving U.S. members does not

exceed $40 million, and (2) the exchange’s

worldwide average daily volume does not exceed

10 percent of the average daily trading volume

on the LSE. The SEC exemptive order requires

the exchange to comply with other conditions

that are designed to ensure orderly and fair

markets and to protect U.S. investors.

The Board had not previously determined by

regulation or order that the operation of a securi-

ties exchange is closely related to banking within

the meaning of section 4(c)(8) of the BHC Act.

The principal function of a securities exchange

is to provide a centralized facility for the execu-

tion, clearance, and settlement of securities trans-

actions. The Board indicated in its order that

banks and BHCs are authorized to provide secu-

rities brokerage services to their customers and,

as part of those services, to execute and clear

such transactions on a securities exchange. The

Board also noted that BHC subsidiaries autho-

rized to act as dealers in securities (section 20

subsidiaries) may provide securities execution,

clearance, and settlement services in connection

with their dealer operations. In addition, the

Board noted that broker or dealer subsidiaries of

banks and BHCs often become members of

securities exchanges and thus acquire a small

ownership (less than 5 percent) in a mutually

owned exchange (for example, the New York

Stock Exchange). Through the development of

these relationships, banks and BHCs have gained

BHC Supervision Manual June 2000

Page 1

considerable experience with and knowledge of

the rules and operations of securities exchanges.

Banks and BHCs also provide services that

are functionally and operationally similar to

those of the exchange. Banks and BHC subsidi-

aries acting as securities brokers may execute

cross-trades for their customers and thereby

match equal bid and offer orders received from

them. In addition, section 20 subsidiaries may, if

authorized, act as a specialist or market maker

on a securities exchange such as the NYSE or

NASDAQ. A specialist generally maintains a

book of current buy and sell orders received

from other brokers and matches equal bid and

offer quotes for execution. Market makers on

NASDAQ also publish bid and ask prices at

which they stand ready to execute transactions

in the relevant security.

For the above reasons, and based on all the

facts on record, the Board concluded that operat-

ing a securities exchange is an activity that is

closely related to banking for the purposes of

section 4(c)(8) of the BHC Act. The application

was approved on November 8, 1999. See 2000

FRB 61 for the order and more speciﬁc informa-

tion regarding the Board’s approval.

Operating a Securities Exchange 3600.6

BHC Supervision Manual June 2000

Page 2

Permissible Activities by Board Order (Acting as a

Certiﬁcation Authority for Digital Signatures) Section 3600.7

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2007, this section is amended

to include another Board order in which the

Board approved a notice for a foreign bank to

act as a certiﬁcation authority (CA) in connec-

tion with ﬁnancial and nonﬁnancial transac-

tions and to engage in related data processing

activities. The bank planned to engage in the

activities by entering into an agreement with a

newly organized, wholly owned indirect subsidi-

ary of the bank. (See 2006 FRB C150.) The

proposed CA nonbanking activities are slightly

different, but are consistent with those CA non-

banking activities that were previously approved

by the Board (discussed below).

3600.7.1 ACTING AS CERTIFICATION

AUTHORITY IN CONNECTION WITH

FINANCIAL AND NONFINANCIAL

TRANSACTIONS

A foreign banking organization (FBO)

subject

to the BHC Act and several bank holding com-

panies (BHCs), deemed to be BHCs (all referred

to as the notiﬁcants) within the meaning of the

BHC Act, requested the Board’s approval under

section 4(c)(8) of the BHC Act and section

225.24 of the Board’s Regulation Y (12 C.F.R.

225.24) to retain 12.5 percent of the voting

interests in Indent Company (Indent), and to

engage through Indent and other nonbank sub-

sidiaries in acting as a CA in the United States

in connection with ﬁnancial and nonﬁnancial

transactions and other related activities. Indent

represents a joint venture among the notiﬁcants

and other commercial banks and foreign bank-

ing organizations. As proposed, Indent would

act as the global rulemaking and coordinating

body for a network of ﬁnancial institutions that

would act as CAs and thereby provide services

designed to verify or authenticate the identity of

customers conducting ﬁnancial and nonﬁnancial

transactions over the Internet and other ‘‘open’’

electronic networks. To provide these services,

Indent and its network of participating ﬁnancial

institutions (the identity system) would use digi-

tal certiﬁcates and digital signatures created

through the use of public-key cryptography.

In a CA system using public-key cryptogra-

phy, a company generates (or is assigned) a

public-key/private-key pair and registers with a

CA as the unique ‘‘owner’’ of the key pair.

Private keys and public keys are a set of differ-

ent but related mathematical functions that can

be used to encrypt and decrypt electronic com-

munications. A message encrypted by a particu-

lar private key can be decrypted only by its

corresponding public key. Although a private

key and its corresponding public key are related,

a private key cannot feasibly be derived from its

corresponding public key. Thus, while a private

key must be kept conﬁdential by the company

that is the registered owner of the key pair, the

company’s public key can be made publicly

available without jeopardizing the conﬁdential-

ity of the company’s private key.

A company sending a business communica-

tion (for example, a purchase order) to another

entity over an open electronic network like the

Internet uses its conﬁdential private key to digi-

tally sign the message being sent. A digital

signature is a compressed and encrypted version

of the message to which it is attached. The

entity receiving the digitally signed message

then uses the sender’s public key to decrypt the

digital signature.

If the receiver successfully

decodes the signature with the sender’s public

key, the receiver can be assured that the mes-

sage was created using the sender’s private key.

To be assured that the message was actually

sentby the purportedsender,however,the receiver

must conﬁrm that the private-key/public-key

pair used to sign and decode the message is

uniquely ‘‘owned’’ by the purported sender. A

CA provides this assurance by issuing ‘‘digital

certiﬁcates’’ certifying that the relevant private-

key/public-key pair is uniquely associated with

the message sender and by verifying upon request

the validity of such digital certiﬁcates.

1. Foreign banks may engage in permissible nonbanking

activities in the United States directly through a U.S. branch

or agency. A foreign bank, however, must receive the Board’s

approval under section 4(c)(8) of the BHC Act to engage in

the United States in activities that are deemed to be closely

related to banking.

2. A number of nonbanking companies currently operate

CA systems that rely on public-key cryptography to provide

identity-authentication services to senders and receivers of

electronic communications.

3. The sender’s public key may be attached to the digitally

signed communication, or the receiver of the message may

obtain the sender’s public key from a publicly available

database.

4. The receiver also can conﬁrm that the message was not

altered after it was signed by comparing the message received

with the decrypted version of the message text embedded in

the digital signature.

BHC Supervision Manual January 2007

Page 1

The notiﬁcants and other ﬁnancial institutions

participating in the identity system (partici-

pants)

would create unique private-key/public-

key pairs for, and issue digital certiﬁcates on

behalf of, eligible customers that contract with

one of the participants to receive Indent identity-

authentication services.

Each participant would

act as a repository for the digital certiﬁcates that

it has issued, that is, it would maintain a data-

base containing information on the status of the

outstanding, expired, or revoked digital certiﬁ-

cates that it has issued to customers. The partici-

pants also would verify for third parties the

validity of digital certiﬁcates issued to their

customers and, upon request of the third party,

may provide an explicit warranty as to the valid-

ity of the customers’ digital certiﬁcates.

The

participants also may process and transmit veri-

ﬁcation and warranty requests received from

customers concerning digital certiﬁcates issued

by other participants in the identity system. In

addition, the participants may provide custom-

ers with a limited range of software and hard-

ware that is required for customers to use the

identity system.

Indent would provide the infrastructure frame-

work within which the participants would act as

CAs and provide related services. The primary

function of Indent would be to act as the ‘‘root

certiﬁcation authority’’ of the identity system,

that is, issuing digital certiﬁcates to the partici-

pants that establish their status as CAs in the

identity system and authenticating for customers

of, and the other participants in, the identity

system the identity of the participants.

Indent

also would (1) establish and maintain the operat-

ing rules governing the identity system, includ-

ing the minimum technical requirements for

digital certiﬁcates and other components of the

system; (2) monitor compliance by the partici-

pants with the identity system’s operating rules

and technical standards; and (3) monitor collat-

eral requirements and aggregate warranty expo-

sure for the participants in the identity system.

Section 4(c)(8) of the BHC Act provides that

a bank holding company may, with the Board’s

approval, engage in any activity that the Board

determines to be closely related to banking. The

Board previously has authorized BHCs under

section 4(c)(8) of the BHC Act to act as CAs

and provide identity-authentication services in

connection with payment-related and other ﬁnan-

cial transactions conducted over electronic net-

works.

The Board has not previously autho-

rized BHCs under section 4(c)(8) to act as CAs

or provide identity-authentication services in

connection with nonﬁnancial transactions.

Banks and BHCs have long provided identity-

authentication services in connection with nonﬁ-

nancial transactions conducted by third parties

and for their own traditional banking and lend-

ing activities. For example, banks and BHCs are

authorized to provide notary services to custom-

ers.

The role of a notary is to authenticate

signatures on ﬁnancial or nonﬁnancial docu-

ments for the beneﬁt of third parties.

To verify

a signature on a paper-based document, a notary

must verify the identity of the person signing

5. Participation in the identity system is available only to

organizations that are engaged primarily in the business of

providing ﬁnancial services; are subject to regulation and

examination by a government authority in their home country;

and that meet certain eligibility criteria, such as minimum

capital requirements and debt-rating criteria. A participant

also must agree to be bound by the identity system operating

rules and to execute certain participation agreements. Finan-

cial institutions would not be required to purchase an owner-

ship interest in Indent to become a participant.

6. The participants may provide identity system–related

services only to customers that have agreed to be bound by

applicable provisions of Indent’s operating rules and have

signed the appropriate customer agreements. Indent’s operat-

ing rules allow the participants to provide identity system–

related services only to business entities, such as corporations

and governmental organizations, and not to natural persons.

Indent’s operating rules and customer agreements would make

each customer contractually responsible for ensuring that its

private key is kept conﬁdential.

7. The operating rules of the identity system would provide

that a company relying on a digital certiﬁcate issued by the

participant would have recourse against the participant only if

the company purchased an explicit warranty from the partici-

pant, and then only up to the amount of the purchased war-

ranty. The participant that issues a digital certiﬁcate could

refuse to issue a warranty for a digital certiﬁcate for any bona

ﬁde reason. The identity system would limit the aggregate

amount of warranties that the participant may have outstand-

ing at any one time, and would require each participant to post

collateral with Indent to cover its warranty exposure.

8. For example, the participants may provide smart cards

containing digital certiﬁcates and smart-card readers to their

customers.

9. Digital certiﬁcates issued by the participant to a cus-

tomer are digitally signed by the participant with its own

private key and are accompanied by a digital certiﬁcate issued

by Indent. The digital certiﬁcates Indent issues would certify

that the participant is an authorized participant in the identity

system and that the private key the participant uses to digitally

sign its certiﬁcates is uniquely associated with it, thereby

authenticating the identity of the participant.

10. The activities of the notiﬁcants and Indent would be

limited to providing the identity-authentication and related

services described above. The notiﬁcants and Indent would

not provide a general encryption or electronic message ser-

vice, or any warranty of the underlying ﬁnancial or nonﬁnan-

cial transactions between customers whose identities are

authenticated through the use of the identity system.

11. See Regulation Y, section 225.28(b)(14); 1997 FRB

602, 606; and 1982 FRB 505, 510.

12. See 1998 FRB 481.

13. 58 Am. Jur. 2d Notaries Public § 31 (2d ed. 1989).

Acting as a Certiﬁcation Authority for Digital Signatures 3600.7

BHC Supervision Manual January 2007

Page 2

the document. The Board noted that the role a

CA serves with respect to electronic documents

is functionally similar to the role a notary serves

with respect to paper-based documents.

Banks have traditionally identiﬁed their cus-

tomers to third parties through the issuance of

letters of introduction or letters of reference.

In addition, banks and BHCs routinely authenti-

cate the identity of customers and noncustomers

in connection with their authorized check-

cashing functions.

Banks and BHCs also have long been autho-

rized to issue signature guarantees to issuers of

securities and their transfer agents in connection

with the transfer of securities.

A bank issuing

a signature guarantee warrants that the custom-

er’s signature endorsing a certiﬁcated security

or authorizing the transfer of an uncertiﬁcated

security is authentic. The issuing bank also war-

rants that the signer was an appropriate person

to endorse the security or authorization (or, if

the signature is by an agent, that the agent had

actual authority to act on behalf of the appropri-

ate person) and that the signer had legal capac-

ity to sign. In light of these warranties, a bank

providing a signature guarantee must verify the

identity of the customer providing the endorse-

ment or signing the instruction.

Identity-authentication services are an inte-

gral part of many traditional banking functions.

Banks and BHCs have developed sophisticated

methods for authenticating the identity of cus-

tomers and noncustomers that transact business

or communicate with the bank or BHC through

electronic means or otherwise. Many of these

activities are operationally and functionally simi-

lar to the proposed activities, and make banks

and BHCs particularly well equipped to provide

the proposed services. For example, banks and

BHCs maintain systems to electronically

authenticate the identity of persons engaged in

credit and debit card, automated teller machine

(ATM), home banking, and wire transfer trans-

actions with the institution.

Banks and BHCs

also electronically authenticate the identity of

persons in connection with the check and credit

card veriﬁcation services they are authorized to

provide to merchants and other businesses.

The Board noted that state banks and national

banks have recently been authorized to act as

CAs and to provide identity-authentication ser-

vices in connection with ﬁnancial and nonﬁnan-

cial transactions conducted over electronic net-

works. Based on the foregoing, the Board

concludes that acting as a CA and, more gener-

ally, authenticating the identity of customers

conducting ﬁnancial and nonﬁnancial transac-

tions are activities that are closely related to

banking within the meaning of section 4(c)(8)

of the BHC Act.

Indent and the notiﬁcants also propose to

engage in a number of activities as part of and in

connection with their proposed CA activities.

These activities include (1) processing, transmit-

ting, and storing data necessary for the opera-

tion of the identity system, such as digital cer-

tiﬁcates, requests for veriﬁcation of digital

certiﬁcates, and warranty requests; (2) develop-

ing and marketing software and hardware neces-

sary for operating the identity system; and

(3) complying with, monitoring, and enforcing

the collateral-posting requirements associated

with identity warranties. In addition, Indent

would establish operating policies, procedures,

and guidelines for the identity system.

The Board’s Regulation Y permits BHCs to

provide data processing and data transmission

services and facilities (including software and

hardware) for the processing and transmission

of ﬁnancial, banking, or economic data, and to

engage in activities related to making, acquir-

ing, brokering, or servicing extensions of credit,

such as posting collateral and monitoring collat-

eral requirements.

Regulation Y also permits

BHCs to engage in incidental activities that are

14. The American Bar Association, for example, has noted

that the issuance of digital certiﬁcates by CAs is ‘‘analogous

to traditional certiﬁcation processes undertaken by notaries

with respect to documents executed with pen and ink.’’ ‘‘Digi-

tal Signature Guidelines,’’ published by the Information Secu-

rity Committee of the Electronic Commerce and Information

Technology Division, Section of Science and Technology,

American Bar Association. (Aug. 1, 1996), p. 54.

15. Banks have drafted letters of introduction or letters of

reference on behalf of their customers for the purpose of

introducing the customer to other banks or third parties with

which the customer seeks to do business.

16. Under the Uniform Commercial Code (UCC), a bank

that accepts a check for deposit warrants to the drawee bank

that all endorsements on the check are genuine, and the bank

is liable to the drawee bank for the amount of the check plus

expenses and lost interest if an endorsement on the check was

forged.

17. Broker-dealer subsidiaries of BHCs also have provided

signature guarantees.

18. A bank issuing a signature guarantee is liable to the

issuer of the security or its transfer agent for any loss that

results from a breach of any of these warranties by the bank.

19. Article 4A of the UCC encourages banks to develop

and maintain commercially reasonable security procedures,

such as algorithms or other encryption devices, for authenti-

cating the identity of customers that transmit wire transfer

instructions to the bank.

20. See Regulation Y, section 225.28(b)(2)(iii) and 1985

FRB 648.

21. See Regulation Y, section 225.28(b)(2) and (14). A

BHC may develop and sell hardware and software that is

Acting as a Certiﬁcation Authority for Digital Signatures 3600.7

BHC Supervision Manual January 2007

Page 3

necessary to the conduct of an activity that is

closely related to banking. Indent and the notiﬁ-

cants have represented that they would engage

in the additional activities only in connection

with their CA activities and would not engage in

such activities separate or apart from their CA

activities. The notiﬁcants also have committed

that the data processing and data transmission

activities of the notiﬁcants and Indent, including

any proposed development or sale of hardware

and software, will comply with the Board’s

regulations and interpretations. In light of the

nature of these additional activities and the fact

that they would be conducted only in connec-

tion with the CA activities of Indent and the

notiﬁcants, and all the other facts of record, the

Board concludes that these activities are encom-

passed within the activities previously approved

by the Board by regulation or are incidental to

the permissible CA activities of Indent and the

notiﬁcants and, therefore, are permissible under

Regulation Y.

Based on the facts stated in the Board’s order,

the Board determined that the certiﬁcation author-

ity and other activities discussed were closely

related to banking under section 4(c)(8) of the

BHC Act. The Board issued its approval order

on November 10, 1999. (See 2000 FRB 56). See

the Board’s order for more speciﬁc information

and for the more detailed information and refer-

ences in the order’s footnotes.

The Board approved another notice for a for-

eign bank, speciﬁcally a foreign banking organi-

zation that is subject to the BHC Act.

The

foreign bank had requested the Board’s approval

under sections 4(c)(8) and 4(j) of the BHC Act

and section 225.24 of the Board’s Regulation

to act as a CA in connection with ﬁnancial

and nonﬁnancial transactions and to engage in

related data processing activities. It was pro-

posed that the agreement be assigned to a newly

organized wholly owned indirect subsidiary of

the bank, CLX.

The proposed activities would be undertaken

within the Identity Trust System (ITS), which

would serve as a central rulemaking and coordi-

nating body for a global network of institutions

that would act as digital CAs. The CAs would

verify or authenticate the identity of customers

conducting ﬁnancial and nonﬁnancial transac-

tions over the Internet and on other ‘‘open’’

electronic networks. To provide these services,

ITS and its network of participating ﬁnancial

institutions would use digital signatures created

with encryption technology. These digital signa-

tures would uniquely identify participants in the

ITS who send signed messages over electronic

networks. The CAs would issue digital certiﬁ-

cates that certify that the digital signature is

uniquely associated with a particular message

sender so that the message recipient can be

assured of the identity of its trading partner.

As a certiﬁcation authority, CLX would pro-

vide the technical systems and support neces-

sary for banks to verify and authenticate the

identity of customers conducting electronic trans-

actions and to register digital certiﬁcates to cus-

tomers. These services would be provided to the

foreign banking organization as well as to other

banks that enter into contracts with CLX.

The

foreign bank, and any other banks to which

CLX may provide services, would be respon-

sible for performing the due diligence on cus-

tomers that request digital credentials, a role

referred to as‘‘registration authority.’’ Bank and

other registration authorities would register the

digital certiﬁcates issued to their customers, and

CLX would maintain a database of all certiﬁ-

cates issued through its registration authorities.

CLX would also provide registration authorities

with the software and hardware required to use

the ITS.

In this order, the Board referenced its previ-

ous approval (2000 FRB 56) in which it deter-

mined that the CA activities conducted in con-

nection with ﬁnancial and nonﬁnancial

transactions and data processing were activities

that are closely related to banking for the pur-

poses of section 4(c)(8) of the BHC Act. Also

for this latter order, the Board found that the

foreign bank’s proposed activities were consis-

tent with those that it had previously approved.

The foreign bank committed that it would con-

duct its proposed nonbanking activities in accor-

designed and marketed for processing and transmitting ﬁnan-

cial, banking, or economic data. It may also develop and sell

general purpose hardware so long as it does not constitute

more than 30 percent of the cost of any packaged offering.

22. The notiﬁcants may engage in data processing and data

transmission activities, including the development and sale of

hardware and software, pursuant to this order only to the

extent such activities are necessary to permit the proper

operation of the identity system. The notiﬁcants and Indent

also must conduct their data processing and data transmission

activities subject to the software and hardware limitations in

Regulation Y.

23. As a foreign bank operating an agency in the United

States, the foreign bank is subject to the BHC Act by opera-

tion of section 8(a) of the International Banking Act of 1978

(12 U.S.C. 3106(a)).

24. 12 U.S.C. 1843(c)(8) and 1843(j).

25. 12 C.F.R. 225.24.

26. These banks would also have to enter into agreements

to participate with ITS.

Acting as a Certiﬁcation Authority for Digital Signatures 3600.7

BHC Supervision Manual January 2007

Page 4

dance with the limitations set forth in Regula-

tion Y and the Board’s above-mentioned previous

order governing these proposed activities. The

Board approved the notice on June 8, 2006

(2006 FRB C149).

3600.7.2 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

Acting as a certiﬁcation author-

ity for ﬁnancial and nonﬁnan-

cial transactions and related data

processing activities.

U.S.C.

1843(c)(8)

225.28(b)(14) 2000 FRB 56

2006 FRB 149

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Acting as a Certiﬁcation Authority for Digital Signatures 3600.7

BHC Supervision Manual January 2007

Page 5

Permissible Activities by Board Order

(Private Limited Investment Partnerships) Section 3600.8

A bank holding company (the applicant) applied

under section 4(c)(8) of the Bank Holding Com-

pany Act and the Board’s Regulation Y to

engage de novo through a wholly owned subsid-

iary (the company) in privately placing limited

partnership interests in a group of partnerships

having a limited number of investors. The com-

pany was to serve as the investment adviser,

administrator, and sole general partner of a

series of seven partnerships (the partnerships)

that would be sold to a number of institutional

investors. The company would maintain an equity

interest of approximately 1.25 percent of the

total capitalization in each partnership.

The partnerships were to be engaged solely in

investing in limited amounts of debt and equity

securities, including interests in real estate invest-

ment equity trusts (REITs).

The partnerships,

together with the applicant and its other subsidi-

aries, were not to hold more than 5 percent of

any class of voting securities of any issuer,

and not more than 25 percent of the total equity

of any issuer.

The equity investments were

to be held in accordance with section 4(c)(6)

of the BHC Act and section 225.22(d)(5) of

Regulation Y.

The company also proposed to privately place

limited partnership interests with new sophisti-

cated institutional investors and possibly form

similar additional partnerships in the future. The

company was not to privately place debt securi-

ties issued by the partnerships without prior

approval from the Federal Reserve System. The

applicant committed that the private placement

of limited partnership interests would conform

to the limitations and conditions for private

placements in previous Board orders approving

private-placement activities (for example, 1990

FRB 26 and 1989 FRB 829).

Each investor was

required to have an initial minimum investment

of $100,000. Investors with $250,000 or more

under management by the company, however,

would be permitted to invest in any partnership

in any amount. The applicant would continue

the company’s practice of allowing existing

investors in a partnership to add to their invest-

ment in the partnership in any amount. The

application was approved on June 28, 1994

(1994 FRB 736).

Subsequently, another bank holding company

(the BHC applicant) applied for the Board’s

approval under section 4(c)(8) of the BHC Act

and section 225.23 of Regulation Y to engage

de novo, through a wholly owned asset-

management subsidiary (AMS), in establishing

and serving as the general partner of limited

partnerships (the limited partnerships) that would

invest in a wide variety of commodities and

exchange-traded and over-the-counter instru-

ments including those speciﬁed in the Board

order. AMS would be the general partner of

each partnership and would hold a nominal

equity interest in each one. In this case, AMS

would not provide investment advice directly to

the limited partnerships, but would employ

unafﬁliated investment advisers to manage the

investments of the limited partnerships, pursu-

ant to parameters set by AMS. Interests in the

limited partnerships would be privately placed

with institutional customers by the BHC appli-

cant’s subsidiary banks.

One or more of the limited partnerships could

invest a substantial portion of their assets in

commodity pools, which would require the appli-

cant to register as a commodity pool operator

(CPO). The interests purchased by the limited

partnerships would consist of less than 5 percent

of the outstanding voting securities of any com-

modity pool and less than 10 percent of the total

equity of any commodity pool. The applicant

proposed that the limited partnerships purchase

such assets with debt. It further stated that it

would not permit any limited partnership that

invested in distressed debt instruments to use

borrowed funds to purchase or carry distressed

debt instruments or to use the distressed debt

instruments as collateral in acquiring other assets.

The applicant also indicated that the leverage

employed by the limited partnerships would

include margin credit from broker-dealers, re-

verse repurchase agreements, and short sales.

The limited partnerships would invest in debt

and equity instruments and distressed debt

instruments.

The applicant stated that invest-

1. The partnerships were not to invest in futures contracts

or options on futures contracts on any ﬁnancial or nonﬁnan-

cial commodity, or knowingly invest in debt that, upon acqui-

sition, is in default without the prior approval of the Federal

Reserve System. The applicant further committed that it

would not use the investments of the partnerships to obtain or

exercise control over any issuer of securities owned or held by

the partnerships. Also, no directors, ofﬁcers, or employees of

the applicant and its afﬁliates will serve as directors, ofﬁcers,

or employees of any issuer of which the applicant and its

afﬁliates held more than 10 percent ownership of total equity.

2. The applicant committed that all subordinated debt of an

issuer would be subject to this 25 percent limit.

3. See the current Regulation Y, section 225.28(b)(7)(iii),

regarding private-placement services.

4. The Board had previously permitted bank holding com-

BHC Supervision Manual June 2000

Page 1

ments in debt and equity securities and dis-

tressed debt would be made in accordance with

the BHC Act’s limitations and those of pre-

vious Board decisions. (See 1995 FRB 1128 and

section 3104.0.)

The limited partnerships, together with the

applicant and its subsidiaries, would make invest-

ments not greater than 5 percent of any class of

voting securities of any issuer, and not greater

than 25 percent of the total equity, including the

subordinated debt, of any issuer. No directors,

ofﬁcers, or employees of the applicant would

serve as directors, ofﬁcers, and employees of

any issuer of which the applicant and its subsid-

iaries (that is, the limited partnerships) would

hold more than 10 percent of the total equity.

For this case, the Board required AMS to con-

solidate the assets and liabilities of the limited

partnerships in the ﬁnancial statements of AMS

for regulatory capital purposes. In addition, AMS

was required to establish an appropriate risk-

management structure consisting of investment

and position limits for each investment adviser

before engaging in the proposed activities. Com-

pliance and trading limits would be monitored

by computerized systems to be established by

the applicant. The Board approved the notice on

April 24, 1996, subject to all the facts of record

and the commitments furnished. See 1996 FRB

569. For more recent Board orders whereby

bank holding companies propose to act as a

CPO and to control a private limited partnership

that invested solely in permissible investments

for a bank holding company, see 1999 FRB 209,

1998 FRB 852, and 1998 FRB 361.

panies to sponsor, organize, and manage closed-end invest-

ment companies and unregistered limited partnerships that

invest in securities.

Private Limited Investment Partnerships 3600.8

BHC Supervision Manual June 2000

Page 2

Permissible Activities by Board Order

(FCM Activities) Section 3600.13

3600.13.1 SERVING AS AND

CONTROLLING A PRIVATE LIMITED

PARTNERSHIP AS A COMMODITY

POOL OPERATOR

A bank holding company applied for the Board’s

approval under section 4(c)(8) of the Bank Hold-

ing Company Act (BHC Act) and section 225.23

of the Board’s Regulation Y (12 C.F.R. 225.23)

to engage de novo through a wholly owned

asset-management subsidiary (ASM) that would

be established to serve as the general partner of

limited partnerships (the partnerships) that would

invest in a wide variety of commodities and

exchange-traded and over-the-counter instru-

ments, including interests in investment funds

that invest in futures and options on futures on

ﬁnancial and nonﬁnancial commodities (com-

modity pools). It was indicated that the partner-

ships would not directly invest in futures or

options on futures contracts for purposes other

than hedging. The partnerships would purchase

and sell derivative contracts on precious metals

and ﬁnancial commodities, instruments, and

indices for hedging purposes. It was further

stated that one of the limited partnerships may

invest a substantial portion of its assets in com-

modity pools, which would require the ASM

(the general partner) to become a registered

commodity pool operator (CPO) with the Com-

modity Futures Trading Commission (CFTC).

As such, the ASM would register as a CPO with

the CFTC, and a portion of the general partner’s

activities would become subject to the record-

keeping, reporting, ﬁduciary standards, and other

requirements of the Commodity Exchange Act

(7 U.S.C. 2 et seq.), CFTC, and National Futures

Association.

The Board previously has found that a subsid-

iary of a state member bank may serve as the

CPO of investment funds engaged in purchasing

and selling futures and options on futures on

certain commodities.

In addition, the Board has

permittedbankholding companiesto trade futures

and options on futures on ﬁnancial and nonﬁ-

nancial commodities.

For these reasons, the

Board has concluded that serving as a CPO, and

controlling as a CPO a private limited partner-

ship that invests solely in investments that a

bank holding company is permitted to make

directly, under the circumstances of this case

(1996 FRB 569) are closely related to banking.

See also 1998 FRB 1075, 1998 FRB 852–854,

1998 FRB 361, and 1994 FRB 736.

1. See 1996 FRB 239.

2. See 1995 FRB 185.

BHC Supervision Manual June 1999

Page 1

Permissible Activities by Board Order

(Insurance Activities) Section 3600.17

3600.17.1 ENGAGING IN TITLE

INSURANCE AGENCY ACTIVITIES

PURSUANT TO REGULATION Y

A bank holding company applied under section

4(c)(8) of the BHC Act and section 225.23(a) of

the Board’s Regulation Y to acquire all the

outstanding shares of a title insurance agency.

The title insurance agency is to conduct activi-

ties pursuant to exemption G of the Garn–St

Germain Depository Institutions Act of 1982

(the act) and section 225.28(b)(11)(vii) of Regu-

lation Y. Title VI of the act amended section

4(c)(8) of the BHC Act to provide that insur-

ance agency, brokerage, and underwriting activi-

ties are not ‘‘closely related to banking’’ and

thus are not permissible activities for bank hold-

ing companies, unless the activities are included

within one of seven speciﬁc exemptions

(A through G) in section 4(c)(8).

The applicant claimed that it was authorized

to operate a title insurance agency under exemp-

tion G, which authorizes those bank holding

companies that engaged in insurance agency

activities before 1971 to engage, or control a

company engaged in, insurance agency activi-

ties. The company has been engaged in the sale

of insurance related to extensions of credit by its

subsidiary banks since 1939.

The bank holding company applicant was one

of 16 active companies with grandfather rights

under exemption G.

Previously, the Board deter-

mined (1985 FRB 171) that those companies

that had received Board approval to engage

in general insurance agency activities before

1971 would be grandfathered under exemption

G with respect to the sale of any type of insur-

ance that is within the scope of general insur-

ance agency activities—even an insuranceagency

activity (such as title insurance) not actually

offered by the applicant bank holding company

before 1971. The Board found that there is no

requirement in the statute that a company quali-

fying for exemption G engage only in those

insurance agency activities it conducted with

Board approval before 1971. Thus, although the

Board may not have speciﬁcally approved title

insurance before 1971, provided the proposed

activity is encompassed within the authorization

of insurance agency activities, the activity falls

within exemption G.

The Board determined selling title insurance

through a title insurance agency to be permis-

sible pursuant to exemption G and the Board’s

regulations. The Board approved the application

on November 17, 1988 (1989 FRB 31).

1. There are currently 12 companies remaining.

BHC Supervision Manual December 1998

Page 1

Permissible Activities by Board Order

(Underwriting and Dealing) Section 3600.21

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2008, this section has been revised

to incorporate a name change to the Financial

Industry Regulatory Authority, or FINRA (for-

merly, the National Association of Securities

Dealers, or NASD).

3600.21.1 UNDERWRITING AND

DEALING IN COMMERCIAL PAPER

TO A LIMITED EXTENT

A bank holding company applied for the Board’s

approval under section 4(c)(8) of the BHC Act

and section 225.21(a) of the Board’s Regula-

tion Y to underwrite and deal in third-party

commercial paper to a limited extent. As pro-

posed, the activity will be conducted through a

commercial ﬁnance subsidiary (the company).

The company is to act for issuers as an under-

writer of commercial paper, purchasing com-

mercial paper for resale to institutional investors

such as banks, insurance companies, mutual

funds, and nonﬁnancial businesses. In addition,

the company may place commercial paper as

agent for issuers and advise issuers on the rates

and maturities of proposed issues that are likely

to be accepted in the market—activities previ-

ously approved by the Board (1987 FRB 138).

The activities in this order (1987 FRB 367)

differ from those previously authorized (1987

FRB 138) in that the applicant will underwrite

and deal in commercial paper as principal.

The Board may not approve a proposal of a

member bank afﬁliate if upon consummation it

would be ‘‘engaged principally’’ in the ﬂotation,

underwriting, public sale, or distribution of com-

mercial paper (hereafter referred to as ‘‘under-

writing and dealing in’’) within the meaning of

the former section 20 of the Glass-Steagall Act

(12 U.S.C. 377). The Board concluded that even

if placement of commercial paper were deemed

to constitute an activity, the commercial lending

subsidiary would not be ‘‘engaged principally’’

in underwriting and dealing in securities. The

subsidiary’s activity was not substantial under a

former 5 percent limit on the subsidiary’s gross

income (increased to 25 percent, effective March

6, 1997) from its commercial paper activities

and a former 5 percent limit on its market share.

The company is required to restrict its commer-

cial paper activities so it does not exceed these

limits.

The Board concluded that underwriting and

dealing in commercial paper is closely related to

banking on the same basis as acting as place-

ment agent and adviser to issuers in commercial

paper (1987 FRB 138). Banks provide services

that are operationally and functionally similar

to the services of underwriting and dealing in

commercial paper. Banking organizations are

particularly well equipped to provide such ser-

vices. In the Board’s view, the underwriting and

dealing activity represents a natural extension of

commercial lending activities traditionally con-

ducted by banks, involving little additional risk

or new conﬂicts of interest, and potentially

yielding signiﬁcant public beneﬁts in the form

of increased competition and convenience.

The Board concluded that the applicant could

conduct the activities to the extent and in the

manner described in the order, consistent with

the former section 20 of the Glass-Steagall Act

and section 4(c)(8) of the BHC Act. The Board’s

approval extended only to commercial paper

underwriting, dealing, placement, and advisory

activity conducted in accordance with the limi-

tations stated in the order (1987 FRB 367).

3600.21.2 ENGAGE IN

UNDERWRITING AND DEALING, TO

A LIMITED EXTENT, IN MUNICIPAL

REVENUE BONDS, MORTGAGE-

RELATED SECURITIES, AND

COMMERCIAL PAPER

On April 30, 1987, the Board approved by order

the applications of three bank holding com-

panies to engage through subsidiaries in under-

writing and dealing in commercial paper, one-

to four-family mortgage-backed securities, and

municipal revenue bonds.

(For a complete

description of the nonbanking activities autho-

rized by the Board in this order, see 1987 FRB

473.) The subsidiaries are to be involved in

underwriting and dealing in U.S. government

securities as their major activity. Board approval

1. The applicants had previously received Board approval

under section 4(c)(8) of the BHC Act for the subsidiaries

mentioned in the order to engage in underwriting and dealing

in U.S. government and agency and state municipal securities

that state member banks are authorized to underwrite and deal

in under section 16 of the Glass-Steagall Act. The newly

proposed underwriting and dealing activities were approved

in addition to the previously approved activities.

BHC Supervision Manual July 2008

Page 1

could only occur if the afﬁliates would not be

‘‘principally engaged’’ in underwriting and deal-

ing in ‘‘securities’’ under the provisions of the

former section 20 of the Glass-Steagall Act.

A hearing was held on February 3, 1987,

because of the important legal and factual issues

involved. The Board reafﬁrmed its ﬁnding in its

previous decisions (1987 FRB 138 and 367) that

the applicants were not principally engaged in

the proposed securities activities if they limited

their underwriting and dealing income from

these securities to 5 percent of the total gross

income of the afﬁliate, and if they limited their

market share in each of these securities to 5 per-

cent of the total domestic market.

The Board

established a number of conditions to ensure

that the underwriting activity would be consis-

tent with safe and sound banking practices and

would avoid conﬂicts of interest, undue concen-

tration of resources, and other adverse effects.

The Board determined, consistent with its

previous underwriting and dealing decisions in

administering the Glass-Steagall Act, that a

range of between 5 percent and 10 percent of

gross revenue and market share is the appropri-

ate framework for determining whether an afﬁli-

ate is engaged principally in securities activities.

The lower end of the range—5 percent—was

the level applied at the time. The Board noted

that it would review this level within a year

on the basis of experience gained from opera-

tions to determine whether a higher level would

be permissible. On September 21, 1989, the

Board modiﬁed section 20 orders to increase

from 5 percent to 10 percent the revenue limit

on the amount of total revenues a section 20

subsidiary may derive from ineligible securities

underwriting and dealing activities (increased to

25 percent, effective March 6, 1997) (1989 FRB

751).

The Board’s approval of the applications

extends only to the activities conducted within

the limitations of the order and is subject to the

gross revenue limitation discussed above. Two

of the applicants also proposed to underwrite

and deal in consumer-receivable-related securi-

ties (CRRs). Although the companies noted cer-

tain similarities between these securities and

mortgage-related securities, the Board did not

believe that the record before the Board pro-

vided a sufﬁcient basis for it to make a formal

ﬁnding (as required by the BHC Act) that under-

writing and dealing in CRRs is closely related to

banking and a proper incident thereto. The Board

noted that the market for CRRs was relatively

new and untested compared with the market for

one- to four-family mortgage-related securities

and municipal revenue bonds. The Board indi-

cated that it would reconsider the matter within

60 days on the basis of more complete informa-

tion to be submitted by the applicants regarding

the types of assets that would be securitized, the

manner in which this would be accomplished,

and other matters bearing on risk.

In a subsequent order, six BHCs applied for

and received the Board’s conditional approval

(1987 FRB 731) for the activity, but the Board

stayed its order for the same period of time

applicable to the stay issued by the Second

Circuit Court of Appeals (see footnote 2 and

section 3600.21.3). After approving the order

set out in 1987 FRB 731, the Board approved

several other orders that rely on this order and

the limitations imposed therein. (See the follow-

ing Board orders: 1987 FRB 607, 616, 618, 620,

622, 731, 738, 742, 928; 1988 FRB 133, 500,

699, 700, 706, 819; 1989 FRB 33, 190, 396,

398, 520, 645, 647; 1990 FRB 79, 158, 256,

461, 554, 568, 573, 652, 682, 756; 1991 FRB

954; 1992 FRB 338; 1993 FRB 141, 716; and

1994 FRB 249, 346.)

The major difference between the three

applications decided on April 30, 1987, and

the two applications previously approved by

the Board (1987 FRB 138 and 367) is that the

underwriting would take place in an afﬁliate

engaged in underwriting and dealing in U.S.

government securities. This arrangement raised

the major legal question of whether these gov-

ernment securities could serve as a basis for

measuring the principal activity of the afﬁliate.

In its approval, the Board took into account the

fact that the Glass-Steagall Act speciﬁcally

2. The U.S. Court of Appeals for the Second Circuit upheld

the Board’s determination that the underwriting subsidiaries

would not be engaged principally in ineligible securities

underwriting and dealing under the above revenue limitation;

the U.S. Supreme Court declined to review that decision

(Securities Industry Association v. Board of Governors of the

Federal Reserve System, 839 F.2d 47 (2d Cir. 1988), cert.

denied, 108 S.Ct. 697 (1988)). The Supreme Court also let

stand the lower court’s determination that the 5 percent mar-

ket share limitation was not adequately supported by the facts

of record, thus sustaining elimination of the market share test

that had been invalidated by the U.S. Court of Appeals.

Accordingly, the Board decided not to impose a market share

limitation on orders approved on August 4 and 8, 1988.

3. The Board in this order also modiﬁed its section 20

orders to permit underwriting and dealing in securities of

afﬁliates if the securities are rated by a nonafﬁliated, nation-

ally recognized rating organization or are issued or guaranteed

by the Federal National Mortgage Association, the Federal

Home Loan Mortgage Corporation, or the Government

National Mortgage Corporation, or represent interests in such

obligations.

Permissible Activities by Board Order (Underwriting and Dealing) 3600.21

BHC Supervision Manual July 2008

Page 2

allows member banks to underwrite U.S. gov-

ernment securities and that the act intends afﬁli-

ates to have a broader scope for underwriting

than member banks. On that basis, the Board

had previously allowed afﬁliates of member

banks to engage in underwriting of U.S. govern-

ment securities.

3600.21.3 ENGAGE IN LIMITED

UNDERWRITING AND DEALING IN

CONSUMER-RECEIVABLE-RELATED

SECURITIES

Six bank holding companies applied for the

Board’s approval to engage in limited under-

writing and dealing in consumer-receivable-

related securities (CRRs). CRRs, which were

ﬁrst issued in 1985, consist of debt obligations

that are secured by or represent an interest in a

diversiﬁed pool of loans to or receivables from

consumers, such as loans to individuals to ﬁnance

the purchase of automobiles or personal credit

card accounts.

The Board concluded that underwriting and

dealing in CRRs is an activity closely related to

banking on the basis that banks provide services

that are operationally and functionally so similar

to the services proposed that banking organiza-

tions are particularly well equipped to provide

them. In accordance with section 16 of the

Glass-Steagall Act, banks underwrite and deal

in certain mortgage-related securities that are

issued or guaranteed by the United States or by

U.S. government agencies. Some of the securi-

ties represent interests in pools of mortgage

loans for residential housing purposes made by

banks and other ﬁnancial institutions. Such

securities are very similar to CRRs.

Both CRRs and bank-eligible mortgage-

related securities represent interests in pools of

loans made by ﬁnancial institutions to individu-

als to ﬁnance the purchase of housing or con-

sumer goods and services.

The techniques involved in underwriting and

dealing in bank-eligible mortgage-related secu-

rities are also very similar to those that would be

involved in conducting the approved activity

with respect to CRRs. In each case, the under-

writer must perform substantially identical func-

tions of evaluating prepayment risk, analyzing

credit and cash ﬂow from a pool of numerous

individuals’ loans, negotiating or bidding, and

distributing and dealing.

In addition, banks now directly perform some

of the functions involved in the approved

activity. Banks select the consumer loans that

form the pool of interests that are then sold to

investors. Banks also advise issuers of CRRs

and assist issuers in privately placing these

securities.

Because of the similarity between securities

involved in CRRs and the previously approved

bank-ineligible one- to four-family mortgage-

related securities nonbanking activities set forth

in a previous order (1987 FRB 473), the Board

required that this activity be conducted in accor-

dance with the same requirements established in

that order. This includes a requirement that the

securities be rated for investment quality by a

nationally recognized agency.

The Board concluded, based on the reasons

set forth in its previous order (1987 FRB 473),

that the approved activity would not result in a

violation of the former section 20 of the Glass-

Steagall Act and is closely related and a proper

incident to banking. The Board’s approval of

these applications is restricted to underwriting

and dealing to a limited extent in securities

representing an interest in or backed by a diver-

siﬁed pool of loans to or receivables from indi-

viduals for the purchase of consumer goods and

services, and the limitations of section

225.25(b)(16) of Regulation Y (1987 FRB 731).

3600.21.4 LIMITED UNDERWRITING

AND DEALING IN DEBT AND

EQUITY SECURITIES

Five bank holding companies applied for the

Board’s approval under section 4(c)(8) of the

BHC Act for their wholly owned subsidiaries to

underwrite and deal in, on a limited basis—

1. debt securities, including, without limitation,

sovereign debt securities, corporate debt, debt

securities convertible into equity securities,

and securities issued by a trust or other vehi-

cle secured by or representing interests in

debt obligations; and

2. equity securities, including, without limita-

tion, common stock, preferred stock, Ameri-

can Depositary Receipts, and other direct and

indirect equity ownership interests in corpo-

rations and other entities.

Section 16 of the Banking Act of 1933

(the Glass-Steagall Act) prohibits a member

bank from underwriting and dealing in these

securities (referred to hereafter as ‘‘bank-

ineligible securities’’). However, as far as the

Glass-Steagall Act is concerned, an afﬁliate of a

Permissible Activities by Board Order (Underwriting and Dealing) 3600.21

BHC Supervision Manual July 2008

Page 3

member bank may underwrite and deal in

bank-ineligible securities so long as it is not

engaged principally or substantially in that

activity (12 U.S.C. 377).

The applicants had previously received Board

approval to underwrite and deal in U.S. govern-

ment and agency securities and state and

municipal securities that state member banks are

speciﬁcally authorized to deal in under section

16 of the Glass-Steagall Act (referred to hereaf-

ter as ‘‘bank-eligible securities’’). The Board

had also authorized the subsidiaries to under-

write and deal in commercial paper, one- to

four-family mortgage-backed securities, munici-

pal revenue bonds, and consumer-receivable-

related securities—all securities that member

banks may not underwrite or deal in under sec-

tion 16 of the Glass-Steagall Act.

To ensure that the subsidiaries would not be

principally or substantially engaged in under-

writing or dealing in the ineligible securities in

violation of the former section 20 of the Glass-

Steagall Act, the Board’s approval was made

subject to the requirement that gross revenues

from those ineligible securities activities would

not exceed 5 percent of the subsidiary’s total

gross revenues on average (moving average)

over any two-year period. (See 1989 FRB 192

and 196–197.) The Board increased this level to

10 percent on September 5, 1989.

The subsidiaries are also subject to a frame-

work of structural and operating limitations

established to avoid the potential for conﬂicts of

interest, unsound banking practices, unfair com-

petition, loss of public conﬁdence in afﬁliate

banks, and other adverse effects from the con-

duct of the bank-ineligible securities underwrit-

ing and dealing activity.

The Board recognized that underwriting and

dealing in securities is a natural extension of

activities currently conducted by banks, involv-

ing manageable risks and potential conﬂicts of

interest when conducted in an organizational

structure that insulates these activities from

banking activities supported by the federal safety

net of deposit insurance and access to Federal

Reserve lending. The Board has acknowledged

that certain bank holding companies have an

existing expertise in securities underwriting,

dealing, brokerage, investment advisory activi-

ties, and broad ﬁnancial skills that make them

well equipped to provide the new services.

The Board’s approval of each application is

subject to the conditions stated in previous

orders (see 1989 FRB 192; 1990 FRB 158, 455,

573, 652, 683, 756; 1991 FRB 672; 1993 FRB

133, 719; and 1994 FRB 249, 449). The condi-

tions consist of structural and operating limita-

tions designed to avoid conﬂicts of interest and

potential adverse effects, and other conditions

designed to ensure safe and sound operations.

The conditions include requirements, limita-

tions, and prohibitions with regard to—

1. capital adequacy;

2. credit extensions to customers of the under-

writing subsidiary;

3. maintaining the separateness of an under-

writing afﬁliate’s activity;

4. disclosures by the underwriting subsidiary;

5. marketing activities on behalf of an under-

writing subsidiary;

6. investment advice by bank or thrift

afﬁliates;

7. extensions of credit to the underwriting sub-

sidiary and to purchasers or issuers of ineli-

gible securities (or to major users of projects

funded by industrial revenue bonds);

8. transfers of information;

9. reporting and recordkeeping requirements;

10. transfer of activities and formation of sub-

sidiaries of an underwriting subsidiary to

engage in underwriting and dealing; and

11. reciprocal arrangements and prohibitions

against discriminatory treatment regarding

unafﬁliated securities ﬁrms.

3600.21.5 ACTING AS A

DEALER–MANAGER IN

CONNECTION WITH CASH-TENDER

AND EXCHANGE-OFFER

TRANSACTIONS

In connection with a bank holding company

application to underwrite and deal in, to a lim-

ited extent, all types of equity securities through

its section 20 nonbanking subsidiary, an appli-

cant also proposed to act as a dealer–manager in

connection with cash-tender and exchange-offer

transactions. Dealer–managers generally act as

agent for tender or exchange offerors in arrang-

ing or facilitating mergers, acquisitions, and

other corporate transactions. All-cash tender

offers do not, of themselves, involve the issu-

ance, public sale, or distribution of securities.

The Board thus concluded that all revenues

4. See the following Board orders: 1987 FRB 473, 607,

616, 618, 620, 622, 731, 738, 742, 928; 1988 FRB 133, 500,

699, 706, 819; 1989 FRB 33, 190, 396, 398, 520, 645, 647;

1990 FRB 79, 158, 256, 461, 554, 568, 573, 652, 682, 756;

1991 FRB 672; 1993 FRB 133, 719; and 1994 FRB 249, 449.

Permissible Activities by Board Order (Underwriting and Dealing) 3600.21

BHC Supervision Manual July 2008

Page 4

derived from the section 20 company acting as a

dealer–manager in connection with such tender

offers may be treated as bank-eligible revenues

for purposes of determining compliance with

the Board’s 10 percent revenue limitation

(changed to 25 percent, effective March 6, 1997)

on bank-ineligible securities activities. The Board

approved the application on November 24, 1993

(see 1994 FRB 49, footnote 5).

3600.21.6 UNDERWRITING

‘‘PRIVATE OWNERSHIP’’

INDUSTRIAL DEVELOPMENT

BONDS

A bank holding company (the notiﬁcant) pro-

vided notice under section 4(c)(8) of the Bank

Holding Company Act (BHC Act) (12 U.S.C.

1843(c)(8)) and section 225.23 of the Board’s

Regulation Y (12 C.F.R. 225.23) of its proposal

to engage de novo through its section 20 subsid-

iary (the company) in underwriting, to a limited

extent, certain ‘‘private ownership’’ industrial

development bonds. The bonds are issued for

the provision of the following governmental

services: water facilities, sewer facilities, solid

waste disposal facilities, electric energy and gas

facilities, and local district heating or cooling

facilities (collectively, traditional governmental

services). The notiﬁcant controls one bank

subsidiary.

The company is currently engaged in limited

underwriting and dealing in certain municipal

revenue bonds, activities permissible under sec-

tion 20 of the Glass-Steagall Act (12 U.S.C.

377).

The company is a broker–dealer regis-

tered with the Securities and Exchange Com-

mission (SEC) under the Securities Exchange

Act of 1934 (15 U.S.C. 78a et seq.) and is a

member of the Financial Industry Regulatory

Authority (FINRA). Thus, the company is sub-

ject to the recordkeeping and reporting obliga-

tions, ﬁduciary standards, and other require-

ments of the Securities Exchange Act of 1934,

the SEC, and the FINRA. The notiﬁcant engages

directly and through subsidiaries in other per-

missible nonbanking activities.

The Board previously determined that the

activities of underwriting and dealing in munici-

pal revenue bonds, including industrial develop-

ment bonds, are so closely related to banking as

to be proper incidents thereto within the mean-

ing of section 4(c)(8) of the BHC Act.

Certain

bank holding companies previously requested

approval to underwrite and deal in only munici-

pal revenue bonds, as opposed to a full range of

debt securities. Their requests were limited to

underwriting and dealing in industrial develop-

ment bonds that are ‘‘public ownership’’ indus-

trial development bonds. Public ownership indus-

trial development bonds are those ‘‘tax-exempt

bonds where the issuer, or the governmental

unit on behalf of which the bonds are issued, is

the sole owner for federal income tax purposes

of the ﬁnanced facility.’’

The notiﬁcant plans to engage through the

company in underwriting private ownership

industrial development bonds issued solely for

the provision of traditional governmental ser-

vices. It committed to conduct this activity sub-

ject to the same limitations and other conditions

that govern underwriting and dealing in public

ownership industrial development bonds.

The underwriting risk and the risk analysis

required to underwrite private ownership indus-

trial development bonds issued for traditional

governmental services is essentially the same as

the risk and analysis related to underwriting

traditional public ownership bonds. For each,

the funds for the repayment of the bonds are

derived from revenue generated by the ﬁnanced

facility, including revenue resulting from a ser-

vice contract between the owner/lessor of the

ﬁnanced facility and a state or local government

or political subdivision, pursuant to which the

state or local government or political subdivi-

sion agrees to purchase the output of the facil-

ity.

The notiﬁcant committed that all the pri-

5. See 1993 FRB 716.

6. Citicorp, J.P. Morgan & Co. Incorporated, and Bankers

Trust New York Corporation, 1987 FRB 473, aff’d sub nom.

Securities Industry Ass’n v. Board of Governors of the Fed-

eral Reserve System, 839 F.2d 47 (2d Cir.), cert. denied, 486

U.S. 1059 (1988), as modiﬁed by order approving modiﬁca-

tions to section 20 orders, 1989 FRB 751 (‘‘Citicorp/Morgan/

Bankers Trust’’). See also J.P. Morgan & Co. Incorporated, et

al., 1989 FRB 192, aff’d sub nom. Securities Industry Ass’n v.

Board of Governors of the Federal Reserve System, 900 F.2d

360 (D.C. Cir. 1990).

7. See 1987 FRB 502. Examples of ﬁnanced facilities

include airports and mass-commuting facilities.

8. Citicorp/Morgan/Bankers Trust. All the bonds that the

notiﬁcant proposed that the company underwrite would qualify

as ‘‘exempt facility bonds’’ under the Internal Revenue Code

(the code). See 26 U.S.C. 142. The types of exempt facility

bonds that the company would underwrite may, subject to

certain volume caps and other limitations, be tax-exempt

under the code even if the proceeds of the bonds are used to

ﬁnance facilities that are privately owned. See 26 U.S.C. 103,

141, 142, 146, and 147.

9. Typically, in the case of public ownership bonds, the

governmental unit that issues the bonds owns the ﬁnanced

facility and repays the bonds from the revenue generated by

the facility and this service contract. The governmental unit

Permissible Activities by Board Order (Underwriting and Dealing) 3600.21

BHC Supervision Manual July 2008

Page 5

vate ownership bonds that the company would

underwrite would be rated ‘‘investment quality’’

by a nationally recognized rating agency to the

same extent as are the municipal revenue bonds

that the company currently underwrites.

Considering these circumstances, the Board

concluded that underwriting and dealing in pri-

vate ownership bonds issued for the provision

of traditional governmental services is a permis-

sible activity if conducted subject to the condi-

tions and prudential limitations set forth in

Citicorp/Morgan/Bankers Trust (1987 FRB 473

and 1989 FRB 751 (Modiﬁcation Order)) and

agreed to in 1993 FRB 716. The notiﬁcation

was approved on October 24, 1995 (see 1995

FRB 1116).

may also enter into a contract with a third party to operate the

ﬁnanced facility. In the case of the private ownership bonds

that the notiﬁcant plans to underwrite, the governmental unit

that issues the bonds either uses the proceeds of the bonds to

acquire or construct a facility, which the governmental unit

then leases to a third party, or lends the proceeds of the bonds

to a third party to acquire or construct the facility. The third

party agrees to make lease payments or loan repayments to

the governmental unit that enable the governmental unit to

pay debt service on the bonds. As security for the lease or

loan agreement, the third party assigns and pledges the rev-

enues generated by the facility and a service contract with a

state or local government or political subdivision.

Permissible Activities by Board Order (Underwriting and Dealing) 3600.21

BHC Supervision Manual July 2008

Page 6

Permissible Activities by Board Order (Issuance & Sale of Mortgage-

Backed Securities Guaranteed by GNMA)

Section 3600.23

A foreign bank subject to the Bank Holding

Company Act applied for the Board’s approval

to engage in various nonbanking activities, one

being to purchase mortgage loans and to issue

securities for its own account, through a wholly

owned subsidiary or third party servicers, and to

sell securities guaranteed by the Government

National Mortgage Association (GNMA).

Because National Banks are speciﬁcally autho-

rized under the Glass–Steagall Act (12 U.S.C.

24) to issue and sell securities guaranteed by

GNMA, as well as to underwrite and deal in

such securities, the Board concluded that the

issuance and sale of GNMA securities is closely

related to banking (1988 FRB 573). In addition,

the Board determined that the statutory exemp-

tion reﬂects a Congressional determination that

GNMA securities are not the type of securities

that would lead to unsound speculation or that

the public interest in the issuance and sale of

GNMA securities by banks outweighs any

potential harm resulting therefrom. Also, the

Board previously determined that underwriting

and dealing in GNMA certiﬁcates is of sufﬁ-

ciently low risk to be generally permissible

activities for bank holding companies (12 C.F.R.

225.25(b)(16)).

BHC Supervision Manual December 1992

Page 1

Permissible Activities by Board Order (Sales Tax Refund Agent

and Cashing U.S. Dollar Payroll Checks) Section 3600.24

A foreign bank, subject to Section 4 of the BHC

Act, applied for the Board’spermission to acquire,

through its wholly owned subsidiary, all the

shares of a company located in New York, New

York. The acquired company would engage in

several nonbanking activities. Two of the activi-

ties, not previously approved by the Board for

BHCs, consisted of acting as a sales tax refund

agent for the State of Louisiana and Cashing

U.S. Dollar Payroll Checks Drawn on Unafﬁli-

ated Banks. Both activities were found to be

closely related to banking subject to the facts

and conditions found in the Board order and

brieﬂy discussed below. The application was

approved on August 15, 1990 (1990 FRB 860).

3600.24.1 ACTING AS A SALES TAX

REFUND AGENT FOR THE STATE OF

LOUISIANA

The company being acquired serves as the State’s

exclusive sales tax refund agent for its tax-free

shopping program for foreign visitors. Under

theprogram, foreignvisitors presentsalesinvoices

evidencing sales taxes paid in Louisiana to the

company’s ofﬁce in the state. It refunds the tax

in U.S. dollars to the visitor, less a handling fee.

A portion of the handling fee is then remitted to

the State and local tax authorities refund to the

company the amount of tax refunds advanced.

The Board found the activity to be closely

related to banking since banks: (1) routinely

forward to taxing authorities tax receipts deliv-

ered to the bank on taxes due; (2) commonly act

as ﬁscal agent for government authorities which

involves disbursing funds on behalf of state and

local governments.

3600.24.2 CASHING U.S. DOLLAR

PAYROLL CHECKS DRAWN ON

UNAFFILIATED BANKS

The company being acquired also cashes, and

the Applicant plans to continue cashing, U.S.

dollar payroll checks on a limited basis, pri-

marily to accommodate employees in airport

facilities that lack banking services, but where

the company maintains ofﬁces. Since check

cashing is a fundamental banking activity per-

formed routinely by banks, and the company

being acquired proposed to cash only checks

drawn on unafﬁliated banks, the Board found

the activity to be closely related to banking. The

Board stipulated, however, that the Applicant

was not to use the acquired company’s ofﬁces as

branches of the Applicant or any afﬁliated bank.

BHC Supervision Manual December 1992

Page 1

Permissible Activities by Board Order

(Providing Government Services) Section 3600.25

A bank holding company (the notiﬁcant)

requested the Board’s approval, under section

4(c)(8) of the BHC Act and section 225.24(a) of

Regulation Y, to acquire through its wholly

owned subsidiary a cash-express company, cer-

tain assets of an exchange company, and another

ﬁrm to engage in various nonbanking activities.

Many of the nonbanking activities had previ-

ously been determined by the Board to be closely

related to banking in Regulation Y, by order, or

by interpretation. In addition to those nonbank-

ing activities already approved, the notiﬁcant

requested the Board’s approval to engage in

providing various governmental service activi-

ties at the ofﬁces of the cash-express company:

1. postage stamps and postage-paid envelopes

2. vehicle registration services, including the

sale, distribution, and renewal of license

plates and license tags for motor vehicles

3. public-transportation tickets and tokens

4. notary public services

The Board noted that banks are permitted to

provide customer access to the type of govern-

ment services involved in the proposal, whereby

the banks may be acting in an agency capacity

or accomplishing the distribution of some of the

services using automated teller machines

(ATMs).

The Board thus concluded that the

proposed nonbank activities are closely related

to banking. Based on all the facts and commit-

ments provided by the notiﬁcant, and the repre-

sentations and conditions relied upon in reach-

ing a decision, the Board approved the proposal

on April 2, 1998 (1998 FRB 481).

1. See 12 C.F.R. 7.1010 and OCC Interpretive Letter No.

718 (March 14, 1996) (postage stamps, acting as an agent for

the state in selling and renewing license plates and license

tags, and public-transportation tickets from ATMs). See also

OCC Conditional Approval Letter No. 267 (January 12,

1988)(notary services).

BHC Supervision Manual June 2000

Page 1

Permissible Activities by Board Order (Real Estate Settlement

Through a Permissible Title Insurance Agency)

Section 3600.26

A BHC Applicant requested the Board’s permis-

sion under section 4(c)(8) of the BHC Act to

acquire all the outstanding shares of a company

engaged in title insurance agency and real estate

settlement activities. The Board previously

determined that title insurance agency activities

are permissible under section 4(c)(8)(G) of

the BHC Act, for which the BHC Applicant

qualiﬁes.

The real estate settlement services consist of:

(1) reviewing the status of the title in the title

commitment, resolving any exceptions to the

title, and reviewing the purchase agreement to

identify any requirement in it in order to ensure

compliance with them; (2) verifying payoffs on

existing loans secured by the real estate and

verifying the amount of and then calculating the

pro rating of special assessments and taxes on

the property; (3) obtaining an updated title

insurance commitment to the date of closing,

preparing the required checks, deeds, afﬁdavits,

and obtaining any authorization letters needed;

(4) establishing a time and place for the closing,

conducting the closing, and ensuring that all

parties properly execute all appropriate docu-

ments and meet all commitments; (5) collecting

and disbursing funds for the parties, holding

funds in escrow pending satisfaction of certain

commitments, preparing the HUD settlement

statement, the deed of trust, mortgage notes, the

Truth-in-Lending statement, and purchaser’s

afﬁdavits; and (6) recording all of the docu-

ments required under law.

In reviewing the proposed activity, the Board

noted that real estate settlement services are

provided by the Applicant’s bank subsidiaries in

connection with their origination of mortgage

loans, and banks within the Applicant’s state are

generally permitted to conduct real estate settle-

ment activities. It was further noted that banks

routinely prepare collateral security agreements

and other documentation required to close loans

in accordance with federal and state lending

requirements as part of the general lending

activities authorized under the Board’s Regula-

tion Y.

The Board concluded that aspects of the pro-

posed real estate settlement activities are directly

linked to permissible title insurance agency ac-

tivities by BHCs. These activities can directly

affect the insured risks under a title insurance

policy. Title insurance agents have special expe-

rience in assessing potential title defects that

can arise in real estate settlement. Title insur-

ance agents thus have the expertise to generally

engage in real estate settlements.

For these reasons, the proposed real estate

settlement activities conducted through a per-

missible title insurance agency, were deemed by

the Board to be closely related to banking for

purposes of section 4(c)(8) of the BHC Act. The

Board approved the application by order on

October 15, 1990 (1990 FRB 1058).

BHC Supervision Manual December 1992

Page 1

Providing Administrative and Certain

Other Services to Mutual Funds Section 3600.27

A bank holding company (the applicant) applied

under sections 3(a)(3) and 4(c)(8) of the BHC

Act to acquire another company (the company),

thereby indirectly acquiring its subsidiary (the

subcompany) as well as the subsidiary bank and

nonbank companies of the company and the

subcompany. Upon consummation of the trans-

action, the company and subcompany would be

subject to the provisions of the BHC Act. Both

companies applied for permission under section

3(a)(1) of the BHC Act to become a bank hold-

ing company.

The applicant also applied for the Board’s

permission to engage, through one subsidiary of

the subcompany (the adviser), in providing

administrative and certainotherservicesto mutual

funds, nonbanking activities that the Board has

not previously considered under section 4(c)(8)

of the BHC Act. The applicant also applied for

the Board’s permission to acquire certain other

nonbanking subsidiaries of the company (as

listed in appendix B of the order) to engage in

making or servicing loans, providing trust ser-

vices, and providing investment advisory non-

bankingservicespursuant to section225.28(b)(1),

(b)(5), and (b)(6) of Regulation Y.

In addition, the applicant provided notice of

its intent to indirectly acquire a foreign trust

company, a trust administration company, and

an advisory company. The companies engage in

activities that are permissible under section

211.10 of Regulation K.

3600.27.1 GLASS-STEAGALL ACT

ISSUES IN PROVIDING

ADMINISTRATIVE SERVICES

The administrative services the applicant pro-

posed to provide through the adviser and its

afﬁliates raised a number of issues under the

Glass-Steagall Act. Under that act, a company

that owns a member bank may not control

‘‘through stock ownership or in any other man-

ner’’ a company that engages principally in dis-

tributing, underwriting, or issuing securities.

Because mutual funds continuously issue and

redeem securities, the Board in 1972 issued an

interpretation setting out its position on the

Glass-Steagall Act as it governs the relationship

between mutual funds and companies that own

member banks (12 C.F.R. 225.125). The Board

found that the Glass-Steagall Act prohibits

afﬁliates of banks from sponsoring, organizing,

or controlling mutual funds or distributing their

shares.

The Board also found, however, that the Glass-

Steagall Act does not prohibit all relationships

between a bank holding company and a mutual

fund and that it is permissible, under the BHC

Act and the Glass-Steagall Act, for bank hold-

ing companies to provide investment advice to

mutual funds. Also, the Board found that the

Glass-Steagall Act does not prohibit bank hold-

ing companies from providing certain other ser-

vices to mutual funds, such as acting as custo-

dian, transfer agent, or registrar.

Banks and

afﬁliates of banks may serve as investment ad-

viser, transfer agent, custodian, and registrar.

They may not act as distributor to the fund. The

application raised the question whether it was

consistent with the Glass-Steagall Act for an

afﬁliate of a member bank to act as an adminis-

trator to a mutual fund.

3600.27.2 PERMISSIBILITY OF

PROPOSED ADMINISTRATIVE-

SERVICES ACTIVITIES

The adviser furnishes a variety of services to

open-end investment companies (mutual funds)

and closed-end investment companies in the

United States. Because certain of the activities

of the adviser and its afﬁliates are prohibited by

the Glass-Steagall Act, the applicant has taken

steps and has committed to terminate the

1. The Board imposed a number of restrictions on the

relationship between bank holding companies and mutual

funds to avoid conﬂicts of interest and to address potential

safety-and-soundness concerns. The Board’s rule includes

restrictions preventing a bank holding company or any of its

subsidiaries from—

• acting as investment adviser to any investment company

that has a name similar to the holding company or any of its

subsidiary banks;

• purchasing for its own account shares of any investment

company for which the holding company serves as invest-

ment adviser;

• purchasing in its sole discretion in a ﬁduciary capacity

shares of an investment company advised by the holding

company; or

• extending credit to an investment company advised by the

holding company as collateral for a loan used to purchase

shares of the investment company.

In addition, the rule requires that, in cases in which a cus-

tomer purchases or sells securities of the fund through the

holding company or is advised by the holding company to

purchase shares of the fund, the customer be informed in

writing of the holding company’s involvement with the fund,

and be informed that the shares of the fund are not federally

insured and are not guaranteed by, or obligations of, a bank.

BHC Supervision Manual June 2002

Page 1

adviser’s role as a sponsor of new mutual funds.

The applicant also committed that it would not

acquire those of the adviser’s subsidiaries that

engaged in the distribution of mutual fund

shares. The applicant further committed that it

would not be involved in the distribution of the

shares of any mutual fund. The applicant repre-

sented to the Board, that, after the acquisition of

the company, neither the adviser nor any of its

afﬁliates would be obligated by any agreement

to engage in any sales activities in connection

with any mutual fund’s shares and would not

enter into any distribution agreement with any

mutual fund, unless permitted to do so by a

change in current law.

The adviser will not—

1. engage in the development of marketing

plans except to give advice to the distributor

regarding regulatory compliance;

2. engage in advertising activities with respect

to the funds and will not be involved in the

preparation of a fund’s sales literature, except

to review it for the sole purpose of ensuring

compliance with pertinent regulatory

requirements; or

3. permit employees of the adviser to engage

in sales activities at meetings or seminars

(such activities would be conducted solely

by the fund’s distributor).

It was noted that the applicant did not propose

providing administrative services to those mutual

funds that are marketed and sold primarily to

customers of any of the applicant’s subsidiary

banks.

The Board believes that it is permissible

under the Glass-Steagall Act for the applicant to

provide the following administrative services to

mutual funds as proposed:

1. maintaining and preserving the records of

the fund, including ﬁnancial and corporate

records

2. computing the fund’s net asset value, divi-

dends, and performance data and ﬁnancial

information regarding the fund

3. furnishing statistical and research data

4. preparing and ﬁling with the Securities and

Exchange Commission (SEC) and state

securities regulators registration statements,

notices, reports, and other material required

to be ﬁled under applicable laws

5. preparing reports and other informational

materials regarding the fund, including prox-

ies and other shareholder communications,

and reviewing prospectuses

6. providing legal and regulatory advice to the

fund in connection with its other adminis-

trative functions

7. providing ofﬁce facilities and clerical sup-

port for the fund

8. developing and implementing procedures

for monitoring compliance with regulatory

requirements and compliance with the fund’s

investment objectives, policies, and restric-

tions as established by the fund’s board

9. providing routine fund accounting services

and liaison with outside auditors

10. preparing and ﬁling tax returns

11. reviewing and arranging for payment of

fund expenses

12. providing communication and coordination

services with regard to the fund’s invest-

ment adviser, transfer agent, custodian, dis-

tributor, and other service organizations that

render recordkeeping or shareholder com-

munication services

13. reviewing and providing advice to the dis-

tributor, fund, and investment adviser

regardingsales literature and marketing plans

to ensure regulatory compliance

14. providing the distributor’s personnel

with information about fund performance

and administration

15. participating in seminars, meetings, and con-

ferences designed to present information to

brokers and investment companies, but not

in connection with the sale of shares of the

funds to the public, concerning the opera-

tion of the funds, including administrative

services provided by the bank holding com-

pany to the funds

16. assisting existing funds in the development

of additional portfolios

17. providing reports to the fund’s board

regarding fund activities

A mutual fund administrator provides ser-

vices that are essentially ministerial or clerical.

The administrator does not have policymaking

authority or control over the mutual fund. The

policymaking functions rest with the board of

directors of the mutual fund. The board of direc-

tors is responsible for the selection and review

of the major contractors to the fund, including

the investment adviser and, in certain circum-

stances, the administrator.

The Investment Company Act of 1940

requires that at least 40 percent of the board of

directors of a mutual fund be disinterested per-

sons who are not afﬁliated with the investment

adviser, with any person that the SEC has deter-

Providing Administrative and Certain Other Services to Mutual Funds 3600.27

BHC Supervision Manual June 2002

Page 2

mined to have a material business or profes-

sional relationship with the fund, with any

employee or ofﬁcer of the fund, with any regis-

tered broker or dealer, or with any other inter-

ested or afﬁliated person. These unafﬁliated

board members must approve the fund’s con-

tracts with its investment adviser, underwriter,

and often its administrator. The applicant com-

mitted that the adviser will provide administra-

tive services only to mutual funds whose board

of directors consists of a majority of disinter-

ested persons.

In situations in which the applicant’s subsidi-

aries serve as administrator to the mutual fund,

the Board permitted one representative of the

administrator to serve as a director of the fund.

The applicant contended that such an interlock-

ing director would facilitate the provision of

administrative services by providing the fund

with a person knowledgeable in the operation of

the fund who would be in a position to advise

the board of directors on administration.

The applicant proposed that a director inter-

lock would be used only in situations in which a

company unafﬁliated with it serves as the invest-

ment adviser to the mutual fund. With regard to

the adviser’s serving as an administrator, this

interlocking director would be deemed an inter-

ested person and would be excluded from those

actions that must be taken by disinterested board

members, such as the approval of an investment

advisory contract or a contract for the adminis-

trator. The applicant committed that the adviser

would serve as administrator only to mutual

funds for which a majority of the board of

directors are disinterested individuals. The Board

believed that, in this proposed arrangement, the

applicant would not control a mutual fund if one

employee of the adviser or an afﬁliate

would

serve as a director of a mutual fund to which the

advisor provides administrative services.

The applicant plans, in a small number of

cases, to provide mutual funds with a combina-

tion of administrative, investment advisory, and

other services. The OCC has permitted national

banks that serve as investment adviser to mutual

funds also to provide some administrative ser-

vices to those mutual funds. In addition, a num-

ber of national banks have been providing these

and other services as ‘‘subadministrator’’ to

mutual funds that are advised by the bank or an

afﬁliate.

In the Board’s opinion, permitting a bank

holding company thatservesasinvestment adviser

to a mutual fund and also in essence provides

ministerial or supporting functions as

administrator to that fund would not signiﬁ-

cantly increase the bank holding company’s

ability to control the mutual fund. In other

words, the adviser would not, by virtue of

becoming an administrator to a fund that it or an

afﬁliate advises, become involved in policy-

making functions of these funds to a greater

extent than when it provides solely investment

advisory services. The Board believes that con-

trol would continue to rest with the board of

directors of the mutual fund.

With regard to providing a combination of

advisory and administrative services, the appli-

cant further committed that it would not have

any director or ofﬁcer interlocks with these

mutual funds. It would also not have any direc-

tor or ofﬁcer interlocks with mutual funds to

which it provides both advisory and administra-

tive services.

In providing the combination of services, the

applicant would be subject to the Board’s inter-

pretation on investment advisory activities

(12 C.F.R. 225.125) and would therefore be

required to conform the adviser’s activities to

the interpretation within two years. On this con-

dition, and subject to the commitments made by

the applicant, the Board concluded that the pro-

posal was permissible under the Glass-Steagall

Act.

3600.27.3 BOARD’S CONCLUSION

ON PROVIDING ADMINISTRATIVE

SERVICES

The Board found the applicant’s proposed

activities to be closely related to banking because

(1) it had previously determined by regulation

that a bank holding company could act as invest-

ment adviser to a mutual fund; (2) national

banks, including national bank trust depart-

ments, provide administrative services to mutual

funds; and (3) it had also permitted bank hold-

ing companies to provide certain individual

ﬁnancial data processing services (calculation of

investment values and tax consulting) by a

mutual fund administrator. The Board thus

approved the application on April 21, 1993

(1993 FRB 626), based on the facts of record

and all of the commitments and representations

made by the applicant, and subject to the terms

and conditions set forth in the order.

2. This director cannot serve as an ofﬁcer, director, or

employee of the applicant, its bank, or any subsidiary bank or

bank holding company of the applicant.

Providing Administrative and Certain Other Services to Mutual Funds 3600.27

BHC Supervision Manual June 2002

Page 3

Developing Broader Marketing Plans and Advertising

and Sales Literature for Mutual Funds Section 3600.28

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2008, this section has been revised

to incorporate a name change to the Financial

Industry Regulatory Authority, or FINRA (for-

merly, the National Association of Securities

Dealers, or NASD).

A foreign banking organization (FBO), subject

to the provisions of the Bank Holding Company

Act, had requested the Board’s approval to

acquire, through a wholly owned subsidiary (the

company), substantially all the assets of an

asset-management partnership (the partnership).

The company would be an investment adviser

registered with the Securities and Exchange

Commission (SEC) under the Investment Com-

pany Act of 1940. The company’s acquisition of

the partnership would also include a member-

ship interest in a services ﬁrm that would pro-

vide transfer-agency services to mutual funds

advised by the company (the funds).

The FBO, among other things, proposed to

provide marketing support to a mutual fund by

directly contacting broker-dealers, 401(k) plan

providers, ﬁnancial planners, insurance compa-

nies, and other ﬁnancial intermediaries to rec-

ommend the funds. It would be primarily

responsible for the development of marketing

plans and the preparation of advertising and

sales literature materials for the funds. The

Board had not previously considered whether a

bank holding company could provide promo-

tional or marketing services to the extent that

was proposed.

3600.28.1 CONTROL

CONSIDERATIONS INVOLVING

PROMOTIONAL AND MARKETING

ACTIVITIES

Under the Glass-Steagall Act, a company that

owns a member bank may not own or control

‘‘through stock ownership or in any other man-

ner’’ a company that engages principally in dis-

tributing, underwriting, or issuing securities.

The Board has found that this provision prohib-

its afﬁliates of banks from sponsoring, organiz-

ing, or controlling a mutual fund. The Board

previously has determined, however, that the

Glass-Steagall Act does not prohibit a bank

holding company from providing advisory and

administrative services to a mutual fund.

The proposed promotional and marketing

activities would not, it was believed, cause the

FBO to control the funds or to be involved in

the underwriting and distribution of the funds’

securities to the public. The proposed promo-

tional activities involved contact only with ﬁnan-

cial intermediaries. The activities are similar to

the activities previously approved by the Board.

The Board had previously permitted bank hold-

ing companies to present information about the

operations of the mutual funds advised and

administered by the bank holding company at

meetings or seminars for brokers of mutual

funds.

In addition, the Ofﬁce of the Comptrol-

ler of the Currency (OCC) had also authorized

subsidiaries of national banks to provide mar-

keting and advertising support to mutual funds

in connection with their brokerage and advisory

services.

As for the distribution and sales of the funds,

it was proposed that an independent distributor

be given that responsibility.

The independent

distributor would serve as the principal under-

writer of the funds and would enter into sales

agreements with ﬁnancial intermediaries to sell

shares of the funds on their behalf.

Actual sales

would be conducted by the independent dis-

tributor or by an independent broker–dealer for

the funds.

The FBO did not propose to solicit retail

customers to purchase shares in particular funds,

to accept orders for the purchase of shares, or to

engage in any retail sales activities. Neither the

company nor any of its employees would receive

transaction-based income or commissions in

connection with the company’s promotional or

marketing activities.

The company would have primary responsi-

bility for preparing the advertising and market-

ing materials. The independent distributor, how-

ever, would be responsible for placing all

1. 12 U.S.C. 221a and 377.

2. See 12 C.F.R. 225.28(b)(6) and 12 C.F.R. 225.125.

3. See 1993 FRB 626 (footnote 15).

4. The FBO committed that none of its U.S. afﬁliates,

including the company, would be obligated by any agreement

to engage in any sales activities with regard to shares of the

funds, nor would such afﬁliates enter into any distribution

agreement with the funds without the prior approval of the

Board.

5. The funds could enter into distribution agreements with

intermediaries, but in no event could the company enter into

such agreements.

BHC Supervision Manual July 2008

Page 1

advertisements. The independent distributor

would also have legal responsibility, under the

rules of the FinancialIndustryRegulatoryAuthor-

ity (FINRA), for the form and use of all adver-

tising and sales literature prepared by the com-

pany, and would also be responsible for ﬁling

these materials with the FINRA or SEC.

For the reasons cited, the Board believed that

the promotional and marketing activities pro-

posed by the FBO would not involve the com-

pany in the underwriting or distribution of shares

of the funds for the purposes of the Glass-

Steagall Act.

3600.28.2 MANAGEMENT

INTERLOCK CONTROL

CONSIDERATIONS

The FBO also proposed that the chief executive

ofﬁcer serve as the chairman of the four-member

board of trustees of the funds and that no more

than three ofﬁcers or employees of the company

serve as junior-level ofﬁcers of the funds. The

employees would serve as assistant secretary,

assistant treasurer, or assistant vice president of

the funds and would be supervised by the board

of trustees or senior-level ofﬁcers. These

employees would have no policymaking author-

ity at the funds and would not be responsible

for, or involved in, making recommendations on

policy decisions. No employee or ofﬁcer of the

company would serve as a senior-level ofﬁcer

of the funds.

The Board had previously authorized a bank

holding company to have director and ofﬁcer

interlocks with mutual funds that the bank hold-

ing company advises or administers.

The Board

concluded that the proposed interlocks between

the company and the funds, in this case, would

not compromise the independence of the boards

of trustees of the funds, compromise the inde-

pendent distribution of the funds, or result in

control of the funds by the FBO.

Based on the facts given, the Board con-

cluded that the control of the funds would rest

with the independent members of the boards of

trustees of the funds and that the proposed inter-

locks between the company and the funds would

not compromise the independence of the boards

of the funds or permit the FBO to control the

funds. The Board concluded that the proposal

was consistent with the Glass-Steagall Act. The

notice was approved on June 16, 1997. See

1997 FRB 679, 1998 FRB 1075–77, 1998 FRB

852–853, and 1998 FRB 680–82.

6. See 1996 FRB 1129.

Broader Marketing Plans and Advertising and Sales Literature for Mutual Funds 3600.28

BHC Supervision Manual July 2008

Page 2

Permissible Activities by Board Order (Providing

Employment Histories to Third Parties) Section 3600.29

A bank holding company gave notice under

section 4(c)(8) of the Bank Holding Company

Act (BHC Act) (12 U.S.C. 1843(c)(8)) and sec-

tion 225.23 of the Board’s Regulation Y

(12 C.F.R. 225.23) of its intention to engage

de novo through its mortgage subsidiary in pro-

viding employment histories to third parties for

a fee.

The employment histories to be provided by

the mortgage subsidiary would include the names

of past and current employers of an individual

and the salary and length of employment for

each position, if the individual has consented to

the release of such information. The mortgage

subsidiary would compile an individual’s

employment history from information available

from state departments of employment services

and other similar sources. This information would

be provided for a fee to any third-party credit

grantor for the purpose of assessing the credit-

worthiness of a prospective borrower.

3600.29.1 CREDIT-RELATED

EMPLOYMENT HISTORIES

The mortgage subsidiary will provide employ-

ment histories to third-party credit grantors,

including depository and nondepository grant-

ors, for use in making decisions to extend credit

only with the express consent of the individual

involved. The bank holding company commit-

ted that the mortgage subsidiary will comply

with the Fair Credit Reporting Act (15 U.S.C.

1681 et seq.) (FCRA) and all applicable state

and federal laws and regulations.

In the normal course of their lending activi-

ties, banks collect and analyze employment and

salary information, including names of past and

current employers and salary histories. The Board

previously determined that providing past credit

information, which includes employment his-

tory information, to a credit grantor who is

considering a borrower’s application for credit

is an activity that is closely related to banking

and permissible for bank holding companies.

Accordingly, the Board concluded that provid-

ing employment histories to third-party credit

grantors for use in making decisions to extend

credit is an activity that is closely related to

banking.

3600.29.2 NON-CREDIT-RELATED

EMPLOYMENT HISTORIES

The bank holding company also intends to pro-

vide employment histories to third-party deposi-

tory institutions and their afﬁliates, including

credit unions and their afﬁliates, for use in the

regular course of their business, including the

hiring of employees. The mortgage subsidiary

would provide this information to such entities

only with the express consent of the individual

involved. Regardless of whether the customer is

a third-party depository institution or other credit

grantor, the activity would only involve provid-

ing employment information. The bank holding

company does not plan to provide any addi-

tional service, such as analyzing an individual’s

creditworthiness. The bank holding company

committed that its mortgage subsidiary will

comply with the FCRA and all applicable state

and federal laws and regulations in performing

the proposed activity.

The Board had not previously determined

whether providing such employment informa-

tion to third parties for a fee is closely related to

banking under section 4 of the BHC Act and,

therefore, permissible for bank holding compa-

nies. The Board had previously permitted bank

holding companies to provide employment

information, including employment histories, to

depository institutions and their afﬁliates in con-

nection with the provision of career counseling

services (see section 3600.15.1.1).

To the extent

that these organizations use the information to

be provided by the mortgage subsidiary for

other purposes, it will only be used in con-

nection with the operation of their banking

business.

The Board thus concluded that providing

employment histories for use by depository

institutions and their afﬁliates in the regular

course of their business is an activity that is

closely related to banking. For these reasons,

the Board, on May 8, 1995, approved the bank

holding company’s notice to provide such

employment information (1995 FRB 732). The

1. Credit grantors could include lessors if the leasing trans-

action was the functional equivalent of an extension of credit.

2. See Regulation Y, section 225.25(b)(24) (12 C.F.R.

225.25(b)(24)). The bank holding company committed that it

would not promote its mortgage subsidiary as a provider of

employment information to non–depository institutions for

general business purposes unrelated to credit decisions.

3. See 1994 FRB 51.

BHC Supervision Manual December 1996

Page 1

approval was speciﬁcally conditioned on com-

pliance with the commitments made in connec-

tion with the notice.

Permissible Activities by Board Order (Providing Employment Histories to Third Parties)

3600.29

BHC Supervision Manual December 1996

Page 2

Permissible Activities by Board Order

(Title Abstracting) Section 3600.30

3600.30.1 REAL ESTATE TITLE

ABSTRACTING ACTIVITIES

A bank holding company (the notiﬁcant) gave

notice under section 4(c)(8) of the Bank Hold-

ing Company Act (the BHC Act) (12 U.S.C.

1843(c)(8)) and section 225.23 of the Board’s

Regulation Y (12 C.F.R. 225.23) of its intention

to acquire a title abstracting company (the com-

pany) and thereby engage in real estate title

abstracting in the state of Iowa.

Real estate title

abstracting, as proposed by the notiﬁcant, is

limited to reporting factual information concern-

ing the interests or ownership of selected real

property. An abstracter obtains this information

by performing a title search of records main-

tained at a local public records ofﬁce to deter-

mine the ownership history of the property,

including any liens, encumbrances, mortgages,

or future interests affecting it. The abstracter

then prepares a written report, also known as an

‘‘abstract of title,’’ that recites the results of the

title search. Because Iowa state law does not

permit the sale of title insurance, real estate

lenders obtain the opinion of an attorney certify-

ing that title to a particular parcel of real prop-

erty is free of defects. The abstract of title

provides the factual information necessary for

the attorney to determine whether a lender would

have an unencumbered security interest in the

property to be mortgaged.

The notiﬁcant proposes to provide real estate

title abstracting services to afﬁliated and unaf-

ﬁliated lenders in an Iowa county. The company

would perform the proposed activities in con-

nection with real estate loans made by afﬁliates

or unafﬁliated companies and, in certain cases,

when no ﬁnancing is provided, such as in con-

nection with intrafamily transfers of real estate

and property distributed as part of estate planning.

The notiﬁcant would not provide any insurance

against title defects, guarantee any title, or pro-

vide any certiﬁcation with respect to a title. The

notiﬁcant would be liable for damages caused

by negligence in performing a title search but

would not be responsible for any defects in the

title.

The equivalent of title insurance in Iowa

is provided by the attorney who certiﬁes that the

title is free from defects. The Board has not

previously determined that providing real estate

title abstracting is closely related to banking

under section 4(c)(8) of the BHC Act and, there-

fore, permissible for bank holding companies.

The Board believes that the proposed real

estate title abstracting activities are integrally

related to the provision of loans secured by real

estate. A bank must be aware of any encum-

brances on property that serves as collateral for

a loan made by the bank. Banks in the state

typically rely on an attorney’s opinion, based on

information in an abstract of title, to determine

that they have a secured position in real estate

serving as collateral. The abstract of title pro-

vides information necessary to determine the

adequacy of the real estate collateral for the loan

and is an integral part of secured real estate

lending in Iowa. Thus, the bank has a particular

need for the information in the abstract of title.

Accordingly, the Board believes that the pro-

posed activities are integrally related to the

provision of secured real estate lending and,

therefore, are closely related to banking.

The Ofﬁce of the Comptroller of the Cur-

rency (OCC) has authorized national banks to

conduct this activity.

The OCC has concluded

that the performance of a title search and the

preparation of an abstract of title are necessary

parts of the real estate lending process and that

it would be convenient and useful under the

applicable standards in the National Bank Act

for national banks to be able to perform these

tasks themselves.

The proposed activities are not equivalent to

providing title insurance—an activity that is not

generally permissible under section 4(c)(8) of

the BHC Act.

Title insurance generally includes

providing an indemniﬁcation againstlossesresult-

ing from a title defect discovered after the con-

veyance of property. Title insurance typically

protects a purchaser or lender against claims not

identiﬁed by a title search or claims not speciﬁ-

cally exempted by the title insurance policy. The

notiﬁcant does not propose to certify or guaran-

tee title and would not be liable to the purchaser

or the lender for any title defects.

1. The notiﬁcant would merge the company into its wholly

owned leasing subsidiary.

2. Title abstracters may insure against liability for negli-

gence by purchasing an errors and omissions policy.

3. OCC Interpretative Letter No. 450, September 22, 1988.

4. National banks are not permitted to sell title insurance.

5. Section 4(c)(8) provides that insurance agency, broker-

age, and underwriting activities are not ‘‘closely related to

banking’’ and, thus, are not permissible activities for bank

holding companies, unless the activities are included within

one of seven speciﬁc exemptions (A through G) in sec-

tion 4(c)(8) (12 U.S.C. 1843(c)(8)(A)–(G)).

BHC Supervision Manual December 2003

Page 1

The Board concluded, based on all the facts

of record, that the proposed activities are closely

related to banking and approved the notice on

June 30, 1995. (See 1995 FRB 805.) Approval

of the proposal was speciﬁcally conditioned on

the notiﬁcant’s compliance with the commit-

ments made in connection with the notice.

3600.30.2 AIRCRAFT TITLE

ABSTRACTING ACTIVITIES

An attorney representing a bank holding com-

pany (BHC) requested an opinion as to whether

the providing of title abstracts on U.S.-registered

aircraft would be a permissible activity for a

new subsidiary of a BHC. The aircraft title

abstracting activities would be limited to report-

ing factual information concerning the owner-

ship history of the relevant aircraft and the

existence of liens or encumbrances affecting the

aircraft. The information would be obtained by

performing a title search of records. The title

search would be documented in a written report,

known as an ‘‘abstract of title,’’ describing the

factual information located by the title search

concerning the existing title owner of the air-

craft, previous transfers of the aircraft’s title,

and the existence of any liens or encumbrances

affecting title to the aircraft.

The subsidiary

would provide the information to afﬁliated and

unafﬁliated lenders and other parties in connec-

tion with aircraft ﬁnancing and sales transac-

tions. The aircraft title abstracting activities

would not include providing insurance against

defects in the title of any aircraft, guarantee any

aircraft title, or provide any certiﬁcation with

respect to an aircraft title. Based on facts and

information provided and other facts, the Legal

Division staff issued an opinion on October 7,

2002, that concluded that the proposed aircraft

title abstracting to be conducted by the subsidi-

ary would be within the scope of the title

abstracting activities previously authorized by

the Board on June 30, 1995. (See 1995 FRB

805, 806.)

6. The attorney requesting the opinion reported that federal

law requires that all changes in title of, and liens and encum-

brances affecting, U.S.-registered aircraft must be ﬁled with

the Federal Aviation Administration.

Permissible Activities by Board Order (Title Abstracting) 3600.30

BHC Supervision Manual December 2003

Page 2

Section 4(c)(8) of the BHC Act (Board Staff Legal Interpretation—Financing

Customers’ Commodity Purchase and Forward Sales) Section 3610.1

A bank holding company (BHC), that has elected

to be a ﬁnancial holding company within the

meaning of the Bank Holding Company Act of

1956 (12 U.S.C. 1841 et seq.) (the BHC Act)

inquired if it would be permissible under the

BHC Act and the Board’s Regulation Y (12

C.F.R. 225) for the BHC to engage in ‘‘com-

modity purchase and forward sale’’ (CPFS) trans-

actions as a method of ﬁnancing the commodity

inventories of its customers.

Two alternative structures were described for

the CPFS transactions. In the ﬁrst structure, the

BHC would purchase a commodity from its

customer and simultaneously enter into a for-

ward sale agreement under which the customer

would be obligated to repurchase the commod-

ity from the BHC at a predetermined price on a

predetermined future date. The second structure

is similar to the ﬁrst structure except that it

would involve a third party, either as the initial

seller of the commodity to the BHC or as the

ultimate purchaser of the commodity from the

BHC. During the term of a CPFS transaction,

the BHC would hold title to the underlying

commodity, would mark the commodity to mar-

ket on a daily basis, and would call for addi-

tional margin if the market value of the com-

modity falls below a speciﬁc collateral threshold.

The BHC Act permits bank holding compa-

nies to engage in any activity that the Board had

determined by regulation or order as of Novem-

ber 11, 1999, ‘‘to be so closely related to bank-

ing as to be a proper incident thereto.’’

The

Board had determined by regulation issued prior

to November 11, 1999, that ‘‘[m]aking, acquir-

ing, brokering, or servicing loans or other exten-

sions of credit (including factoring, issuing let-

ters of credit and accepting drafts) for the

company’s account or for the account of others’’

is such an activity.

Under the proposed CPFS transactions, the

BHC would earn a ﬁxed return on a CPFS

transaction, just as it would on an ordinary

secured loan, and its risk exposure would effec-

tively be limited to counterparty credit risk. The

BHC would subject any prospective CPFS coun-

terparty to the same credit-review process used

for loan applicants, and the BHC’s internal

credit-review personnel would also review out-

standing CPFS arrangements. As proposed, the

BHC would never enter into an agreement to

purchase a commodity unless it simultaneously

enters into an agreement to sell the commodity

to a creditworthy counterparty on a ﬁxed future

date at a ﬁxed price. The BHC indicated that a

ﬁxed future sale price would be equal to the

initial purchase price plus a ﬁxed interest com-

ponent (and thus would not vary based on move-

ments in the price of the commodity). In other

words, unless the ultimate purchaser defaults,

the BHC would be repaid its principal plus a

ﬁxed amount of interest at maturity of the trans-

action. In addition, the BHC would not bear any

commodity price risk; the price it would receive

for the commodities on the maturity date of the

transaction would be ﬁxed on the date it enters

into the transaction. If the ultimate purchaser

defaults on its obligation to purchase the under-

lying commodity upon maturity, the BHC would

have a claim against this purchaser to recover

the equivalent of principal and interest. The

BHC could then sell the commodity into the

market to mitigate credit losses in the same

manner as it would liquidate any collateral sup-

porting a loan in default. Any commodities

acquired by the BHC as a result of counterparty

default would be held in accordance with the

limits applicable to assets acquired by a BHC in

the course of collecting a debt previously

contracted.

Moreover, the BHC represented that all non-

price risks and costs of owning the commodity

during the term of the CPFS transaction, such as

storage risk and the cost of insurance, would be

borne by the ultimate purchaser. In all cases,

although the BHC would take title to the under-

lying commodity at the inception of a CPFS

transaction, it would take title in the form of a

warehouse receipt only; that is, the commodity

would continue to be stored in a licensed ware-

house owned and operated by an entity other

than the BHC. The commodity would not be

physically moved as a result of the transaction.

The BHC would acquire title to the underlying

commodity in a CPFS transaction as an incident

1. The BHC indicated that the commodities involved in

these transactions would include agricultural commodities

(such as corn, wheat, soybeans and other legumes, cotton,

cocoa, coffee, sugar, various oilseeds and oils, and dairy

products), live cattle, timber, and exchange-traded metals. The

BHC’s CPFS transactions would, in all cases, involve com-

modities (1) for which contracts have been approved for

trading on a U.S. futures exchange by the Commodity Futures

Trading Commission or (2) which the BHC can show, to

Board staff’s satisfaction, have readily-available price quotes

and are traded regularly in global commodity markets.

2. See 12 U.S.C. 1843(c)(8).

3. See 12 C.F.R. 225.28(b)(1).

4. See 12 C.F.R. 225.22(d)(1).

BHC Supervision Manual July 2006

Page 1

to the ﬁnancing it provides to its customers and

not for speculative purposes. The BHC repre-

sented that the BHC does not and will not hold

itself out as making a market in the commodity.

In addition, the BHC also represented that the

BHC does not and will not (1) own, operate, or

invest in facilities for the extraction, transporta-

tion, storage, or distribution of commodities or

(2)process, reﬁne,or otherwisealtercommodities.

The BHC would account for the CPFS trans-

action as an ‘‘asset purchased under an agree-

ment to resell’’ and would recognize proﬁt and

loss on the transaction on an accrual basis, in a

manner similar to a traditional loan. During the

term of the transaction, the ultimate purchaser

counterparty in a CPFS transaction would gen-

erally record the underlying commodity as an

asset on its balance sheet and would record its

obligation to purchase the commodity as a short-

term debt liability.

The interpretation noted that the Board had

previously found a three-party commodity ﬁnanc-

ing arrangement similar to the BHC’s proposed

three-party CPFS transactions to be an exten-

sion of credit permissible for BHCs under Regu-

lation Y. In a 1973 order, the Board approved as

a permissible lending activity for bank holding

companies an arrangement under which a BHC

would ﬁnance a utility’s coal purchases by pur-

chasing from a third party, and taking title to, a

quantity of coal on a monthly basis at the direc-

tion of the utility customer. (See 1973 FRB

698.) The BHC would store the coal on the

premises of the utility under a lease arrange-

ment with the utility. The utility would use the

coalcontinuously throughoutthe followingmonth

and would pay the BHC monthly for the amount

of coal used, at a price equal to the BHC’s

acquisition cost for the coal plus a ﬁxed amount

of interest. The utility explicitly bore the risk of

loss or damage to the coal during storage. If the

utility defaulted, the BHC had the right to sell

the coal to cover its losses and the right to sue

the utility for any shortfall in the liquidation

proceeds. As with the proposed CPFS transac-

tions, the utility’s motive for the transaction was

to obtain ﬁnancing for its commodities inventory.

Based on the information the BHC provided

and the Board’s precedents, Board legal staff

opined that the proposed CPFS transactions are

within the scope of permissible lending activi-

ties for BHCs under section 225.28(b)(1) of

Regulation Y. The BHC should have policies

and procedures to identify whether a CPFS

transaction would create heightened legal or

reputational risk to the BHC, and to manage any

such risk. In particular, the BHC should have

policies and procedures to identify whether a

particular CPFS transaction (1) lacks economic

substance or business purpose; (2) may be

accounting, regulatory, or tax purposes;or (3) may

be accounted for or disclosed by the counter-

party in a way that is misleading or inconsistent

with the substance of the transaction or applica-

ble regulatory or accounting requirements.

The Board legal staff’s opinion is limited

solely to the permissibility of the proposed

CPFS activities described above under Regula-

tion Y and does not address the permissibility of

any other activities or authorize the BHC to

engage in any other activities in the United

States. (See the Board’s staff legal interpretation

dated May 15, 2006.)

Board Staff Legal Interpretation—Financing Customers’ Commodity Purchase and Forward Sales

3610.1

BHC Supervision Manual July 2006

Page 2

Section 4(c)(8) of the BHC Act (Board Staff Legal Interpretation—Certain Volumetric-

Production-Payment Transactions Involving Physical Commodities) Section 3610.2

A foreign bank (that qualiﬁes as a ﬁnancial

holding company under section 4(k) of the BHC

Act and is treated as a bank holding company

(BHC) under section 4(c)(9) of the BHC Act

requested a conﬁrmation from the Board’s legal

staff on whether certain volumetric-production-

payment (VPP) transactions involving physical

commodities would be considered as extensions

of credit that are permissible for a BHC under

section 4(c)(8) of the BHC Act and section

225.28(b)(1) of the Board’s Regulation Y.

In 2004, the Board approved a proposal by

the BHC to engage in physical-commodity trad-

ing as an activity that is complementary to the

BHC’s commodity derivatives activities.

The

order limited the value of physical commodities

that the BHC may hold under this authority to

5 percent of the BHC’s tier 1 capital. The BHC

also requested conﬁrmation that VPP transac-

tions and any physical commodities delivered to

the BHC under a VPP would not count against

the 5 percent of tier 1 capital limit.

A VPP is a royalty interest, typically in a

hydrocarbon (such as oil or natural gas) reserve

that entitles the VPP holder, in exchange for an

upfront payment, to receive speciﬁed quantities

of hydrocarbons on a regular basis during the

life of the VPP transaction. A VPP is considered

to be a real property interest in most states.

Relying on its physical-commodity trading

authority, the BHC had already entered into two

VPP transactions in the United States. In each of

these transactions, a wholly owned, consoli-

dated, U.S. special-purpose-vehicle subsidiary

of the BHC (the SPV) had acquired a VPP from

a hydrocarbon producer (the customer) in

exchange for cash.

The VPP transactions are

designed to provide funding to the customers.

The VPP does not give the BHC the right to

control production of the oil or gas, and the

BHC is therefore dependent on the customer

meeting its contractual obligation to produce the

agreed-upon volume of oil or gas according to

the agreed-upon schedule.

Simultaneously with its purchase of the VPP

interest from the customer, the SPV and the

BHC enter into an agreement under which the

BHC makes an upfront payment to the SPV and

the SPV agrees to deliver to the BHC the vol-

umes of oil or gas to be received by the SPV

from the customer under the VPP. As the SPV

delivers the oil or gas to the BHC under this

agreement, the BHC arranges to sell it, either

back to the customer or into the marketplace, at

the then-current market price for the commodity.

The BHC also may decide to temporarily

retain hydrocarbons it acquires pursuant to a

VPP in order, for example, to take advantage of

an anticipated rise in price for the relevant com-

modity. The BHC agreed that any hydrocarbons

acquired under a VPP will be counted against

the BHC’s 5 percent of tier 1 capital limit under

the order if they are not immediately sold to a

third party. The BHC represented that it hedges

its commodity-price risk from the VPP by enter-

ing into a ﬁxed-rate commodity swap with a

third party (which may be the customer) that

converts the BHC’s variable proceeds from the

periodic sale of the oil or gas into ﬁxed-rate

payments. Accordingly, in the absence of coun-

terparty defaults, by the end of the VPP term the

BHC will have recouped the original amount

advanced to the customer plus a ﬁxed return.

The BHC stated that the VPP transactions

generally are treated as loans for U.S. federal

income tax purposes. In addition, the BHC indi-

cated that it will treat VPP transactions as loans

for accounting purposes. Board staff stated that

it expects (1) the BHC will follow generally

accepted accounting principles in reporting any

VPP transactions and (2) all of the BHC’s VPP

transactions will be entered into for legitimate

business purposes.

The BHC argued that a VPP transaction is

very similar to a traditional lending arrangement

because the discounted present value of the

hydrocarbons to be delivered to the BHC over

the life of a VPP transaction is estimated to

equal the purchase price paid by the BHC for

the VPP interest plus a margin meant to cover

the BHC’s cost of funds, risk associated with

the transaction, and a ﬁxed proﬁt. Importantly,

the VPP does not give the BHC any variable

upside potential if there is excess production

from the producer’s hydrocarbon reserve.

More-

over, the commodity-price swap hedges the

BHC’s commodity-price risk associated with

the VPP, thus guaranteeing the BHC a return of

principal and a ﬁxed amount of interest if nei-

1. 12 C.F.R. 225.28(b)(1).

2. See 2004 FRB 215.

3. [TEXT REDACTED]

4. If the reserve produces more hydrocarbons than are

subject to the VPP, the production is for the beneﬁt of the

producer. If the reserve underproduces in a given period

during the life of the VPP, the BHC would be entitled to an

appropriate amount of overproduction in subsequent months

(and extra reimbursement to reﬂect default interest).

BHC Supervision Manual July 2006

Page 1

ther the producer nor the swap counterparty

defaults. Accordingly, the VPP transactions are

not designed to serve as a vehicle for the BHC

to take on commodity-price risk, own commodi-

ties, or engage in commodity dealing.

As described above, as part of a VPP transac-

tion, the BHC will hold a royalty interest in a

hydrocarbon reserve and will periodically take

title, if only momentarily, to physical commodi-

ties. The Board has previously concluded, how-

ever, that ownership of commodities in connec-

tion with a ﬁnancing transaction does not prevent

the transaction from being treated as a form of

credit extension permissible for a BHC if the

economics of the transaction are substantially

the same as those of a loan.

Based on the information provided by the

BHC’s counsel, Board legal staff opined that the

above-described VPP transactions are a form of

permissible lending activity for BHCs under

section 225.28(b)(1) of Regulation Y when

entered into for the purpose of providing ﬁnanc-

ing to a third-party customer. Any commodities

that the BHC receives pursuant to a VPP trans-

action and that are not immediately sold to third

parties would be subject to the 5 percent of tier

1 capital limit on the value of commodities that

the BHC may hold under its physical-commodity-

trading authority.

The staff opinion informed the BHC that it

should have in place policies and procedures to

(1) identify whether a VPP transaction would

create heightened legal or reputational risk to

the BHC and (2) manage any such risk. In

particular, the BHC should have policies and

procedures to identify whether a particular VPP

transaction (1) lacks economic substance or

business purpose; (2) may be designed by the

counterparty for questionable accounting, regu-

latory, or tax purposes; or (3) may be accounted

for or disclosed by the counterparty in a way

that is misleading or inconsistent with the sub-

stance of the transaction or applicable regula-

tory or accounting requirements.

The staff opinion is limited solely to the per-

missibility of the VPP transactions described in

the opinion under Regulation Y. The opinion

does not address the permissibility of any other

activities or authorize the BHC to engage in any

other activities in the United States. (See the

Board legal staff’s opinion dated May 15, 2006.)

5. As noted above, the BHC has the authority to engage in

physical-commodity trading, including making and taking

delivery of physical commodities, and may use this authority

to retain ownership of hydrocarbons delivered under a VPP in

order to beneﬁt from anticipated changes in hydrocarbon

prices.

6. See 1973 FRB 698.

Board Staff Legal Interpretation—Certain Volumetric-Production-Payment Transactions Involving Physical Commodities

3610.2

BHC Supervision Manual July 2006

Page 2

Impermissible Activities

Section 3700.0

The BHC Act states that a nonbank activity is

impermissible unless explicitly exempt from the

general prohibition of section 4. While this

could cause an unlimited list of impermissible

activities, the Board has compiled a list of activ-

ities which have been speciﬁcally determined to

be impermissible (see Manual section 3000.0,

Appendix 3).

The inspection objective is to determine

whether a speciﬁc activity conducted by a bank

holding company or its subsidiary is permissible

for the bank holding company. The Board has

ruled speciﬁc activities to be impermissible

although it has stated also that certain imper-

missible activities may be engaged in under

limited special circumstances.

In addition, a bank holding company may be

entitled to grandfather privileges which are con-

sidered as either permanent (where there is no

deadline for termination of an activity) or tem-

porary, in which case the activity must have

been terminated prior to December 31, 1980. A

holding company may be granted an exemption

from section 4 of the Act (i.e., family, hardships,

etc.) which allows it to engage in activities that

would otherwise be impermissible. Because of

the variety of factors which must be considered,

the examiner should exercise care when deter-

mining the permissibility of an activity for a

bank holding company.

The subsections of this chapter present a

selected number of those activities which have

been determined to be impermissible for bank

holding companies. While an activity is permis-

sible only after it has been determined as such

by the Board, it must be remembered that in

determining permissibility, the Board has in

some instances (i.e., data processing services,

courier services, etc.) included restrictions which

would limit the overall nature or performance of

the activity. Therefore, even the permissible

activitiesmaybecomeimpermissible if the actions

of the bank holding company are not in accor-

dance with the stated restrictions.

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(Land Investment and Development) Section 3700.1

The Board of Governors has ruled that land

development

is impermissible for bank holding

companies. However, for land acquired through

foreclosure, a limited amount of development

may be allowed in an effort to minimize the

potential loss on the project. Each case must be

considered separately to determine if it warrants

additional development.

The basic determination of impermissibility

was established by the Board in denying a por-

tion of the application by UB Financial Corp.,

Phoenix, Arizona, to retain the H. S. Pickrell

Company, Phoenix, Arizona (1972 FRB 429).

The order stated in part, ‘‘The Board is of the

opinion that the activities of purchasing and

selling of land or participating as a joint ven-

turer in real estate development are not so

closely related to banking as to be a proper

incident thereto, and that insofar as the applica-

tion pertains to those activities, it should be

denied.’’

The determination that limited development

for land acquired through foreclosure is permis-

sibleis contained inaBoardorderdatedNovember

1, 1973, in connection with an application by

Liberty National Corporation, Oklahoma City,

Oklahoma, to retain Liberty Mortgage Com-

pany, Oklahoma City, Oklahoma (1973 FRB

919), in which it is indicated that a limited

amount of real estate development might be

permissible if necessary to minimize losses on

real estate acquired in connection with debts

previously contracted.

1. The Board, by speciﬁc order, has permitted a limited

incursion into this area as an accommodation to BHCs acquir-

ing thrifts or to thrifts that qualify as ‘‘banks’’ and seek to

form bank holding companies (1986 FRB 487, 731)

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(Insurance Activities) Section 3700.2

3700.2.1 PREMIUM FUNDING

Insurance premium funding, sometimes known

as equity funding, is the ﬁnancing of the sales of

mutual fund shares and life insurance policies as

a package. It should not be confused with loans

made to an insured for the purpose of paying

premiums on hazard insurance (insurance pre-

mium ﬁnancing); in that case the lender may be

named loss payee or owner of the policy and the

lender has the right to submit the policy for

cancellation in order to collect the amount owed.

Insurance premium ﬁnancing is a permissible

activity pursuant to Section 225.25(b)(1) of

Regulation Y (Refer to 1974 FRB 310).

The Board has determined insurance pre-

mium funding to be impermissible for bank

holding companies (12 C.F.R. 225.126). This

determination is based on the policies contained

in sections 20, 21, and 32 of the Banking Act of

1933 (the Glass–Steagall Act Provisions) as

described in the opinion of the United States

Supreme Court in Investment Company Insti-

tute v. Camp, 401 U.S. 617 (1971).

‘‘In the Board’s opinion, the Glass–Steagall

Act provisions, as interpretedby the U.S. Supreme

Court, forbid a bank holding company to spon-

sor, organize or control a mutual fund’’ (12

C.F.R. 225.125). In enacting the Glass–Steagall

Act, Congress indicated that afﬁliations of com-

mercial banks and securities companies give

rise to a potential conﬂict of interest and un-

sound banking practices. Pursuant to section

4(c)(8) of the Act, the Board is required to

consider whether the performance of a particu-

lar nonbank activity by a holding company pro-

duces beneﬁts to the public that outweigh possi-

ble adverse effects, such as potential conﬂict of

interest and unsound banking practices. There-

fore, the potential conﬂict of interest and un-

sound banking practices arising in the afﬁliation

of commercial banks and mutual funds pre-

cludes the Board from approving insurance pre-

mium funding as a permissible banking activity.

3700.2.2 LIFE INSURANCE

UNDERWRITING

The life insurance discussed in this section is

that life insurance which is not sold in connec-

tion with a credit transaction by a bank holding

company or its subsidiary. The Board has ruled

that this activity is impermissible for bank hold-

ing companies (12 C.F.R. 225.126). The Board

developed its position during consideration of

the application of First Oklahoma Bancorpora-

tion, Inc., Oklahoma City, Oklahoma, for prior

approval pursuant to section 4(c)(8) of the Act

to acquire sufﬁcient additional shares of Under-

writers Life Insurance Company, Oklahoma City,

Oklahoma, so as to own at least 80 per cent of

the outstanding shares and thereby to engage in

the activity of underwriting life insurance not

sold in connection with a credit transaction by a

bank holding company or a subsidiary.

In acting on the First Oklahoma application,

the Board relied on an earlier decision denying

an application by Transamerica Corporation,

San Francisco, California, to retain its shares of

Occidental Life Insurance Company of Califor-

nia (1957 FRB 1014). In the Transamerica case,

a hearing examiner found that the life insurance

underwriting activities of Occidental were not

so closely related to banking to be a proper

incident to managing and controlling banks. In

the First Oklahoma case, the application was

presented on the question of whether the activi-

ties of Underwriters Life were so closely related

to banking or managing or controlling banks as

to be a proper incident thereto. The Board deter-

mined in First Oklahoma, that there was no

reasonable basis for the contention that the ac-

tivities of Underwriters Life were permissible.

The activity of acting as an underwriter (rein-

surer) for credit life and credit accident and

health (disability) insurance is, however, consid-

ered a permissible activity (12 C.F.R. 225.135).

3700.2.3 SALE OF LEVEL-TERM LIFE

INSURANCE

The Board has stated that the sale of level-term

life insurance is not covered by section

225.25(b)(8)(ii) of Regulation Y. This position

was stated in its order approving the application

by Fidelity Corporation of Pennsylvania, Rose-

mount, Pennsylvania, to acquire Local Finance

Corporation, Providence, Rhode Island, except-

ing those proposed activities of level-term life

insurance sales (1973 FRB 472). Insurance that

does not decline in coverage as the outstanding

loan balance is reduced results in the insured

party carrying more insurance than is necessary

to cover the outstanding loan balance. Because

of this position, the Board would not allow the

sale of this type of insurance by the applicant

and its subsidiary.

BHC Supervision Manual December 1992

Page 1

3700.2.4 UNDERWRITING REAL

ESTATE MORTGAGE GUARANTEE

INSURANCE

Mortgage guaranty insurance is essentially a

limited guarantee of a mortgage loan. Such in-

surance typically covers the top 20 or 25 percent

of a mortgage loan. In the event of default by

the borrower, the lender acquires title to the

property and then submits a claim to the insurer.

The insurer then has a choice of two options:

(1) take title to the property and pay the lender

the unpaid principal and interest; or (2) pay the

lender the 20 or 25 percent insured portion of

the loan, with the lender retaining title to the

property.

The Board has determined that ‘‘the under-

writing of mortgage guarantee insurance is prin-

cipally a credit determination, similar to those

made by banks in their regular course of business’’

(1974 FRB 727). Therefore, this activity is con-

sidered closely related to banking for purposes

of permissibility under section 4(c)(8) of the

Act. However, the Board noted that the private

mortgage insurance industry was relatively young

and still developing with a limited, untested,

operating history. In addition, the Board be-

lieved that the times were such that it was

‘‘desirable for bank holding companies gener-

ally to slow their present rate of expansion and

direct their energies toward strong and efﬁcient

operations within their existing activities, rather

than toward expansion into new activities’’ (the

go-slow policy), and, therefore, concluded that

it would not be appropriate to adopt the under-

writing of mortgage guarantee insurance as per-

missible for bank holding companies.

3700.2.5 UNDERWRITING PROPERTY

AND CASUALTY INSURANCE

On May 12, 1978, the Board denied NCNB

Corporation’s application to retain its indirect

subsidiaries, Superior Insurance Company and

Superior Claim Service, both of Florence, North

Carolina. These companies engaged, respec-

tively in the activities of underwriting property

and casualty insurance related to extensions of

credit by NCNB’s afﬁliates, in adjusting insur-

ance claims and in appraising and valuing prop-

erty in connection therewith. Neither of these

activities had previously been determined by the

Board to be closely related to banking. The

Board concluded that the circumstances pre-

sented did not provide a reasonable basis for

believing that the proposed activity was closely

related to banking or managing and controlling

banks (1978 FRB 506).

3700.2.6 TITLE INSURANCE

The Board issued a letter (See Board letter re

Independence Bancorp, Inc., dated 3/17/86) to a

bank holding company which ﬁled an applica-

tion with the Board to acquire a de novo title

abstract company which planned to engage in,

among other things, the sale of title insurance.

The sale of title insurance had not been previ-

ously approved by the Board as a permissible

nonbanking activity. In responding to the appli-

cation, the Board determined that the proposed

title insurance activities were not closely related

to banking.

The Board’s discretion to decide what types

of insurance activities are closely related to

banking was removed by the Garn–St Germain

Depository Institutions Act of 1982 (‘‘Garn

Act’’), which amended section 4(c)(8) of the

BHC Act. The Garn Act stated that ‘‘it is not

closely related to banking or managing or con-

trolling banks for a bank holding company to

provide insurance as a principal, agent, or

broker. . . .’’ The Garn Act lists certain speciﬁc

exceptions to this general prohibition, none of

which permits the sale of title insurance. The

Board thus concluded that the Garn Act does

not allow it the discretion to approve this type of

nonbanking activity.

Impermissible Activities (Insurance Activities) 3700.2

BHC Supervision Manual December 1992

Page 2

Impermissible Activities

(Real Estate Brokerage and Syndication) Section 3700.3

3700.3.1 BROKERAGE

Real estate brokerage is the negotiating of a real

estate contract between a buyer and seller for

which the broker receives a fee or commission

and in which the broker takes no possessory

interest in the subject matter of the contract. The

Board has stated that this activity is considered

impermissible for bank holding companies. The

Board’s position was expressed in its order

approving an application by Boatmen’s Banc-

shares, Inc., St. Louis, Missouri, to acquire

Williams, Kurrus and Company, St. Louis, Mis-

souri (1972 FRB 428). The Board stated that it

had determined that real estate brokerage activi-

ties were not so closely related to banking or

managing or controlling banks as to be a proper

incident thereto. Since Boatman’s had not dem-

onstrated to the Board’s satisfaction that the real

estate brokerage ﬁeld activities are so closely

related to banking or managing or controlling

banks as to be a proper incident thereto, the

Board approved the Boatman’s application on

the condition that Boatman’s terminate its real

estate brokerage activities.

3700.3.2 SYNDICATION

The Board ruled that this activity is not permis-

sible for bank holding companies. The Board’s

position was developed during consideration of

the application of BankAmerica Corporation,

San Francisco, California, for prior Board ap-

proval to engage de novo under section 4(c)(8)

of the Act in the activity of real estate syndica-

tion through a subsidiary, BankAmerica Realty

Services, Inc., San Francisco, California. The

Board concluded that the subsidiary’s proposed

activities of organizing, promoting, selling part-

nership interests, and acting as the sole general

partner of real estate syndicates went beyond

the functions performed by an advisory com-

pany to a real estate investment trust permissi-

ble under section 225.25(b)(4) of Regulation Y.

The Board also stated that it felt that the

policies contained in sections 20 and 32 of the

Banking Act of 1933 (the Glass–Steagall Act

Provisions) must be considered in conjunction

with section 4(c)(8) of the Act. These policies,

described in the opinion of the United States

Supreme Court in Investment Company Insti-

tute v. Camp, 401 U.S. 617 (1971), forbid a

bank holding company to sponsor, organize or

control an open-ended investment company

(mutual fund) or a closed-end investment com-

pany primarily or frequently engaged in the

issuance, sale and distribution of securities.

Because the activities of real estate syndication

resemble the issuance, sale and distribution of

securities of a closed-end investment company,

this activity is not permissible for a bank hold-

ing company (12 C.F.R. 225.125).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(General Management Consulting) Section 3700.4

The Board has stated that general management

consulting is not so closely related to banking or

managing or controlling banks as to be a proper

incident thereto. This ruling is contained in the

Board’s order denying the application of First

Commerce Corporation, New Orleans, Louisi-

ana, to acquire W. R. Smolkin & Associates,

Inc., New Orleans, Louisiana. In its order the

Board describes general management consulting

as follows:

‘‘. . . including, but not limited to, the provi-

sion of analysis or advice as to a ﬁrm’s

(i) purchasing operations, such as inventory con-

trol, sources of supply, and cost minimization

subject to constraints; (ii) production opera-

tions, such as quality control, work measure-

ment, product methods, scheduling shifts, time

and motion studies, and safety standards;

(iii) marketing operations, such as market test-

ing, advertising programs, market development,

packaging, and brand development; (iv) plan-

ning operations, such as demand and cost

projections, plant location, program planning,

corporate acquisitions and mergers, and deter-

mination of long-term and short-term goals;

(v) personnel operations, such as recruitment,

training, incentive programs, employee compen-

sation, and management-personnel relations;

(vi) internal operations, such as taxes, corporate

organization, budgeting systems, budget con-

trol, data processing systems evaluation, and

efﬁciency evaluation; or (vii) research opera-

tions, such as product development, basic

research, and product design and innovation.’’

(1972 FRB 674) The Board denied the case and

determined that the activity of providing general

management consulting services could lead to

unwanted conﬂict of interest situations for BHCs

that advised clients that were also customers of

its own subsidiary banks. The Board also desired

to maintain a distinct separation between bank-

ing and commerce.

In its order denying the application of Marine

Midland Banks, Inc., Buffalo, New York, to

acquire Carter H. Golembe Associates, Inc.,

Washington, D.C., the Board further deﬁnes the

concept of management consulting by stating

that Golembe, ‘‘. . . provides consulting services

on a conﬁdential basis to banks, bank holding

companies and bankers’ associations. It makes

bank feasibility studies and renders advice with

respect to geographic expansion, product exten-

sion, mergers and acquisitions and applications

to State and federal regulatory agencies. A por-

tion of Golembe’s consulting services also relates

to internal bank operations, such as marketing,

trust and bank credit card operations and loan or

interest rate policies. Other studies and analyses

are performed upon request of individual banks.

Golembe also provides advice with respect to

the organization and operation of State Bankers’

associations and serves as a consultant to vari-

ous banking groups with respect to legislative

and regulatory matters affecting the banking

industry. The foregoing consulting services fur-

nished by Golembe are considered by the Board

to be but a specialized form of management

consulting.’’ (1972 FRB 676)

Management consulting to nonafﬁliated com-

mercial banks and nonbank depository institu-

tions has been determined by the Board to be a

permissible activity for bank holding companies

under section 4(c)(8) of the Act (Regulation Y,

section 225.25(b)11, as amended).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(Property Management) Section 3700.5

The Board has ruled that this activity is imper-

missible for bank holding companies. However,

bank holding companies may conduct property

management activities for three types of prop-

erty as follows:

1. Property held in a ﬁduciary capacity;

2. Property owned by the holding company

or its subsidiary for its own bank and bank-

related operations;

3. Property acquired by the holding company

or its subsidiary as a result of a default on a debt

previously contracted.

The Board announced on June 30, 1972, that

it would not include this general activity on the

list of permissible activities. Because the Board

did not intend to limit any authority given by

statute or regulation to a holding company or its

subsidiary concerning property management,

the Board described in its order the three types

of property, as shown above, for which a hold-

ing company or its subsidiary could engage in

property management activities (1972 FRB 652).

In addition to the prohibition of property

management activities in general, the Board has

ruled that the operation of a commercial parking

lot is impermissible. In its order approving the

application by Multibank Financial Corpora-

tion, Boston, Massachusetts, to acquire the

B. M. C. Durfee Trust Company, Fall River,

Massachusetts, a commercial bank, the Board

stated that operating a commercial parking lot

was not considered closely related to banking

and conditioned its approval on divestment of

the parking lot operation (1973 FRB 679).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(Travel Agencies) Section 3700.6

The Board through its rulemaking authority did

not include operating a travel agency on the list

of permissible activities for bank holding com-

panies. This activity is considered not to be

closely related to banking or managing or con-

trolling banks (1976 FRB 148). The Board refer-

enced a decision of the United States Court of

Appeals for the District of Columbia, Courier

Association vs. Board, 516 F. 2d 1229 (1975).

The Board felt the only relevant criteria for

this activity was whether banks have generally

provided the service. The Board noted that there

were few bank-afﬁliated travel agencies, most

of which had only been recently established.

The Board concluded that operating a travel

agency was not closely related to banking.

On June 1, 1978, the Comptroller of the Cur-

rency issued Banking Circular No. 108, which

requested all national banks then operating travel

agencies, to divest themselves of those agencies

within a reasonable period of time not to exceed

three years. The Comptroller’s ofﬁce concluded

that the continued operation of a travel agency

by a national bank is inappropriate and may

expose the bank to a substantial risk of loss by

litigation. This action by the Comptroller pre-

cludes bank holding companies from relying on

section 4(c)(5) of the Act to conduct travel

agencies. Thus, holding companies have no

authority to engage in travel agency activities

under the Act unless grandfathered.

On April 2, 1979, the Board issued a letter, a

copy of which went directly to all bank holding

companies engaging in the activity of operating

a travel agency pursuant to section 4(c)(5) of the

Act, indicating that no bank holding companies

could engage in the activity solely pursuant to

section 4(c)(5) and that those engaged in such

activity had to terminate the activity by Decem-

ber 31, 1980 (Z–8421 on ofﬁce copy only).

Subsequently, a bank holding company applied

to the Board to acquire a company (‘‘Company’’)

that engages in a variety of data processing and

data transmission activities for customers. The

Company’s data bases that are provided to cus-

tomers included a program by which customers

could receive airline and hotel information and

could make airline and hotel reservations. The

Board determined that the receipt of such infor-

mation and the ability to make airline and hotel

reservations was not closely related to banking.

Accordingly, the Board required, as a condition

for approval of the application, the bank holding

company to eliminate the travel reservation ser-

vice from the roster of third party data base

programs provided by Company (Refer to 1986

FRB 497).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities (Providing Credit Ratings on Bonds,

Preferred Stock, and Commercial Paper) Section 3700.7

As part of the Security Paciﬁc Corporation’s

(bank holding company) application to acquire

Duff & Phelps, Inc. (Company), which engaged

in investment advisory, investment manage-

ment, and ﬁnancial advisory services, the Board,

on December 11, 1984, denied the Applicant’s

request to engage in the activity of providing

credit ratings on bonds, preferred stock and

commercial paper. Private credit ratings were

included as part of the investment research

reports sold to institutional investors. The Com-

pany also provided credit ratings on a fee basis

for companies that request public disclosure.

As part of the public rating process, the rated

company is given the opportunity to make a

presentation to the Company’s Credit Rating

Committee.

In this situation, the Security Paciﬁc Corpora-

tion had a vested interest in the ratings of the

corporations to which it lends in the ratings of

municipal bonds it underwrites, in the ratings of

the commercial paper and municipal bonds for

which it provides backup lines of credit, and in

the ratings of ﬁxed-income securities which it

holds for trades. Numerous potential conﬂicts

existed such as: possible inadvertent releases of

conﬁdential information obtained during the

credit rating process; the advance release to the

Applicant of credit ratings for companies to

which the Applicant had very large loans out-

standing; the potential for pressures by the Appli-

cant on the Company to modify favorably the

credit rating of one of the Applicant’s major

customers; and the subtle pressure on the Com-

pany’s staff resulting from ownership by Appli-

cant about companies in which the Applicant

had a substantial interest. Similar conﬂicts could

have also arisen between the Company’s credit

rating function and the Applicant’s investment

of trust assets.

The Applicant acknowledged the potential

conﬂicts but argued that various steps could be

taken to ameliorate them and bring them within

a manageable framework. The Applicant there-

fore proposed a number of techniques for isolat-

ing the credit rating activities of the Company

from inﬂuence by the Applicant, including the

establishment of a separate corporation with a

number of independent directors, a prohibition

on contacts between the Applicant and the mem-

bers of the Company’s Credit Rating Commit-

tee, and also certain record keeping require-

ments for that committee.

The Board considered these positive sugges-

tions as well as others to assure full disclosure

of the relationships between the Applicant and

any of the companies that would be rated by the

Company as well as a prohibition on the Com-

pany rating the Applicant’s securities, securities

which the Applicant has underwritten, or securi-

ties for which the Applicant provided a guaran-

tee or backup letter of credit. The Board, how-

ever, believed that the conﬂicts in the relationship

between a major lender and a credit rating com-

pany were so pervasive that they could not be

overcome through adoption of an information

barrier. The employees of the Company would

inevitably be aware of interests of the Applicant

in ﬁrms being rated by them and, it seems

reasonable to assume that this knowledge could,

at times, inﬂuence their decisions.

The Board’s concerns regarding conﬂicts of

interest with respect to the credit rating activity

were not based on any doubts regarding the

integrity of the parties to the application, but

rather were based on the Board’s responsibility

to assess the possible adverse effects that might

be associated with an afﬁliation between a bank

holding company and a public credit rating

organization. Thus the Board was acting in fur-

therance of one of the general purposes of the

Bank Holding Company Act, ‘‘to prevent possi-

ble future problems rather than to solve existing

ones.’’ The Board, in view of the pervasive

conﬂicts of interest between the Applicant’s

existing operations and the Company’s credit

rating business, decided against approving the

performance of public credit ratings.

BHC Supervision Manual December 1992

Page 1

Impermissible Activities (Acting as a Specialist in Foreign-

Currency Options on a Securities Exchange) Section 3700.8

Currency options are a new and innovative

aspect of foreign exchange. A currency option

represents the contractual right (but not the obli-

gation) to purchase or sell a predetermined

amount of currency at a speciﬁc price at any

time before a speciﬁc date. Currency-options

advocates argue that currency options eliminate

the risk of a loss due to exchange movements

and give the holder a chance to proﬁt if the

currency ﬂuctuation is favorable. They require a

premium to be paid when the contract is entered

into. The premiums can run from about 1.5 per-

cent to 5 percent, depending on the expiration

date and the exercise price of the option.

Currency options are traded on two types of

markets: the over-the-counter, or interbank

market, and on three regulated exchanges, the

Chicago Mercantile Exchange (CME), the Chi-

cago Board Options Exchange (CBOE), and the

Philadelphia Exchange (PHLX). The CBOE, a

securities exchange, uses multiple ‘‘market mak-

ers’’ instead of specialist positions; the CME, a

commodities exchange, like other commodities

exchanges, does not use specialist positions.

Most of the writing of currency options is

currently done by banks which will customize

the option, with maturity dates and currency

values in excess of the standardized exchange

contracts. Banks developed the over-the-counter

market where they trade currency options among

themselves, and banks are also the largest cus-

tomers on the exchanges where they hedge the

risks associated with their foreign-exchange

positions.

In general, the specialist system is unique to

securities exchanges, and specialists exist for

the purpose of achieving certain market results.

Commodity exchanges do not use the services

of specialists. The rules of the Securities and

Exchange Commission permit the designation

of specialists to ‘‘engage in a course of dealings

for . . . their . . . own account to assist in the

maintenance, so far as practicable, of a fair and

orderly market . . .’’ provided that the securities

exchanges adopt the following types of rules

governing specialists: minimum capital require-

ments, rules to suspend or remove specialists if

they fail to perform their designated market

functions, rules restricting dealing activities to

those reasonably necessary to permit the spe-

cialist to maintain a fair and orderly market or

necessary to permit him or her to act as an

odd-lot dealer, provisions governing his or her

brokerage activities in specialist securities, and

procedures to provide for the effective and sys-

tematic surveillance of the activities of special-

ists (17 C.F.R. 240.11(b)(1)). In addition, the

IRS formerly granted special tax treatment to

specialists transactions.

The rules of the PHLX require that odd-lot

orders must be given to the specialist. The spe-

cialist functions as a broker with respect to

certain transactions that cannot be executed by

ﬂoor traders immediately, for example, stop-loss

orders and limit orders. All such orders are

given to the specialist for execution and become

part of his ‘‘book’’; PHLX rules address priority

of orders (customers’ orders receive priority)

and conﬂicts of interest by governing special-

ists’ trades and those of afﬁliated persons and

ﬁrms in ‘‘securities’’ in which the person is

designated as specialist.

There is one specialist position for each cur-

rency option traded on the PHLX, and the pri-

mary function of a specialist is to act as market

maker, as necessary, for its assigned currency

option. The specialist thus undertakes all activ-

ity, including dealing for its own account, to the

extent necessary, as required to maintain a fair

and orderly market in options on a particular

currency. In essence, the specialist makes a con-

tinuous two-sided market in the assigned cur-

rency option when market forces do not.

Although currency options are functionally

equivalent to other instruments which banks

regularly deal in for their own account, the

applicant’s proposed activities were not consid-

ered as closely related to banking. The appli-

cant’s analysis did not focus on the critical

components of the proposed specialist activities,

which are distinct from the foreign-exchange

brokerage and dealing activities generally con-

ducted by banks. Because the proposed special-

ist activities are to be carried out in the context

of market making on a regulated exchange, they

were signiﬁcantly different from the foreign-

exchange activities currently conducted by banks.

When a bank engages in foreign-exchange trad-

ing, it does so to service the needs of its custom-

ers and to generate trading proﬁts. However,

unlike traditional foreign-exchange trading, bank

customers are not serviced directly by a special-

ist. Instead, the exchange beneﬁts from the

specialist’s efforts if markets are perceived

to be deep and liquid. Depth and liquidity make

the contracts viable and the exchange proﬁtable,

and do not directly beneﬁt the bank’s customers.

The applicant’s original proposal implicitly

acknowledged that banks have not traditionally

BHC Supervision Manual December 1998

Page 1

been involved with trading on stock exchanges,

and thus have not generally possessed the expe-

rience and expertise in trading, hedging, and

managing aggregate exposure required for the

successful operation of a specialist position. The

applicants originally proposed to engage in the

activities through a joint venture because they

lacked the requisite trading expertise to proﬁt-

ably undertake the activity alone. In its discus-

sion of the management of risk exposure of the

specialist, the applicants originally stated, ‘‘The

choice of the appropriate hedge to start with and

the monitoring over the life of the option of that

hedge are specialized and difﬁcult tasks that

require expertise and experience.’’ Conducting

exchange specialist activities requires the ﬂoor-

trading experience and back-ofﬁce capabilities

of an experienced exchange member.

As of December 1984, only one commercial

bank, Bank of America, acted as a specialist in

exchange-traded currency options. In Janu-

ary 1984, the Ofﬁce of the Comptrol-

ler of the Currency granted permission for Bank

of America to act as the specialist in PHLX-

traded options on the Deutschemark through a

joint venture subsidiary with Tague Securities

Corporation. The Board, however, was not bound

to a determination that specialist activities were

closely related to banking simply because one

bank engages in the activity. Bank of America

apparently considered it necessary to conduct its

specialist activity through a joint venture with a

securities ﬁrm, which reinforced the view that

the activity requires experience and expertise

not generally possessed by banks.

Given the applicant’s acknowledgment of the

importance of ﬂoor-trading expertise and experi-

ence to the specialist function, and the substan-

tive absence of bank involvement in such an

activity, the Board concluded that the proposed

activities were not closely related to banking

and thus denied the applicant’s request.

Impermissible Activities (Specialist in Foreign-Currency Options on a Securities Exchange)

3700.8

BHC Supervision Manual December 1998

Page 2

Impermissible Activities (Design and Assembly of Hardware for Processing

or Transmission of Banking and Economic Data)

Section 3700.9

A bank holding company applied to acquire all

the voting shares of a company (‘‘Company’’)

that engages in a variety of data processing and

data transmission activities for customers such

as securities and commodities exchanges, bro-

kerage ﬁrms, commercial banks, savings and

loan associations, insurance companies, and

investment managers. In addition to engaging in

other nonbanking activities, the company designs

and assembles the hardware that is used in con-

nection with the services it provides. The Board

had not previously considered whether the as-

sembly of hardware designed for the processing

and transmission of banking, ﬁnancial and eco-

nomic data is closely related to banking or per-

missible as an incidental activity.

The bank holding company stated that Com-

pany’s assembly of hardware was incidental to

its provision of data processing services because

such assembly was necessary to assure the avail-

ability, reliability, and quality of components

used by Company, and that stock quotation

ﬁrms like Company could only assure such

product characteristics by the design and assem-

bly of the hardware that provides the quotation

information. In support of the argument, the

bank holding company asserted that competitors

of Company also design and assemble the hard-

ware that provides the Company service.

In view of the fact that ﬁnished hardware of

the type provided by Company is available, and,

in fact, is marketed by companies providing

services similar to Company, the Board found

that the continuation of Company’s design and

assembly of hardware activities could not be

considered ‘‘necessary’’ to the Company’s pro-

vision of its permissible data processing ser-

vices, and thus could not be considered inci-

dental to Company’s provision of permissible

services. As a condition for approval of the bank

holding company’s application to acquire all of

the voting shares of Company, the Board required

the bank holding company to divest of Compa-

ny’s hardware assembly activities within two

years of the acquisition (Refer to 1986 FRB

497).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities

(Armored Car Services) Section 3700.10

In 1971 and again in 1984, the Board issued for

public comment proposals to expand the activi-

ties permissible to bank holding companies

under section 4(c)(8). Included in those propos-

als was the provision of armored car services.

The proposals would have authorized bank hold-

ing companies to provide fully insured trans-

portation of cash, securities, and valuables (pri-

marily between commercial customers and

ﬁnancial institutions) and such ancillary ser-

vices as coin wrapping, change delivery, mail

delivery, payroll-check cashing, servicing of

automatic teller machines, and leasing safes to

commercial customers.

In response to both the 1971 and 1984 pro-

posals, the Board received various comments

against adding this activity to the Regulation Y

list of permissible nonbanking activities, prima-

rily from armored car operators and their trade

associations. The commenters maintained that

the activity is not closely related to banking but,

rather, is essentially a transportation activity

requiring no banking expertise.

In view of the issues raised by the comments

on this activity and the minimal interest by bank

holding companies, the Board decided not to

add the activity to the Regulation Y list of

permissible activities. However, the Board stated

it would consider individual applications for

this activity (1973 FRB 898); 51 Federal Regis-

ter 39,999 (1986). The Board expressed no

opinion as to whether the activity would meet

the National Courier test and would be a proper

incident to banking.

In 1988, a bank holding company (the appli-

cant) ﬁled an application to engage in armored

car activities through a de novo nonbank subsid-

iary. After notice of the application was pub-

lished, the Board received comments opposing

the proposal and was requested to order a for-

mal hearing. In response, the Board published

an order requiring a formal public administra-

tive hearing on the application. One issue, among

others, that the Board directed to be considered

was whether the proposed armored car services

were ‘‘so closely related to banking or manag-

ing or controlling banks as to be a proper inci-

dent thereto’’ under section 4(c)(8) of the BHC

Act.

An administrative hearing was held on

June 16 and July 11, 1989, before an administra-

tive law judge (ALJ). The ALJ issued a recom-

mended decision in which he concluded that

the proposed armored car activities were not

‘‘closely related to banking’’ and recommended

that the Board deny the application. The ALJ

found that none of the National Courier criteria

were demonstrated by the record. The ALJ’s

conclusion relied on certain operational distinc-

tions between the proposed armored car services

and the services banks traditionally perform

themselves.

Following receipt of exceptions to the recom-

mended decision, the Board reviewed the entire

record of the proceedings and determined that

the ALJ had erred in concluding that armored

car services were not ‘‘closely related to bank-

ing.’’ The Board concluded that, even accepting

the factual ﬁndings, the slight operational dis-

tinctions cited in the recommended decision

were not signiﬁcant. The Board found that

although there may be some distinctions between

bank-provided armored car services and the pro-

posed full-service, for-hire armored car service,

the nature of the customers served and the eco-

nomic basis of the services provided do not

fundamentally alter the nature of the services. It

was therefore clear to the Board that the ser-

vices then provided by the applicant as well as

other banks and bank holding companies to

themselves and their customers are sufﬁciently

‘‘operationally and functionally similar’’ to the

proposed service as to equip banking organiza-

tions particularly well to perform the proposed

service, and hence fulﬁll the second National

Courier test.

The Board also noted that bank holding com-

panies are permitted to provide courier services

forunafﬁliatedparties undersection225.25(b)(10)

of Regulation Y. The only essential difference

between the two services relates to the intrinsic

value of the materials transported. The Board

concluded that the services themselves were

certainly functionally and operationally similar,

thereby lending additional support to its favor-

able ﬁnding under the second National Courier

test.

The Board also found that the third National

Courier test was met, that the applicant had

demonstrated ‘‘the dependence of banks on a

specialized form of the proposed services.’’ The

Board found that the record amply demonstrated

that banks are highly dependent upon the spe-

cialized transportation services provided by

armored cars, which transport cash and valu-

ables with a high degree of security. The appli-

cant was proposing to engage in just those spe-

cialized services; it did not propose to start a

general moving or trucking service. The record

BHC Supervision Manual December 1993

Page 1

therefore supported a determination that the

third National Courier test was also satisﬁed.

Accordingly, the Board found, based on the

record before it, that providing for-hire armored

car services to the general public was an activity

that is closely related to banking.

This determination, however, is only one of

two steps needed for the Board to approve a

nonbank activity for a bank holding company.

The Board must also ﬁnd that the activity is a

‘‘proper incident thereto.’’ On this issue, the

ALJ declined to make any factual or legal deter-

minations concerning the proper-incident test or

state branching laws. However, under the Board’s

rules (12 C.F.R. 262.4 (1990)), the ALJ was

required to provide a recommended decision

with regard to all unresolved issues prior to a

ﬁnal Board determination (12 C.F.R. 263.11). A

ﬁnal disposition on the application therefore

was not possible at that juncture, and the Board

remanded the case to the ALJ for a recom-

mended decision on the proper-incident stan-

dard and other unresolved issues (see 1990 FRB

676).

In accordance with the Board’s remand order,

a second formal hearing was held before the

ALJ. Additional evidence and post-hearing briefs

were submitted, including evidence on the proper-

incident test, in support of this and other unre-

solved issues. The ALJ then issued his supple-

mental decision, which again recommended

denial of the application. The ALJ found that, in

this case, the applicant’s record failed to provide

a deﬁnitive proposal on which the Board could

make a determination under the proper-incident

test. The ALJ found that the applicant had

offered only a skeletal structure and operation

plan that was ﬂeshed out only to a limited extent

at the hearings. In addition, the ALJ found the

application and other facts of record to be deﬁ-

cient with regard to possible public beneﬁts and

adverse effects. The ALJ further determined that

the record had not shown that the proposed

activity, as structured, would be lawful under

the branch-banking laws of the states in which

the applicant proposed to operate.

Based on its review of the ALJ’s supplemen-

tal decision and the remainder of the record, the

Board determined that the record failed to sup-

port a ﬁnding that the proposed armored car

activities, in this particular instance, would be a

‘‘proper incident’’ to banking. The Board there-

fore adopted the ALJ’s recommendation to deny

the application, but only on the narrow grounds

of inconsistency of the proposal, as then struc-

tured, with section 23B of the Federal Reserve

Act.

In its order, the Board stressed that the burden

of proof is upon an applicant to establish that

the nonbanking activity it proposes to conduct—

in this case the provision of armored car

services—is not only closely related to banking,

but also a ‘‘proper incident thereto.’’ The Board’s

review of the entire proceeding disclosed certain

aspects of the application that appeared on its

face to violate the arm’s-length transaction

requirement of section FRA 23B. In the Board’s

view, a proposal to engage in nonbanking activ-

ities pursuant to section 4(c)(8) will not produce

net beneﬁts to the public, as required under the

public-beneﬁt test, if it violates the kind of

statutory requirement, such as section 23B, that

was speciﬁcally intended to prevent unsafe or

unsound banking practices when a bank afﬁliate

engages in nonbanking activities.

The ﬁrst potential violation would arise from

the fact that the proposed service by the bank

holding company’s nonbank subsidiary to its

bank afﬁliate would cost more than the bank

was paying for similar armored car services

provided by an unafﬁliated provider. The Board

noted that although there may be a justiﬁcation

for the higher pricing structure that would meet

the standards set forth in section 23B, no justiﬁ-

cation appeared in the record. The Board could

therefore only conclude that the bank may not

be obtaining services from the nonbank provider

‘‘on terms . . . at least as favorable to such bank

. . . as those prevailing for comparable transac-

tions with or involving other nonafﬁliated com-

panies,’’ as required by section 23B.

The second potential violation of section 23B

arose from the absence of a ‘‘precise breakdown

of the services the nonbank subsidiary will pur-

chase from the bank holding company’s subsid-

iary bank and the projected cost of those ser-

vices,’’ as called for in the Board’s prior order in

this matter. The applicant provided no detailed

cost ﬁgures for the wide variety of services the

applicant’s banking subsidiary was to provide to

the nonbank subsidiary. The bank holding com-

pany proposed to charge the bank subsidiary an

‘‘estimated’’ percentage (the fee was admitted

to have had no ‘‘factual basis’’ reﬂected in the

record) of the nonbank subsidiary’s direct oper-

ating expenses to cover all of the services pro-

vided by the bank holding company’s banking

subsidiary to its nonbanking subsidiary. Under

section 23B, the provision of services by a bank

to an afﬁliate must be paid for on an arm’s-

length basis. This requires, where there are no

comparable transactions between a bank and a

nonafﬁliate, that the bank’s provision of ser-

Impermissible Activities (Armored Car Services) 3700.10

BHC Supervision Manual December 1993

Page 2

vices to its afﬁliate be on terms that in good

faith would be offered to, or would apply to,

nonafﬁliated companies. The Board found that

the banking subsidiary would not in good faith

have provided back-ofﬁce services to an unafﬁl-

iated armored car company by charging a ﬂat

fee that had no factual basis and without deter-

mining the relationship of the fee to the actual

costs of providing the services. Therefore, the

potential violations of section 23B, on their

face, constrained the Board to deny the applica-

tion as it was structured (see 1993 FRB 352).

The Board noted its denial did not affect the

Board’s prior ruling in the case that armored car

services are closely related to banking, and was

without prejudice to the ﬁling of a new proposal

from which a favorable proper-incident ﬁnding

could be made.

Impermissible Activities (Armored Car Services) 3700.10

BHC Supervision Manual December 1993

Page 3

Impermissible Activities

(Computer Output Microﬁlm Service) Section 3700.11

The authority of bank holding companies under

section 225.25(b) of the Board’s Regulation Y

to engage in data processing activities is intended

to limit those activities to providing facilities

that perform banking functions, such as check

collection, or other similar functions for custom-

ers that are depository or other similar insti-

tutions, suchas mortgagecompanies.Withrespect

to this activity, the Board issued an interpreta-

tion that authorizes bank holding companies to

provide the formatting for computer output

microﬁlm only as an output option for data

otherwise permissibly processed by the holding

company system (1982 FRB 552).

BHC Supervision Manual December 1992

Page 1

Impermissible Activities (Clearing Securities Options and Other Financial

Instruments for the Accounts of Professional Floor Traders)

Section 3700.12

A foreign banking organization subject to the

BHC Act applied for the Board’s approval under

section 4(c)(8) to engage de novo through its

subsidiary (Company), in the exchange and clear-

ance of: (1) exchange traded securities options

and other securities and (2) futures and options

on futures that relate to ﬁnancial instruments.

The proposed customer base was comprised pri-

marily of market makers and other professional

ﬂoor traders dealing for their own accounts.

Most of the professional traders were expected

to be market makers and specialists, including

individuals, small partnerships, or small corpo-

rations, that were to trade primarily on the Chi-

cago Board of Options Exchange (CBOE).

Previously, the Board approved the execution

and clearance of ﬁnancial instruments as a

permissible nonbanking activity.

Under Board

precedent, the nonbanking subsidiary engaged

in such services has generally serviced a broad

range of retail and/or institutional customers.

Under this proposal, Company was to clear

trades for a specialized customer base com-

prised primarily of professional ﬂoor traders

that executed trades for their own accounts.

Nonbanking subsidiaries of BHCs, operating

in accordance with prior Board approvals, have

generally performed both execution and clear-

ance services. By performing both services, the

nonbank subsidiary is able to control risk

because it executes the majority of the trans-

actions that it clears. The nonbank subsidiary

can refuse to execute an order that it deems

inappropriate or it can require additional funds

or collateral from the customer in advance of

and as a condition to executing the transaction.

Unlike prior Board cases, Company plans to

provide primarily clearing services. As a clear-

ing agent, it would guarantee the ﬁnancial per-

formance of its customers to the clearing organi-

zation of the exchanges on which it operates.

After the start of trading on any day, Com-

pany would be obligated to settle each trade

entered into by its customers even when the

customer may not have the ﬁnancial resources

to honor its obligation. Since the trades have

already been executed by the time that they

would be presented to Company by these pro-

fessional ﬂoor traders, Company would be un-

able to decline transactions that posed unaccept-

able risk. On an intraday basis, professional

traders, who are not employees of Company and

who trade in relatively volatile instruments,

could expose Company to ﬁnancial risks be-

yond the trader’s capacity to repay and beyond

Company’s own resources.

The applicants proposed to limit the risk ex-

posure created by Company’s activities through

the establishment of risk guidelines and proce-

dures that were intended to monitor the intraday

trading activities of its ﬂoor traders. No such

system had been developed for the industry for

monitoring the intraday activities of ﬂoor trad-

ers on a real-time basis. Most of Company’s

traders would primarily operate on exchanges

that used an open outcry system rather than an

electronic trading system. As a result, Company

may not know its real-time committed positions

until the end of the trading day and therefore the

possibility existed that a ﬂoor trader could ex-

ceed Company’s risk limits and incur substan-

tial losses before Company could act to mitigate

its credit risk exposure. Professional ﬂoor trad-

ers generally operate with much higher levels of

leverage than the average brokerage customer of

a securities ﬁrm. Since most of Company’s cus-

tomers were to be market makers, such traders

could at times take positions contrary to the

market.

1. Market makers on the CBOE are ﬂoor traders that

perform a dealer function by trading for their own accounts, at

their own risk, and for their own proﬁt. Market makers

compete with other market makers assigned to the same class

of options. In contrast, ﬂoor brokers on the CBOE generally

act only as an agent, executing customer and ﬁrm proprietary

orders.

2. Refer to sections 225.25(b)(3) (trust companies engag-

ing in agency activities related to the clearing of securities);

225.25(b)(15) (securities brokerage activities); 225.25(b)(18)

(execution and clearance of futures and options on futures) of

the Board’s Regulation Y.

3. With this arrangement clearing ﬁrms may also be liable

for the obligations of other members of the exchange. Gener-

ally, losses of a failed member ﬁrm are covered in the follow-

ing order:

1. by the assets of the failed ﬁrm;

2. by the excess capital of the clearing organization;

3. by the guarantee fund of the clearing organization;

and

4. by direct assessments made on surviving member

ﬁrms.

Since member clearing ﬁrms are the ultimate source of capital

for both the clearing association and the guarantee fund, the

surviving ﬁrms will bear the ultimate burden of any loss.

BHC Supervision Manual December 1992

Page 1

Such circumstances potentially expose the

clearing ﬁrms to substantial losses. If the clear-

ing ﬁrm exhausts all or most of its capital in

funding the obligations of ﬂoor traders that have

lost substantial amounts of money in trading,

parent companies of the clearing ﬁrm may have

to cover the ﬁrm’s remaining contingent liabili-

ties. Such risks may be acceptable for some

nonbanking institutions currently providing these

services, but they may be inappropriate for U.S.

domiciled banking organizations.

The Board carefully considered the beneﬁts

of the proposal, including the Applicants entry

into a concentrated market, its experience with

similar activities on foreign exchanges, and

Company’s proposed risk management systems.

The Board concluded that the proposal, as it was

currently structured (including the absence of an

effective means to monitor and limit the poten-

tial credit risk exposure to the parent bank hold-

ing company) involved potential adverse effects

that outweighed the potential public beneﬁts.

The Board thus determined that the balance of

public interest factors that it is required to con-

sider under section 4(c)(8) of the BHC Act were

not favorable. The application was denied by

the Board on January 9, 1991 (1991 FRB 189).

Impermissible Activities (Clearing Securities Options and Other Financial Instruments for the

Accounts of Professional Floor Traders) 3700.12

BHC Supervision Manual December 1992

Page 2

Financial Holding Companies

(Section 4(k) of the BHC Act) Section 3900.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective January 2015, footnote 1 is revised to

indicate that SR-12-17/CA-12-14 supersedes

SR-99-15. See section 2124.05 of this manual.

The Gramm-Leach-Bliley Act (the GLB Act)

became effective on March 11, 2000. The GLB

Act authorized afﬁliations among banks, securi-

ties ﬁrms, insurance ﬁrms, and other ﬁnancial

companies. To further this goal, the GLB Act

amended section 4 of the BHC Act to allow a

bank holding company (BHC) or foreign bank

that qualiﬁes as a ﬁnancial holding company

(FHC) to engage in a broad range of activities

that (1) the GLB Act deﬁnes as ﬁnancial in

nature or incidental to a ﬁnancial activity, or

(2) the Board, in consultation with the Secretary

of the Treasury, determines to be ﬁnancial in

nature or incidental to a ﬁnancial activity. Fur-

thermore, section 4 of the BHC Act authorizes

an FHC to engage in designated ﬁnancial activi-

ties, including insurance and securities under-

writing and agency activities, merchant bank-

ing, and insurance company portfolio investment

activities.

The GLB Act includes conditions that must

be met for a BHC or a foreign bank to be

deemed a ‘‘ﬁnancial holding company’’ and

engage in expanded activities. The GLB Act

also allows an FHC to seek Board approval to

engage in any activity that the Board determines

(1) is complementary to a ﬁnancial activity and

(2) does not pose a substantial risk to the safety

and soundness of depository institutions or the

ﬁnancial system generally. BHCs that do not

qualify as FHCs are limited to engaging in those

nonbanking activities that were permissible under

section 4(c)(8) of the BHC Act before enact-

ment of the GLB Act.

The GLB Act provides that, in most cases, an

FHC may engage in or acquire the shares of a

company that is engaged in ﬁnancial activities

without obtaining prior approval from the Board.

An FHC is instead required to provide a post-

commencement notice to the Board within 30

days after commencing a ﬁnancial activity or

acquiring a company. See section 4(k) of the

BHC Act. Prior approval from the Board is

required to acquire or engage in the activities of

a savings association.

3900.0.1 FHC SUPERVISORY

OVERSIGHT AUTHORITY

Under the GLB Act, the Federal Reserve has

supervisory oversight authority and responsibil-

ity for BHCs, including BHCs that operate as

FHCs. The GLB Act sets forth parameters for

operating relationships between the Federal

Reserve and other regulators. The statute differ-

entiates between the Federal Reserve’s relations

with (1) depository institution regulators and

(2) functional regulators, which include insur-

ance, securities, and commodities regulators.

There should be minimal, if any, noticeable

change in the well-established relationships

between the Federal Reserve as BHC (including

FHC) supervisor and the bank and thrift supervi-

sors (federal and state). The Federal Reserve’s

relationships with functional regulators will, in

practice, depend on the extent to which an FHC

is engaged in functionally regulated activities;

those relationships will also be inﬂuenced by

existing working arrangements.

The Federal Reserve’s supervisory oversight

role is that of an umbrella supervisor concentrat-

ing on a consolidated or group-wide analysis of

an organization. Umbrella supervision is not an

extension of more traditional bank-like supervi-

sion throughout an FHC. The FHC framework

is consistent with and incorporates principles

that are well established for BHCs. The FHC

supervisory policy focuses on addressing super-

visory practice for and relationships with FHCs,

particularly those that are engaged in securities

or insurance activities. See SR-00-13.

3900.0.2 ROLES OF SUPERVISORS

The Federal Reserve is responsible for the con-

solidated supervision of FHCs. In this regard,

the Federal Reserve will assess the holding com-

pany on a consolidated or group-wide basis with

the objective of ensuring that the holding com-

pany does not threaten the viability of its deposi-

tory institution subsidiaries. The manner in which

the Federal Reserve fulﬁlls this role will likely

evolve along with the activities and structure of

FHCs, and it may differ depending on the mix

of banking, securities, and insurance activities

of an FHC.

Depository institution subsidiaries of FHCs

are supervised by their appropriate primary bank

BHC Supervision Manual January 2015

Page 1

or thrift supervisor (federal and state). The GLB

Act did not alter the role of the Federal Reserve,

as holding company supervisor, vis-a-vis the

primary supervisors of FHC-associated bank

and thrift subsidiaries. Traditionally, the Federal

Reserve has relied to the fullest extent possible

on those supervisors.

Nonbank (or nonthrift) subsidiaries engaged

in securities, commodities, or insurance activi-

ties are supervised by their appropriate func-

tional regulators. Such functionally regulated

subsidiaries include a broker, dealer, investment

adviser, and investment company registered with

and regulated by the Securities and Exchange

Commission (SEC) (or, in the case of an invest-

ment adviser, registered with any state); an

insurance company or insurance agent subject to

supervision by a state insurance regulator; and a

nonbank subsidiary engaged in activities regu-

lated by the Commodity Futures Trading Com-

mission (CFTC).

3900.0.3 FHC SUPERVISION

OBJECTIVES

The Federal Reserve, as umbrella supervisor,

will seek to determine that FHCs are operated in

a safe and sound manner so that their ﬁnancial

condition does not threaten the viability of afﬁli-

ated depository institutions. Oversight of FHCs

(particularly those engaged in a broad range of

ﬁnancial activities) at the consolidated level is

important because the risks associated with those

activities can cut across legal entities and busi-

ness lines. The purpose of FHC supervision is to

identify and evaluate, on a consolidated or group-

wide basis, the signiﬁcant risks that exist in a

diversiﬁed holding company to assess how these

risks might affect the safety and soundness of

depository institution subsidiaries.

Accordingly, the Federal Reserve will focus

on the ﬁnancial strength and stability of FHCs,

their consolidated risk-management processes,

and overall capital adequacy.The Federal Reserve

will review and assess the internal policies,

reports, and procedures and the effectiveness of

the FHC consolidated risk-management pro-

cess. The appropriate bank, thrift, or functional

regulator will continue to have primary respon-

sibility for evaluating risks, hedging, and risk

management at the legal-entity level for the

entity or entities that it supervises.

FHC supervision is not intended to impose

bank-like supervision on FHCs, nor is it intended

to duplicate or replace supervision by the pri-

mary bank, thrift, or functional regulators of

FHC subsidiaries. Rather, FHC supervision seeks

to protect the depository institution subsidiaries

of increasingly complex organizations with sig-

niﬁcant interrelated activities and risks, while

not imposing an unduly duplicative or onerous

burden on the subsidiaries of the organization.

Effective ﬁnancial holding company supervision

requires—

1. strong, cooperative relationships between the

Federal Reserve and primary bank, thrift,

and functional regulators and foreign super-

visors (these relationships respect the indi-

vidual statutory authorities and responsibili-

ties of the respective supervisors, but also

allow for enhanced information ﬂows and

coordination so that individual responsibili-

ties can be carried out effectively without

creating duplication or excessive burden);

2. substantial reliance by the Federal Reserve

on reports ﬁled with or prepared by bank,

thrift, and functional regulators, as well as on

publicly available information for both regu-

lated and nonregulated subsidiaries; and

3. continued reliance on the risk-focused super-

vision and examination process and on mar-

ket discipline.

3900.0.4 FHC SUPERVISION IN

PRACTICE

The supervisory activities of the Federal Reserve

fall into three broad categories: (1) information

gathering, assessments, and supervisory coop-

eration; (2) ongoing supervision; and (3) promo-

tion of sound practices and improved disclosure.

3900.0.4.1 Information Gathering,

Assessments, and Supervisory

Cooperation

To fulﬁll its GLB Act responsibilities, the Fed-

eral Reserve needs to interact closely and

exchange information with the primary bank,

thrift, and functional regulators. The Federal

Reserve will foster strong relationships with

senior management and the boards of directors

of FHCs, and have access to timely informa-

tion from FHCs. These relationships will need

to include heads of signiﬁcant business lines

and key internal-audit, control, and risk-

management ofﬁcials in order to understand

how risk-management and internal-control poli-

cies and procedures established at the consoli-

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

BHC Supervision Manual January 2015

Page 2

dated level are being implemented and assessed.

To achieve these objectives, Federal Reserve

supervisory staff will take the following actions:

1. Regularly assess an FHC’s centralized risk-

management and control processes. Such

assessments are necessary to understand an

organization’s overall risk proﬁle, identify

material contributions to core risks, and deter-

mine how such risks are being managed and

controlled on a consolidated basis.

2. Perform limited, targeted transaction testing.

The purpose of this transaction testing is to

verify that the risk-management systems of

the FHC are adequately and appropriately

measuring and managing areas of risk for the

organization, and to conﬁrm that laws and

regulations applicable to the FHC and within

the jurisdiction of the Federal Reserve are

being observed.

3. Have periodic discussions with FHC senior

management and boards of directors. Such

discussions will enable the Federal Reserve

to build relationships with key personnel and

to understand changing activities and the

evolving risk proﬁle of the consolidated

organization. Periodic discussions also will

provide a forum for supervisory staff to pres-

ent any ﬁndings or concerns related to the

activities of the group as a whole or to busi-

ness lines that cut across legal entities.

4. Have periodic discussions with key person-

nel. Discussions will be held with the person-

nel responsible for corporate management

and control functions, such as heads of busi-

ness lines, risk management, internal audit,

and internal control.

When performing the above tasks, Federal

Reserve supervisory staff, to the extent possible,

will coordinate their actions with those of the

primary bank, thrift, and functional regulators of

the FHC’s subsidiaries. For example, to under-

stand the risks and risk-management systems of

an FHC at the consolidated level, the Federal

Reserve will need information concerning assets

or liabilities booked in signiﬁcant bank, thrift,

and functionally regulated subsidiaries within

the FHC group. The primary bank, thrift, and

functional regulators of such subsidiaries also

may need information from the FHC to perform

their respective statutory mandates. To assist in

sharing needed information, Federal Reserve

supervisory staff should do the following:

1. Have periodic meetings with the primary

bank, thrift, and functional regulators of an

FHC’s subsidiaries. The purpose of these

meetings is to develop an understanding of

the risk proﬁles of the individual regulated

legal entities and their relation to the FHC’s

overallrisk proﬁle. These meetings also should

be used, when appropriate, to share informa-

tion regarding supervisory plans and to coor-

dinate supervisory activities and follow-up,

as needed.

2. Review the examination ﬁndings of primary

bank, thrift, and functional regulators (and

their self-regulatory organizations) together

with other relevant information. The purpose

of this review is to develop a consolidated

picture of the FHC’s ﬁnancial condition and

risk proﬁle, the effectiveness of risk-

management and internal-control policies,

and the implications for the afﬁliated deposi-

tory institutions.

3. Make available to primary bank, thrift, and

functional regulators, to the extent permis-

sible, pertinent information regarding the

FHC. Included is information on the ﬁnan-

cial condition, risk-management policies, and

operations of an FHC that may have a mate-

rial impact on individual regulated subsidi-

aries, as well as information concerning trans-

actions or relationships between the regulated

subsidiaries and other subsidiaries within the

FHC group. This process will assist supervi-

sors in performing their statutory and super-

visory responsibilities over regulated

subsidiaries.

4. Participate in the sharing of information

among international supervisors, consistent

with applicable law. The purpose of this

exchange is to ensure that an FHC’s global

activities are supervised on a consolidated

basis and to minimize material gaps in

supervision.

5. Review internal-audit and management

reports and publicly available information

(including market information on equity and

debt prices of the consolidated organiza-

tion), as well as reports and statistics col-

lected by other regulators, including regula-

tors of depository institution subsidiaries. To

limit regulatory burden, this information

should be obtained, to the fullest extent pos-

sible, from (1) the parent organization; (2) pri-

mary bank, thrift, and functional regulators

of the FHC’s regulated subsidiaries; and

(3) publicly available sources, such as exter-

nally audited ﬁnancial statements.

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

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Page 3

3900.0.4.2 Ongoing Supervision

3900.0.4.2.1 FHC Structure,

Management, and the Applications

Process

The Federal Reserve is responsible for under-

standing the consolidated organization’s legal,

organizational, and risk-management structure;

major business activities; and risk exposures

and risk-management systems. The Federal

Reserve needs to understand the nature and

degree of involvement of the board of directors

in overseeing their organization’s risk-

management and control process at the consoli-

dated group level. The Federal Reserve, when

considering any formal application, declaration,

or notiﬁcation at the FHC level, will coordinate,

as appropriate, with primary bank, thrift, and

functional regulators.

3900.0.4.2.2 Reporting and Examination

The Federal Reserve will rely, to the fullest

extent possible, on reports that an FHC or its

subsidiaries are required to ﬁle with federal or

state authorities (or self-regulatory organiza-

tions) or on reports that are prepared by the

federal or state authorities. The Federal Reserve

will rely on routinely prepared management

reports, publicly reported information, and

externally audited ﬁnancial statements. The Fed-

eral Reserve also will rely to the fullest extent

possible on the examination of an FHC’s bank

and nonbank subsidiaries by their appropriate

primary bank, thrift, and functional regulators

(and their self-regulatory organizations).

If supervisory staff requires a specialized

report from a functionally regulated subsidiary

of an FHC, staff will ﬁrst request it from the

subsidiary’s appropriate functional regulator. In

the event that the report is not made available to

the Federal Reserve, supervisory staff may obtain

the report directly from the functionally regu-

lated subsidiary if it is necessary to assess—

1. a material risk to the FHC or any of its

depository institution subsidiaries;

2. compliance with any federal law that the

Federal Reserve has speciﬁc jurisdiction to

enforce against the FHC or a subsidiary; or

3. the FHC’s systems for monitoring and con-

trolling ﬁnancial and operational risks that

may pose a safety-and-soundness threat to a

depository institution subsidiary.

The Federal Reserve may examine a function-

ally regulated subsidiary under certain circum-

stances. Before examining a functionally regu-

lated subsidiary, supervisory staff should ﬁrst

seek to obtain the necessary information from

the appropriate functional regulator. If an exami-

nation is determined to be necessary, the Federal

Reserve should coordinate its actions with the

appropriate functional regulator. An examina-

tion may be conducted when the Federal Reserve

has reasonable cause to believe (or reasonably

determines) that—

1. the subsidiary is engaged in an activity that

poses a material risk to an afﬁliated deposi-

tory institution,

2. the examination is necessary to be adequately

informed about the FHC’s systems for moni-

toring and controlling the ﬁnancial and

operational risks that may pose a safety-and-

soundness risk to a depository institution

subsidiary; or

3. the subsidiary is not in compliance with any

federal law that the Board has speciﬁc juris-

diction to enforce (and the Board cannot

determine compliance by examining the FHC

or its afﬁliated depository institutions).

The Federal Reserve, consistent with its cur-

rent practice, will continue relying to the fullest

extent possible on the work performed by bank,

thrift, and functional regulators to validate that

material risks are measured and managed

adequately at the regulated subsidiary level.

Where necessary and appropriate, and consis-

tent with (1) through (3) immediately above, the

Federal Reserve may conduct or participate in

reviews at banks, thrifts, or functionally regu-

lated subsidiaries to validate that risk-

management and internal-control policies estab-

lished at the consolidated level are being

implemented effectively.

For an FHC subsidiary that is not supervised

by a bank, thrift, or functional regulator, the

Federal Reserve will obtain information from

the subsidiary, as appropriate and necessary, to

assess the ﬁnancial condition of the FHC as a

whole. In addition, the Federal Reserve will

conduct examinations of such subsidiaries, if

necessary, to be informed about (1) the nature of

the subsidiary’s operations and ﬁnancial condi-

tion, (2) the subsidiary’s ﬁnancial and opera-

tional risks that may pose a threat to the safety

and soundness of any depository institution sub-

sidiary of the FHC, and (3) the systems for

monitoring and controlling such risks. Under

the GLB Act, the Federal Reserve may not

examine any subsidiary of an FHC that is an

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

BHC Supervision Manual January 2015

Page 4

investment company registered with the SEC

and that is not itself a BHC.

3900.0.4.2.3 Capital Adequacy

The Federal Reserve is responsible for assessing

consolidated capital adequacy for FHCs, with

the ultimate objective of protecting the insured

depository subsidiaries from the effects of dis-

ruptions in the nonbank portions of the organi-

zation. Capital adequacy will be assessed in

relation to the risk proﬁle of the consolidated

organization. The Federal Reserve will review

the FHC’s internal risk assessment and related

capital-analysis process for determining the

adequacy of its overall capital position. Such a

review will include consideration of current and

future economic conditions, business-

development plans for the future, possible stress

scenarios, and internal risk-control and audit

procedures. As BHCs, FHCs are subject to the

FederalReserve’sholding companycapital guide-

lines, which set forth minimum capital ratios

that serve as tripwires for additional supervisory

scrutiny and corrective action. The Federal

Reserve will review these requirements as they

apply to FHCs and may, if warranted, adapt the

manner in which they apply to FHCs that engage

in a broad range of ﬁnancial activities.

Although the Federal Reserve is responsible

for assessing the consolidated capital adequacy

of FHCs, the primary bank, thrift, or functional

regulators of FHC subsidiaries will continue to

set and enforce applicable capital requirements

for the regulated entities within their jurisdic-

tion. Under the GLB Act, the Federal Reserve

may not establish separate capital adequacy

requirements for an FHC subsidiary that is in

compliance with the capital requirements of its

functional regulator.

Consistent with current practice, the Federal

Reserve will continue to place signiﬁcant reli-

ance on the primary bank, thrift, or functional

regulator’s analysis of the capital adequacy of a

regulated subsidiary. That analysis will be a

signiﬁcant input in the Federal Reserve’s assess-

ment of an FHC’s consolidated capital adequacy,

especially when a securities broker-dealer or

insurance company is a predominant part of an

FHC.

Several issues become particularly important

when assessing the consolidated capital adequacy

of FHCs with functionally regulated subsidi-

aries. The capital adequacy requirements that

have been established for banking, securities,

and insurance entities by their respective regula-

tors reﬂect varying deﬁnitions of the elements

of capital and varying approaches to asset and

liability valuations. Yet techniques for assessing

capital adequacy must be able to identify situa-

tions such as double or multiple leverage or

double-gearing. In such cases, the actual capital

protection may be overstated.

3900.0.4.2.4 Intra-Group Exposures and

Concentrations

Intra-group exposures, including servicing

arrangements and risk concentrations, have the

potential to threaten the condition of regulated

entities. Intra-group exposures may be signiﬁ-

cant at large, complex FHCs, especially those

that operate their businesses on global lines that

cut across legal entities within the ﬁrm. The

Federal Reserve’s focus in this area is the poten-

tial impact of intra-group exposures and concen-

trations on insured depository institution subsid-

iaries of an FHC.

Risk concentrations can take many forms,

including exposures to one or more counterpar-

ties or related entities, industry sectors, and geo-

graphic regions. For risk concentrations, the

holding company supervisor is uniquely posi-

tioned to understand the combinations of expo-

sures within an organization across all legal

entities. This understanding is critical at the

group level—risk concentrations that are pru-

dent on a legal-entity basis may aggregate to an

unsafe level for the consolidated organization.

The Federal Reserve will monitor intra-group

exposures and risk concentrations as follows:

1. The appropriate primary bank and thrift regu-

lators will continue to monitor and enforce

section 23A and 23B restrictions at the bank

or thrift level. The Federal Reserve will focus

on assessing whether the FHC monitors and

ensures compliance with these statutory

requirements. The Federal Reserve plans to

begin collecting data from each depository

institution subsidiary of BHCs, including

FHCs, on their covered transactions with

afﬁliates that are subject to sections 23A and

23B and will share that data with primary

bank and thrift regulators.

2. Functional regulators will continue to moni-

tor and enforce any intra-group exposure

restrictions that may apply to the regulated

entities under their jurisdictions.

3. The Federal Reserve will focus on under-

standing and monitoring related-party expo-

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

BHC Supervision Manual January 2015

Page 5

sures at the group level (including areas such

as servicing agreements, derivatives expo-

sures, and payments-system exposures). An

important emphasis will be the extent to

which risk management in a group’s subsidi-

ary depository instutions depends on transac-

tions with afﬁliates.

4. The Federal Reserve will focus on manage-

ment’s effectiveness in monitoring and con-

trolling intra-group exposures and risk con-

centrations. The Federal Reserve will consider

how an organization’s risk-management pro-

cesses measure and manage group-wide risk

concentrations.

3900.0.4.2.5 Enforcement Powers

The Federal Reserve is authorized generally to

take enforcement action against FHCs and their

nonbank subsidiaries. The primary bank and

thrift supervisors have the authority to take

enforcement action against the banks and thrifts

under their respective jurisdictions. Under the

GLB Act, the Federal Reserve may take

enforcement action against a functionally regu-

lated subsidiary of an FHC, but only when such

action is necessary to prevent or redress an

unsafe or unsound practice or breach of ﬁdu-

ciary duty that poses a material risk either to

(1) the ﬁnancial safety, soundness, or stability of

an afﬁliated depository institution or (2) the

domestic or international payments system. In

such circumstances, the Federal Reserve may

only take the action if it is not reasonably pos-

sible to protect effectively against the material

risk through an action directed at or against an

afﬁliated depository institution.

Under any circumstances, the Board may take

enforcement action against a functionally regu-

lated subsidiary to enforce compliance with any

federal law that the Federal Reserve has speciﬁc

jurisdiction to enforce against the subsidiary. If

the Federal Reserve believes that an enforce-

ment action against a functionally regulated

entity is necessary, the Federal Reserve will

notify the entity’s appropriate functional regula-

tor and, whenever practical, will coordinate such

an action with any action taken by the func-

tional regulator. It is expected that the Federal

Reserve will not take an enforcement action

against a functionally regulated subsidiary (or a

person associated with the subsidiary) if the

problem involves factors and statutes that are

the primary responsibility of the functional regu-

lator.

Under the existing bank holding company

framework, the Federal Reserve coordinates

enforcement actions with the primary bank and

thrift regulators, possibly with some adaptation

of the action for the holding company context

(such as limitations on parent company debt or

dividends). The Federal Reserve will continue

to coordinate enforcement actions with these

regulators. Similarly, the Federal Reserve will

coordinate with functional regulators when for-

mulating and issuing enforcement actions that

involve or may have an impact on functionally

regulated subsidiaries.

3900.0.4.3 Promotion of Sound Practices

and Improved Disclosure

The Federal Reserve can promote sound prac-

tices in a number of ways, such as by monitor-

ing trends in risk exposures and risk-

management practices across the FHC population

through a combination of efforts, including—

1. regulardiscussions, centered on speciﬁc issues

and emerging risks, with FHC management;

2. regular meetings with primary bank, thrift,

and functional regulators to explore and dis-

cuss issues of mutual interest or concern;

3. interagencyworking groups or specialty teams

to gain early insight into risks that cut across

the various entities of a conglomerate or

groups of conglomerates; and

4. industry conferences on relevant topics of

interest.

These initiatives will contribute to the develop-

ment of sound practices that the Federal Reserve

and the primary bank, thrift, and functional

regulators can communicate to the senior man-

agement and boards of directors of the FHCs, as

well as to the senior management of their bank

and nonbank subsidiaries.

Improved transparency and public disclosure

can meaningfully supplement the efforts of

supervisors to monitor the increasingly complex

and global activities of diversiﬁed banking orga-

nizations. Consistent with sound accounting prin-

ciples,practices,and depositoryinstitution safety-

and-soundness practices, the Federal Reserve

will participate in efforts to enhance disclosures

that will illuminate group-wide activities, risk

exposures, risk management, controls, and intra-

group exposures.

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

BHC Supervision Manual January 2015

Page 6

3900.0.4.4 Supervisory Response to

Challenges Posed by FHCs

The Federal Reserve’s response to the supervi-

sory challenges of FHCs has been in the context

of the consolidated supervision of BHCs.

Examples include greater reliance on risk-

focused supervision; strengthening relationships

with senior management; improving coordina-

tion with other federal, state, and international

regulatory and supervisory authorities; greater

reliance on specialty teams, sound-practices

papers, and public disclosures; and simpliﬁca-

tion of the applications process.

The more diversiﬁed FHCs present new

supervisory challenges. To address these chal-

lenges, the Federal Reserve will continue to

strengthen—

1. cooperative arrangements with bank and thrift

regulators, the SEC, the CFTC, state insur-

ance and securities regulators, and foreign

supervisors;

2. relationships with the FHC management and

personnel responsible for signiﬁcant risk-

management functions and, when necessary,

the management of the organization’s non-

bank subsidiaries;

3. information ﬂows that provide supervisors

with relevant, up-to-date information without

imposing an unwarranted burden on ﬁnancial

organizations;

4. techniques for evaluating capital adequacy

for FHCs engaged in an expanded range of

nonbank ﬁnancial activities;

5. public disclosures and market discipline;

6. techniques for assessing the overall risk pro-

ﬁle of FHCs and the implications for afﬁli-

ated depository institutions; and

7. incentives for FHCs to continually review

and improve their risk-management pro-

cesses, internal controls, and audit practices.

The Federal Reserve is committed to working

constructively and cooperatively with all regula-

tors involved in overseeing the activities of

FHCs and their bank and nonbank subsidiaries.

1. The Federal Reserve’s framework for supervising large

complex banking organizations (LCBOs) is described in

SR-12-17/CA-12-14, “Consolidated Supervision for Large

Financial Institutions.” See section 2124.05.

Financial Holding Companies (Section 4(k) of the BHC Act) 3900.0

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Page 7

U.S. Bank Holding Companies Operating as Financial Holding

Companies (Section 4(k) of the BHC Act) Section 3901.0

To become a ﬁnancial holding company (FHC),

a domestic bank holding company (BHC) must

ﬁle a written declaration with the appropriate

Federal Reserve Bank. This declaration should

contain the following information:

1. A statement that the BHC elects to be an

FHC.

2. The name and head-ofﬁce address of the

company and each depository institution con-

trolled by the company. For purposes of the

election process for both domestic BHCs and

foreign banks, the term ‘‘depository institu-

tion’’ here means any national bank, state-

chartered bank, federal branch of a foreign

bank, insured branch of a foreign bank, sav-

ings association, savings bank, and industrial

bank. It also includes any trust company that

engages in the business of receiving deposits

other than trust funds. (See 12 U.S.C. 1813.)

A depository institution does not have to

have FDIC insurance.

3. A certiﬁcation that all depository institutions

controlled by the company are well capital-

ized as of the date the company ﬁles its

declaration.

4. The capital ratios for all relevant capital mea-

sures (as deﬁned in section 38 of the Federal

Deposit Insurance Act), as of the close of the

previous quarter, for each depository institu-

tion controlled by the company on the date

the company ﬁles its declaration.

5. A certiﬁcation that all depository institutions

controlled by the company are well managed

as of the date the company ﬁles its declara-

tion.

A depository institution is well managed if, at

the most recent inspection or examination or

subsequent review by its appropriate federal

banking agency, the institution received (1) at

least a satisfactory composite rating and (2) at

least a satisfactory rating for management, if

such a rating is given. In the case of a deposi-

tory institution that has not received an inspec-

tion or examination rating, a depository institu-

tion is well managed if the Board has determined,

after a review of the depository institution’s

managerial and other resources and after con-

sulting with the depository institution’s appro-

priate federal and state banking agency, that the

institution is well managed. In addition, a deposi-

tory institution that results from the merger of

two or more depository institutions that are well

managed will be considered to be well managed

unless the Board determines otherwise after

consulting with the appropriate federal banking

agency for each depository institution involved

in the merger.

A depository institution that results from the

merger of a depository institution that is well

managed with one or more depository institu-

tions that are not well managed or that have not

been examined will be considered to be well

managed, if the Board determines that the result-

ing institution is well managed. The Board

makes this determination after a review of the

managerial and other resources of the resulting

institution and after consulting with the appro-

priate federal and state banking agencies for the

institutions involved in the merger, as

applicable.

The Gramm-Leach-Bliley Act (the GLB Act)

also requires that all the insured depository insti-

tutions controlled by the FHC at the time of the

declaration must be rated satisfactory or better

under the Community Reinvestment Act (CRA).

When determining whether the insured deposi-

tory institutions controlled by a BHC meet the

CRA requirement, the Federal Reserve excludes

an institution that was acquired during the 12

months preceding the date the company ﬁled its

declaration. To qualify for this exception, (1) the

company must have submitted the depository

institution’s afﬁrmative correction plan to the

appropriate federal banking agency and (2) the

agency must have accepted the plan.

A BHC must ﬁle its declaration to become an

FHC with the appropriate responsible Reserve

Bank. A BHC’s election to become an FHC is

effective on the thirty-ﬁrst day after the date that

a complete declaration was received, unless the

Board notiﬁes the company before that time that

the election is ineffective. The Board or the

appropriate Federal Reserve Bank also may

notify a BHC in writing that its election to

become an FHC is effective before the thirty-

ﬁrst day after the date that a complete declara-

tion was ﬁled.

When an FHC’s declaration becomes effec-

tive, it may engage in the expanded ﬁnancial

activities available to such companies. If, how-

ever, the Board has timely notiﬁed a BHC that

its declaration is ineffective, the BHC will not

be considered an FHC and may not begin to

engage in any expanded activities.

A company that is not a BHC may simulta-

neously submit an application under section

3(a)(1) of the Bank Holding Company Act (BHC

BHC Supervision Manual July 2009

Page 1

Act) to become a BHC and to request to become

an FHC on consummation of that transaction.

The company must (1) state that it seeks to

become an FHC on consummation of its section

3 proposal to become a BHC and (2) certify that

each depository institution that would be con-

trolled by the company on consummation of the

section 3 proposal will be both well capitalized

and well managed on the date of consummation.

To coordinate action on these two requests, the

acceptance of the declaration as complete does

not occur until the date the company lawfully

consummates its section 3 proposal and becomes

a BHC. A simultaneous declaration will not be

effective if the Board notiﬁes the company at

any time before consummation that (1) any

depository institution that would be controlled

by the company on consummation will not be

well capitalized and well managed or (2) any

insured depository institution that would be con-

trolled by the company on consummation has

not achieved at least a satisfactory rating at its

mostrecentCRA examination.An insureddeposi-

tory institution that is controlled or would be

controlled by a company ﬁling a simultaneous

declaration and section 3(a)(1) application to

become a BHC may not be excluded for the

purposes of evaluating the CRA performance

record under this provision or the general FHC

certiﬁcation requirements of section 225.82(d)

of Regulation Y.

In most cases, an FHC may, without provid-

ing prior notice to or obtaining prior approval

from the Board, conduct an activity that is ﬁnan-

cial in nature or incidental to a ﬁnancial activity

(a ﬁnancial activity). (See section 225.85(a)(1)

of Regulation Y.) An FHC may conduct a ﬁnan-

cial activity by engaging directly in the activity

or by acquiring and retaining the shares of any

company that is engaged exclusively in one or

more ﬁnancial activities. An FHC may conduct

a ﬁnancial activity at any location inside or

outside of the United States, subject to the laws

of the jurisdiction in which the activity is con-

ducted. A company acquired or to be acquired

by an FHC also may engage in other activities

that are permissible for an FHC, in accordance

with any applicable notice, approval, or other

requirements.

An FHC may acquire more than 5 percent of

the voting shares or control of a company that is

not engaged exclusively in activities that are

ﬁnancial in nature, incidental to ﬁnancial activi-

ties, or otherwise permissible for the acquiring

FHC. (See section 225.85(a)(3) of Regulation

Y.) To do so, the acquisition must meet three

requirements:

1. The company to be acquired must be sub-

stantially engaged in activities that are ﬁnan-

cial in nature, incidental to a ﬁnancial activ-

ity, or otherwise permissible for the FHC

under section 4(c) of the BHC Act. A com-

pany is considered to be substantially engaged

in permissible activities if at least 85 percent

of the company’s consolidated total annual

gross revenues is derived from and at least

85 percent of the company’s consolidated

total assets is attributable to the conduct of

activities that are ﬁnancial in nature, inciden-

tal to a ﬁnancial activity, or otherwise per-

missible for an FHC under section 4(c) of the

BHC Act. An FHC’s management should

consult with Board staff if they are uncertain

whether a proposed acquisition meets this

standard.

2. The FHC must comply with the notice

requirements of section 225.87 of Regulation

Y. The acquired company must conform, ter-

minate, or divest, within two years of the

date the FHC acquires shares or control of

the company, all activities that are not ﬁnan-

cial in nature, incidental to a ﬁnancial activ-

ity, or otherwise permissible for the FHC

under section 4(c) of the BHC Act. Although

an FHC may acquire any percentage of shares

or control of a company engaged in limited

impermissible activities, the FHC needs only

to provide a post-transaction notice if such

anacquisition resultsincontrol ofthecompany.

3. After being acquired by an FHC, the com-

pany engaged in impermissible activities may

not engage in or acquire a company engaged

in any activity that is not permissible for the

FHC.

Section 225.85(c) of Regulation Y identiﬁes

two circumstances in which Board approval is

still required to engage in ﬁnancial activities.

First, prior approval in accordance with section

4(j) of the BHC Act and section 225.24 of

Regulation Y is required to acquire more than

5 percent of the voting shares or control of a

savings association or any company that owns,

operates, or controls a savings association. Sec-

ond, the Board may, in the exercise of its super-

visory authority, require an FHC to provide it

with prior notice or obtain prior Board approval

if circumstances warrant. The GLB Act did not

change in any way the requirement that a com-

pany receive prior Board approval under section

3 of the BHC Act before acquiring shares or

control of a bank.

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

BHC Supervision Manual July 2009

Page 2

Section 225.87(a) of Regulation Y requires

an FHC that commences an activity, or that

acquires control or shares of a company engaged

in an activity under section 225.86 of Regula-

tion Y, to provide written notice to the appropri-

ate Reserve Bank within 30 calendar days after

commencing the activities or consummating the

acquisition. The notice must be provided on the

FR Y-10 form, obtained from the Board or any

Reserve Bank. This requirement also applies to

an activity that the FHC may engage in under

section 4(c)(8) of the BHC Act that is incorpo-

rated under section 4(k) of the act.

There are two circumstances in which notice

to the Board is not required to engage in an

activity: (1) when an FHC acquires shares of a

company without acquiring control of the com-

pany, or (2) when an FHC is engaged in securi-

ties underwriting, dealing, or market-making

activities described in section 4(k)(4)(E), mer-

chant banking investment activities conducted

pursuant to section 4(k)(4)(H), or insurance

company investment activities conducted pursu-

ant to section 4(k)(4)(I) of the BHC Act, and

has provided the System with the appropriate

notice regarding the relevant activity. (See sec-

tion 225.87(b) of Regulation Y.) Under these

circumstances, the FHC must provide written

notice to the Board within 30 days after acquir-

ing, as part of a merchant banking activity under

section 4(k)(4)(H) or an insurance company

investment activity under section 4(k)(4)(I) of

the BHC Act, more than 5 percent of any com-

pany at a cost that exceeds 5 percent of the

FHC’s tier 1 capital or $200 million, whichever

is less.

3901.0.1 SUPERVISORY CONCERNS

In some instances, a U.S. BHC or a foreign bank

may meet the statutory requirements to be an

FHC, but its capital strength and managerial

resources are less than satisfactory on a consoli-

dated basis. In this situation, the Federal Reserve

may have supervisory concerns about the con-

solidated entity although it technically qualiﬁes

as an FHC. The Federal Reserve may, in the

exercise of its supervisory authority, restrict or

limit the conduct of new activities or future

acquisitions of an FHC, or take other appropri-

ate action, if it ﬁnds that the FHC does not have

the ﬁnancial or managerial resources to conduct

the activity or make the acquisition. This super-

visory action could be based, for example, on a

determination that the company does not have

adequate capital or risk-management systems to

conduct a speciﬁc activity in a safe and sound

manner and may involve the issuance of cease-

and-desist orders, the execution of written agree-

ments, or other appropriate supervisory action.

3901.0.2 HOLDING COMPANY FAILS

TO CONTINUE MEETING FHC

CAPITAL AND MANAGEMENT

REQUIREMENTS

If a domestic bank holding company has made

an effective election to be an FHC, and the

Board ﬁnds that any depository institution sub-

sidiary owned or controlled by the company

ceases to be well capitalized or well managed,

the company must execute an agreement accept-

able to the Federal Reserve Board to comply

with all applicable capital and management

requirements. This agreement should be executed

within 45 days after the Board notiﬁes the com-

pany that it is not in compliance with the appli-

cable requirements for an FHC. (See section

225.83 of Regulation Y.)

At the request of the bank holding company,

the Federal Reserve Board may extend the 45-

day period. The request should state why an

extension is necessary. The agreement must

explain the speciﬁc actions that the bank hold-

ing company will take to correct all areas of

noncompliance, provide a schedule for all such

actions, and provide any other information the

Board may require, and be acceptable to the

Board.

During the period of noncompliance, the Fed-

eral Reserve Board may impose limitations or

conditions on the activities of the company. In

addition, the company must obtain the Board’s

approval before conducting any of the activities

that are newly authorized for FHCs by the GLB

Act. Section 225.83 of Regulation Y also sets

forth the consequences of failing to correct the

noncompliance within a period of 180 days.

Such consequences may include divestiture of

ownership or control of any depository institu-

tion the company owns or controls, or the cessa-

tion of the expanded activities permitted for

FHCs.

3901.0.3 DEPOSITORY INSTITUTION

SUBSIDIARY FAILS TO MAINTAIN A

SATISFACTORY OR BETTER CRA

RATING

The Federal Reserve Board prohibits an FHC

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

BHC Supervision Manual December 2001

Page 3

from engaging in any additional activity

acquiring control of a company engaged in any

activity under section 4(k) and 4(n) of the BHC

Act if any insured depository institution con-

trolled by the FHC fails to maintain a satisfac-

tory or better CRA rating.

3901.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

BHCs and foreign banks that qualify

as FHCs can engage in ﬁnancial

activities and those incidental thereto

1843

Deﬁnition of an FHC 225.81 4-056

Election to become an FHC 225.82 4-056.1

Failure to meet applicable capital and

management requirements

225.83 4-056.2

Consequences of the failure to main-

tain at least a satisfactory CRA rating

225.84 4-056.3

Notices or approvals for FHCs to

engage in ﬁnancial activities

225.85 4-056.4

Activities permissible for FHCs 228.86 4-056.5

Post-commencement notice for FHC

to engage in a ﬁnancial activity

225.87 4-056.6

Board determination that an FHC

activity is ﬁnancial in nature or inci-

dental thereto

225.88 4-056.7

Board approval for an FHC to engage

in an activity that is complementary to

a ﬁnancial activity

225.89 4-056.8

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

1. With respect to engaging in any additional activities, see

section 225.84 of Regulation Y for the exceptions.

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

BHC Supervision Manual December 2001

Page 4

Foreign Banks Operating as Financial Holding

Companies (Section 4(k) of the BHC Act) Section 3903.0

3903.0.1 FINANCIAL HOLDING

COMPANY QUALIFICATION

REQUIREMENTS FOR FOREIGN

BANKS

A foreign bank that owns or controls a U.S.

bank (and any company that controls the foreign

bank) must comply with the same requirements

as a domestic bank holding company (BHC)

that elects to be treated as a ﬁnancial holding

company (FHC). Either entity is thus able to

engage in authorized ﬁnancial activities under

the Gramm-Leach-Bliley Act (GLB Act). If a

foreign bank does not own a subsidiary bank in

the United States, but instead operates through a

branch, agency, or commercial lending com-

pany located in the United States, the foreign

bank (and any company that controls the foreign

bank) is subject to the Bank Holding Company

Act (BHC Act) as if the foreign bank or com-

pany were a BHC. Such foreign banks may, like

U.S. BHCs, also elect to be treated as FHCs.

Foreign banks electing to be treated as FHCs

must meet ‘‘well-capitalized’’ and ‘‘well-

managed’’ standards comparable to those that

are applicable to U.S. depository institutions.

Futher, any U.S. branches of the foreign bank

that are FDIC-insured must be rated satisfactory

or better under the Community Reinvestment

Act (CRA).

(See section 225.90 of Regulation

Y.)

To be treated as an FHC, a foreign bank (or a

company that owns or controls a foreign bank)

that operates in the United States only through

U.S. branches, agencies, or commercial lending

subsidiaries must ﬁle a written declaration with

the appropriate Reserve Bank. This declaration

must contain items 1 through 6 below. Foreign

banks or companies that operate in the United

States through U.S. branches, agencies, or com-

mercial lending companies and through a U.S.

subsidiary bank are not required to provide item

1, but they must provide the items domestic

BHCs are to provide.

1. a statement that the foreign bank or company

elects to be treated as an FHC

2. the risk-based capital ratios and the amounts

of tier 1 capital and total assets of the foreign

bank as of the close of the most recent quar-

ter, and as of the close of the most recent

audited reporting period

3. a certiﬁcation that the foreign bank meets the

standards to be well capitalized that are set

out in section 225.90(b)(1)(i) and (ii) or sec-

tion 225.90(b)(2) of Regulation Y, as of the

date the foreign bank or company ﬁles its

election

4. a certiﬁcation that the foreign bank is well

managed, as deﬁned in section 225.90(c)(1)

of Regulation Y, as of the date the foreign

bank or company ﬁles its election

5. a certiﬁcation that all U.S. depository institu-

tions controlled by the foreign bank or com-

pany (including thrifts and nonbank trust

companies) are well capitalized and well

managed as of the date the foreign bank or

company ﬁles its election

6. the capital ratios and all relevant capital mea-

sures (as deﬁned in section 38 of the Federal

Deposit Insurance Act) for all U.S. deposi-

tory institution subsidiaries of the foreign

bank or company as of the end of the previ-

ous quarter

The well-capitalized and well-managed tests in

items 2, 3, and 4 above apply to each foreign

bank that has U.S. operations in the form of a

branch, agency, or commercial lending com-

pany subsidiary that is part of a foreign banking

organization seeking certiﬁcation as an FHC.

For those foreign banks whose home-country

supervisors have adopted risk-based capital stan-

dards consistent with the Basel Accord, their

tier 1 and total risk-based capital ratios, as calcu-

lated under the home-country standard, must be

at least 6 percent and 10 percent, respectively.

The Board will determine the comparability of

the foreign bank’s capital under the listed com-

parability factors in section 225.92(e) of Regula-

tion Y. Among these factors are the composition

of the foreign bank’s capital, accounting stan-

dards, long-term debt ratings, the ratio of tier 1

capital to total assets, reliance on government

support to meet capital requirements, the for-

eign bank’s anti–money laundering procedures,

whether the foreign bank is subject to compre-

hensive consolidated supervision, and other fac-

tors that may affect the analysis of capital and

management.

For those foreign banks whose

1. Under the GLB Act, the capital and management stan-

dards the Board must apply to foreign banking organizations

that elect to become FHCs should be comparable to the

standards applied to domestic institutions, giving due regard

to the principle of national treatment and equality of competi-

tive opportunity.

2. The Board may consider whether the overall level of the

foreign bank’s capital and other factors indicate that addi-

BHC Supervision Manual December 2001

Page 1

home-country supervisors have not adopted the

Basel Accord and for any other foreign banking

organizations that otherwise do not meet the

capital standards noted above, the foreign bank

may be considered well capitalized by obtaining

from the Board a prior determination that its

capital is otherwise comparable to the capital

that would be required of a U.S. banking organi-

zation to become an FHC. The pre-clearance

process provided by section 225.91(c) of Regu-

lation Y can be used to obtain this determina-

tion.

A foreign bank will be considered well man-

aged if—

1. the branches, agencies, and commercial lend-

ing subsidiaries of the foreign bank have

received at least a satisfactory composite rat-

ing at their most recent examination;

2. the home-country supervisor of the foreign

bank consents to the foreign bank expanding

its activities in the United States to include

FHC activities;

and

3. the Board determines that the management

of the foreign bank meets standards compa-

rable to those required of a U.S. bank owned

by an FHC.

The Board believes that, as a general rule, the

top tier foreign bank in a foreign banking group

that requests an FHC determination should be

subject to comprehensive consolidated supervi-

sion by the home-country supervisor.

As a general matter, a foreign bank will not

be determined to be well capitalized and well

managed when it is not subject to comprehen-

sive consolidated supervision. When a foreign

bank has not been determined by the Board to

be subject to comprehensive consolidated super-

vision, and the Board has not deemed any other

bank from the country where the foreign bank is

chartered to be subject to comprehensive con-

solidated supervision, the foreign bank must use

the pre-clearance process provided by section

225.91(c) of Regulation Y—even if it otherwise

meets the objective screening criteria. The Board

may review a foreign bank’s home-country

supervision through the pre-clearance process

and make a comprehensive consolidated super-

vision determination in that context. The Board

will try to make a determination on pre-

clearance requests within 30 days of receipt.

There may be limited situations when an

exceptionally strong bank from a country that

has not yet fully implemented comprehensive

consolidated supervision should be considered

for FHC status. Such a foreign bank can qualify

for FHC status if (1) the home-country supervi-

sor has made signiﬁcant progress in adopting

and implementing arrangements for the consoli-

dated supervision of its banks, and (2) the for-

eign bank demonstrates signiﬁcant ﬁnancial

strength, such as through high levels of capital

or exceptional asset quality. The Board antici-

pates, however, that a foreign bank that is not

subject to comprehensive consolidated supervi-

sion will be granted FHC status only in rare

instances.

As in the case of domestic BHCs, each U.S.

depository institution subsidiary of a foreign

bank is required to meet all the well-capitalized

and well-managed standards in order for the

foreign bank or company to obtain FHC status

in the same manner as required for U.S. BHCs.

In addition, all the U.S. insured depository insti-

tutions controlled by the foreign bank or com-

pany must be rated satisfactory or better under

the CRA. If the foreign bank operates a U.S.

branch that is FDIC-insured, the branch must be

rated satisfactory or better under the CRA.

tional analysis should be undertaken to assess comparability.

The Board will not impose a speciﬁc standard for the foreign

bank’s ratio of tier 1 capital to total assets (the leverage ratio),

but a foreign bank’s leverage ratio may be among the factors

taken into account in the comparability review.

3. The Federal Reserve’s foreign bank examination pro-

cess includes the assignment of a combined assessment (the

combined ROCA rating) of a foreign banking organization’s

(FBO’s) U.S. branch, agency, and commercial lending opera-

tions through the regular examination cycle. (See SR-00-14.)

The combined ROCA rating will be factored into the FBO’s

overall combined U.S. operations rating, which will continue

to be a single composite rating that reﬂects the U.S. supervi-

sors’ collective assessment of all operations (that is, banking

and nonbanking) of the FBO in the United States. If a foreign

bank wishes to obtain FHC status, but does not have the

assignment of a combined U.S. banking assessment as part of

the regular examination cycle, the foreign bank can contact its

responsible Federal Reserve Bank or engage in the pre-

clearance process. If a foreign banking group contains more

than one foreign bank with U.S. banking ofﬁces, each such

foreign bank in the group must have a satisfactory composite

U.S. banking assessment in order for the foreign banking

group or any of its subsidiaries to obtain FHC status.

4. The home-country supervisor should consider the FBO’s

consolidated capital and management before providing its

consent to the expansion. If the home country has no formal

consent process, the Board will consult with the supervisor to

assure itself that the supervisor considers the capital and

management of the bank to satisfy its home-country standards

and that the supervisor has no objections to the expansion.

5. If the Board makes an afﬁrmative comprehensive con-

solidated supervision determination through the FHC pre-

clearance process, the determination will be relied on for the

foreign bank to establish additional branches and agencies

under the Foreign Bank Supervision Enhancement Act.

Foreign Banks Operating as Financial Holding Companies 3903.0

BHC Supervision Manual December 2001

Page 2

An election by a foreign bank or company to

be treated as an FHC will become effective on

the thirty-ﬁrst day after the date that an election

was received by the appropriate Reserve Bank,

unless the Board notiﬁes the foreign bank or

company before that time that the election is

ineffective or unless the period for the Board’s

determination is extended with the consent of

the foreign bank or company making the elec-

tion. The date the Federal Reserve Bank receives

the declaration should be considered the ﬁrst

day of the 30-day review period. The Board or

the Reserve Bank also may notify a foreign

bank or company in writing that its election to

become an FHC is effective before the thirty-

ﬁrst day after the election was ﬁled. A foreign

bank or company should ﬁle the declaration (or

pre-clearance request) with the responsible

Reserve Bank.

If the election is determined to be effective,

the foreign bank or company may engage in the

ﬁnancial activities available to FHCs. The GLB

Act requires that an FHC that engages in an

activity, or that acquires control or shares of a

company engaged in an activity, under section

4(k) of the BHC Act provide written notice to

the appropriate Reserve Bank within 30 calen-

dar days after commencing the activities or

acquisition.Thenotice shoulddescribethe activity

commenced or identify the name of the com-

pany acquired and describe its activities.

3903.0.2 FOREIGN BANK FAILS TO

CONTINUE MEETING FHC CAPITAL

AND MANAGEMENT

REQUIREMENTS

If a foreign bank or company has made an

effective election, and the Board ﬁnds that the

foreign bank; any foreign bank that is controlled

by the foreign bank and maintains a U.S. branch,

agency, or commercial lending company; or any

U.S. depository institution owned or controlled

by the foreign bank or company ceases to be

well capitalized or well managed, the foreign

bank or company must execute an agreement

acceptable to the Federal Reserve Board to com-

ply with all applicable capital and management

requirements. This agreement should be executed

within 45 days after the Board notiﬁes the for-

eign bank or company that it is not in compli-

ance with the applicable requirements for an

FHC. (See section 225.93 of Regulation Y.) At

the request of the foreign bank or company, the

Board may extend the 45-day period. (The request

should state why an extension is necessary.) The

agreement must explain the speciﬁc actions that

the foreign bank or company will take to correct

all areas of noncompliance, provide a schedule

for all such actions, provide any other informa-

tion the Board may require, and be acceptable to

the Board. During the period of non-

compliance, the Board also may impose limita-

tions or conditions on the U.S. activities of the

foreign bank or company. Section 225.93 of

Regulation Y also sets forth the consequences

of failing to correct the noncompliance within a

period of 180 days. Such consequences may

include termination of the foreign bank’s U.S.

branches and agencies and divestiture of its

commercial lending company subsidiaries, or

cessation of the expanded activities permitted

for FHCs. The foreign bank may also choose to

cease engaging in activities not permitted for a

foreign bank under sections 2(h) and 4(c) of the

BHC Act.

3903.0.3 INSURED BRANCH FAILS

TO MAINTAIN A SATISFACTORY OR

BETTER CRA RATING

When an insured branch of a foreign bank, or an

insured depository institution controlled by a

foreign bank, fails to maintain a satisfactory or

better CRA rating, section 225.94 of Regulation

Y applies the provisions of section 225.84 to the

foreign bank and to any company that owns or

controls the foreign bank. For these purposes,

the insured branch is treated as an ‘‘insured

depository institution.’’ An FHC is thus prohib-

ited by the Board from engaging in any addi-

tional activity or acquiring control of a company

engaged in activities under section 4(k) or 4(n)

of the BHC Act.( See section 225.84 of Regula-

tion Y.)

Foreign Banks Operating as Financial Holding Companies 3903.0

BHC Supervision Manual December 2001

Page 3

3903.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

BHCs and foreign banks that qualify

as FHCs can engage in ﬁnancial

activities and those incidental thereto

1841(h)

1843(c)

Election of a foreign bank to become

an FHC

225.91 4-057.2

How elections by foreign banks to be

an FHC become effective

225.92 4-057.3

Foreign bank fails to satisfy capital

and management requirements

225.93 4-057.4

Foreign branch fails to retain a satis-

factory CRA rating

225.94

225.84

4-057.7

4-056.5

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Foreign Banks Operating as Financial Holding Companies 3903.0

BHC Supervision Manual December 2001

Page 4

Permissible Activities for FHCs

(Section 4(k) of the BHC Act) Section 3905.0

WHAT’S NEW IN THIS REVISED

SECTION

Effective July 2008, this section was revised to

include the Board’s September 7, 2007, determi-

nation, by order, at the FDIC’s request, that

disease management and mail-order pharmacy

activities complement the ﬁnancial activity of

underwriting and selling health insurance; per-

missible for an FHC under section 4 (k) of the

BHC Act, as amended by the Gramm-Leach-

Bliley (GLB) Act (see 2007 FRB C133). (An

applicant had ﬁled an application with the FDIC

for deposit insurance for a proposed de novo

industrial loan company.) The Board determined

the activities to be ﬁnancial in nature under

section 4(k) of the BHC Act and complementary

to a ﬁnancial activity. The Board’s determina-

tion is conditioned and based on the limitations

it placed on the activities in the aggregate (that

is, the speciﬁed percentages of the applicants’

consolidated total assets, consolidated total

annual revenues, and total capital).

The section is also amended for the Board’s

approvals of FHC notices, under section 4 of

the BHC Act, to provide energy management

services under energy management agreements

and also, energy tolling. On December 4, 2007,

the Board determined, by order, that an FHC’s

provision of energy management services is

complementary to the ﬁnancial activities of

engaging as principal in physical commodity

derivatives and the providing of ﬁnancial and

investment advisory services for derivative trans-

actions. (See 2008 FRB C20.) On March 27,

2008, the Board also determined, by order, that

an FHC’s providing energy tolling is comple-

mentary to the ﬁnancial activity of engaging in

commodity derivatives activities (see 2008 FRB

60).

The section has been revised to also delete a

reference to an interim Board rule that is ﬁnal.

See 225.4(g) of Regulation Y (12 C.F.R. 225.4(g)).

This rule pertains to nonbank activities involv-

ing the underwriting and dealing in, or making

a market in, bank-ineligible securities under

section 4(k)(4)(E) of the BHC Act.

3905.0.1 NONBANK ACTIVITY

AUTHORIZATIONS FOR FHCS

The Gramm-Leach-Bliley Act (the GLB Act)

amended the Bank Holding Company Act (the

BHC Act) to allow a BHC or foreign bank that

qualiﬁes as a ﬁnancial holding company (FHC)

to engage in a broad range of activities that the

GLB Act deﬁnes as ‘‘ﬁnancial in nature.’’ Sec-

tion 4(k)(4)(A)–(E) of the BHC Act deﬁnes the

following activities as ﬁnancial in nature:

1. lending, exchanging, transferring, investing

for others, or safeguarding money or

securities

2. insuring, guaranteeing, or indemnifying

against loss, harm, damage, illness, disabil-

ity, or death, or providing and issuing annu-

ities, and acting as principal, agent, or broker

for purposes of the foregoing, in any state

3. providing ﬁnancial, investment, or economic

advisory services, including advising an

investment company (as deﬁned in section 3

of the Investment Company Act of 1940)

4. issuing or selling instruments representing

interests in pools of assets permissible for a

bank to hold directly

5. underwriting, dealing in, or making a market

in securities

The Board had previously determined that some

of these activities were impermissible for BHCs,

such as acting as principal, agent, or broker for

purposes of insuring, guaranteeing, or indemni-

fying against loss, harm, damage, illness, dis-

ability, or death, and issuing annuity products.

Permissible insurance activities as principal

include reinsuring insurance products.

An FHC acting under section 4(k)(4)(B) of

the BHC Act may conduct insurance activities

without regard to the restrictions on the insur-

ance activities imposed on BHCs under section

4(c)(8).

Providing claims-administration and risk-

management services. Legal counsel represent-

ing an FHC sought an opinion as to whether an

insurance agency owned by an FHC may engage

in certain insurance claims activities, as described

below, under section 4(k)(4)(B) of the BHC

Act. In particular, it was asked whether such an

insurance agency may engage in the following

claims-administration activities in connection

with its insurance sales activities: (1) collecting

insurance premiums; (2) holding insurance pre-

miums in trust; (3) establishing an insurance

claims–paying account; (4) adjusting insurance

claims (which would include obtaining facts

about claims, investigating the veracity of claims,

and estimating losses relating to claims);

BHC Supervision Manual July 2008

Page 1

(5) negotiating with insureds and their represen-

tatives concerning insurance claims; and (6) pay-

ing and settling insurance claims. A representa-

tion was made that insurance agents typically

perform these claims-administration services for

an insurance underwriter in connection with

insurance policies sold by the agents on behalf

of an insurance underwriter.

With respect to the insurance risk-

management activities provided in connection

with insurance sales activities, a legal opinion

was requested as to whether an insurance agency

or broker owned by an FHC could engage in the

following activities: (1) assessing the risks of a

client seeking insurance and identifying the cli-

ent’s exposures to loss; (2) designing programs,

policies, and systems (such as workplace safety

programs) to reduce the client’s risks; (3) advis-

ing clients about risk-management alternatives

to insurance (such as self-insurance, securitiza-

tion, or derivatives); and (4) negotiating insur-

ance coverages, deductibles, and premiums for

an insurance client. It was represented that

insurance agents and brokers provide these risk-

management services to their customers in con-

nection with the sale of insurance products,

including, in particular, commercial property

and casualty insurance, and other insurance

activities. It also was understood that the pro-

posed risk-management services would (1) be

related to managing insurable risks, (2) be advi-

sory in nature, and (3) not allow the risk man-

ager to control or perform operations of its

clients.

Board staff noted that most states require a

person performing one or more of the insurance

claims–administration services listed above to

be licensed by, or registered with, the appropri-

ate insurance authority of the state as an insur-

ance company, an insurance agent, or a third-

partyadministrator (TPA).

Thelegislative history

of the GLB Act also suggests that the Congress

believed that insurance-related claims-

administration services are a necessary part of

the insurance sales and underwriting activities

authorized by section 4(k)(4)(B).

State insurance laws generally do not require

companies that provide insurance risk-

management services to obtain a special insur-

ance license. However,states generally do require

a license of any person who negotiates insur-

ance coverages, deductibles, and premiums for

another.

In a legal opinion dated July 10, 2002, Board

staff opined that the speciﬁc insurance claims–

administration services listed above are encom-

passed within the insurance activities authorized

by section 4(k)(4)(B) of the BHC Act and that

the services may be conducted by an FHC when

they are provided by an insurance agent or

broker in connection with its other insurance

sales activities. In addition, Board staff believes

that the speciﬁc insurance risk-management ser-

vices listed above are encompassed within sec-

tion 4(k)(4)(B) insurance activities and that the

services may be conducted by an FHC if they

(1) are provided by an insurance agent or broker

in connection with its other insurance sales

activities, (2) involve managing insurable risks,

(3) are advisory in nature, and (4) do not allow

the FHC to control, or perform operations of,

the person to whom the services are provided.

Acting as a third-party administrator. Other

legal counsel representing a BHC that had elected

to become an FHC requested an opinion on

whether acting as a TPA on behalf of an insur-

ance company is an activity that is permissible

for an FHC under the BHC Act. The BHC

proposed to invest in a company that acts as a

TPA for licensed insurance companies that

underwrite and sell credit life insurance. A TPA

provides one or more insurance companies with

administrative and related services that support

and assist the sale of insurance products by the

1. For example, the Model Third Party Administrator Stat-

ute adopted by the National Association of Insurance Com-

missioners (NAIC) requires a person who collects premiums

or adjusts or settles claims for an insurer in connection with

the sale of life or health insurance policies or annuities to

the person is not already registered with the state as an

insurance company, agent, or broker. See the NAIC Model

Third Party Administrator Statute, sections 1.A and 11 (1996).

The NAIC’s Model Managing General Agents Act also

requires a person to register with the relevant state insurance

authority if the person adjusts or pays claims for an insurer

and engages in certain other activities on behalf of an insurer.

See NAIC Model Managing General Agents Act, sections 2.C

and 3 (1993).

2. See H.R.Rep. No. 106-74,part I, p. 122 (1999) (‘‘Activities

such as administering, marketing, advising or assisting with . .

. claim administration or similar programs shall be deemed to

be incidental to insurance activities as described in [section

4(k)(4)(B)].’’).

3. See NAIC Producer Licensing Model Act, sections 2.K

and 3 (2000).

4. A BHC or an FHC may provide advice to customers

concerning ﬁnancial matters, including insurance, self-

insurance, securitizations, and derivatives, under 12 C.F.R.

225.28(b)(6), and may provide management consulting advice

to customers regarding nonﬁnancial equity matters, such as

workplace safety, subject to Regulation Y’s limits and restric-

tions. See 12 C.F.R. 225.28(b)(9) (management consulting

activities permissible for all bank holding companies) and

225.86(b)(1) (management consulting activities permissible

for all FHCs).

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 2

insurance company. A TPA may provide some

or all of the following services to an insurance

company: (1) assisting the insurance company

in designing its insurance programs (which would

include policy and certiﬁcate development and

issuance); (2) determining whether a prospec-

tive insured meets the insurance company’s

established underwriting guidelines; (3) collect-

ing and processing insurance premiums; (4) pro-

cessing, adjudicating, and paying claims on

behalf of the insurance company; (5) investing

excess cash and maintaining bank accounts for

the insurance company; (6) establishing risk

reserves for the insurance company; (7) advis-

ing on, and arranging for, reinsurance or stop-

loss insurance for the insurance company; (8) pre-

paring and ﬁling tax returns and regulatory

reports for the insurance company and provid-

ing other related services designed to ensure

that the insurance company remains properly

licensed and in compliance with applicable gov-

ernment regulations; (9) providing accounting

and recordkeeping services to the insurance

company in connection with its insurance activi-

ties; and (10) providing insurance-product sales

training to employees of the insurance company.

It was represented that the BHC may engage in

some, but not all, of the activities in its capacity

as a TPA.

The Board’s staff noted that the activities

listed above are directly related to the provision

and sale of insurance by a third-party insurance

company and constitute an integral part of the

regulated insurance activities of the third-party

insurance company. Consequently, most states

require a person performing one or more of

these services for an insurance company to be

licensed by, or registered with, the appropriate

insurance authority of the state either as an

insurance company or agent or as a TPA. In

addition to the previously stated requirements,

the Model Third Party Administrator Statute

(Model TPA Statute) requires a person to regis-

ter as a TPA if the person accepts insurance

contracts for an insurer that meet the insurer’s

underwriting guidelines, assists an insurer in the

overall planning and coordination of its insur-

ance program, or collects premiums or adjusts

claims for an insurer.

In a legal opinion dated July 10, 2002, the

Board staff opined that the above-listed services

are encompassed within the insurance activities

authorized by section 4(k)(4)(B) of the BHC

Act when provided to, or on behalf of, an insur-

ance company in connection with the sale or

underwriting of insurance. Staff concluded that

an FHC could, under section 4(k)(4)(B) of the

BHC Act, provide these services to a third-party

insurance company.

Section 4(k)(4)(F) of the BHC Act also deﬁnes

as ‘‘ﬁnancial in nature’’ any activity that the

Board determined to be closely related to bank-

ing under section 4(c)(8) of the BHC Act by a

regulation or order that was in effect on Novem-

ber 12, 1999. Section 225.86(a)(1) of Regula-

tion Y cross-references the long-standing ‘‘laun-

dry list’’ of nonbanking activities (at section

225.28(b)) permissible by regulation for BHCs.

Section 225.86(a)(2) lists nonbanking activities

approved for BHCs by Board order as of Novem-

ber 12, 1999.

All activities an FHC may engage

in pursuant to section 225.86(a) must be con-

ducted subject to the terms and conditions in

Regulation Y and the Board orders authorizing

those activities.

Section 4(k)(4)(G) of the BHC Act also deﬁnes

‘‘ﬁnancial in nature’’ as any activity (1) in which

a BHC may engage outside the United States

and (2) that the Board has determined, by regu-

lation or interpretations issued under section

(4)(c)(13) of the BHC Act that were in effect on

November 11, 1999, to be usual in conducting

banking or other ﬁnancial services abroad.

Sec-

tion 225.86(b) lists three activities that the Board

has found to be usual in connection with the

transaction of banking or other ﬁnancial opera-

tions abroad. These activities are—

1. providing management consulting services,

including services to any person with respect

to nonﬁnancial matters, as long as the ser-

vices are advisory and do not allow the FHC

to control the person to whom the services

are provided (these services go beyond the

5. See the NAIC Model TPA Statute, sections 1.A and 11

(1996). A person generally does not have to register as a TPA

if the person is currently registered with the state as an insurer

or as an insurance agent or broker. See Model TPA Statute,

section 1.A.(3) and (4).

Similarly, the NAIC’s Model Managing General Agents

Act requires a person to register with the relevant state insur-

ance authority if the person manages all or part of the business

of an insurer or, subject to certain conditions, accepts or

rejects policies for the insurer and either adjusts or pays

claims for the insurer or negotiates reinsurance for the insurer.

See the NAIC Model Managing General Agents Act, sections

2.C and 3 (1993).

6. Section 20 company activities are not included in this

list. Section 4(k)(4)(E) of the BHC Act authorizes FHCs to

engage in securities underwriting, dealing, and market-making

activities in a broader form than was previously authorized by

Board order.

7. See sections 211.8 and 211.10 of Regulation K (12

C.F.R. 211.8 and 211.10).

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 3

management consulting services that are

allowed under section 225.28(b)(9) of Regu-

lation Y and are incorporated by reference at

section 225.86(a)(1));

2. operating a travel agency in connection with

ﬁnancial services offered by the FHC or oth-

ers; and

3. organizing, sponsoring, and managing a

mutual fund, as long as the fund does not

exercise managerial control over the compa-

nies in which it invests and the FHC reduces

its ownership, if any, of the fund to less than

25 percent of the equity of the fund within

one year (or such longer time as the Board

permits) after sponsoring the fund.

The activities that a BHC is authorized to

engage in outside the United States under sec-

tions 211.8 and 211.10 of Regulation K have

been either (1) authorized for FHCs in a

broader form by the GLB Act (for example,

underwriting, distributing, and dealing in secu-

rities and underwriting various types of insur-

ance) or (2) authorized in the same or a broader

form in Regulation Y (for example, data pro-

cessing activities; real and personal property

leasing; and acting as agent, broker, or adviser

in leasing property).

The remaining activities

authorized by section 4(k)(4) of the BHC Act

are deﬁned to be ‘‘ﬁnancial in nature’’ under

section 4(k)(4)(H) and (I). These are merchant

banking activities conducted under section

4(k)(4)(H) through a securities afﬁliate or an

afﬁliate thereof, or through an afﬁliate of an in-

surance company (as deﬁned in section

4(k)(4)(I)(ii)) when the afﬁliate is registered

under the Investment Advisers Act of 1940 and

provides investment advice to an insurance

company or is an afﬁliate of such a registered

company. Under section 4(k)(4)(I), these mer-

chant banking activities may be conducted by

an insurance company. These activities must be

conducted in accordance with the restrictions

and limitations under subpart J of Regulation

Y, sections 225.170 through 225.177.

Section 4(k)(1)(A) of the BHC Act also allows

FHCs to engage in activities that the Board, in

coordination with the Secretary of the Treasury,

determines to be ﬁnancial in nature or incidental

to such ﬁnancial activity (section 4(k)(2)(A)).

Section 225.86(d) of Regulation Y lists only one

activity, acting as a ﬁnder, that has been autho-

rized under this provision. (See section 3910.0

of this manual.)

The Board, in consultation with the Secretary

of the Treasury, authorizes an FHC to engage in

activities by Board order that are determined

and approved to be ﬁnancial in nature or

incidental to a ﬁnancial activity (section

228.86(e)). Only one activity has been approved

by Board order under 225.86(e) in consulta-

tion with the Secretary of the Treasury: the

acquisition, management, and operation in the

United Kingdom of certain deﬁned-beneﬁt pen-

sion plans that are established by nonafﬁliated

third parties. This order was approved by the

Board on October 12, 2007. (See section 3912.0

of this manual.)

Section 4(k)(1)(B) of the BHC Act allows

FHCs to seek Board approval to engage in any

activity that the Board determines to be comple-

mentary to a ﬁnancial activity and does not pose

a substantial risk to the safety and soundness of

depository institutions or the ﬁnancial system

generally. Also with regard to section 4(k)(1)(B)

of the BHC Act that an activity is complemen-

tary to a ﬁnancial activity, the Board determined

on September 7, 2007, by order, at the FDIC’s

request, that disease management and mail-

order pharmacy activities complement the ﬁnan-

cial activity of underwriting and selling health

insurance. (See 2007 FRB C133). An applicant

had ﬁled an application with the FDIC for

deposit insurance for a proposed de novo indus-

trial loan company. The Board determined the

disease management and mail-order pharmacy

activities to be ﬁnancial in nature under section

4(k) of the BHC Act and activities that are

complementary to a ﬁnancial activity. The Board

conditioned its determination based on the limi-

tations it placed on the activities in the aggre-

gate (that is, the speciﬁed percentages of the

applicants’ consolidated total assets, consoli-

dated total annual revenues, and total capital).

Also with regard to other activities that are

deemed to be complementary to a ﬁnancial

activity, the Board approved, on December 4,

2007, an FHC’s request to provide energy man-

agement services to owners of power generation

facilities under energy management agreements.

This is an activity that is complementary to the

ﬁnancial activities of engaging as principal in

commodity derivatives and providing ﬁnancial

and investment advisory services for derivatives

transactions. (See 2008 FRB C20.) In addition,

the Board, on March 27, 2008, determined that

providing energy tolling services is complemen-

tary to the ﬁnancial activity of engaging in

8. The Board also has approved, under section 4(c)(13) of

the BHC Act, activities in individual orders. Section 4(k)(4)(G)

of the BHC Act does not authorize an FHC to engage in

activities that the Board has authorized a BHC to provide in

individual orders.

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 4

commodity derivatives activities. (See 2008 FRB

C60).

Previously, the Board had approved physical

commodity trading in commodities that were

CFTC-approved for trading on a U.S. futures

exchange (unless speciﬁcally excluded by the

Board) or that were speciﬁcally approved by the

Board. With the Board’s approval of its March

27, 2008, order (2008 FRB C60), the Board

speciﬁcally approved physical commodity trad-

ing in commodities not CFTC-approved for

trading on a U.S. futures exchange. The Board

recognized that a market-maker may not seek

CFTC approval for a particular commodity if

there is already an established foreign trading

market, which may deter a U.S. exchange from

listing a product. A derivatives contract that is

based on a commodity that trades on a non-

U.S. exchange may be subject to a regulatory

structure comparable to the one administered by

the CFTC (trading on a non-U.S. exchange that

may be sufﬁcient to demonstrate that a market

for the commodity in ﬁnancially settled

contracts exists, that the commodity is fungible,

and that it has a reasonably liquid market).

Within this order, the Board approved the

FHC’s request to take and make physical

delivery of nickel, a metal that is traded on the

London Metal Exchange. Within the same

Board order, the Board recognized that many

commodities for which derivatives contracts

have not been approved for trading by the

CFTC or that are not traded on a non-U.S.

exchange but that trade on established alterna-

tive trading platforms may also be commodi-

ties that have viable markets with ﬁnancially

settled contracts on the commodities and that

satisfy fungibility and liquidity concerns.

Standards were established to receive Board

approval to engage in physical commodity trad-

ing in non-CFTC-approved commodities traded

on alternative trading platforms in the U.S. or on

certain non-U.S. exchanges. The standards are

consistent with the Board’s existing limited

physical commodity trading authority. (See sec-

tion 3920.0 for more information on Board

orders approving limited physical-commodity-

trading activities that are complementary to a

ﬁnancial activity.)

Other permissible activities under section

4(k)(4)(E) of the BHC Act are underwriting and

dealing in or making a market in securities

without any limitation on revenues that can be

derived from bank-ineligible securities. These

activities must be conducted in accordance with

applicable restrictions and limitations found in

the BHC Act and any regulations or supervisory

guidance adopted by the Board. The Board

adopted a rule pertaining to these activities.

imposed two restrictions on FHCs engaged in

securities underwriting, dealing, or market-

making activities. All intraday extensions of

credit by a bank, thrift, or U.S. branch or agency

of a foreign bank to an afﬁliated company

engaged in these activities under section

4(k)(4)(E) must be on market terms consistent

with section 23B of the Federal Reserve Act

(FRA). In addition, a foreign bank that is an

FHC must ensure that its U.S. branch or agency

making a loan to, or purchasing securities as a

principal or ﬁduciary from, such an afﬁliated

company complies with sections 23A and 23B

of the FRA as if the branch or agency were a

member bank.

Section 4(k)(5) of the BHC Act requires the

Board and the Secretary of the Treasury to

deﬁne three categories of activities as ﬁnancial

in nature, as well as the extent to which these

activities are ﬁnancial in nature or incidental to

a ﬁnancial activity. These three categories

encompass a wide range of activities:

1. lending, exchanging, transferring, investing

for others, or safeguarding ﬁnancial assets

other than money or securities

2. providing any device or other instrumentality

for transferring money or other ﬁnancial assets

3. arranging, effecting, or facilitating ﬁnancial

transactions for the account of third parties

The above categories include activities in which

FHCs and national banks and their ﬁnancial

subsidiaries are already permitted to engage.

For example, the categories include safe deposit

services,electronic funds transfer activities,credit

and stored-value card activities, securities bro-

kerage, and ﬁnder activities. The categories are

intended to allow FHCs and ﬁnancial subsidi-

aries to engage in activities that were not other-

wise permitted for these companies. The proce-

dure below allows an FHC or ﬁnancial subsidiary

to obtain a determination from the Board and

the Secretary of the Treasury that an activity is

ﬁnancial in nature or incidental to a ﬁnancial

activity pursuant to section 4(k)(5).

An FHC’s request for the Board to determine

whether an activity falls within one of the three

categories listed above must be in writing. The

request must—

1. identify and deﬁne the activity for which the

9. See section 225.4(g) of Regulation Y.

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 5

determination is sought, speciﬁcally describ-

ing what the activity would be and how the

activity would be conducted, and

2. provideinformationthatsupportsthe requested

determination, including information on how

the proposed activity falls into one of the

three categories, as well as any other infor-

mation the Board requires concerning the

proposed activity.

In making its determination, the Board will

take into account the same factors that it must

consider when determining whether an activity

is ﬁnancial in nature or incidental to a ﬁnancial

activity. These factors include, among other

things, changes in the marketplaces in which

FHCs and banks compete, changes in technol-

ogy for delivering ﬁnancial services, and whether

the activity is necessary or appropriate to allow

FHCs and their afﬁliates, or banks and their

subsidiaries, to compete effectively with any

company seeking to provide ﬁnancial services

in the United States.

If an activity is listed in more than one provi-

sion of section 4 of the BHC Act, the FHC may

choose to conduct the activity under any appli-

cable provision. The FHC is subject only to the

procedures and limitations that the chosen source

of authority imposes on the activity.

3905.0.2 ACTIVITIES THAT ARE PERMISSIBLE FOR FHCs UNDER SECTION

225.86(a) OF REGULATION Y

Activities That Are Financial in Nature or That Are Incidental to a Financial Activity

Manual

Section

3600.

1. Nonbanking activities listed in section 225.28(b) of Regulation Y that have been

determined to be so closely related to banking as to be a proper incident thereto

(see section 3000.0.2).

2. Any nonbanking activity that the Board has determined by order (those in effect

on November 12, 1999) to be so closely related to banking as to be a proper inci-

dent thereto. The activities are—

a. providing administrative and other services to mutual funds; 27

b. owning shares of a securities exchange; 6

c. acting as a certiﬁcation authority for digital signatures, and authenticating the

identity of persons conducting ﬁnancial and nonﬁnancial transactions (includes

transactions abroad);

d. providing employment histories to third parties for use in making credit deci-

sions and to depository institutions and their afﬁliates for use in the ordinary

course of business;

e. check-cashing and wire-transmission services;

f. in connection with offering banking services, providing notary public services,

selling postage stamps and postage-paid envelopes, providing vehicle-

registration services, and selling public-transportation tickets and tokens; and

g. real estate title abstracting. 30

1. See 1990 FRB 860 and 1995 FRB 1130.

An FHC or other interested party may request

that the Board, in consultation with the Secre-

tary of the Treasury, determine that an addi-

tional activity is ﬁnancial in nature or incidental

to a ﬁnancial activity. The written request should

(1) identify and deﬁne the activity, speciﬁcally

describing what the activity would involve and

how the activity would be conducted; (2) explain

in detail why the activity should be considered

ﬁnancial in nature or incidental to a ﬁnancial

activity; and (3) provide information supporting

the request and any other information the Board

requests concerning the proposed activity. (See

section 225.88(b) of Regulation Y.)

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 6

An FHC may request an advisory opinion

from the Board on whether a proposed speciﬁc

activity falls within the scope of an activity

already determined to be a ﬁnancial activity and

listed in section 225.86 of Regulation Y. The

request must be in writing and provide (1) a

detailed description of the activity, product, or

service about which the company proposes to

engage in or provide; (2) an explanation sup-

porting an interpretation on the scope of the

permissible ﬁnancial activity; and (3) any other

information the Board requests. (See section

225.88(e) of Regulation Y.)

An FHC may request approval to engage in

an activity that is complementary to a ﬁnancial

activity. The written request must (1) identify

the proposed complementary activity, speciﬁ-

cally describing what the activity would involve

and how it would be conducted; (2) identify the

ﬁnancial activity for which the proposed activity

would be complementary and provide informa-

tion to support a ﬁnding that the proposed activ-

ity should be considered complementary to the

identiﬁed ﬁnancial activity; (3) describe the

scope and relative size of the proposed activity,

as a percentage of projected FHC revenues and

on the basis of assets associated with conduct-

ing the activity; (4) discuss the risks that con-

ducting the proposed activity pose to the subsid-

iary depository institutions of the FHC and the

ﬁnancial system in general; (5) describe the

potential adverse effects of conducting the activ-

ity and explain the proposed measures the FHC

would take to address these potential effects;

and (6) provide any other information the Board

requests. (See section 225.89(a) of Regulation

Y.)

3905.0.3 SECURITIES

UNDERWRITING, DEALING, AND

MARKET-MAKING ACTIVITIES

The GLB Act also authorizes securities under-

writing, dealing, and market making without

regard to whether such securities may be sold

by a bank. This activity includes underwriting

or distributing shares of open-end investment

companies commonly referred to as mutual funds.

Securities underwriting activities conducted

under section 4(k)(4)(E) of the BHC Act may be

conducted without regard to the 25 percent rev-

enue limitation that is applicable to section 20

nonbank subsidiaries of BHCs engaged in secu-

rities underwriting and dealing, as authorized by

Board order under section 4(c)(8). In addition,

dealing may be done without regard to the 5 per-

cent limitation on ownership of voting securities.

The operating standards applicable to section

20 companies do not apply to FHCs that engage

in securities underwriting, dealing, and market

making under section 4(k)(4)(E) of the BHC

Act, with two exceptions. First, intraday exten-

sions of credit to a securities ﬁrm from an

afﬁliated bank or thrift or U.S. branch or agency

of a foreign bank must be on market terms

consistent with section 23B of the FRA. Sec-

ond, foreign banks that are FHCs or that are

treated as FHCs are required to comply with the

restrictions of sections 23A and 23B of the FRA

with respect to lending and securities-purchase

transactions between the U.S. branch or agency

of a foreign bank and a U.S. securities afﬁliate.

The operating standards and revenue limit con-

tinue to apply to BHCs that are not FHCs and to

FHCs that continue to conduct securities activi-

ties pursuant to section 4(c)(8) of the BHC Act.

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 7

3905.0.4 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws

Regulations

Interpretations

Orders

BHCs and foreign banks that

qualify as FHCs can engage in

ﬁnancial activities and those

incidental thereto

1843

Activities permissible for an

FHC

225.86 4-056.5

Notice requirement for FHCs

engaging in a ﬁnancial activity

225.87 4-056.6

Requests for Board to determine

whether an activity is ﬁnancial

in nature or incidental to a ﬁnan-

cial activity

225.88 4-056.7

Request to engage in an activity

that is complementary to the

ﬁnancial activity of engaging as

principal in BHC-permissible

commodity derivatives

225.89 4-056.8 2003 FRB 508

2004 FRB 215

2004 FRB 511

Physical commodity trading in

energy-related commodities

(natural gas, crude oil, electric-

ity, and emissions allowances) as

a complement to a ﬁnancial

activity

1843(k)(1)(B) 2006 FRB C54

2006 FRB C57

2006 FRB C113

Disease management and mail-

order pharmacy activities are

complementary to the ﬁnancial

activity of underwriting and sell-

ing health insurance

1843(k)(1)(B) 2007 FRB C133

Providing energy management

services is complementary to the

ﬁnancial activities of engaging

as principal in commodity

derivatives and providing

derivatives investment advisory

services

1843(k)(1)(B) 2008 FRB C20

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 8

Subject Laws

Regulations

Interpretations

Orders

Providing energy tolling services

as a complement to the ﬁnancial

activity of engaging in commod-

ity derivatives activities

1843(k)(1)(B) 2008 FRB C60

Trading in commodities not

approved by the CFTC for trad-

ing on a U.S. futures exchange

(e.g., nickel on London Metal

Exchange) or on certain non-

U.S. exchanges

2008 FRB C60

1. 12 U.S.C., unless speciﬁcally stated otherwise.

2. 12 C.F.R., unless speciﬁcally stated otherwise.

3. Federal Reserve Regulatory Service reference.

Permissible Activities for FHCs 3905.0

BHC Supervision Manual July 2008

Page 9

Disease Management and Mail-Order Pharmacy Activities

(Section 4(k) of the BHC Act) Section 3906.0

In 2007, the Federal Deposit Insurance Corpora-

tion (FDIC) requested the Board to determine

whether the disease management and mail-order

pharmacy activities are permissible for a ﬁnan-

cial holding company (FHC) under the Bank

Holding Company Act (BHC Act), as amended

by the Gramm-Leach-Bliley Act (GLB Act).

WP had ﬁled an application with the FDIC to

obtain deposit insurance for AFB, a proposed

U.S.-based de novo industrial loan company

(ILC).

Section 4(k) (see 12 U.S.C. 1843(k)(4)) of the

BHC Act permits a bank holding company

(BHC) that qualiﬁes to be an FHC to engage in

a broad range of activities that are deﬁned by

statute to be ﬁnancial in nature. The FDIC

requested that the Board determine the permissi-

bility of WP’s disease management and mail-

order pharmacy activities under the BHC Act,

as amended by the GLB Act, in connection with

the FDIC’s moratorium then in place on actions

on ILC applications by companies engaged in

any nonbanking activity not permissible for an

FHC.

WP is principally engaged in underwriting

and selling health insurance and related activi-

ties. Underwriting and selling health insurance

as principal, agent, or broker are activities deemed

by Congress in the GLB Act to be ﬁnancial in

nature.

WP, through its regulated insurance

company subsidiaries, provides health insur-

ance. WP’s insurance offerings include pre-

ferred provider, health maintenance, point of

service, Medicare and Medicaid health plans;

vision, dental, pharmacy beneﬁt, life, disability,

and long-term care insurance products; and

consumer-directed, high-deductible, and limited-

service health insurance products. WP also

engages in a variety of related activities, includ-

ing claims processing.

WP also provides disease management and

mail-order pharmacy services through subsidi-

aries to persons who obtain health insurance

from WP or another insurance company. Through

its disease management services, WP provides

insurance plan members with access to a variety

of tools and resources designed to help them

maintain healthy lifestyles and properly manage

their medical conditions. These disease manage-

ment services typically are provided by, or under

the direction of, licensed health-care profession-

als (including doctors and nurses) employed by

WP. WP’s subsidiaries engage in providing mail-

order pharmacy services, ﬁll prescriptions for

customers who have pharmacy beneﬁt insurance

coverage from WP or another insurance com-

pany, provide drug-related information to cus-

tomers, and track potential issues with customer

prescriptions, such as drug interactions. WP’s

mail-order pharmacy subsidiaries are state-

licensed and employ state-licensed pharmacists.

WP’s disease management and mail-order

pharmacy activities are not within the scope of

activities that the Board previously determined

to be ﬁnancial in nature, incidental to a ﬁnancial

activity, or complementary to a ﬁnancial activity

under the provisions of the BHC Act. The

activities do not themselves involve providing

insurance, are not regulated as insurance by

state insurance authorities, and are not provided

by an afﬁliate that is licensed as an insurance

company or as an insurance agent or broker.

Both activities involve the provision of health-

care services that, while related to insurance

underwriting activities, are themselves nonﬁ-

nancial activities. The Board concluded, how-

ever, for the reasons set forth below, that there is

a reasonable basis for construing these activities

as complementary to a ﬁnancial activity within

the meaning of the GLB Act.

WP’s disease management and mail-order

pharmacy services help employers that obtain

health insurance from an insurance company to

manage and reduce the risks and costs of provid-

ing health insurance to employees. In its submis-

sions to the Board, WP provided data demon-

strating that many of the largest health insurers

in the U.S. provide these services to their own

customers and those of other health insurance

companies and that employer-customers of heath

insurance companies often demand such services.

Based on the foregoing, the information pro-

vided by WP, and other facts of record, the

Board concluded that disease management and

mail-order pharmacy activities complement the

ﬁnancial activity of underwriting and selling

health insurance. Section 4(k)(1)(B) of the BHC

Act requires that the Board determine that any

proposed complementary activity does not pose

a substantial risk to the safety or soundness of

depository institutions or the ﬁnancial system

1. Under section 4(c)(2)(H) of the BHC Act, an exemption

is provided from the deﬁnition of ‘‘bank’’ for ILCs. A BHC

may own, control, or operate an ILC, provided that it is not a

bank. Under section 225.28(b)(4) of the Board’s Regulation

Y, a BHC may acquire or retain an industrial bank to the

extent authorized by state law.

2. See section 4(k)(4)(B) of the BHC Act (12 U.S.C.

1843(k)(4)(B)).

BHC Supervision Manual July 2008

Page 1

generally.

Moreover, the Board previously has

stated that complementary activities should be

limited in size and scope relative to the ﬁnancial

activities that they complement.

As a condition

of its determination that the proposed activities

are complementary to a ﬁnancial activity, the

Board required that these activities in the aggre-

gate not account for more than 2 percent of

WP’s consolidated total assets or 5 percent of its

consolidated total annual revenues. In addition,

the total assets of WP’s subsidiaries engaged in

disease management or mail-order pharmacy

activities in the aggregate could not exceed

5 percent of the total capital (calculated in

accordance with applicable statutory accounting

principles) of all regulated insurance company

subsidiaries and health plans of WP. The Board

also considered how WP managed and addressed

the risks posed by the activities through insur-

ance training and other measures. The Board

also stated that any future extensions of credit

by AFB to, or other covered transactions by

AFB with, these or other afﬁliates, including

any covered transaction with an unafﬁliated per-

son the proceeds of which are transferred to or

used for the beneﬁt of an afﬁliate, must comply

with sections 23A and 23B of the Federal Reserve

Act and the Board’s Regulation W.

For these

reasons, the Board concluded that the proposed

activities would not pose a substantial risk to the

safety and soundness of depository institutions

or the ﬁnancial system generally. The Board

approved the order on September 7, 2007 (The

previous discussion is only a summary. See the

full text of the Board order at 2007 FRB C133).

3. See section 4(k)(1)(B) of the BHC Act (12 U.S.C.

1843(k)(1)(B))

4. See 68 Federal Register 68493, 68497 (December 9,

2003).

5. See the Federal Reserve Act, sections 371c and 371c-1

(12 U.S.C. 371c, 371c-1) and 12 C.F.R. Part 223.

Disease Management and Mail-Order Pharmacy Activities 3906.0

BHC Supervision Manual July 2008

Page 2

Merchant Banking

(Section 4(k) of the BHC Act) Section 3907.0

3907.0.1 MERCHANT BANKING

INVESTMENT AUTHORITY

The Gramm-Leach-Bliley Act (GLB Act) and

the Board’s Regulation Y permit ﬁnancial hold-

ing companies (FHCs) (but not bank holding

companies (BHCs) generally) to make invest-

ments as part of a bona ﬁde securities underwrit-

ing or merchant or investment banking activity.

These investments may be made in any type of

ownership interest in any type of nonﬁnancial

entity (portfolio company), and they may include

any amount up to all of the ownership interests

in the company. The investments that may be

made are substantially broader in scope than the

investment activities that are otherwise permis-

sible for BHCs.

The authority section 4(k)(4)(H) of the Bank

Holding Company Act (BHC Act) grants to

FHCs to make merchant banking investments

(MBIs) is an alternative to any other authority

that the FHC may have to make investments in

nonﬁnancial companies under other provisions

of the BHC Act, except as speciﬁcally noted in

the rule. For example, the rule’s provisions do

not apply to investments acquired as part of

securities underwriting, dealing, or market-

making activities conducted under section

4(k)(4)(E) of the BHC Act; investments made

by insurance underwriting subsidiaries of an

FHC in accordance with section 4(k)(4)(I) of

the BHC Act; investments made under section

4(c)(6) or (7) of the BHC Act; or investments

made overseas under the Board’s Regulation K

(12 C.F.R. 211).

As described below, the BHC

Act allows an FHC to make MBIs if it controls a

securities afﬁliate or controls both an insurance

underwriter and a registered investment adviser.

The GLB Act does contain certain limitations

on MBIs made by FHCs, and it provides a

framework for MBIs that is designed to help

maintain the separation between banking and

commerce to ensure the safety and soundness of

depository institutions. All MBIs made by an

FHC under section 4(k)(4)(H) must comply with

the Board’s rule.

3907.0.2 PERMITTED INVESTMENTS

Under section 4(k)(4)(H) of the BHC Act and

the Board’s rule, an FHC may acquire or control

any amount of shares, assets, or a full range of

ownership interests in a company or other entity

that is engaged in an activity that is not ﬁnancial

in nature, incidental to a ﬁnancial activity, or

otherwise permissible for the FHC under section

4 of the BHC Act. The interests an FHC may

acquire include securities, warrants, partnership

interests, trust certiﬁcates, other instruments rep-

resenting an ownership interest in a company,

and instruments convertible into a security or

other ownership interest whether the interest is

voting or nonvoting. An FHC can acquire any

amount of ownership interests in the company

or other entity, whether or not that amount

results in control for purposes of the BHC Act.

An FHC must ﬁle a notice with the Board under

section 4(k)(6) of the BHC Act and section

225.87 of Regulation Y (12 C.F.R. 225.87)

within 30 days after commencing MBI activities

or acquiring any company that makes MBIs.

An FHC also can acquire and control ‘‘assets’’

other than debt or equity securities or other

ownership interests of a company. For example,

assets acquired as an MBI may include real

estate or the assets of a division of an operating

company. To be permissible, the assets must be

acquired through or promptly transferred to a

portfolio company that has and maintains a

separate corporate existence, management, and

operations to the extent required by the rule.

(See section 225.170(e)(3) of Regulation Y.)

3907.0.2.1 Securities Afﬁliate

A BHC may make MBIs only if it becomes an

FHC.

The FHC must either (1) control or be a

‘‘securities afﬁliate’’ or (2) control both an

insurance underwriter afﬁliate and an invest-

1. Unless stated otherwise in this section, the ‘‘merchant

banking statutory provisions’’ refer to section 4(k)(4)(H) of

the Bank Holding Company Act, and references to the ‘‘rule’’

or ‘‘regulatory provisions’’ pertain to Regulation Y and are

found in sections 225.170 through 225.177.

2. Although the rule does not apply to investments held

under section 4(c)(6) or (7) of the BHC Act or the Board’s

Regulation K, those authorities are only available if the FHC’s

aggregate investment in the relevant company under a combi-

nation of authorities, including any investment made under

the merchant banking authority, is within the applicable

investment limitations and restrictions set forth in section

4(c)(6) or (7) or Regulation K.

3. See section 4(k)(6)(A) of the BHC Act (12 U.S.C.

1843(k)(6)(A)) and section 225.87(a) of Regulation Y (12

C.F.R. 225.87(a)).

4. The Board’s Regulation Y sets forth the procedures and

qualiﬁcation criteria applicable to BHCs that seek to elect to

become an FHC. See section 225.81 et seq. of Regulation Y

(12 C.F.R. 225.81 et seq.).

BHC Supervision Manual June 2001

Page 1

ment adviser afﬁliate registered under the Invest-

ment Advisers Act of 1940 that provides invest-

ment advice to an insurance company. The GLB

Act and the rule, however, do not require that

the FHC make its MBIs through such a securi-

ties,insuranceunderwriting,or investment adviser

afﬁliate. Instead, an FHC may make MBIs

directly or through any afﬁliate other than a

depository institution or a subsidiary of a deposi-

tory institution.

The rule deﬁnes a ‘‘securities afﬁliate’’ to

include any broker or dealer registered with the

Securities and Exchange Commission (SEC)

under the Securities Exchange Act of 1934

(Exchange Act). The deﬁnition also includes an

SEC-registered municipal securities dealer,

including a separately identiﬁable division or

department of a bank that is registered as a

municipal securities dealer under the Exchange

Act. An FHC may make MBIs if the holding

company is itself a registered securities broker

or dealer.

3907.0.2.2 Investments in Companies

Engaged in Nonﬁnancial Activities

An FHC is authorized under section 4(k)(4)(H)

of the BHC Act to acquire or control a company

or entity ‘‘engaged in any activity not autho-

rized pursuant to [section 4 of the BHC Act].’’

An FHC may not make MBIs in ﬁnancial com-

panies under section 4(k)(4)(H) or the rule.

FHCs have separate authority under other provi-

sions of the BHC Act to make investments in

companies engaged in ﬁnancial activities. How-

ever, a company held as an MBI may be engaged

in both nonﬁnancial and ﬁnancial activities, and

an FHC may retain an MBI in a nonﬁnancial

company even if the company subsequently

commences a ﬁnancial activity. An FHC also is

not prohibited from using a combination of

authorities to invest, through the same subsidi-

ary or fund, in ownership interests of both non-

ﬁnancial and ﬁnancial companies.

Investments in ﬁnancial companies are not

authorized in section 4(k)(4)(H) of the BHC

Act. The rule’s restrictions, such as those for

holding periods and cross-marketing, therefore

do not apply to FHC investments in ﬁnancial

companies that are made under other provisions

of the BHC Act and the Board’s Regulation

Y—even if such investments are made for stra-

tegic reasons or for reselling the investment. An

FHC may not, however, use the merchant bank-

ing authority to evade restrictions, such as con-

sent or approval requirements or restrictions that

address conﬂicts of interest or that govern the

acquisition of ﬁnancial companies.

In addition,

nothing in section 4(k)(4)(H) or the rule over-

rides the prior-approval requirements of section

3 of the BHC Act, which governs the acquisi-

tion of shares of a bank or BHC, or the provi-

sions of section 4(k)(6) and (j) of the BHC Act,

which governs the acquisition of shares of a

savings association or a company that controls a

savings association.

3907.0.2.3 Bona Fide Underwriting or

Merchant Banking or Investment Activity

An FHC may only make MBIs as part of a bona

ﬁde underwriting or merchant banking or invest-

ment banking activity.

An FHC is not autho-

rized to make an investment in a nonﬁnancial

company for the purpose of engaging in the

activities of the nonﬁnancial company, such as

real estate investment or development or other

activities that have not been found to be ﬁnan-

cial in nature. This ‘‘bona ﬁde’’ requirement

thus preserves the ﬁnancial nature of MBI

activities and the separation of banking from

commerce.

The bona ﬁde requirement does not prohibit

an FHC from specializing in making MBIs in

particular industries or from making its ﬁrst

MBI in a company engaged in real estate invest-

ment or development. However, such invest-

ments should be made only for investment as

part of an ongoing underwriting or investment

or merchant banking activity, and they should

be held in accordance with the Board’s rules.

3907.0.2.3.1 Investments Made Directly

or Through Funds

An FHC may acquire or control MBIs directly

or through any subsidiary other than a deposi-

tory institution or subsidiary of a depository

institution. An FHC also may not acquire or

control MBIs on behalf of a depository institu-

tion or subsidiary of a depository institution. A

5. See section 4(l)(2) of the BHC Act (12 U.S.C.

1843(l)(2)) and section 225.84 of Regulation Y (12 C.F.R.

225.84).

6. See section 4(k)(4)(H) of the BHC Act (12 U.S.C.

1843(k)(4)(H)).

7. Concentration in particular industries or in individual

investments may present supervisory concerns. The Board

expects all FHCs that engage in MBI activities to establish

policies governing portfolio diversiﬁcation and to maintain

capital that is adequate, considering the FHC’s investment

portfolio. See section 3900.0 of this manual and SR-00-9.

Merchant Banking 3907.0

BHC Supervision Manual June 2001

Page 2

U.S. branch or agency of a foreign bank is

considered a ‘‘depository institution’’ for pur-

poses of the merchant banking rule and its

related restrictions. Accordingly, a U.S. branch

or agency of a foreign bank may not acquire or

control MBIs, and MBIs may not be acquired or

controlled on behalf of a U.S. branch or agency

of a foreign bank.

An FHC is allowed to make MBIs through a

private equity fund or other investment fund

that, in turn, invests in nonﬁnancial companies.

When an FHC makes such an investment, the

holding company’s investment in the fund is

considered an MBI that must comply with the

rule. Certain beneﬁts for investments in or held

through a qualifying private equity fund are

provided, including an extended holding period

and certain relief from the rule’s cross-

marketing restrictions. Investments in funds that

do not qualify as private equity funds are treated

as any other type of MBI.

3907.0.2.3.2 Deﬁnition of Portfolio

Company and Financial Holding

Company

Some of the rule’s requirements—such as the

restrictions on routine management and

operation—apply only to portfolio companies.

A ‘‘portfolio company’’ means any company or

entity that is directly or indirectly held, owned,

or controlled by an FHC that is using the mer-

chant banking authority, and the company or

entity is engaged in an activity that is not autho-

rized for the FHC under section 4 of the BHC

Act. (See section 225.177 of Regulation Y.)

The term ‘‘ﬁnancial holding company,’’ as

used in the rule, refers to the FHC and any

direct or indirect subsidiary of the holding com-

pany (including a private equity fund or other

fund controlled by the FHC). The term does not

include—

1. a portfolio company that is controlled by the

FHC or

2. any depository institution controlled by the

FHC or any subsidiary of such a depository

institution, unless otherwise provided in the

rule.

3907.0.3 LIMITS ON MANAGING OR

OPERATING A PORTFOLIO

COMPANY HELD AS A MERCHANT

BANKING INVESTMENT

The GLB Act prohibits an FHC from routinely

managing or operating a portfolio company,

except as may be necessary or required to obtain

a reasonable return on the resale or disposition

of the investment. (See section 225.171 of Regu-

lation Y.)

3907.0.3.1 Relationships That Involve

Routine Management or Operation

An FHC routinely manages or operates a port-

folio company if any director, ofﬁcer,or employee

of the FHC serves as or has the responsibilities

of an executive ofﬁcer of the portfolio company.

The term ‘‘executive ofﬁcer’’ has the same mean-

ing as used in the Board’s Regulation O. This

deﬁnition includes any person who participates

or has the authority to participate (other than in

the capacity of a director) in major policymak-

ing functions of the portfolio company, whether

or not the ofﬁcer has an ofﬁcial title, the title

designates the ofﬁcer as an assistant, or the

ofﬁcer serves without salary or other compensa-

tion.

(See section 225.177(d) of Regulation Y

and 12 C.F.R. 215.2(e)(1).) An FHC is also

considered to routinely manage or operate a

portfolio company if an executive ofﬁcer of the

parent FHC or certain of its major subsidiaries

serves as (or has the responsibilities of) an ofﬁ-

cer or employee of the portfolio company. For

the purposes of these restrictions, an FHC’s

major subsidiaries include any subsidiary that is

(1) a depository institution, (2) an SEC-

registered broker-dealer, (3) engaged in MBI

activities or insurance company investment

activities under section 4(k)(4)(H) or (I) of the

BHC Act, (4) a small business investment com-

pany, or (5) engaged in signiﬁcant equity invest-

ment activities that are subject to a special capi-

tal charge under the Board’s capital guidelines

(for example, a company engaged in investment

activities under section 4(c)(6) or (7) of the

BHC Act). An FHC also is considered to rou-

tinely manage or operate a portfolio company if

8. An executive ofﬁcer does not include a person who may

exercise a certain measure of discretion in the performance of

his or her duties, including the discretion to make decisions in

the ordinary course of business, but who does not participate

in the determination of major policies of the company and

whose decisions are limited by policy standards ﬁxed by

senior management. In addition, the term does not include any

person who is excluded from participating (other than in the

capacity of a director) in major policymaking functions of the

company by resolution of the board of directors or by the

bylaws of the company, provided the person does not in fact

participate in such policymaking functions.

Merchant Banking 3907.0

BHC Supervision Manual June 2001

Page 3

it restricts, by covenants, agreements, or other-

wise, the portfolio company’s ability to make

routine business decisions. Covenants or agree-

ments that involve routine business decisions

include covenants that restrict the portfolio com-

pany’s ability to enter into transactions in the

ordinary course of business or to hire nonexecu-

tive ofﬁcers or employees. As described below,

an FHC may have covenants and agreements

that restrict actions that are outside the ordinary

course of business.

In addition, an FHC is presumed to be involved

in the day-to-day management or operations of

a portfolio company if a director, ofﬁcer, or

employee of the FHC serves as a nonexecutive

ofﬁcer or employee of the portfolio company or

if an ofﬁcer or employee of the portfolio com-

pany is supervised by or reports to an ofﬁcer or

employee of the FHC. An FHC may rebut this

presumption by presenting speciﬁc facts demon-

strating that the junior-ofﬁcer or employee inter-

lock with the portfolio company would not

involve the investing FHC in the routine man-

agement and operating of the company.

Any

request to rebut a presumption must be made to

the Board and should fully describe all the facts

and circumstances related to the FHC’s invest-

ment in and relationships with the portfolio

company.

3907.0.3.2 Relationships That Do Not

Constitute Routine Management or

Operation

The rule identiﬁes several relationships that an

FHC may have with a portfolio company that

would not involve the FHC in routinely manag-

ing or operating the portfolio company.

The

following relationships allow the FHC to moni-

tor and provide strategic and ﬁnancial advice to

a portfolio company without becoming involved

in the day-to-day management or operations of

the company:

1. Director interlocks. An FHC may have one

or more representatives on the board of direc-

tors of a portfolio company. The Board con-

siders the selection of the partners (including

the general partner) of a partnership to be the

equivalent of selecting the directors of a

company. An FHC representative who serves

as a director of a portfolio company may

participate fully in those matters that are

typically presented to directors of a com-

pany, whether the director participates in

these matters at a meeting of the board, at

meetings of committees of the board, through

written votes, through meetings with ofﬁcers

or employees of the portfolio company, or in

other ways. The FHC’s director representa-

tives, however, may not participate in the

day-to-day operations of the portfolio com-

pany or in management decisions that are

made in the ordinary course of business and

that are not customarily presented to the

directors of a company. The portfolio com-

pany also must have ofﬁcers and employees

that routinely manage and operate the com-

pany, and the FHC must not have other

arrangements or relationships with the port-

folio company that would involve the FHC

in the routine management or operation of

the portfolio company.

2. Covenants concerning actions outside the or-

dinary course of business. An FHC may

restrict, by covenant or otherwise, the ability

of a portfolio company to take actions that

are outside the ordinary course of business.

Some examples of actions that are outside

the ordinary course of business and that may

be subject to these types of covenants or

agreements are—

a. the acquisition of signiﬁcant assets or con-

trol of another company by the portfolio

company or any of its subsidiaries;

b. the removal or selection of the portfolio

company’s independent accountant or

investment banker;

c. signiﬁcant changes to the portfolio com-

pany’s business plan or accounting meth-

ods or policies;

d. the removal or replacement of any or all

of the executive ofﬁcers of the portfolio

company;

e. the redemption, authorization, or issuance

of any equity or debt securities of the

portfolio company;

f. any borrowing by the portfolio company

that is outside the ordinary course of busi-

ness;

g. the amendment of the portfolio compa-

ny’s articles of incorporation, bylaws, or