Bank Holding Company, Supervision Manual, Section 2000-2010

Table of Contents2000 Supervisory Policy and Issues

Sections Subsections Title

2000.0 Introduction to Topics for Supervisory Review

2010.0 Supervision of Subsidiaries

2010.0.1 Policy Statement on the Responsibility of BankHolding Companies to Act as Sources of Strengthto Their Subsidiary Banks

2010.0.2 Board Order Requesting a Waiver from the Board’sSource of Strength Policy

2010.0.3 Inspection Objectives2010.0.4 Inspection Procedures

2010.1 Funding Policies


2010.2 Loan Administration

2010.2.1 Uniform Real Estate Lending Standards2010.2.2 Lending Standards for Commercial Loans2010.2.2.1 Sound Practices in Loan Standards and Approval2010.2.2.1.1 Formal Credit Policies2010.2.2.1.2 Formal Credit-Staff Approval of Transactions2010.2.2.1.3 Loan-Approval Documents2010.2.2.1.4 Use of Forward-Looking Tools in the Approval Process2010.2.2.1.5 Stress Testing of the Borrower’s Financial Capacity2010.2.2.1.6 Management and Lender Information2010.2.3 Leveraged Lending2010.2.3.1 Interagency Guidance on Leveraged Lending2010.2.3.1.1 Risk-Management Framework2010.2.3.1.2 Leveraged Lending Definition2010.2.3.1.3 General Policy Expectations2010.2.3.1.4 Participations Purchased2010.2.3.1.5 Underwriting Standards2010.2.3.1.6 Valuation Standards2010.2.3.1.7 Pipeline Management2010.2.3.1.8 Reporting and Analytics2010.2.3.1.9 Risk Rating Leveraged Loans2010.2.3.1.10 Credit Analysis2010.2.3.1.11 Problem-Credit Management2010.2.3.1.12 Deal Sponsors2010.2.3.1.13 Credit Review2010.2.3.1.14 Stress Testing2010.2.3.1.15 Conflicts of Interest2010.2.3.1.16 Reputational Risk2010.2.3.1.17 Compliance2010.2.4 Credit-Risk Management Guidance for Home Equity

Lending2010.2.4.1 Credit-Risk Management Systems

BHC Supervision Manual January 2015


2010.2.4.1.1 Product Development and Marketing2010.2.4.1.2 Origination and Underwriting2010.2.4.1.3 Third-Party Originations2010.2.4.1.4 Collateral-Valuation Management2010.2.4.1.5 AVMs2010.2.4.1.6 Account Management2010.2.4.1.7 Portfolio Management2010.2.4.1.8 Operations, Servicing, and Collections2010.2.4.1.9 Secondary-Market Activities2010.2.4.1.10 Portfolio Classifications, Allowance for Loan and

Lease Losses, and Capital2010.2.5 Oversight of Concentrations in Commercial Real Estate

Lending and Sound Risk-Management Lending2010.2.5.1 Scope of the CRE Concentration Guidance2010.2.5.2 CRE Concentration Assessments2010.2.5.3 CRE Risk Management2010.2.5.3.1 Board and Management Oversight of CRE Concentration

Risk2010.2.5.3.2 CRE Portfolio Management2010.2.5.3.3 CRE Management Information Systems2010.2.5.3.4 Market Analysis2010.2.5.3.5 Credit Underwriting Standards2010.2.5.3.6 CRE Portfolio Stress Testing and Sensitivity Analysis2010.2.5.3.7 Credit-Risk Review Function2010.2.5.4 Supervisory Oversight of CRE Concentration Risk2010.2.5.4.1 Evaluation of CRE Concentrations2010.2.5.4.2 Assessment of Capital Adequacy for CRE Concentration

Risk2010.2.6 Guidance on Private Student Loans with Graduated

Repayment Terms at Origination2010.2.6.1 Principles for Private Student Loans with Graduated

Repayment Terms at Origination2010.2.7 Loan Participations, the Agreements and Participants2010.2.7.1 Board Policies on Loan Participations2010.2.7.2 Loan Participation Agreement2010.2.7.3 Accounting for Loan Participations2010.2.7.4 Structuring the Loan Participation Agreement2010.2.7.5 Independent Credit Analysis2010.2.7.6 Sales of Loan Participations in the Secondary Market2010.2.7.7 Sale of Loan Participations With or Without the Right of

Recourse2010.2.7.8 Sales of 100 Percent Participations2010.2.7.9 Participation Transactions Between Affiliates2010.2.7.9.1 Transfer of Low-Quality Assets2010.2.7.10 Concentrations of Credit Involving Loan Participations2010.2.7.11 Loan Participations and Environmental Liability2010.2.7.12 Red Flag Warning Signals2010.2.8 Inspection Objectives2010.2.9 Inspection Procedures2010.2.10 Internal Control Questionnaire2010.2.11 Appendix I − Examiner Loan-Sampling Requirements for

Credit-Extending Nonbank Subsidiaries of BHCs with$10-50 Billion in Total Consolidated Assets

Table of Contents 2000 Supervisory Policy and Issues

BHC Supervision Manual January 2015


2010.2.11.1 Loan Sampling Methodology2010.2.11.2 Documentation of Loan Sampling Analysis and

Methodology2010.2.11.3 Follow-Up Expectations for Inspections with Adverse

Findings2010.3 Investments



BHC Supervision Manual January 2015Page 2.1


2010.4 Consolidated Planning Process


2010.5 Environmental Liability

2010.5.1 Background Information on Environmental Liability2010.5.2 Overview of Environmental Hazards2010.5.3 Impact on Banking Organizations2010.5.4 Protection against Environmental Liability2010.5.5 Conclusion2010.5.6 Inspection Objectives2010.5.7 Inspection Procedures

2010.6 Financial Institution Subsidiary Retail Salesof Nondeposit Investment Products

2010.6.1 Interagency Statement on Retail Sales of NondepositInvestment Products

2010.6.1.1 Scope2010.6.1.2 Adoption of Policies and Procedures2010.6.1.2.1 Program Management2010.6.1.2.2 Arrangements with Third Parties2010.6.1.3 General Guidelines2010.6.1.3.1 Disclosures and Advertising2010.6.1.3.2 Setting and Circumstances2010.6.1.3.3 Qualifications and Training2010.6.1.3.4 Suitability and Sales Practices2010.6.1.3.5 Compensation2010.6.1.3.6 Compliance2010.6.1.4 Supervision by Banking Agencies2010.6.2 Supplementary Federal Reserve Supervisory and

Examination Guidance Pertaining to the Sale ofUninsured Nondeposit Investment Products

2010.6.2.1 Program Management2010.6.2.1.1 Types of Products Sold2010.6.2.1.2 Use of Identical or Similar Names2010.6.2.1.3 Permissible Use of Customer Information2010.6.2.1.4 Arrangements with Third Parties2010.6.2.1.5 Contingency Planning2010.6.2.2 Disclosures and Advertising2010.6.2.2.1 Content, Form, and Timing of Disclosure2010.6.2.2.2 Advertising2010.6.2.2.3 Additional Disclosures2010.6.2.3 Setting and Circumstances2010.6.2.3.1 Physical Separation from Deposit Activities2010.6.2.4 Designation, Training, and Supervision of Sales

Personnel and Personnel Making Referrals2010.6.2.4.1 Hiring and Training of Sales Personnel2010.6.2.4.2 Training of Bank Personnel Who Make Referrals2010.6.2.4.3 Supervision of Personnel


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2010.6.2.5 Suitability and Sales Practices2010.6.2.5.1 Suitability of Recommendations2010.6.2.5.2 Sales Practices2010.6.2.5.3 Customer Complaints2010.6.2.6 Compensation2010.6.2.7 Compliance2010.6.2.8 Audit2010.6.2.9 Joint Interpretations of the Interagency Statement2010.6.2.9.1 Disclosure Matters2010.6.2.9.2 Joint Interpretations on Retail Sales of Nondeposit

Investment Products2010.6.3 Inspection/Examination Objectives2010.6.4 Inspection/Examination Procedures2010.6.4.1 Scope of the Procedures

2010.7 Reserved

2010.8 Sharing of Facilities and Staff by BankingOrganizations

2010.8.1 Identification of Facilities and Staff2010.8.2 Examiner Guidance on Sharing Facilities and Staff

2010.9 Supervision of Subsidiaries—Required Absencesfrom Sensitive Positions

2010.9.1 Statement on Required Absences from Sensitive Positions2010.9.2 Inspection Objectives2010.9.3 Inspection Procedures

2010.10 Internal Loan Review


2010.11 Private-Banking Functions and Activities

2010.11.1 Overview of Private Banking and Its Associated Activities2010.11.1.1 Products and Services2010.11.1.1.1 Personal Investment Companies, Offshore Trusts,

and Token-Name Accounts2010.11.1.1.2 Deposit-Taking Activities of Subsidiary Institutions2010.11.1.1.3 Investment Management2010.11.1.1.4 Credit2010.11.1.1.5 Payable-Through Accounts2010.11.1.1.6 Personal Trust and Estates2010.11.1.1.7 Custody Services2010.11.1.1.8 Funds Transfer2010.11.1.1.9 Hold Mail, No-Mail, and Electronic-Mail Only2010.11.1.1.10 Bill-Paying Services2010.11.2 Functional Review2010.11.2.1 Supervision and Organization2010.11.2.2 Risk Management




2010.11.2.2.1 Customer-Due Diligence Policy and Procedures2010.11.2.2.1.1 Suspicious Activity Reports2010.11.2.2.2 Credit-Underwriting Standards2010.11.2.3 Fiduciary Standards2010.11.2.4 Operational Controls2010.11.2.4.1 Segregation of Duties2010.11.2.4.2 Inactive and Dormant Accounts2010.11.2.4.3 Pass-Through Accounts and Omnibus Accounts2010.11.2.4.4 Hold-Mail, No-Mail, and E-mail-Only Controls2010.11.2.4.5 Funds Transfer—Tracking Transaction Flows2010.11.2.4.6 Custody—Detection of “Free-Riding”2010.11.2.5 Management Information Systems2010.11.2.6 Audit2010.11.2.7 Compliance2010.11.2.7.1 Office of Foreign Assets Control2010.11.2.7.2 Bank Secrecy Act2010.11.3 Preparation for Inspection2010.11.3.1 Pre-Inspection Review2010.11.3.2 Inspection Staffing and Scope2010.11.3.3 Reflection of Organizational Structure2010.11.3.4 Risk-Focused Approach2010.11.3.5 First-Day Letter2010.11.4 Inspection Objectives2010.11.5 Inspection Procedures2010.11.5.1 Private-Banking Pre-Inspection Procedures2010.11.5.2 Full-Inspection Phase

2010.12 Fees Involving Investments of Fiduciary Assets inMutual Funds and Potential Conflicts of Interest

2010.12.1 Due-Diligence Review Needed before Enteringinto Fee Arrangements


2010.13 Establishing Accounts for Foreign Governments,Embassies, and Political Figures

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

2010.13.2 Risk Mitigation and Supervisory Expectations for ForeignMissions

2020.0 Intercompany Transactions—Introduction

2020.0.1 Analysis of Intercompany Transactions2020.0.2 Role of the Examiner

2020.1 Intercompany Transactions Between Affiliates—Sections 23A and 23B of the Federal Reserve Act

2020.1.01 What’s New in this Revised Section2020.1.05 Sections 23A and 23B of the Federal Reserve Act, and

Regulation W


BHC Supervision Manual September 2017Page 4.1


2020.1.1 Section 23A of the Federal Reserve Act2020.1.1.1 Definition of an Affiliate2020.1.1.2 Definition of Affiliates by Type of Entity2020.1.1.2.1 Investment Funds Advised by the Member Bank or an

Affiliate of the Member Bank2020.1.1.2.2 Financial Subsidiaries2020.1.1.2.3 Partnerships2020.1.1.2.4 Subsidiaries of Affiliates2020.1.1.2.5 Companies Designated by the Appropriate Federal Banking

Agency2020.1.1.2.6 Merchant Banking2020.1.1.2.7 Companies that are not Affiliates2020.1.1.2.8 Employee Benefit Plans2020.1.2 Quantitative Limits2020.1.3 Capital Stock and Surplus2020.1.3.1 Determination of Control2020.1.4 Covered Transactions2020.1.4.1 Attribution Rule2020.1.4.2 Credit Transactions with an Affiliate2020.1.4.2.1 Extension of Credit to an Affiliate or Other Credit

Transaction with an Affiliate2020.1.4.2.2 Valuation of Credit Transactions with an Affiliate2020.1.4.2.3 Timing of a Credit Transaction with an Affiliate2020.1.4.2.4 Leases2020.1.4.2.5 Extensions of Credit Secured by Affiliate Securities—

General Valuation Rule (Section 223.24(a) and (b))2020.1.4.2.6 Extensions of Credit Secured by Affiliate Securities—

Mutual Fund Shares2020.1.4.3 Asset Purchases2020.1.4.3.1 Purchase of Assets under Regulation W2020.1.4.4 IDIs Purchase of Securities Issued by an Affiliate2020.1.4.5 Issuance of a Letter of Credit or Guarantee2020.1.4.5.1 Confirmation of a Letter of Credit Issued by an Affiliate2020.1.4.5.2 Credit Enhancements Supporting a Securities Underwriting2020.1.4.5.3 Cross-Guarantee Agreements and Cross-Affiliate Netting

Arrangements2020.1.4.5.4 Keepwell Agreements2020.1.4.5.5 Prohibition on the Purchase of Low-Quality Assets2020.1.5 Collateral for Certain Transactions with Affiliates2020.1.5.1 Collateral Requirements in Regulation W2020.1.5.1.1 Deposit Account Collateral2020.1.5.1.2 Ineligible Collateral2020.1.5.1.3 Perfection and Priority2020.1.5.1.4 Unused Portion of an Extension of Credit2020.1.5.1.5 Purchasing Affiliate Debt Securities in the Secondary

Market2020.1.5.1.6 Credit Transactions with Nonaffiliates that Become

Affiliates2020.1.6 Limitations on Collateral2020.1.7 Derivative Transactions with Affiliates

2020.1.7.1 Derivative Transactions between Insured DepositoryInstitutions and Their Affiliates


BHC Supervision Manual September 2017Page 4.2


2020.1.7.1.1 Section 23A on Derivatives Transactions2020.1.7.1.2 Section 23B and Regulation W Regarding Derivative

Transactions2020.1.7.1.3 Covering Derivatives that are the Functional Equivalent of

a Guarantee2020.1.8 Intraday Extensions of Credit2020.1.8.1 Standard under Which the Agencies May Grant Additional

Exemptions2020.1.9 Exemptions from Section 23A2020.1.9.1 Covered Transactions Exempt from the Quantitative Limits

and Collateral Requirements2020.1.9.1.1 Parent Institution/Subsidiary Institution Transactions2020.1.9.1.2 Sister-Bank Exemption (Section 223.41(b)).2020.1.9.1.3 Purchase of Loans on a Non-Recourse Basis from an

Affiliate IDI2020.1.9.1.4 Internal Corporate Reorganizations2020.1.9.2 Other Covered Transactions Exempt from the Quantitative

Limits, Collateral Requirements, and Low-Quality-AssetProhibition

2020.1.9.2.1 Correspondent Banking2020.1.9.2.2 Secured Credit Transactions2020.1.10 Asset Purchases from an Affiliate—Exemptions2020.1.10.1 Purchase of a Security by an Insured Depository Institution

from an Affiliate2020.1.10.2 Purchases of Assets with Readily Identifiable Market Quotes2020.1.10.3 Purchasing Certain Marketable Securities2020.1.10.3.1 Broker-dealer Requirement and Securities Purchases from

Foreign Broker-Dealers2020.1.10.3.2 Securities Eligible for Purchase by a State Member Bank2020.1.10.3.3 No Purchases Within 30 Days of an Underwriting2020.1.10.3.4 No Securities Issued by an Affiliate2020.1.10.3.5 Price-Verification Methods2020.1.10.3.6 Record Retention2020.1.10.4 Purchasing Municipal Securities2020.1.10.5 Purchase of Loans on a Non-Recourse Basis2020.1.10.6 Purchases of Assets by Newly Formed Institutions2020.1.10.7 Transactions Approved under the Bank Merger Act2020.1.11 Purchases of Extensions of Credit—the Purchase

Exemption2020.1.12 Other Board-Approved Exemptions from Section 23A2020.1.12.1 Exemptions and Interpretations from the Attribution Rule

of Section 23A2020.1.12.2 Interpretation—Loans to a Nonaffiliate that Purchases

Securities or Other Assets Through a DepositoryInstitution Affiliate Agent or Broker

2020.1.12.3 Exemption—Loans to a Nonaffiliate that PurchasesSecurities from a Depository Institution SecuritiesAffiliate That Acts as a Riskless Principal

2020.1.12.4 Exemption—Depository Institution Loan to a NonaffiliatePursuant to a Preexisting Line of Credit and theProceeds Are Used to Purchase Securities from theInstitution’s Broker-Dealer Affiliate


BHC Supervision Manual July 2014Page 4.3


2020.1.12.5 Exemption—Credit Card Transactions2020.1.13 An IDI’s Acquisition of an Affiliate that Becomes an

Operating Subsidiary2020.1.14 Step-Transaction Exemption (Section 223.31(d) and (e))2020.1.14.1 Application of Sections 23A and 23B of Subpart G to U.S.

Branches and Agencies of Foreign Banks2020.1.14.1.1 Applicability of Sections 23A and 23B to Foreign Banks

Engaged in Underwriting Insurance, Underwriting orDealing in Securities, Merchant Banking, or InsuranceCompany Investment in the United States

2020.1.15 Section 23B of the Federal Reserve Act2020.1.15.1 Transactions Exempt from Section 23B of the FRA2020.1.15.2 Purchases of Securities for Which an Affiliate Is the

Principal Underwriter2020.1.15.3 Definition of Affiliate under Section 23B2020.1.15.4 Advertising and Guarantee Restriction2020.1.16 Inspection Objectives2020.1.17 Inspection Procedures2020.1.18 Laws, Regulations, Interpretations, and Orders

2020.2 Loan Participations—Intercompany Transactions

2020.2.1 Inspection Objectives




2020.2.2 Inspection Procedures2020.2.3 Laws, Regulations, Interpretations, and Orders

2020.3 Sale and Transfer of Assets


2020.4 Compensating Balances


2020.5 Dividends

2020.5.1 Policy Statement on Cash Dividend Payments2020.5.1.1 Policy Statement on the Payment of Cash Dividends

by State Member Banks and Bank HoldingCompanies

2020.5.2 Inspection Objectives2020.5.3 Inspection Procedures2020.5.4 Laws, Regulations, Interpretations, and Orders

2020.6 Management and Service Fees

2020.6.1 Transactions Subject to Federal Reserve ActSection 23B


2020.7 Transfer of Low-Quality Loans or Other Assets


2020.8 (Reserved for Future Use)

2020.9 Split-Dollar Life Insurance

2020.9.1 Split-Dollar Life Insurance Arrangements2020.9.1.1 Split-Dollar Life Insurance Endorsement Plan2020.9.1.2 Split-Dollar Life Insurance Collateral Assignment2020.9.2 Compliance with Applicable Laws2020.9.2.1 Compliance with Sections 23A and 23B of the FRA2020.9.2.2 Investment Authority under the National Banking Act2020.9.3 Safety-and-Soundness Concerns2020.9.4 Examiner Review of Split-Dollar Life Insurance2020.9.5 Inspection Objectives2020.9.6 Inspection Procedures2020.9.7 Laws, Regulations, Interpretations, and Orders




2030.0 Grandfather Rights—Retention and Expansion ofActivities

2030.0.1 Indefinite Grandfather Privileges2030.0.2 Activities and Securities of New Bank Holding

Companies2030.0.3 Limitations on Expansion of Grandfather Rights for

Insurance Agency Nonbanking Activities of BankHolding Companies

2030.0.4 Successor Rights2030.0.5 Expansion of Grandfather Activities2030.0.6 Divestitures2030.0.7 Inspection Objectives2030.0.8 Inspection Procedures2030.0.9 Laws, Regulations, Interpretations, and Orders2030.0.10 Appendix 1—Expansion of Grandfathered Activities

2040.0 Commitments to the Federal Reserve


2050.0 Extensions of Credit to BHC Officials

2050.0.1 BHC Official and Related Interest Transactionsbetween the Parent Company or Its NonbankSubsidiaries

2050.0.2 Transactions Involving Other Property or Services2050.0.3 Regulation O2050.0.3.1 FDICIA and BHC Inspection Guidance for

Regulation O2050.0.3.2 Definitions in Regulation O (abbreviated listing)2050.0.3.2.1 Extension of Credit2050.0.3.2.2 Insiders Use of a Bank-Owned Credit Card2050.0.3.3 General Prohibitions and Limitations of Regulation O2050.0.3.4 Additional Restrictions on Loans to Executive Officers

of Member Banks2050.0.3.5 Grandfathering Provisions2050.0.3.6 Reports by Executive Officers2050.0.3.7 Report on Credit to Executive Officers2050.0.3.8 Disclosure of Credit from Member Banks to Executive

Officers and Principal Shareholders2050.0.3.9 Civil Penalties of Regulation O2050.0.3.10 Records of Member Banks (and BHCs)2050.0.3.10.1 Recordkeeping for Insiders of the Member Bank’s

Affiliates2050.0.3.10.2 Special Rule for Noncommercial Lenders2050.0.3.11 Section 23A Ramifications2050.0.4 Remedial Action2050.0.5 Inspection Objectives2050.0.6 Inspection Procedures2050.0.7 Laws, Regulations, Interpretations, and Orders




2060.0 Management Information Systems

2060.05 Policy Statement on the Internal Audit Functionand Its Outsourcing

2060.05.01 An Effective System of Internal Controls2060.05.02–2060.05.04

Reserved

2060.05.05 Application of the Sarbanes-Oxley Act to NonpublicBanking Organizations

2060.05.06 Interagency Policy Statement on the Internal AuditFunction and Its Outsourcing

2060.05.1 Internal Audit Function (Part I)2060.05.1.1 Director and Senior Management Responsibilities for

Internal Audit2060.05.1.1.1 Internal Audit Placement and Structure Within the

Organization2060.05.1.1.2 Internal Audit Management, Staffing, and Audit Quality2060.05.1.1.3 Internal Audit Frequency and Scope2060.05.1.1.4 Communication of Internal Findings to the Directors,

Audit Committee, and Management2060.05.1.1.5 Contingency Planning2060.05.1.2 U.S. Operations of Foreign Banking Organizations2060.05.1.3 Internal Audit Systems and the Audit Function for

Small Financial Institutions2060.05.2 Internal Audit Outsourcing Arrangements (Part II)2060.05.2.1 Examples of Internal Audit Outsourcing Arrangements2060.05.2.2 Additional Inspection and Examination Considerations

for Internal Audit Outsourcing Arrangements2060.05.2.2.1 Management of the Outsourced Internal Audit Function2060.05.2.2.2 Communication of Outsourced Internal Audit Findings

to Directors and Senior Management2060.05.2.3 Independence of the External Auditor2060.05.2.3.1 Agencies’ Views on Independence2060.05.3 Independence of the Independent Public Accountant

(Part III)2060.05.3.1 Applicability of the SEC’s Auditor Independence

Requirements2060.05.3.1.1 Institutions That Are Public Companies2060.05.3.1.2 Depository Institutions Subject to the Annual Audit

and Reporting Requirements of Section 36 of theFDI Act

2060.05.3.1.3 Institutions Not Subject to Section 36 of the FDI ActThat Are Neither Public Companies Nor Subsidiariesof Public Companies

2060.05.3.1.4 AICPA Guidance2060.05.4 Inspection Guidance (Part IV)2060.05.4.1 Review of Internal Audit Function and Outsourcing

Arrangements2060.05.4.2 Inspection Concerns About the Adequacy of the

Internal Audit Function2060.05.4.3 Concerns About the Independence of the Outsourcing

Vendor


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2060.05.5 Inspection Objectives2060.05.6 Inspection Procedures2060.05.6.1 Internal Audit Function Inspection Procedures2060.05.6.2 Other Internal Audit Function Inspection Procedures2060.05.6.3 Additional Aspects of the Examiner’s Review of an

Outsourcing Arrangement2060.05.6.4 Assessment of Auditor Independence2060.05.6.5 Supplemental Procedures to Evaluate the Effectiveness

of the Internal Audit Function2060.05.6.6 Continuous Monitoring between Inspections of Internal

Audit2060.05.6.7 Evaluating the Ability to Rely on Internal Audit2060.05.6.8 Considerations for Consolidated Supervision

2060.07 Supplemental Policy Statement on the Internal AuditFunction and its Outsourcing

2060.07.1 Supplemental Policy Guidance2060.07.1.1 Enhanced Internal Audit Practices2060.07.1.1.1 Risk Analysis2060.07.1.1.2 Thematic Control Issues2060.07.1.1.3 Challenging Management and Policy2060.07.1.1.4 Infrastructure2060.07.1.1.5 Risk Tolerance2060.07.1.1.6 Governance and Strategic Objectives2060.07.1.2 Internal Audit Function (Part I of the 2003 Policy

Statement)

2060.07.1.2.1 Attributes of Internal Audit2060.07.1.2.2 Corporate Governance Considerations2060.07.1.2.3 The Adequacy of the Internal Audit Function’s Processes2060.07.1.2.4 Internal Audit Performance and Monitoring Processes2060.07.1.3 Internal Audit Outsourcing Arrangements (Part II of the

2003 Policy Statement)

2060.07.1.3.1 Vendor Competence2060.07.1.3.2 Contingency Planning2060.07.1.3.3 Quality of Audit Work2060.07.1.4 Independence Guidance for the Independent Public

Accountant (Part III of the 2003 Policy Statement)

2060.07.1.4.1 Depository Institutions Subject to the Annual Audit andReporting Requirements of Section 36 of the FDI Act

2060.07.1.5 Examination Guidance (Part IV of the 2003 Policy

Statement)

2060.07.1.5.1 Determining the Overall Effectiveness of Internal Audit2060.07.1.5.2 Relying on the Work Performed by Internal Audit

2060.1 Audit

2060.1.2 External Auditors and the Release of RequiredInformation

2060.1.3 External Auditor Inquiries2060.1.4 Unsafe and Unsound Use of Limitation-of-Liability

Provisions in External Audit Engagement Letters2060.1.4.1 Scope of the Advisory on Engagement Letters2060.1.4.2 External Audits and Their Engagement Letters




2060.1.4.3 Limitation-of-Liability Provisions2060.1.4.4 Auditor Independence2060.1.4.5 Alternative Dispute-Resolution Agreements and Jury-Trial

Waivers2060.1.4.6 The Advisory’s Conclusion2060.1.4.7 Examples of Unsafe and Unsound Limitation-of-Liability

Provisions2060.1.4.8 Frequently Asked Questions on the Application of the

SEC’s Auditor-Independence Rules2060.1.5 Inspection Objectives2060.1.6 Inspection Procedures2060.1.7 Reserved

2060.1.8 Overview: Interagency Advisory on External Audits ofInternationally Active U.S. Financial Institutions

2060.1.8.1 Appendix A—Interagency Advisory on External Audits ofInternationally Active U.S. Financial Institutions

2060.2 Budget


2060.3 Records and Statements


2060.4 Structure and Reporting


2060.5 Insurance

2060.5.1 Introduction2060.5.2 Banker’s Blanket Bond2060.5.3 Types of Blanket Bonds2060.5.4 Determining the Coverage Needed2060.5.5 Notification of Loss2060.5.6 Directors’ and Officers’ Liability Insurance2060.5.7 Inspection Objectives2060.5.8 Inspection Procedures

2065.1 Accounting, Reporting, and Disclosure Issues—Nonaccrual Loans and Restructured Debt

2065.1.1 Cash-Basis Income Recognition on Nonaccrual Assets2065.1.2 Nonaccrual Assets Subject to SFAS 15 and SFAS 114

Restructurings2065.1.3 Restructurings Resulting in a Market Interest Rate2065.1.4 Nonaccrual Treatment of Multiple Loans to One

Borrower




2065.1.4.1 Troubled-Debt Restructuring—Returning aMultiple-Note Structure to Accrual Status

2065.1.4.2 Nonaccrual Loans That Have Demonstrated SustainedContractual Performance

2065.1.5 Acquisition of Nonaccrual Assets2065.1.6 Treatment of Nonaccrual Loans with Partial

Charge-Offs2065.1.7 In-Substance Foreclosures2065.1.8 Liquidation Values of Real Estate Loans

2065.2 Determining an Adequate Level for the Allowance forLoan and Lease Losses


2065.3 Maintenance of an Appropriate Allowance for Loanand Lease Losses (ALLL)

2065.3.0 Overview of the ALLL Policy Statement2065.3.1 2006 Interagency Policy Statement on the Allowance for

Loan and Lease Losses2065.3.1.1 Nature and Purpose of the ALLL2065.3.1.2 Responsibility of the Board of Directors and Management2065.3.1.2.1 Appropriate ALLL Level2065.3.1.2.2 Factors to Consider in the Estimation of Credit Losses2065.3.1.2.3 Measurement of Estimated Credit Losses2065.3.1.2.4 Analyzing the Overall Measurement of the ALLL2065.3.1.2.5 Estimated Credit Losses in Credit-Related Accounts2065.3.1.3 Examiner Responsibilities2065.3.1.4 ALLL Level Reflected in Regulatory Reports2065.3.1.5 Appendix 1—Loan-Review Systems2065.3.1.5.1 Loan Classification or Credit Grading Systems2065.3.1.5.2 Elements of Loan-Review Systems2065.3.1.6 Appendix 2—International Transfer Risk Considerations

2065.4 ALLL Methodologies and Documentation

2065.4.1 2001 Policy Statement on ALLL Methodologiesand Documentation

2065.4.1.1 Documentation Standards2065.4.1.2 Policies and Procedures2065.4.1.3 Methodology2065.4.1.3.1 Documentation of ALLL Methodology in Written Policies

and Procedures2065.4.1.4 ALLL Under FAS 1142065.4.1.5 ALLL Under FAS 52065.4.1.5.1 Segmenting the Portfolio2065.4.1.5.2 Estimating Loss on Groups of Loans2065.4.1.6 Consolidating the Loss Estimates2065.4.1.7 Validating the ALLL Methodology2065.4.1.7.1 Supporting Documentation for the Validation Process




2065.4.1.8 Appendix—Application of GAAP2065.4.2 Inspection Objectives2065.4.3 Inspection Procedures

2065.5 ALLL Estimation Practices for Loans Securedby Junior Liens

2065.5.1 ALLL Estimation Practices for Loans and Lines of CreditSecured by Junior Liens on 1–4 Family ResidentialProperties

2065.5.1.1 Responsibilities of Management2065.5.1.1.1 Consideration of All Significant Factors2065.5.1.1.2 Adequate Segmentation2065.5.1.1.3 Qualitative or Environmental Factor Adjustments2065.5.1.1.4 Charge-Off and Nonaccrual Policies2065.5.1.1.5 Responsibilities of Examiners2065.5.2 Inspection Objectives2065.5.3 Inspection Procedures

2068.0 Sound Incentive Compensation Policies

2068.0.1 Scope of Application2068.0.2 Principles of a Sound Incentive Compensation System2068.0.2.1 Principle 1: Balanced Risk-Taking Incentives2068.0.2.2 Principle 2: Compatibility with Effective Controls

and Risk-Management2068.0.2.3 Principle 3: Strong Corporate Governance2068.0.3 Conclusion on Sound Incentive Compensation

2070.0 Taxes—Consolidated Tax Filing

2070.0.1 Interagency Policy Statement on Income Tax Allocationin a Holding Company Structure

2070.0.1.1 Tax-Sharing Agreements2070.0.1.2 Measurement of Current and Deferred Income Taxes2070.0.1.3 Tax Payments to the Parent Company2070.0.1.4 Tax Refunds from the Parent Company2070.0.1.5 Income-Tax-Forgiveness Transactions2070.0.2 Qualifying Subchapter S Corporations2070.0.3 Inspection Objectives2070.0.4 Inspection Procedures2070.0.5 Laws, Regulations, Interpretations, and Orders

2080.0 Funding—Introduction

2080.05 Bank Holding Company Funding and Liquidity

2080.05.1 Funding and Liquidity2080.05.2 Additional Supervisory Considerations2080.05.3 Examiner’s Application of Principles in Evaluating

Liquidity and in Formulating Corrective ActionPrograms




2080.1 Commercial Paper and Other Short-Term UninsuredDebt Obligations and Securities

2080.1.1 Meeting the SEC Criteria2080.1.1.1 Nine-Month Maturity Standard2080.1.1.2 Prime Quality2080.1.1.3 Current Transactions2080.1.1.4 Sales to Institutional Investors2080.1.2 Marketing of Commercial Paper2080.1.3 Thrift Notes and Similar Debt Instruments2080.1.4 Other Short-Term Indebtedness2080.1.5 Current Portion of Long-Term Debt2080.1.6 Inspection Objectives2080.1.7 Inspection Procedures

2080.2 Long-Term Debt

2080.2.1 Convertible Subordinated Debenture2080.2.2 Convertible Preferred Debenture2080.2.3 Negative Covenants2080.2.4 Inspection Objectives2080.2.5 Inspection Procedures

2080.3 Equity

2080.3.1 Preferred Stock2080.3.2 Inspection Objectives2080.3.3 Inspection Procedures

2080.4 Retention of Earnings

2080.4.1 Payment of Dividends by Bank Subsidiaries2080.4.1.1 Net Income Test2080.4.1.2 Undivided Profits Test

2080.5 Pension Funding and Employee Stock Option Plans

2080.5.1 Stock Option Programs2080.5.2 Employee Stock Ownership Plans (ESOPs)2080.5.2.1 Accounting Guidelines for Leveraged ESOP

Transactions2080.5.2.2 Fiduciary Standards under ERISA Pertaining

to ESOPs2080.5.3 Status of ESOPs under the BHC Act2080.5.4 Inspection Considerations

2080.6 Bank Holding Company Funding from Sweep Accounts

2080.6.1 Funding by Sweeping Deposit Accounts

2090.0 Control and Ownership—General




2090.0.05 Definitions2090.0.1 Conclusive Presumptions of Control2090.0.2 Direct Control

2090.0.3 Indirect Control2090.0.4 Rebuttable Presumptions of Control2090.0.4.1 Regulation Y Determinants of Control2090.0.4.2 Other Presumptions of Control2090.0.5 Procedures for Determining Control2090.0.6 Inspection Objectives2090.0.7 Inspection Procedures2090.0.8 Laws, Regulations, Interpretations, and Orders

2090.05 Qualified Family Partnerships

2090.05.1 Qualified Family Partnership Exemption2090.05.2 Assignment of Economic Partnership Interest that is a QFP

2090.1 Change in Control

2090.1.1 Commitments and Conditions for Approval2090.1.2 Completion of the Transaction2090.1.3 Information to Be Included in Notices2090.1.4 Transactions Requiring Submission of Prior Notice2090.1.4.1 Rebuttable Presumption of Control2090.1.4.2 Rebuttable Presumption of Concerted Action2090.1.5 Transactions Not Requiring Any Notice2090.1.6 Transactions Not Requiring Prior Notice2090.1.7 Unauthorized or Undisclosed Changes in Bank Control2090.1.8 Changes or Replacement of an Institution’s Chief Executive

Officer or Any Director2090.1.9 Disapproval of Changes in Control2090.1.10 Additional Reporting Requirements2090.1.11 Stock Redemptions2090.1.12 Corrective Action2090.1.13 Inspection Objectives2090.1.14 Inspection Procedures

2090.2 BHC Formations

2090.2.1 Formation of a Bank Holding Company and Changesin Ownership

2090.2.2 History of the Policy Statement on the Formation ofSmall Bank Holding Companies

2090.2.3 Small Bank Holding Company and Savings and LoanHolding Company Policy Statement

2090.2.3.1 Applicability of Policy Statement2090.2.3.2 Ongoing Requirements2090.2.3.2.1 Reduction in Parent Company Leverage2090.2.3.2.2 Capital Adequacy2090.2.3.2.3 Dividend Restrictions2090.2.3.3 Core Requirements for All Applicants2090.2.3.3.1 Minimum Down Payment




2090.2.3.3.2 Ability to Reduce Parent Company Leverage2090.2.3.4 Additional Application Requirements for Expedited

Processing2090.2.3.4.1 Expedited Notices under Sections 225.14 and 225.23

of Regulation Y2090.2.3.4.2 Waiver of Stock-Redemption Filing2090.2.4 Inspection Objectives2090.2.5 Inspection Procedures2090.2.6 Laws, Regulations, Interpretations, and Orders

2090.3 Treasury Stock Redemptions

2090.3.1 Change in Control Act Considerations2090.3.2 Inspection Objectives2090.3.3 Inspection Procedures

2090.4 Policy Statements on Equity Investments in Banksand Bank Holding Companies

2090.4.1 Overview and Guiding Principles2090.4.2 Board’s 1982 Policy Statement on Nonvoting Equity

Investments by Bank Holding Companies

2090.4.2.1 Statutory and Regulatory Provisions

2090.4.2.2 Review of Agreements2090.4.2.3 Provisions that Avoid Control2090.4.2.4 Review by the Board2090.4.3 Activities of Banking Organizations and Board

Determinations Subsequent to the 1982 Policy Statement

2090.4.4 Board’s 2008 Policy Statement on Equity Investmentsin Banks and Bank Holding Companies

2090.4.4.1 Specific Approaches to Avoid Control2090.4.4.1.1 Director Representation2090.4.4.1.2 Total Equity2090.4.4.1.3 Consultations with Management2090.4.4.1.4 Other Indicia of Control2090.4.4.1.4.1 Business Relationships2090.4.4.1.4.2 Covenants2090.4.4.2 Conclusion of the 2008 Policy Statement2090.4.5 Laws, Regulations, Interpretations, and Orders

2090.5 Acquisitions of Bank Shares through FiduciaryAccounts

2090.6 Divestiture Control Determinants

2090.6.05 Control Determinants2090.6.1 Inspection Objectives2090.6.2 Inspection Procedures2090.6.3 Laws, Regulations, Interpretations, and Orders




2090.7 Nonbank Banks

2090.7.1 CEBA and FIRREA Provisions for Nonbank Banks2090.7.2 Retaining Grandfather Rights Under Section 4(f)

of the BHC Act2090.7.3 Laws, Regulations, Interpretations, and Orders

2090.8 Control and Ownership—Liability of CommonlyControlled Depository Institutions

2090.8.1 Five-Year Protection from Liability (5-YearTransition Rule)

2090.8.2 Cross-Guarantee Provisions2090.8.3 Exclusions for Institutions Acquired in Debt

Collections

2092.0 Reserved

2093.0 Control and Ownership—Shareholder ProtectionArrangements

2093.0.1 Shareholder Protection Arrangements—Supervisory Issues2093.0.2 Supervisory Oversight

2100.0 International Banking Activities2100.0.1 Foreign Operations of U.S. Banking Organizations2100.0.2 Edge Act and Agreement Corporations2100.0.3 Supervision of Foreign Banking Organizations




2110.0 Formal Corrective Actions

2110.0.1 Statutory Tools for Formal Supervisory Action2110.0.2 Types of Corrective Actions2110.0.2.1 Cease-and-Desist Orders2110.0.2.2 Temporary Cease-and-Desist Orders2110.0.2.3 Written Agreements2110.0.2.4 Prohibition and Removal Authority2110.0.2.5 Termination of Nonbank Activity2110.0.2.6 Violations of Final Orders and Written Agreements2110.0.2.7 Civil Money Penalties2110.0.2.8 Administration of Formal Actions2110.0.2.8.1 Publication of Final Orders2110.0.2.8.2 Public Hearings2110.0.2.8.3 Subpoena Power2110.0.3 Indemnification Payments and Golden Parachute Payments2110.0.3.1 Indemnification Agreements and Payments2110.0.3.2 Golden Parachute Payments2110.0.4 Disciplinary Actions Against Accountants and Accounting

Firms Performing Certain Audit Services2110.0.5 Appointment of Directors and Senior Executive Officers

2120.0 Foreign Corrupt Practices Act and Federal ElectionCampaign Act

2120.0.1 Introduction2120.0.2 Summary of the Federal Election Campaign Act2120.0.3 Banks and the FECA2120.0.4 Contributions and Expenditures2120.0.5 Separate Segregated Funds and Political Committees2120.0.6 Inspection Objectives2120.0.7 Inspection Procedures2120.0.8 Apparent Violations of the Statutes2120.0.9 Advisory Opinions

2122.0 Internal Credit-Risk Ratings at Large BankingOrganizations

2122.0.1 Application to Large Bank Holding Companies2122.0.2 Sound Practices in Function and Design of Internal Rating

Systems2122.0.3 Sound Practices in Assigning and Validating Internal Risk

Ratings2122.0.4 Application of Internal Risk Ratings to Internal

Management and Analysis2122.0.4.1 Limits and Approval Requirements2122.0.4.2 Reporting to Management on Credit-Risk Profile of

the Portfolio2122.0.4.3 Allowance for Loan and Lease Losses2122.0.4.4 Pricing and Profitability2122.0.4.5 Internal Allocation of Capital2122.0.5 Inspection Objectives




2122.0.6 Inspection Procedures

2124.0 Risk-Focused Safety-and-Soundness Inspections

2124.0.1 Full Scope Inspections and Transaction Testing2124.0.2 Risk-Focused Inspections2124.0.2.1 Risk Assessment2124.0.2.2 Preparation of a Scope Memorandum2124.0.2.3 On-Site Procedures2124.0.2.4 Evaluation of Audit Function as Part of Assessment

of Internal Control Structure2124.0.2.5 Evaluation of Overall Risk-Management Process2124.0.2.6 Evaluation of Compliance with Laws and Regulations2124.0.2.7 Documentation of Supervisory Findings2124.0.2.8 Communication of Supervisory Findings2124.0.3 Inspection Objectives2124.0.4 Inspection Procedures2124.0.5 Appendix A—Definitions of Risk Types Evaluated

at Inspections

2124.01 Risk-Focused Supervision Framework for LargeComplex Banking Organizations

2124.01.1 Inspection Approach for Risk-Focused Supervision2124.01.1.1 Risk-Focused Supervisory Objectives2124.01.1.2 Key Elements of the Risk-Focused Framework2124.01.1.3 Banking Organizations Covered by the Framework2124.01.1.3.1 Foreign Institutions2124.01.1.3.2 Nonbank Subsidiaries of Domestic Institutions2124.01.1.3.3 Edge Act Corporations2124.01.1.3.4 Specialty Areas Covered by the Framework2124.01.2 Coordination of Supervisory Activities2124.01.2.1 Responsible Reserve Bank2124.01.2.2 RRBs Working with Local Reserve Banks2124.01.2.2.1 RRB Defined2124.01.2.2.2 Duties of RRB2124.01.2.2.3 Sharing of RRB Duties2124.01.2.3 Central Point of Contact2124.01.2.4 Sharing of Information2124.01.2.5 Coordination with Other Supervisors2124.01.3 Functional Approach and Targeted Inspections2124.01.4 Overview of the Process and Products2124.01.5 Understanding the Institution2124.01.5.1 Sources of Information2124.01.5.2 Preparation of the Institutional Overview2124.01.6 Assessing the Institution’s Risks2124.01.6.1 Assessment of the Overall Risk Environment2124.01.6.1.1 Internal Risk-Management Evaluation2124.01.6.1.2 Supervision Program for Consumer Compliance Risk

Assessment at BHCs2124.01.6.1.3 Adequacy of Information Technology Systems2124.01.6.2 Preparation of the Risk Matrix2124.01.6.2.1 Identification of Significant Activities




2124.01.6.2.2 Type and Level of Inherent Risk of Significant Activities2124.01.6.2.3 Risk-Management Adequacy Assessment for Significant

Activities2124.01.6.2.4 Composite Risk Assessment of Significant Activities2124.01.6.2.5 Overall Composite Risk Assessment2124.01.6.2.6 Preparation of the Risk Assessment2124.01.7 Planning and Scheduling Supervisory Activities2124.01.7.1 Preparation of the Supervisory Plan2124.01.7.2 Preparation of the Inspection or Examination Program2124.01.8 Defining Inspection or Examination Activities2124.01.8.1 Scope Memorandum2124.01.8.2 Entry Letter2124.01.9 Performing Inspection or Examination Procedures2124.01.10 Reporting the Findings2124.01.11 Appendix A—Risk-Focused Supervisory Letters with BHC

Supervision Manual Section Number References2124.01.12 Appendix B—Risk-Assessment Questionnaire2124.01.13 Appendix C—Federal Reserve Bank Cover Letter and BHC

Inspection Questionnaire

2124.02–2124.04 Reserved

2124.05 Consolidated Supervision Framework for Large FinancialInstitutions

2124.05.1 Framework Applicability2124.05.2 Framework Overview2124.05.3 Enhancing Resiliency of a Firm2124.05.3.1 Capital and Liquidity Planning and Positions2124.05.3.2 Corporate Governance2124.05.3.3 Recovery Planning2124.05.4 Reducing the Impact of a Firm’s Failure2124.05.4.1 Management of Critical Operations2124.05.4.2 Support for Banking Offices2124.05.4.3 Resolution Planning2124.05.4.4 Additional Macroprudential Supervisory Approaches to

Address Risks to Financial Stability

2124.05.5 Conduct of Supervisory Activities2124.05.6 Appendix A2124.05.6.1 Risk Transfer Considerations When Assessing Capital

Adequacy2124.05.7 Managing Foreign Exchange Settlement Risks for

Physically Settled Transactions2124.07 Compliance Risk-Management Programs and Oversight

at Large Banking Organizations with ComplexCompliance Profiles

2124.07.1 Firmwide Compliance Risk Management and Oversight2124.07.1.1 Overview2124.07.1.2 Federal Reserve Supervisory Policies on Compliance Risk

Management and Oversight

2124.07.1.2.1 Large Banking Organizations with Complex ComplianceProfiles




2124.07.1.2.2 Large Banking Organizations with Less-ComplexCompliance Profiles

2124.07.1.2.3 Foreign Banking Organizations2124.07.2 Independence of Compliance Staff2124.07.3 Compliance Monitoring and Testing2124.07.3.1 Risk Assessments and Monitoring and Testing Programs2124.07.3.2 Testing2124.07.4 Responsibilities of the Board of Directors and Senior

Management

2124.07.4.1 Boards of Directors2124.07.4.2 Senior Management

2124.1 Assessment of Information Technology in Risk-FocusedSupervision

2124.1.1 Changing Role of Information Technology2124.1.2 Implications for Risk-Focused Supervision2124.1.3 Framework for Evaluating Information Technology2124.1.4 Aligning Examiner Staffing with the Technology

Environment2124.1.5 Inspection Objectives2124.1.6 Inspection Procedures2124.1.7 Appendix A—Examples of Information Technology

Elements That Should Be Considered in AssessingBusiness Risks of Particular Situations

2124.2 Reserved

2124.3 Managing Outsourcing Risk2124.4 Information Security Standards

2124.4.1 Interagency Guidelines Establishing Information SecurityStandards

2124.4.1.1 Disposal of Customer and Consumer Information2124.4.2 Response Programs for Unauthorized Access to Customer

Information and Customer Notice

2124.4.2.1 Response Programs2124.4.2.1.1 Components of a Response Program2124.4.2.2 Customer Notice2124.4.2.2.1 Standard for Providing Notice2124.4.2.2.2 Sensitive Customer Information2124.4.2.2.3 Affected Customers2124.4.2.2.4 Content of Customer Notice2124.4.2.2.5 Delivery of Customer Notice2124.4.3 Inspection Objective2124.4.4 Inspection Procedures2124.4.5 Appendix A—Interagency Guidelines Establishing

Information Security Standards

2124.5 Identity Theft Red Flags and Address Discrepancies

2124.5.1 Identity Theft Red Flags Prevention Program2124.5.1.1 Risk Assessment




2124.5.1.2 Elements of the Program2124.5.1.3 Guidelines2124.5.1.3.1 Identification of Red Flags2124.5.1.3.2 Categories of Red Flags2124.5.1.3.3 Detect the Program’s Red Flags2124.5.1.3.4 Respond Appropriately to any Detected Red Flags2124.5.1.3.5 Periodically Updating the Program’s Relevant Red Flags2124.5.1.4 Administration of Program2124.5.2 Inspection Objectives2124.5.3 Inspection Procedures

2125.0 Trading Activities of Banking Organizations—Risk Management and Internal Controls

2125.0.1 Oversight of the Risk Management Process2125.0.1.1 Board of Directors’ Approval of Risk Management

Policies2125.0.1.2 Senior Management’s Risk Management

Responsibilities2125.0.1.3 Independent Risk Management Functions2125.0.2 The Risk Management Process2125.0.2.1 Risk Measurement Systems2125.0.2.2 Limiting Risks2125.0.2.3 Reporting2125.0.2.4 Management Evaluation and Review of the Risk

Management Process2125.0.2.5 Managing Specific Risks2125.0.2.5.1 Credit Risks2125.0.2.5.2 Market Risk2125.0.2.5.3 Liquidity Risk2125.0.2.5.4 Operational Risk, Legal Risk, and Business Practices2125.0.3 Internal Controls and Audits

2126.0 Model Risk Management

2126.0.1 Introduction—Part I2126.0.2 Purpose and Scope—Part II2126.0.3 Overview of Model Risk Management—Part III2126.0.4 Model Development, Implementation, and Use—Part IV2126.0.4.1 Model Development and Implementation2126.0.4.2 Model Use2126.0.5 Model Validation—Part V2126.0.5.1 Key Elements of Comprehensive Validation2126.0.5.1.1 Evaluation of Conceptual Soundness2126.0.5.1.2 Ongoing Monitoring2126.0.5.1.3 Outcomes Analysis2126.0.5.2 Validation of Vendor and Other Third-Party Products2126.0.6 Governance, Policies, and Controls—Part VI2126.0.6.1 Board of Directors and Senior Management2126.0.6.2 Policies and Procedures2126.0.6.3 Roles and Responsibilities2126.0.6.4 Internal Audit2126.0.6.5 External Resources




2126.0.6.6 Model Inventory2126.0.6.7 Documentation2126.0.7 Conclusion—Part VII

2126.1 Investment Securities and End-User Derivatives Activities

2126.1.0 Sound Risk-Management Practices for Portfolio Investment2126.1.1 Supervisory Policy Statement on Investment Securities

and End-User Derivatives Activities2126.1.1.1 Purpose2126.1.1.2 Scope2126.1.1.3 Board and Senior Management Oversight2126.1.1.4 Risk-Management Process2126.1.1.4.1 Policies, Procedures, and Limits2126.1.1.4.2 Risk Identification, Measurement, and Reporting2126.1.1.4.3 Internal Controls2126.1.1.5 Risks of Investment Activities2126.1.1.5.1 Market Risk2126.1.1.5.2 Credit Risk2126.1.1.5.3 Liquidity Risk2126.1.1.5.4 Operational (Transaction) Risk2126.1.1.5.5 Legal Risk

2126.2 Investing in Securities without Reliance on Ratings ofNationally Recognized Statistical Rating Organizations

2126.2.1 Appendix 1—OCC Guidance on Due Diligence Require-ments in Determining Whether Securities are Eligible forInvestment.

2126.3 Counterparty Credit Risk Management Systems

2126.3.1 Fundamental Elements of Counterparty-Credit-RiskManagement

2126.3.2 Targeting Supervisory Resources2126.3.3 Assessment of Counterparty Creditworthiness2126.3.4 Credit-Risk-Exposure Measurement2126.3.5 Credit Enhancements2126.3.6 Credit-Risk-Exposure Limit-Setting and Monitoring

Systems2126.3.7 Inspection Objectives2126.3.8 Inspection Procedures

2126.5 Procedures for a Banking Entity to Request an ExtendedTransition Period for Illiquid Funds

2126.5.1 Volcker Rule’s Background2126.5.2 Requirements for Submitting Requests2126.5.3 Procedures for Filing an Extension Request

2127.0 Interest-Rate Risk—Risk Management and InternalControls

2127.0.1 Assessing the Management and Internal Controls OverInterest-Rate Risk




2127.0.2 Joint Agency Policy Statement: Interest-Rate Risk2127.0.3 Interagency Advisory on Interest Rate Risk Management

2128.0 Structured Notes

2128.0.1 Supervisory Policy—Structured Notes

2128.02 Asset Securitization

2128.02.1 Overview of Asset Securitization2128.02.2 Securitization Process2128.02.3 Credit Enhancement2128.02.4 Structure of Asset-Backed Securities2128.02.5 Supervisory Considerations Regarding Asset

Securitization2128.02.6 Policy Statement on Investment Securities and End-User

Derivatives Activities2128.02.6.1 Mortgage-Derivative Products2128.02.7 Risk-Based Capital Provisions Affecting Asset

Securitization2128.02.7.1 Assigning Risk Weights2128.02.7.2 Recourse Obligations2128.02.7.2.1 Residuals2128.02.7.2.2 Credit-Equivalent Amounts and Risk Weights of Recourse

Obligations and Direct-Credit Substitutes2128.02.7.2.3 Low-Level-Recourse Treatment2128.02.7.2.4 Standby Letters of Credit2128.02.8 Concentration Limits Imposed on Residual Interests2128.02.9 Inspection Objectives2128.02.10 Inspection Procedures

2128.03 Credit-Supported and Asset-Backed CommercialPaper

2128.03.1 Credit-Supported and Asset-Backed CommercialPaper as an Alternative Funding Source

2128.03.2 Commercial Bank Involvement in Credit-Enhancedand Asset-Backed Commercial Paper

2128.03.3 Risk-Based Capital Asset-Backed CommercialPaper Program

2128.03.3.1 Liquidity Facilities Supporting ABCP2128.03.3.2 Overlapping Exposures to an ABCP Program2128.03.3.3 Asset-Quality Test2128.03.3.4 Market Risk Capital Requirements for ABCP Programs2128.03.4 Board-of-Directors Policies Pertaining to Credit-

Enhanced or Asset-Backed Commercial Paper2128.03.5 Inspection Objectives2128.03.6 Inspection Procedures

2128.04 Implicit Recourse Provided to Asset Securitizations





2128.05 Securitization Covenants Linked to Supervisory Actionsor Thresholds


2128.06 Valuation of Retained Interests and Risk Managementof Securitization Activities

2128.06.05 Retained Interests from Securitization Activities2128.06.1 Asset Securitization2128.06.2 Independent Risk-Management Function2128.06.3 Valuation and Modeling Processes2128.06.4 Use of Outside Parties2128.06.5 Internal Controls2128.06.6 Audit Function or Internal Review2128.06.7 Regulatory Reporting of Retained Interests2128.06.8 Market Discipline and Disclosures2128.06.9 Risk-Based Capital for Recourse and Low-Level-Recourse

Transactions




2128.06.10 Concentration Limits Imposed on Retained Interests2128.06.11 Inspection Objectives2128.06.12 Inspection Procedures

2128.07 Reserved

2128.08 Subprime Lending

2128.08.1 Interagency Guidance on Subprime Lending2128.08.1.1 Risk Management2128.08.1.2 Examination Review and Analysis2128.08.1.2.1 Transaction-Level Testing2128.08.1.3 Adequacy of the ALLL2128.08.1.3.1 New Entrants to the Business2128.08.1.3.2 Pools of Subprime Loans—Not Classified2128.08.1.4 Classification Guidelines for Subprime Lending2128.08.1.4.1 Individual Loans2128.08.1.4.2 Portfolios2128.08.1.5 Required Documentation for Cure Programs2128.08.1.6 Predatory or Abusive Lending Practices2128.08.1.7 Capitalization2128.08.1.7.1 Stress Testing2128.08.1.8 Subprime-Lending Examiner Responsibilities2128.08.1.9 Appendix—Questions and Answers for Examiners

Regarding the Expanded Guidance for Subprime-Lending Programs

2128.08.1.9.1 Applicability of the Guidance2128.08.1.9.2 Subprime Characteristics2128.08.1.9.3 Capital Guidance2128.08.2 Inspection Objectives2128.08.3 Inspection Procedures2128.09 Elevated-Risk Complex Structured Finance Activities2128.09.1 Interagency Statement on Sound Practices Concerning

Elevated-Risk Complex Structured Finance Activities2128.09.2 Scope and Purpose of Statement2128.09.3 Identification and Review of Elevated-Risk Complex

Structured Finance Transactions2128.09.3.1 Identifying Elevated-Risk CSFTs2128.09.3.2 Approval and Documentation Process for Elevated-Risk

CSFTs2128.09.3.2.1 Due Diligence2128.09.3.2.2 Approval Process2128.09.3.2.3 Documentation2128.09.3.3 Other Risk-Management Principles for Elevated-Risk

CSFTs2128.09.3.3.1 General Business Ethics2128.09.3.3.2 Reporting2128.09.3.3.3 Monitoring Compliance with Internal Policies and

Procedures2128.09.3.3.4 Audit2128.09.3.3.5 Training2128.09.4 Conclusion




2129.0 Credit Derivatives

2129.0.1 Supervisory and Examiner Guidance2129.0.2 Types of Credit Derivatives2129.0.2.1 Credit-Default Swaps2129.0.2.2 Total-Rate-of-Return Swaps2129.0.3 Other Supervisory Issues2129.0.3.1 Credit Exposure2129.0.3.2 Concentrations of Credit2129.0.3.3 Classifications of Assets2129.0.3.4 Transactions Involving Affiliates2129.0.4 Inspection Objectives2129.0.5 Inspection Procedures

2129.05 Risk and Capital Adequacy Management of the ExposuresArising from Secondary-Market Credit Activities

2129.05.05 Risk Identification and Risk Management of SecondaryMarket Credit Activities

2129.05.1 Credit Risks in Secondary-Market Credit Activities2129.05.1.1 Loan Syndications2129.05.1.2 Credit Derivatives2129.05.1.3 Recourse Obligations, Direct Credit Substitutes, and

Liquidity Facilities2129.05.1.3.1 Recourse Obligations2129.05.1.3.2 Direct Credit Substitutes2129.05.1.3.3 Liquidity Facilities2129.05.1.4 Asset Securitization Structures2129.05.2 Reputational Risks2129.05.3 Liquidity Risks2129.05.4 Incorporating the Risks of Secondary-Market Credit

Activities into Risk Management2129.05.4.1 Board of Directors and Senior Management

Responsibilities2129.05.4.2 Management Information and Risk-Measurement Systems2129.05.4.3 System of Internal Controls2129.05.5 Stress Testing2129.05.6 Capital Adequacy2129.05.7 Inspection Objectives2129.05.8 Inspection Procedures

2130.0 Futures, Forward, and Option Contracts

2130.0.1 Introduction2130.0.2 Definitions2130.0.3 Financial Contract Transactions2130.0.3.1 Markets and Contract Trading2130.0.3.1.1 Forward Contracts2130.0.3.1.2 Standby Contracts2130.0.3.1.3 Futures Contracts2130.0.4 Margin Requirements2130.0.4.1 Variation Margin Calls




2130.0.5 The Delivery Process2130.0.6 Mechanics and Operation of Futures Exchanges2130.0.7 Comparison of Futures, Forward, and Standby

Contracts2130.0.8 Option Contracts2130.0.8.1 Other Options2130.0.8.1.1 Stock Index Options2130.0.8.1.2 Foreign Currency Options2130.0.8.2 Caps, Floors, and Collars2130.0.9 Regulatory Framework2130.0.10 Examples of Contract Strategies2130.0.10.1 The Mortgage Banking Price Hedge2130.0.10.2 Basis2130.0.10.3 Trading Account Short Hedge2130.0.10.3.1 Example 1: A Perfect Short Hedge2130.0.10.4 Long Hedge2130.0.10.4.1 Evaluation of the Hedge2130.0.10.5 Using Options to Create an Interest Rate Floor2130.0.10.6 Hedging a Borrowing with an Interest Rate Cap2130.0.11 Asset–Liability Management2130.0.12 Inspection Objectives2130.0.13 Inspection Procedures2130.0.13.1 Evaluating the Risks of Contract Activities2130.0.13.2 Reviewing Financial Contract Positions2130.0.13.3 Factors to Consider in Evaluating Overall Risk2130.0.13.4 Contract Liquidity2130.0.13.5 Relationship to Banking Activities2130.0.13.6 Parties Executing or Taking the Contra Side of a

Financial Contract2130.0.14 Accounting for Futures Contracts2130.0.14.1 Performance Bonds under Futures Contracts2130.0.14.2 Valuation of Open Positions2130.0.14.3 Criteria for Hedge Accounting Treatment2130.0.14.4 Gains and Losses from Monthly Contract Valuations

of Futures Contracts That Qualify as Hedges2130.0.14.5 Gains and Losses from Monthly Contract Valuations

of Futures Contracts That Do Not Qualify as Hedges2130.0.15 Preparing Inspection Reports2130.0.16 Internal Controls and Internal Audit2130.0.16.1 Internal Controls2130.0.16.2 Internal Audit2130.0.17 Laws, Regulations, Interpretations, and Orders

2140.0 Securities Lending

2140.0.1 Securities Lending Market2140.0.2 Definitions of Capacity2140.0.3 Guidelines2140.0.3.1 Recordkeeping2140.0.3.2 Administrative Procedures2140.0.3.3 Credit Analysis and Approval of Borrowers2140.0.3.4 Credit and Concentration Limits




2140.0.3.5 Collateral Management2140.0.3.6 Cash as Collateral2140.0.3.7 Letters of Credit as Collateral2140.0.3.8 Written Agreements2140.0.3.9 Use of Finders2140.0.3.10 Employee Benefit Plans2140.0.3.11 Indemnification2140.0.4 Laws, Regulations, Interpretations, and Orders

2150.0 Repurchase Transactions

2150.0.1 Credit Policy Guidelines2150.0.1.1 Dealings with Unregulated Securities Dealers2150.0.2 Guidelines for Controlling Repurchase Agreement

Collateral2150.0.2.1 Confirmations2150.0.2.2 Control of Securities2150.0.2.3 Margin Requirements2150.0.2.4 Overcollateralization2150.0.3 Operations2150.0.4 Laws, Regulations, Interpretations, and Orders

2160.0 Recognition and Control of Exposure to Risk

2160.0.1 Risk Evaluation2160.0.2 Risk Control2160.0.3 Inspection Objectives2160.0.4 Inspection Procedures

2170.0 Purchase and Sale of Loans Guaranteed by the U.S.Government

2170.0.1 Introduction2170.0.2 Recommendations for Originating and Selling

Institutions2170.0.3 Recommendations for Purchasing Institutions

2175.0 Sale of Uninsured Annuities

2175.0.1 Introduction2175.0.2 Permissibility of Uninsured Annuity Sales2175.0.3 Characteristics of Annuity Instruments2175.0.4 Improper Marketing Practices2175.0.5 Inspection Objectives2175.0.6 Inspection Procedures

2178.0 Support of Bank-Affiliated Investment Funds

2178.0.1 Policy on Banks Providing Financial Support to AdvisedFunds

2178.0.2 Notification and Consultation with the PrimaryFederal Regulator





2180.0 Securities Activities in Overseas Markets

2187.0 Violations of Federal Reserve Margin RegulationsResulting from ‘‘Free-Riding’’ Schemes

2187.0.1 Typical Day Trading or Free-Riding Activities2187.0.2 Securities Credit Regulations2187.0.2.1 Regulation U, Credit by Banks or Persons Other

Than Brokers or Dealers for the Purposeof Purchasing or Carrying Margins Stocks

2187.0.2.2 Regulation T, Credit by Brokers and Dealers, andRegulation X, Borrowers of Securities Credit

2187.0.3 New-Customer Inquiries and Warning Signals2187.0.4 Scope of the Inspection for Free-Riding Activities2187.0.5 SEC and Federal Reserve Sanctions and

Enforcement Actions2187.0.6 Inspection Objectives2187.0.7 Inspection Procedures2187.0.8 Laws, Regulations, Interpretations, and Orders

2220.3 Note Issuance and Revolving Underwriting CreditFacilities

2220.3.1 Note Issuance Facility (NIF)2220.3.2 Revolving Underwriting Facility (RUF)2220.3.3 Risk2220.3.4 Pricing and Fees2220.3.5 Standby RUFs2220.3.6 RUF Documents

2231.0 Real Estate Appraisals and Evaluations

2231.0.1 Interagency Appraisal and Evaluation Guidelines2231.0.2 Supervisory Policy2231.0.3 Appraisal and Evaluation Program2231.0.4 Independence of the Appraisal and Evaluation Program2231.0.5 Selection of Appraisers or Persons Who Perform

Evaluations2231.0.5.1 Approved Appraiser List2231.0.5.2 Engagement Letters2231.0.6 Transactions that Require Appraisals2231.0.7 Minimum Appraisal Standards2231.0.8 Appraisal Development2231.0.9 Appraisal Reports2231.0.10 Transactions that Require Evaluations2231.0.11 Evaluation Development2231.0.12 Evaluation Content2231.0.13 Validity of Appraisals and Evaluations2231.0.14 Reviewing Appraisals and Evaluations




2231.0.14.1 Reviewer Qualifications2231.0.14.2 Depth of Review2231.0.14.3 Resolution of Deficiencies2231.0.14.4 Documentation of the Review2231.0.15 Third-Party Arrangements2231.0.16 Program Compliance2231.0.16.1 Monitoring Collateral Values2231.0.16.2 Portfolio Collateral Risk2231.0.16.3 Modifications and Workouts of Existing Credits2231.0.17 Referrals2231.0.18 Appendixes in Interagency Appraisal And Evaluation

Guidelines2231.0.19 Background Information On Appraisal Valuation

Approaches2231.0.19.1 Cost Approach2231.0.19.2 Sales Comparison Approach2231.0.19.3 Income Approach2231.0.19.4 Value Correlation2231.0.19.5 Other Definitions of Value2231.0.20 Supervisory Expectations and Findings2231.0.21 Inspection Objectives2231.0.22 Inspection Procedures2231.0.23 Internal Control Questionnaire2231.0.23.1 Policies2231.0.23.2 Appraisals2231.0.23.3 Appraisers2231.0.23.4 Evaluations2231.0.23.5 Evaluators2231.0.23.6 Monitoring Collateral Values2231.0.23.7 Third Party Arrangements2231.0.23.8 Analytical Methods and Technological Tools2231.0.24 Laws, Regulations, Interpretations, Board Orders

2240.0 Guidelines for the Review and Classification ofTroubled Real Estate Loans

2240.0.1 Examiner Review of Commercial Real Estate Loans2240.0.1.1 Loan Policy and Administration Review2240.0.1.2 Indicators of Troubled Real Estate Markets and Projects,

and Related Indebtedness2240.0.1.3 Examiner Review of Individual Loans, Including

Analysis of Collateral Value2240.0.2 Classification Guidelines2240.0.2.1 Classification of Troubled Project-Dependent

Commercial Real Estate Loans2240.0.2.2 Guidelines for Classifying Partially Charged-Off Loans2240.0.2.3 Guidelines for Classifying Formally Restructured Loans2240.0.3 Treatment of Guarantees in the Classification Process2240.0.3.1 Considerations Relating to a Guarantor’s Financial

Capacity2240.0.3.2 Considerations Relating to a Guarantor’s Willingness

to Repay




2240.0.3.3 Other Considerations as to the Treatment ofGuarantees in the Classification Process

2241.0 Retail-Credit Classification

2241.0.1 Uniform Retail-Credit Classification and Account-Management Policy

2241.0.1.1 Other Considerations for Classification2241.0.1.2 Partial Payments on Open-End and Closed-End Credit2241.0.1.3 Re-aging, Extensions, Deferrals, Renewals, or Rewrites2241.0.1.4 Depository Institution Examination Considerations

2250.0 Domestic and Other Reports to Be Submittedto the Federal Reserve

2250.0.1 Penalties for Errors in Reports2250.0.2 Approval of Directors and Senior Officers of

Depository Institutions2250.0.3 Inspection Objectives2250.0.4 Inspection Procedures2250.0.5 Laws, Regulations, Interpretations, and Orders

2260.0 Venture Capital

2260.0.1 Introduction2260.0.2 Loans and Investments2260.0.3 Funding2260.0.4 Profitability2260.0.5 Capitalization2260.0.6 Inspection Objectives2260.0.7 Inspection Procedures2260.0.7.1 Pre-Inspection2260.0.7.2 On-Site Inspection2260.0.7.3 Matters Warranting Recommendation in Inspection

Report2260.0.8 Laws, Regulations, Interpretations, and Orders2260.0.9 Appendix 1—Venture Capital Company Sample

Balance Sheet2260.0.10 Appendix 2—Venture Capital Company Sample Income

Statement

2500.0 Supervision of Savings and Loan Holding Companies

2500.0.1 Applicable Law, Regulations, and Guidance



Introduction To Topics For Supervisory ReviewSection 2000.0

Discussed within these subsections are topicsassociated with regard to the overall bankholding company organization. Included is gen-eral information, inspection objectives andprocedures, and in some instances references tolaws, interpretations, and Board orders. Theprimary topics addressed are the supervision ofsubsidiaries, grandfather rights, commitments,extensions of credit to BHC officials, man-

agement information systems, taxes, funding,control and ownership, reporting by foreignand domestic banking organizations, formalcorrective actions, sharing of criminal referralinformation, investment transactions, recog-nition and control of risk, purchase and sale ofU.S. Government guaranteed loans, and venturecapital.

BHC Supervision Manual December 1992Page 1

Supervision of SubsidiariesSection 2010.0

WHAT’S NEW IN THIS REVISEDSECTION

This section is revised to include a revision ofthe Federal Deposit Insurance Act (FDIA) thatrequires a BHC or SLHC to serve as a ‘‘sourceof strength’’ to its depository institution subsidi-aries. See section 38A of the FDIA and section616(d) of the Dodd-Frank Act.

The relative merit of the degree of supervisionis dependent upon a number of factors, and mustbe analyzed in light of efficiency and operatingperformance. The degree and nature of controlover subsidiary organizations in a holdingcompany system usually falls between twoextremes: a tightly controlled, centralized net-work similar to a branch system, or a looselycontrolled, decentralized system with each sub-sidiary operating autonomously. A bank holdingcompany 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 inorder to expand through acquisition of nonbankconcerns or other banks. The management anddirectorate of such a holding company are oftenthe same as that of the bank. As the holdingcompany expands through acquisitions, the par-ent may continue to exercise control through thestaff of the lead bank, or may form a separatestaff 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 andoperating performance.

The level at which policies are establishedand supervised, the frequency of contactbetween the parent and subsidiaries, and theextent to which officers and directors of theparent serve also as officers and directors of thesubsidiary organizations are indicative of thelevel of control exercised by the parent. A cen-tralized bank holding company is characterizedby the placement of directors and officers of theparent company (or those of the lead bank) ineach of its subsidiaries, with frequent groupmeetings held between the officers of the leadbank or holding company and those of the sub-sidiary organizations. While this is an efficientmethod of operation, this type of organizationbuilds in the potential for conflicts of interest forthose individuals who serve in dual capacities.Corporate policies should recognize this poten-tial and provide guidance for resolution. Theoverriding principle should be that no member

of the bank holding company organizationshould be disadvantaged by a transaction withanother affiliate. Management of the investmentportfolio, budgets, tax planning, personnel, cor-respondent relationships, loans and loan partici-pations, and liability management are usuallycontrolled by the parent or lead bank in a cen-tralized system.

A decentralized system is one in which thebanks 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 withinthe system and infrequent reporting by subsidi-aries concerning investments and operating per-formance. The bank holding company might actonly in a minor advisory capacity. In such adecentralized system each subsidiary operatesas a relatively autonomous unit, with authorityand responsibility for certain actions delegatedby the parent to the board and/or chief executiveofficer of each subsidiary.

It is the responsibility of the directors andmanagement of the parent company to establishand supervise the policies of subsidiaries, eitherdirectly or through delegation of authority. Theimportance 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. Ifwritten policies have not been developed by theholding company, the examiner should recom-mend that major policies be written and commu-nicated to subsidiaries. Policies should ensurethat subsidiaries are not managed for cross pur-poses and should avoid concentrations of riskson a consolidated basis.

2010.0.1 POLICY STATEMENT ONTHE RESPONSIBILITY OF BANKHOLDING COMPANIES TO ACT ASSOURCES OF STRENGTH TO THEIRSUBSIDIARY BANKS

The Board is concerned about situations wherea bank has been threatened with failurenotwithstanding the availability of resources toits parent bank holding company. In order toassure that the Board’s policy that bank hold-ing companies serve as sources of financialstrength to subsidiary banks is understood bybank holding companies, the Board has issued a


general policy statement reaffirming andarticulating these principles, and confirming thatthe policy applies to failing bank situations.This long-standing policy has been recognizedby the Supreme Court in its decision in Board ofGovernors v. First Lincolnwood Corp., 439 U.S.234 (1978), and has been incorporated explicitlyin the Board’s Regulation Y, 12 C.F.R.225.4(a)(1).

A fundamental and long-standing principleunderlying the Federal Reserve’s supervisionand regulation of bank holding companies isthat bank holding companies should serve assources of financial and managerial strength totheir subsidiary banks. The Federal DepositInsurance Act (FDIA) requires that a bank hold-ing company or savings and loan holding com-pany act as a source of strength to its depositoryinstitution(s). The term ‘‘source of strength’’means the ability of a company that directly orindirectly owns or controls an insured deposi-tory institution to provide financial assistance tosuch insured depository institution in the eventof financial stress to the insured depository insti-tution. (See the FDIA, section 38A(a)–(c).) It isthe policy of the Board that in serving as asource of strength to its subsidiary banks, a bankholding company should stand ready to useavailable resources to provide adequate capitalfunds to its subsidiary banks during periods offinancial stress or adversity and should maintainthe financial flexibility and capital-raisingcapacity to obtain additional resources for assist-ing its subsidiary banks in a manner consistentwith the provisions of this policy statement.

Since the enactment of the Bank HoldingCompany Act in 1956, the Board has formallystated on numerous occasions that a bank hold-ing company should act as a source of financialand managerial strength to its subsidiary banks.As the Supreme Court recognized, in the 1978First Lincolnwood decision, Congress hasexpressly endorsed the Board’s long-standingview that holding companies must serve as a‘‘source of strength to subsidiary financial insti-tutions.’’1 In addition to frequent pronounce-ments over the years and the 1978 SupremeCourt decision, this principle has been incorpo-rated explicitly in Regulation Y since 1983. Inparticular, Section 225.4(a)(1) of Regulation Yprovides that:

‘‘A bank holding company shall serve as asource of financial and managerial strength toits subsidiary banks and shall not conduct itsoperations in an unsafe or unsound manner.’’

The important public policy interest in the sup-port provided by a bank holding company to itssubsidiary banks is based upon the fact that inacquiring a commercial bank, a bank holdingcompany derives certain benefits at thecorporate level that result, in part, from theownership of an institution that can issuefederally-insured deposits and has access toFederal Reserve credit. The existence of thefederal ‘‘safety net’’ reflects importantgovernmental concerns regarding the criticalfiduciary responsibilities of depository institu-tions as custodians of depositors’ funds andtheir strategic role within our economy asoperators of the payments system and impartialproviders of credit. Thus, in seeking theadvantages flowing from the ownership of acommercial bank, bank holding companies havean obligation to serve as a source of strengthand 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 bankingorganizations 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 essentialelement of a strong and growing economy. Astrong capital cushion also limits the exposureof the federal deposit insurance fund to lossesexperienced by banking institutions. For thesereasons, the Board has long considered adequatecapital to be critical to the soundness of indi-vidual banking organizations and to the safetyand stability of the banking and financialsystem.

Accordingly, it is the Board’s policy that abank holding company should not withholdfinancial support from a subsidiary bank in aweakened or failing condition when the holdingcompany is in a position to provide the support.A bank holding company’s failure to assist atroubled or failing subsidiary bank under thesecircumstances would generally be viewed as anunsafe and unsound banking practice or a viola-tion of Regulation Y or both.

Where necessary, the Board is prepared totake supervisory action to require such assis-tance. Finally, the Board recognizes that theremay be unusual and limited circumstanceswhere flexible application of the principles setforth 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


sary, and the Board may from time to timeidentify situations that may justify exceptions tothe policy.

This statement is not meant to establish newprinciples of supervision and regulation; rather,as already noted, it builds on public policy con-siderations as reflected in banking laws andregulations and long-standing Federal Reservesupervisory policies and practices. A bank hold-ing company’s failure to meet its obligation toserve as a source of strength to its subsidiarybank(s), including an unwillingness to provideappropriate assistance to a troubled or failingbank, will generally be considered an unsafeand unsound banking practice or a violation ofRegulation Y, or both, particularly if appropriateresources are on hand or are available to thebank holding company on a reasonable basis.Consequently, such a failure will generallyresult in the issuance of a cease and desist orderor other enforcement action as authorized underbanking law and as deemed appropriate underthe circumstances.

2010.0.2 BOARD ORDERREQUESTING A WAIVER FROM THEBOARD’S SOURCE OF STRENGTHPOLICY

On December 23, 1991, the Board approved anapplication of a BHC to eventually acquire100 percent of the outstanding stock of anotherBHC under a 5 year option. Initially, the BHCwould acquire approximately 26 percent of theacquiree’s total capital by purchasing a 15-yearsubordinated capital note agreement. It wouldthen have the option to acquire all of the remain-ing stock within 5 years. The acquiring BHCrequested that the Board waive any requirementof the Board that it serve as a source of financialstrength to the subsidiary bank (the Board’s‘‘Source of Strength’’ policy) of the BHCacquired until such time that the option is exer-cised to acquire the actual ownership of all theshares. The Board considered the request anddetermined that it would not be appropriate towaive the responsibility to serve as a source offinancial strength to the bank in this case. TheBoard noted that the option agreement and thecapital note agreement together provide amechanism for the acquiring BHC to exert con-trol over the future ownership of the acquiredBHC and many of the most important manage-ment decisions. Refer to 1992 FRB 159 and theF.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 andperforming its duties and responsibilities.

2. To determine the adequacy of written poli-cies and compliance with such policies by theparent 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 oversubsidiaries and whether the supervision asstructured has a beneficial or detrimental effectupon 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 sameas those of a subsidiary.

2. Determine whether the board of directorsof the parent company reviews the audit reports,regulatory examination reports, and board min-utes of its subsidiaries.

3. Determine the extent to which subsidiariesrely upon the parent for investment and lendingguidance.

4. Determine which specific functions anddecisions 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 determinewhether the parent company reviews loan de-linquency reports, comparative balance sheetsand comparative income statements of thesubsidiaries.

7. Review the extent of influence and controlover both bank and nonbank subsidiaries.

8. Determine the degree of influence by theparent 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.



9. Determine the degree to which man-agement of the subsidiary companies interfaceswith management of the parent company todiscuss policies.



Supervision of Subsidiaries(Funding Policies) Section 2010.1

The responsibility for the performance of theorganization rests with the board of directorsof 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 consolidatedorganization.The parent’s supervision and control of sub-

sidiary funding activities and the funding be-tween itself and its subsidiaries should be thusevaluated. The parent should be expected tomaintain policies for itself and its subsidiariesthat provide guidance and controls for fundingpractices. The presence and wording of fundingpolicies and the degree to which the policiesare followed by the subsidiaries, and the effec-tiveness of the policies in reducing risk to theentire 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 beemphasized. 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 capitalfor the bank subsidiaries, the nonbank subsidi-aries, and the consolidated organization. Thepolicy for bank and consolidated capital shouldbe consistent with the Board’s Capital Ade-quacy Guidelines and should address the assetquality of the entity in question. The policy fornonbank capital should include maintaining thecapital level at industry standards and shouldalso address the asset quality of the subsidiary,the holding company’s capital for each entityshould address what measures would be takenin the event capital falls below a targeted level.

Capital should also be addressed at theparent company level by specifying the degreeof double leveragethat the parent is willingto accept. The parent’s capital policy shouldprovide some measure of assessing each indi-vidual subsidiary’s capital adequacy in thecontext of the double leverage within theorganization.

The capital policies should include themethod for calculating dividends from each en-tity. The amount of dividends from subsidiariesto the parent is affected by the parent’s philoso-phy on the distribution of capital throughout theorganization. Some companies tend to keepminimum capital levels in their subsidiary banksby transferring the excess capital to the parent inthe form of dividends. The parent then investsthese funds for its own benefit, and down-streams the funds as needed. Other companies

calculate dividends based strictly on the parent’scash needs and thus keep any excess capital atthe bank level.2. Asset/Liability Management—The holding

company’s policies in the area ofasset/liabilitymanagement should include interest rate sensi-tivity matching, maturity matching, and the useof interest rate futures and forwards.Thesetopics should be addressed for each entity aswell as the organization as a whole. It is theparent’s responsibility to see that each entity isoperating consistently with the corporate goals.

The interest rate sensitivity policiesshouldbe designed to reduce the organization’s vulner-ability to interest rate movements. Policies con-cerning the asset/liability rate sensitivity matchshould not be limited to the subsidiary leadbank. The rate charged on parent company debtand the rate received by the parent on its ad-vances to subsidiaries should also be addressedto monitor the parent’s ability to service its debtin the face of changing interest rates. The policyshould specify what degree of mismatching isconsidered acceptable. The interest rate sensitiv-ity matching of the organization should be mon-itored on a frequent basis through the timelypreparation of a matching schedule.

Maturity matching policiesshould be de-signed to provide adequate liquidity to the orga-nization. These policies should not be limited tothe subsidiary lead bank, since a parent com-pany serving as a funding vehicle for nonbanksubsidiaries can have substantial exposurethrough its advances to these subsidiaries. Theholding company’s policies should include somemeasure of the liquidity of the assets in thenonbank subsidiary (determined partially by thequality of these assets), for comparison againstthe parent’s source of funding. The policiesshould quantify the maximum degree of expo-sure in the organization that is considered ac-ceptable to management. The reporting in thisarea should clearly indicate the current exposureand thus the potential for liquidity problems.

The holding company’spolicies ad-dressing interest rate futures and forwardsshould be consistent with the Board’s policy inthis area. Involvement in this activity should begeared towards hedging against interest ratemovements rather than speculating that interestrates will either increase or decrease. The policy


should specify what use of futures and forwardsis considered appropriate.3. Funding of Nonbank Subsidiaries—The

parent company should have policies addressinghow nonbank subsidiaries fund their activities.If the subsidiaries obtain their own funding,market discipline may be a factor in controllingthe activities of the subsidiaries. However, theparent cannot rely solely on market disciplinedue to the risks from interdependence. The par-ent company is still responsible under the cen-tralized accountability approach to approve andsupervise the subsidiaries’ funding policies.

If the subsidiaries obtain funds from theparent, the risk from interdependence is in-creased. The subsidiary is less able to standalone since it is reliant on the parent for fund-ing. If the parent capitalizes the nonbank subsid-iary through borrowed funds, bank capital is putat risk due to the increased exposure of theorganization. If the borrowing results indouble-leverage, the risk is increased since less ‘‘hard’’capital is available for support. The parent’spolicy on advances to nonbank subsidiariesshould address this additional risk by specifyingthe level of borrowings that is considered ac-ceptable relative to nonbank capital and consoli-dated capital. The terms of the borrowingsshould 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 liquid-ity problems.


1. To determine if the parent’s funding poli-cies adequately address funding risks to theorganization.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 anddecisions.


1. Review the funding policies at the parentand 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


aggregate limit on such loans. The policyshould set forth credit standards for anyloan purchased as well as require that com-plete documentation be maintained by thepurchasing entities. The policy shoulddefine the extent of contingent liability,

holdback and reserve requirements, and themanner in which the loan will be handledand serviced.

10. Loans to insiders. Lending policies shouldaddress loans to insiders. Such policiesshould incorporate applicable regulatory

Loan Administration and Lending Standards 2010.2


Supervision of Subsidiaries(Loan Administration and Lending Standards) Section 2010.2


Effective January 2016, section 2010.2.5 isrevised to reference SR-15-17, “InteragencyStatement on Prudent Risk Management forCommercial Real Estate Lending” and itsattachment. 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 ofsubsidiary lending activities. The System’s abil-ity to evaluate the effectiveness of a company’ssupervision and control of subsidiary lendingactivities can be strengthened not only by evalu-ating the parent’s role in light of efficiency andoperating performance, but also by evaluatingthe quality of control and supervision.

In order to assess quality, there must be astandard measure against which a company’spolicies can be evaluated. Establishing the mini-mum areas that a company’s loan-administrationpolicies should address will create a standardthat will aid in evaluating the quality of thecompany’s control and its supervision of thatactivity.

Current inspection procedures include thetesting of subsidiaries’ compliance with a parentcompany’s policies. This section summarizesthe parent’s responsibilities with regard tosupervising subsidiary lending. It defines theinternal and external factors that should be con-sidered in the formulation of loan policies and astrategic plan. It also outlines the minimumelements that the lending policies shouldinclude.

Internal and external factors that a bankingorganization should consider when formulatingits 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, and5. market conditions.

Following are the components that generallyform the basis for a sound loan policy:

1. Geographic limits. The trade area should beclearly defined and loan officers should befully aware of specific geographic limita-tions for lending purposes. Such a policyavoids approval of loans to customers out-side the trade area in opposition to primaryobjectives. The primary trade area shouldbe distinguished from any secondary tradearea so that emphasis for each trade areamay be properly placed.

2. Distribution of loans by category. Limita-tions based on aggregate percentages oftotal loans in commercial, real estate, con-sumer, and other categories are common.Such policies are beneficial; however, theyshould contain provisions for deviationsthat are approved by the directorate or acommittee. This allows credit to be distrib-uted in relation to the market conditions ofthe trade area. During times of heavy loandemand 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 appropriateonly until the risk of further increasing theloan concentration outweighs the benefitsto be derived from expanding the portfolioto satisfy credit demand. See component11, ‘‘Concentrations of credit,’’ below.

3. Types of loans. The lending policy shouldstate the types of loans that will be madeand the maximum amount for each type ofloan. The policy should also set forthguidelines to follow in making specificloans. Decisions about the types of loans tobe granted should be based on the exper-tise of the lending officers, the depositstructure, and anticipated creditworthydemands of the trade area. Sophisticatedcredits or loans secured by collateral thatrequire more than normal supervisionshould be avoided unless or until there arethe necessary personnel to properlyadminister them. Information systems andinternal controls should be in place toidentify, monitor, and control the types ofcredit that have resulted in abnormal loss.The amount of real estate and other typesof 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 thatensure realistic repayment plans. Loanmaturities should be set by taking into con-sideration the anticipated source of repay-ment, the purpose of the loan, the type ofproperty, and the useful life of the collat-eral. For term loans, the lending policyshould state the maximum time withinwhich loans may be amortized. Specificprocedures should be developed for situa-tions requiring balloon payments and/ormodification of the original terms of theloan. If a clean-up period1

5. Loan pricing. Rates on various loan typesmust be sufficient to cover the cost offunds loaned and the servicing of the loan,including overhead and possible losses,while providing an acceptable margin ofprofit over the long run. These costs mustbe known and taken into considerationbefore rates are established. Periodicreviews should be conducted to determinewhether 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 loanpricing.

6. Loan amount to appraised value. The pol-icy should outline where the responsibilityfor appraisals rests and should define for-mal, standard appraisal procedures, includ-ing procedures for possible reappraisals incase of renewal or extension. Acceptabletypes of appraisals and limits on the dollaramount and the type of property that per-sonnel are authorized to appraise should beoutlined. Circumstances requiring apprais-als by qualified independent appraisersshould be described. The maximum ratio ofthe loan amount to appraised value,2 themethod of valuation, and differences forvarious types of property should bedetailed. The policy should contain a sched-ule listing the downpayment requirementsfor financing consumer goods and businessequipment.

7. Loan amount to market value of pledgedsecurities. In addition to the legal restric-

tions imposed by Federal Reserve Regula-tion U, the lending policy should set forthmargin requirements for all types of securi-ties acceptable as collateral. Margin require-ments should be related to the marketabilityof the security (for example, closely held,over-the-counter, actively traded). The pol-icy should assign responsibility and set afrequency for the periodic pricing of thecollateral.

8. Financial information. Extension of crediton a safe and sound basis depends on com-plete and accurate information regardingthe borrower’s credit standing. One pos-sible exception is when the loan is predi-cated on readily marketable collateral, thedisposition of which was originally desig-nated as the source of repayment for theadvance. Current and complete financialinformation is necessary, including second-ary sources of repayment, not only at theinception of the loan, but also throughoutthe term of the advance. The lending pol-icy should define the financial-statementrequirements for businesses and individu-als at various borrowing levels and shouldinclude requirements for audited, nonau-dited, fiscal, interim, operating, cash-flow,and other statements.3 It should include ex-ternal credit checks required at various in-tervals. The requirements for financialinformation should be defined in such away that any credit-data exception wouldbe a clear violation of the lending policy.

9. Limits and guidelines for loan partici-pations. Section 2020.2 provides significantinformation regarding intercompany loanparticipations between holding companyaffiliates. The lending policy should placelimits on the amount of loans purchasedfrom any one source and also place an

1. 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.



limitations (for example, Federal ReserveRegulation O) and should also address situ-ations in which it would be prudent to exer-cise certain restrictions even though notexplicitly required to do so by regulation(for example, loans by nonbank subsidiariesto insiders).

11. Concentrations of credit.Credit concentra-tions may be defined as loans collateralizedby a common security; loans to one bor-rower or related group of borrowers; loansdependent upon a particular agriculturalcommodity; aggregate loans to majoremployers, their employees, and their majorsuppliers; loans within industry groups; out-of-territory loans; aggregate amount ofpaper purchased from any one source; orthose loans that often have been includedin other homogeneous risk groupings.Credit concentrations, by their nature, aredependent on common key factors, andwhen weaknesses develop, they have anadverse impact on each individual loanmaking up the concentration.

In identifying asset concentrations, com-mercial real estate loans and residential realestate loans can be viewed separately whentheir performance is not subject to similareconomic or financial risks. In the samevein, commercial real estate developmentloans need not necessarily be grouped withresidential real estate development loans,especially when the residential developerhas firm, reliable purchase contracts for thesale of the homes upon completion. Evenwithin the commercial development andconstruction sector, distinctions for concen-tration purposes may be made, when appro-priate, between those loans that have firmtake-out commitments and those that donot. Groups or classes of real estate loansshould, of course, be combined and viewedas concentrations when they do share sig-nificant common characteristics and aresimilarly affected by adverse economic,financial, or business developments.

Banking organizations should establishand adhere to policies that control ‘‘concen-tration risk.’’ The lending policy shouldaddress the risk involved in various concen-trations and indicate those that should beavoided or limited. However, before con-centrations can be limited or reviewed,accounting systems must be in place toallow for the retrieval of information neces-sary to determine and monitor concentra-tions. The lending policy should provide for

frequent monitoring and reporting of allconcentrations.

Banking organizations with asset concen-trations are expected to put in place effec-tive internal policies, systems, and controlsto monitor and manage this risk. Concentra-tions that involve excessive or undue risksrequire close scrutiny and should bereduced 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 isrealistic, prudent, and achievable in view ofthe particular circumstances and marketconditions. In situations where concentra-tion levels have built up over an extendedperiod, it may take time—in some casesseveral years—to achieve a more balancedand diversified portfolio. What is critical isthat adequate systems and controls are inplace for reducing undue or excessive con-centrations in accordance with a prudentplan, along with strong credit policies andloan-administration standards to control therisks associated with new loans, andadequate capital to protect the institutionwhile its portfolio is being restructured.

Institutions that have in place effectiveinternal controls to manage and reduce con-centrations over a reasonable period of timeneed not automatically refuse credit tosound borrowers simply because of the bor-rower’s industry or geographic location.This principle applies to prudent loanrenewals and rollovers, as well as to newextensions of credit that are underwritten ina sound manner.

The purpose of a lending organization’spolicies should be to improve the overallquality of its portfolio. The replacement ofunsound loans with sound loans canenhance the quality of a portfolio, evenwhen concentration levels are not reduced.

12. Refinancing or renewal of loans.Refinanc-ings or renewals should be structured in amanner that is consistent with sound bank-ing, supervisory, and accounting practices,and in a manner that protects the bankingorganization and improves its prospects forcollecting or recovering on the asset.

13. Loan origination and loan approvals.Thepolicy should establish loan-origination andloan-approval procedures, both generallyand by size and type of loan. The loanlimitations for all lending officers should be



set accordingly. Lending limits should alsobe set for group authority, allowing a com-bination of officers or a committee toapprove larger loans. Reporting proceduresand the frequency of committee meetingsshould also be defined. The loan policyshould further establish identification,review, and approval procedures for excep-tion loans, including real estate and otherloans with loan-to-value percentages inexcess of supervisory limits.4

14. Loan-administration procedures for loanssecured by real estate.The loan policyshould establish loan-administration proce-dures covering documentation, disburse-ment, collateral administration and inspec-tion, escrow administration, collection, loanpayoffs, and loan review. Documentationprocedures would specify, among otherthings, the types and frequency of financialstatements and the requirements for verify-ing information provided by the borrower.They would also cover the type and fre-quency of collateral evaluations (appraisalsand other estimates of value). In addition,loan-administration policies should addressprocedures for servicing and participationagreements and other loan-administrationprocedures such as those for claims process-ing (for example, seeking recovery ondefaulted loans that are partially or fullyguaranteed by a government entity or insur-ance program).

15. Collection and foreclosure and thereporting and disclosure of delinquent obli-gations and charge-offs.The lending policyshould define delinquent obligations, pro-vide guidelines on when loans are to beplaced on nonaccrual or to be restructured,dictate appropriate procedures for reportingto senior management and to the directoratepast-due credits, and provide appropriateguidance on the extent of disclosure of suchcredits. The policy should establish andrequire a follow-up collection procedurethat is systematic and progressively strongerand should set forth guidelines (whereapplicable) for close surveillance by a loanwork-out division. It should also addressextensions and other forms of forbearance,

the acceptance of deeds in lieu of foreclo-sure, and the timing of foreclosure. Thepolicy must be consistent with supervisoryinstructions in the financial statements ofcondition and income for financial institu-tions and BHCs (bank call report and theFR Y-9C and the other FR Y-seriesreports). Guidelines should be establishedto ensure that all accounts are presented toand reviewed by management for charge-off after a stated period of delinquency. Seesection 2065.1 for disclosure, accounting,and reporting issues related to nonaccrualloans and restructured debt.

16. Reserve for loan losses and provisions forloan losses.The policy should set forth theparameters that management considers indetermining an appropriate level of loan-loss reserves as well as provisions neces-sary to attain this level.

Because an analysis of the allowance forloan and lease losses (ALLL) requires anassessment of the relative credit risks in theportfolio, many banking organizations, foranalytical purposes, attribute portions of theALLL to loans and other assets classified‘‘substandard’’ by management or a super-visory agency. Management may do thisbecause it believes, based on past history orother factors, that there may be unidentifiedlosses associated with loans classified sub-standard in the aggregate.

Furthermore, management may use thisas an analytical approach in estimating thetotal amount necessary for the ALLL and incomparing the ALLL to various categoriesof loans over time. As a general rule, anindividual loan classified substandard mayremain in an accrual status as long as theregulatory reporting requirements foraccrual treatment are met, even when anattribution of the ALLL has been made.

17. Other. The policy should address the han-dling of exceptions to the policy as well asprovide for adherence to the policy viainternal 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 withthe BHC’s objectives as well as marketconditions.

2010.2.1 UNIFORM REAL ESTATELENDING STANDARDS

On December 23, 1992, the Board announcedadoption of a uniform rule and guidelines on

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.



real estate lending, along with the FDIC, OCC,and OTS, as mandated by section 304 of theFederal Deposit Insurance CorporationImprovement Act of 1991 (FDICIA). TheBoard’s Regulation H (12 C.F.R. 208, Member-ship of State Banking Institutions in the FederalReserve System) was amended to implement theuniform real estate lending standards for statemember banks. Although the Board did notdirectly apply the regulation to bank holdingcompanies and their nonbank subsidiaries, thoseentities are expected to conduct and to supervisereal estate lending activities prudently, consis-tent with safe and sound lending standards.

The agencies’ regulations require that eachinsured depository institution adopt and main-tain comprehensive written real estate lendingpolicies appropriate to the institution and thenature and scope of its lending activities. Lend-ing policies must be reviewed and approved bythe institution’s board of directors at least annu-ally. The policies are to include standards forloan diversification and prudent underwriting aswell as loan-administration procedures anddocumentation, approval, and reporting require-ments. Depository institutions’ policies are toreflect consideration of the appendix to thebanking agencies’ regulations, ‘‘InteragencyGuidelines for Real Estate Lending Policies.’’The guidelines are designed to help an institu-tion formulate and maintain real estate lendingpolicy that is appropriate to its size and thenature and scope of its operations, as requiredby the regulations. These guidelines are gener-ally comparable to the inspection guidance pro-vided in this section.

2010.2.2 LENDING STANDARDS FORCOMMERCIAL LOANS

The lending decision is properly that of thesenior management and boards of directors ofbanking 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 ensurethat their policies are enforced and that lendingpractices generally remain within the overallability of the institution to manage. The follow-ing subsections describe certain sound practicesregarding lending standards and credit-approvalprocesses for commercial loans.5

Sound lending practices address formal creditpolicies, formal credit-staff approval of transac-tions, loan-approval documentation, the use offorward-looking tools in the approval process,and management and lender information sys-tems. In addition to evaluating adherence tothese sound practices during inspections, super-visory personnel and examiners may wish todiscuss these standards with loan portfolio man-agers at institutions where a full credit review isbeing performed. Senior management should bemade aware of the potential for deterioration inthe loan portfolio if lending discipline is notmaintained, whether from inadequate assess-ment or communication of lending risks, incom-plete adherence to prudent lending standardsthat reflect the risk appetite of the board ofdirectors, or both.

Examiners should evaluate whether adequateinternal oversight exists and whether institutionmanagement has timely and accurate informa-tion. As always, examiners should also discussmatters of concern with the institution andinclude them in their reports of inspection, evenif cited practices and problem loans have not yetreached 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 prudentbounds should be promptly corrected. SeeSR-98-18.

2010.2.2.1 Sound Practices in LoanStandards and Approval

Certain sound practices in lending can help tomaintain strong credit discipline and ensure thatan institution’s decision to take risk in lending iswell informed, balanced, and prudent. Severalof these sound practices are listed and describedbelow.

2010.2.2.1.1 Formal Credit Policies

The Federal Reserve and other supervisoryauthorities have long stressed the importance offormal written credit policies in a sound credit-risk-management process. Such policies canprovide crucial discipline to an institution’slending process, especially when the institu-tion’s standards are under assault due to intensecompetition for loans. They can serve to com-municate formally an institution’s appetite for

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.’’



credit risk in a manner that will support soundlending decisions, while focusing appropriateattention on loans being considered that divergefrom approved standards.

In developing and refining loan policies, someinstitutions specify ‘‘guidance minimums’’ forfinancial performance ratios that apply to certaintypes of loans or borrowers (for example, com-mercial real estate). Such guidance makesexplicit that loans not meeting certain financialtests (based on current performance, projectedfuture performance, or both) should in generalnot be made, or alternatively should only bemade under clearly specified situations. Institu-tions using this approach most effectively tendto avoid specifying standards for broad rangesof lending situations and instead focus on thoseareas of lending most vulnerable to excessiveoptimism, or where the institution expects loanvolume to grow most significantly.

Formal policies can also provide lending dis-cipline by clearly stating the type of covenantsto be imposed for specific loan types. Whendesigned and enforced properly, financial cov-enants can help significantly to reduce creditlosses by communicating clear thresholds forfinancial performance and potentially triggeringcorrective or protective action at an early stage.Often, however, loan-approval documents donot describe the key financial covenants evenwhen discussions with institutional staff dis-close that such covenants are present. The staffand/or management of many institutionsacknowledge that they have a ‘‘common prac-tice’’ of imposing certain types of covenants onvarious types of loans. They indicate that such apractice is well known to lenders and others atthe institution (but not articulated in their writ-ten loan policies), so that describing the actualcovenants in the loan-approval document wouldbe redundant. However, management and otherapproving authorities within an institution thenreceive no formal positive indication that ‘‘com-mon practice’’ controls have been imposed andno 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 asto the risks and controls associated with the loanunder consideration. In contrast, loan policiescan create a clear expectation that (1) all keycovenants should be described in loan-approvaldocuments, (2) certain covenant types should beapplied 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 forunderwriting decisions should be consistent withthe nature, size, and complexity of the bankingorganization’s (BO) activities. Departures fromunderwriting policies and standards, however,can have serious consequences for BOs of allsizes. Internal controls and credit reviews shouldbe established and maintained to ensure compli-ance with those policies and procedures. Whenthere are continued favorable economic andfinancial conditions, compliance monitoring ofthe BO’s lending policies and procedures needsto be diligent to make certain that there is noundue reliance on optimistic outlooks for bor-rowers. Undue reliance on continued favorableeconomic conditions can be demonstrated bythe following characteristics:

1. dependence on very rapid growth in a bor-rower’s revenue as the ‘‘most likely’’ case

2. heavy reliance on favorable collateralappraisals and valuations that may not besustainable over the longer term

3. greater willingness to make loans withoutscheduled amortization prior to the loan’sfinal maturity

4. willingness to readily waive violations ofkey covenants, to release collateral or guar-antee requirements, or even to restructureloan agreements, without corresponding con-cessions on the part of the borrower, on theassumption that a favorable environment willallow the borrower to recover quickly

Among the adverse effects of undue relianceon a continued favorable economy is the possi-bility that problem loans will not be identifiedproperly or in a timely manner. Timely identifi-cation of problem loans is critical for providinga full awareness of the BO’s risk position,informing management and directors of thatposition, taking steps to mitigate risk, and pro-viding a proper assessment of the adequacy ofthe allowance for credit losses and capital.6

Similarly, an overreliance on continued readyaccess to financial markets on favorable termscan originate from the following situations:

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.



1. explicit reliance on future public market debtor equity offerings, or on other sources ofrefinancing, as the ultimate source of princi-pal repayment, which presumes that marketliquidity and the market’s appetite for suchinstruments will be favorable at the time thatthe facility is to be repaid

2. ambiguous or poorly supported analysis ofthe 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 someform of equity infusion), which also assumesthat markets will be receptive to such trans-actions at the time that the facility is to berepaid

3. measuring a borrower’s leverage (for exam-ple, debt-to-equity) based solely on the mar-ket capitalization of the firm without regardto ‘‘book’’ equity, thereby implicitly assum-ing that currently unrealized appreciation inthe value of the firm can be readily realized ifneeded

4. more generally, extending loans with a riskprofile that more closely resembles the pro-file of an equity investment, under circum-stances that leave additional credit or defaultas the borrower’s only resort if favorableexpectations are not met

Banking organizations that become lax in adher-ing to established loan-underwriting policies andprocedures, as a result of overreliance on favor-able economic and financial market conditions,may have significant credit concentrations thatare 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 lendingin an effort to improve credit discipline whileallowing heavier reliance on statistical analysisrather than detailed and costly analysis of indi-vidual loans. Institutions should take care tomake balanced and careful use of credit scoringtechnology for small-business lending and, inparticular, avoid using this technology for loansor credit relationships that are large or complexenough to warrant a formal and individualizedcredit analysis.

In formalizing their lending standards andpractices, institutions are not precluded frommaking loans that do not meet all written stan-dards. Exceptions to policies, though, should beapproved and monitored by management. For-mal reporting that describes exceptions to loanpolicies, by type of exception and organiza-tional unit, can be extremely valuable for

informing management and directors of thenumber and nature of material deviations fromthe policies that they have designed andapproved.

2010.2.2.1.2 Formal Credit-StaffApproval of Transactions

Credit discipline is also enhanced when experi-enced credit professionals are involved in theapproval process and are independent of the linelending functions.7 Such staff can play a vitalrole in ensuring adherence to formal policiesand in ensuring that individual loan approvalsare consistent with the overall risk appetite ofthe institution. These independent credit profes-sionals can be most valuable if they have theauthority to reject a loan that does not meet theinstitution’s credit standards or, alternatively, ifthey must concur with a loan before it can beapproved.

Providing credit staff with independentapproval authority over lending decisions, ratherthan with a more traditional requirement for‘‘consultation’’ between the lending functionand credit staff, allows credit staff to influenceoutcomes on a broad and ongoing basis. Thisinfluence and indeed the ability of credit staff toreinforce lending discipline is clearly enhancedby their early involvement in negotiations withborrowers; a more traditional approach might beto only involve credit staff once the loan pro-posal is well developed, allowing credit staff theopportunity to have only minor influence on theoutcome of negotiations except in extremecases. Maintaining a proper balance of lendingand control functions calls for a degree of part-nership between line lenders and credit staff, butalso requires that the independence of creditstaff not be compromised by conflicting com-pensation policies or reporting structures.

Independent credit staff can also supportsound lending practice by maintaining completeand centralized credit files that contain all keydocuments relevant to each loan, including com-plete loan-approval packages. Such files ensurethat decisions are well documented and avoid

7. For example, loan officers might be compensated forbringing loan business into the institution. Independent creditprofessionals, however, would be another person who wouldnot be compensated for bringing any loan business into theinstitution. That person would, however, serve as a qualitycontrol monitor that would have the independent authority toreject a loan(s) and to ensure that the institution’s risk appetiteand credit standards are not exceeded.



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 andstandardized loan-approval documents. Thor-oughness can be enhanced by requiring formalanalysis of the borrower’s financial condition,key characteristics and trends in the borrower’sindustry, information on collateral and its valua-tion, as well as financial analysis of the entitiesproviding support or guarantees and formalforward-looking analyses appropriate to the sizeand type of loan being considered. Incorporat-ing such elements into standardized formats andrequiring that analysis and supporting commen-tary be complete and in adequate depth allowsapproving authorities access to all relevantinformation on the risk profile of the borrower.Loan-approval documents should also includeall material details on the proposed loan agree-ment itself, including key financial covenants.Standardization of formats, and to some extentcontent, can be useful in ensuring that all rel-evant information is provided to managementand other approving authorities in a manner thatis understandable. Standard formats also drawattention to cases in which certain key informa-tion is not presented.

One area of particular interest in this regard isanalysis and commentary on participations insyndicated loans. While it may be tempting torely on the analysis and documentation providedby the agent institution to the transaction, it hasbeen long-standing Federal Reserve policy thatparticipating institutions should conduct theirown analysis of the borrower and the transac-tions, particularly if the risk appetite or portfoliocharacteristics of the agent differs from that ofthe participating institution.

2010.2.2.1.4 Use of Forward-LookingTools in the Approval Process

During continued periods of favorable economicconditions, institutions should guard againstcomplacency and, in particular, the temptationto base expectations of a borrower’s futurefinancial performance almost exclusively on thatborrower’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 ordevelopments that might limit the ability ofborrowers to fulfill their loan obligations.Unforeseen changes in interest rates, sales rev-enue, and operating expenses can have materialand adverse effects on the ability of many bor-rowers to meet their obligations. In priordecades, inadequate attention to these possibili-ties during the underwriting process contributedsignificantly to asset-quality problems in thesystem. Also, sudden turmoil within variouscountries can result in quick changes in cur-rency valuations and economic conditions.

Examiners should evaluate the frequency andadequacy with which institutions conductforward-looking analysis of borrower financialperformance when considering an institution’scredit-risk-management process. Formal use offorward-looking financial analysis in the loan-approval process, and financial projections inparticular, can be important in guarding againstsuch complacency, especially when financialinstitutions are competing intensely to attractborrowers. Such projections, if they include lessfavorable scenarios for the key determinants ofthe borrower’s financial performance, can helpto contain undue optimism and ensure that man-agement and other approving authorities withinthe organization are formally presented with arobust analysis of the risks associated with eachcredit. They also provide credit staff and otherrisk-management personnel with informationthat is important for ensuring adherence to theinstitution’s lending standards and overall appe-tite for loan risk.

The formal presentation of financial projec-tions and/or other forms of forward-lookinganalyses of the borrower is important in makingexplicit the conditions required for a loan toperform and in communicating the vulnerabili-ties of the transaction to those responsible forapproving loans. Analyses also provide a usefulbenchmark against which institutions can assessthe borrower’s future performance. Although itmay be tempting to avoid analyzing detailedprojections for smaller borrowers, such asmiddle-market firms, these customers may col-lectively represent a significant portion of theinstitution’s loan portfolio. As such, applyingformal forward-looking analysis even on a basiclevel assists the institution in identifying andmanaging the overall risk of its lendingactivities.

Detailed analysis of industry performance andtrends can be a useful supplement to such analy-ses. Such projections have the most value inmaintaining credit discipline when, rather than



only describing the single ‘‘most likely’’ sce-nario for future events, they characterize thekind of negative events that might impair theperformance of the loan in the future.

2010.2.2.1.5 Stress Testing of theBorrower’s Financial Capacity

The analysis of alternative scenarios, or ‘‘stresstesting,’’ should generally focus on the keydeterminants of performance for the borrowerand the loan, such as the level of interest rates,the rate of sales or revenue growth, or the rate atwhich expense reductions can be realized.Meaningful stress testing of the prospectiveborrower’s ability to meet its obligations is avital part of a sound credit decision. Failure torecognize the potential for adverse events—whether specific to the borrower or its industry(for example, a change in the regulatory climateor the emergence of new competitors) or, alter-natively, to the economy as a whole (for exam-ple, a recession)—can prove costly to a bankingorganization.

Mechanical reliance on threshold financialratios (and the ‘‘cushion’’ they imply) alone isgenerally not sufficient, particularly for complexloans and loans to leveraged borrowers or othersthat must perform exceptionally well to meettheir financial obligations successfully. Scenarioanalysis specific to the borrower, its industry,and its business plan is critical to identify thekey risks of a loan. Such an analysis shouldhave a significant influence on the decision toextend credit and, if credit is extended, on thedecisions as to the appropriate loan size, repay-ment terms, collateral or guarantee require-ments, financial covenants, and other elementsof the loan’s structure.

When properly conducted, meaningful stresstesting can include assessing the effect the fol-lowing situations or events will have on theborrower:

1. unexpected reductions in revenue growth orreversals, including shocks to revenue of thetype and magnitude that would normally beexperienced during a recession

2. unfavorable movements in market interestrates, especially for firms with high debtburdens

3. unplanned increases in capital expendituresdue to technological obsolescence or com-petitive factors

4. deterioration in the value of collateral, guar-antees, or other potential sources of principalrepayment

5. adverse developments in key product or inputmarkets

6. reversals in, or the borrower’s reduced accessto, public debt and equity markets

Proper stress testing typically incorporates anevaluation of the borrower’s alternatives formeeting its financial obligations under each sce-nario, including asset sales, access to alternativefunding or refinancing, or ability to raise newequity. In particular, the evaluation should focusnot only on the borrower’s ability to meet near-term interest obligations, but also on its abilityto repay the principal of the obligation. SeeSR-99-23.

2010.2.2.1.6 Management andLender Information

Management information systems that supportthe loan-approval process should clearly indi-cate the composition of the institution’s currentportfolio or exposure to allow for considerationof whether a proposed new loan—regardless ofits own merits—might affect this compositionsufficiently to be inconsistent with the institu-tion’s risk appetite. In particular, institutionsactive in commercial real estate lending shouldknow the nature and magnitude of aggregateexposure within relevant subclasses, such as bythe type of property being financed (that is,office, residential, or retail).

In addition to portfolio information, institu-tions should be encouraged to acquire ordevelop information systems that provide readyaccess for lenders and credit analysts to infor-mation sources that can support and enhance thefinancial analysis of proposed loans. Depend-ing on the nature of an institution’s borrowers,appropriate information sources may includeindustry 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 vehiclefor transactions involving mergers and acquisi-tions, business recapitalizations, and businessexpansions.8 It is an important type of financing

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

finance, or leveraged transactions encompass the entire debt



for national and global economies, and the U.S.financial industry plays an integral role in mak-ing credit available and syndicating that creditto investors. Leveraged transactions are charac-terized by a degree of financial leverage thatmay significantly exceed industry norms asmeasured by ratios such as debt-to-assets, debt-to-equity, cash flow-to-total debt, or other ratiosand standards that are unique to a particularindustry. Leveraged borrowers, however, canhave 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 conductedin a safe-and-sound fashion if pursued with arisk-management structure that provides for theappropriate underwriting, pricing, monitoring,and controls. Comprehensive credit analysisprocesses, frequent monitoring, and detailedportfolio reports are needed to better understandand manage the inherent risk in leveraged port-folios. Sound valuation methodologies must beused in addition to ongoing stress testing andmonitoring.

Financial institutions should ensure they donot unnecessarily heighten risks by originatingand then distributing poorly underwritten loans.9

For example, a poorly underwritten leveragedloan that is pooled with other loans or is partici-pated with other institutions may generate risksfor the financial system. The leveraged lendingguidance that follows is designed to assist finan-cial institutions in providing leveraged lendingto creditworthy borrowers in a safe-and-soundmanner.

On March 21, 2013, the Federal ReserveBoard, along with the Office of the Comptrollerof the Currency (OCC) and the Federal DepositInsurance Corporation (FDIC), issued ‘‘Inter-

agency Guidance on Leveraged Lending.’’ 9a

The statement provides guidance about risk rat-ing leveraged-financed loans. See SR-13-3 andits attachment.

2010.2.3.1 Interagency Guidance onLeveraged Lending

The vast majority of community banks shouldnot be affected by this guidance, as they havelimited involvement in leveraged lending. Com-munity and smaller institutions that are involvedin leveraged lending activities should discusswith their primary regulator the implementationof cost-effective controls appropriate for thecomplexity of their exposures and activities. 9b

2010.2.3.1.1 Risk-ManagementFramework

Given the high-risk profile of leveraged transac-tions, financial institutions engaged in leveragedlending should adopt a risk-management frame-work that has an intensive and frequent reviewand monitoring process. The framework shouldhave as its foundation written risk objectives,risk-acceptance criteria, and risk controls. Alack of robust risk-management processes andcontrols at a financial institution with significantleveraged lending activities could contribute tosupervisory findings that the financial institutionis 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

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.

9a. This guidance augments previously issued supervisory

statements on sound credit-risk management. Refer to SR-98-

18, ‘‘Lending Standards for Commercial Loans.’’

9b. 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.



• Stress Testing• Conflicts of Interest• Reputational Risk• Compliance

2010.2.3.1.2 Leveraged LendingDefinition

The policies of financial institutions shouldinclude criteria to define leveraged lending thatare appropriate to the institution. 9c For example,numerous definitions of leveraged lending existthroughout the financial services industry andcommonly contain some combination of the fol-lowing:

• proceeds used for buyouts, acquisitions, orcapital distributions

• transactions where the borrower’s Total Debtdivided by EBITDA (earnings before interest,taxes, depreciation, and amortization) orSenior Debt divided by EBITDA exceed4.0 * EBITDA or 3.0 * EBITDA, respec-tively, or other defined levels appropriate tothe industry or sector 9d

• a borrower recognized in the debt markets asa 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 othersimilar standards common to particular indus-tries or sectors), significantly exceeds industrynorms or historical levels 9e

A financial institution engaging in leveragedlending should define it within the institution’spolicies and procedures in a manner sufficientlydetailed to ensure consistent application acrossall business lines. A financial institution’s defi-nition should describe clearly the purposes andfinancial characteristics common to these trans-actions, and should cover risk to the institution

from both direct exposure and indirect exposurevia limited-recourse financing secured by lever-aged loans, or financing extended to financialintermediaries (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 addressthe following:

• Identification of the financial institution’s riskappetite, including clearly defined amounts ofleveraged 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). Theinstitution’s designated risk appetite shouldbe supported by an analysis of the potentialeffect on earnings, capital, liquidity, and otherrisks that result from these positions, andshould be approved by its board of directors.

• A limit framework that includes limits orguidelines for single obligors and transac-tions, aggregate hold portfolio, aggregatepipeline exposure, and industry and geo-graphic concentrations. The limit frameworkshould identify the related management-approval authorities and exception-trackingprovisions. In addition to notional pipelinelimits, the agencies expect that financial insti-tutions with significant leveraged transactionswill implement underwriting-limit frame-works that assess stress losses, flex terms,economic capital usage, and earnings at riskor that otherwise provide a more nuancedview of potential risk. 9f

• Procedures for ensuring the risks of leveragedlending activities are appropriately reflectedin an institution’s allowance for loan and leaselosses (ALLL) and capital adequacy analyses.

• Credit and underwriting approval authorities,including the procedures for approving anddocumenting changes to approved transactionstructures and terms.

• Guidelines for appropriate oversight by seniormanagement, including adequate and timelyreporting to the board of directors.

• Expected risk-adjusted returns for leveraged

9c. 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’’).

9d. Cash should not be netted against debt for purposes of

this calculation.

9e. 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.

9f. Flex terms allow the arranger to change interest-rate

spreads during the syndication process to adjust pricing to

current liquidity levels.



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 participationsand assignments in leveraged lending transac-tions should make a thorough, independentevaluation of the transaction and the risksinvolved before committing any funds. 9g Theyshould apply the same standards of prudence,credit assessment and approval criteria, andin-house limits that would be employed if thepurchasing organization were originating theloan. At a minimum, policies should includerequirements for

• obtaining and independently analyzing fullcredit information both before the participa-tion is purchased and on a timely basis there-after;

• obtaining from the lead lender copies of allexecuted and proposed loan documents, legalopinions, title insurance policies, UniformCommercial Code (UCC) searches, and otherrelevant documents;

• carefully monitoring the borrower’s perfor-mance throughout the life of the loan; and

• establishing appropriate risk-managementguidelines as described in this document.

2010.2.3.1.5 Underwriting Standards

A financial institution’s underwriting standardsshould be clear, written, and measurable, andshould accurately reflect the institution’s riskappetite for leveraged lending transactions. Afinancial institution should have clear underwrit-ing limits regarding leveraged transactions,

including the size that the institution willarrange both individually and in the aggregatefor distribution. The originating institutionshould be mindful of reputational risks associ-ated with poorly underwritten transactions, asthese risks may find their way into a wide vari-ety of investment instruments and exacerbatesystemic risks within the general economy. At aminimum, an institution’s underwriting stan-dards should consider the following:

• Whether the business premise for each trans-action is sound and the borrower’s capitalstructure is sustainable regardless of whetherthe transaction is underwritten for the institu-tion’s own portfolio or with the intent to dis-tribute. The entirety of a borrower’s capitalstructure should reflect the application ofsound financial analysis and underwritingprinciples.

• A borrower’s capacity to repay and the abilityto de-lever to a sustainable level over a rea-sonable period. As a general guide, institu-tions also should consider whether base-casecash-flow projections show the ability to fullyamortize senior secured debt or repay a sig-nificant portion of total debt over the mediumterm. 9h Also, projections should include oneor more realistic downside scenarios thatreflect key risks identified in the transaction.

• Expectations for the depth and breadth of duediligence on leveraged transactions. Thisshould include standards for evaluating vari-ous types of collateral, with a clear definitionof credit-risk-management’s role in such duediligence.

• Standards for evaluating expected risk-adjusted returns. The standards should includeidentification of expected distribution strate-gies, including alternative strategies for fund-ing and disposing of positions during marketdisruptions, and the potential for losses duringsuch periods.

• The degree of reliance on enterprise value andother 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-

9g. 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 Agree-

ments 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).

9h. 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.



vided by the sponsor (if any), taking intoconsideration the sponsor’s financial capacity,the extent of its capital contribution at incep-tion, and other motivating factors. Institutionslooking to rely on sponsor support as a sec-ondary source of repayment for the loanshould be able to provide documentation,including, but not limited to, financial orliquidity statements, showing recently docu-mented evidence of the sponsor’s willingnessand ability to support the credit extension.

• Whether credit-agreement terms allow for thematerial dilution, sale, or exchange of collat-eral or cash-flow-producing assets withoutlender approval.

• Credit-agreement covenant protections,including financial performance (such as debt-to-cash flow, interest coverage, or fixed-charge coverage), reporting requirements, andcompliance monitoring. Generally, a leveragelevel after planned asset sales (that is, theamount of debt that must be serviced fromoperating cash flow) in excess of 6* TotalDebt/EBITDA raises concerns for most indus-tries.

• Collateral requirements in credit agreementsthat specify acceptable collateral and risk-appropriate measures and controls, includingacceptable collateral types, loan-to-valueguidelines, and appropriate collateral-valuation methodologies. Standards for asset-based loans that are part of the entire debtstructure also should outline expectations forthe use of collateral controls (for example,inspections, independent valuations, and pay-ment lockbox), other types of collateral andaccount maintenance agreements, and peri-odic reporting requirements.

• Whether loan agreements provide for distribu-tion of ongoing financial and other relevantcredit information to all participants andinvestors.

Nothing in the preceding standards should beconsidered to discourage providing financing toborrowers engaged in workout negotiations, oras part of a pre-packaged financing under thebankruptcy code. Neither are they meant to dis-courage well-structured, standalone asset-basedcredit facilities to borrowers with strong lendermonitoring and controls, for which a financialinstitution should consider separate underwrit-ing and risk-rating guidance.

2010.2.3.1.6 Valuation Standards

Institutions often rely on enterprise value andother intangibles when (1) evaluating the feasi-bility of a loan request; (2) determining the debtreduction potential of planned asset sales;(3) assessing a borrower’s ability to access thecapital markets; and (4) estimating the strengthof a secondary source of repayment. Institutionsmay also view enterprise value as a usefulbenchmark for assessing a sponsor’s economicincentive to provide financial support. Given thespecialized knowledge needed for the develop-ment of a credible enterprise valuation and theimportance of enterprise valuations in the under-writing and ongoing risk-assessment processes,enterprise valuations should be performed byqualified persons independent of an institution’sorigination function.

There are several methods used for valuingbusinesses. 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 orliquidation value. Income valuation methodsconsider an enterprise’s ongoing cash flows orearnings and apply appropriate capitalization ordiscounting techniques. Market valuation meth-ods derive value multiples from comparablecompany data or sales transactions. However,final value estimates should be based on themethod or methods that give supportable andcredible results. In many cases, the incomemethod is generally considered the most reli-able.

There are two common approaches employedwhen using the income method. The ‘‘capital-ized cash flow’’ method determines the value ofa company as the present value of all future cashflows the business can generate in perpetuity.An appropriate cash flow is determined and thendivided by a risk-adjusted capitalization rate,most commonly the weighted average cost ofcapital. This method is most appropriate whencash flows are predictable and stable. The ‘‘dis-counted cash flow’’ method is a multiple-periodvaluation model that converts a future series ofcash flows into current value by discountingthose cash flows at a rate of return (referred toas the ‘‘discount rate’’) that reflects the riskinherent therein. This method is most appropri-ate when future cash flows are cyclical or vari-able over time. Both income methods involvenumerous assumptions, and therefore, support-ing documentation should fully explain the



evaluator’s reasoning and conclusions.

When a borrower is experiencing a financialdownturn or facing adverse market conditions, alender should reflect those adverse conditions inits assumptions for key variables such as cashflow, earnings, and sales multiples when assess-ing enterprise value as a potential source ofrepayment. Changes in the value of a borrower’sassets should be tested under a range of stressscenarios, including business conditions moreadverse than the base-case scenario. Stress testsof enterprise values and their underlyingassumptions should be conducted and docu-mented at origination of the transaction andperiodically thereafter, incorporating the actualperformance of the borrower and any adjust-ments to projections. The institution should per-form its own discounted cash-flow analysis tovalidate the enterprise value implied by proxymeasures such as multiples of cash flow, earn-ings, or sales.

Enterprise value estimates derived from eventhe most rigorous procedures are imprecise andultimately may not be realized. Therefore, insti-tutions relying on enterprise value or illiquidand hard-to-value collateral should have poli-cies that provide for appropriate loan-to-valueratios, discount rates, and collateral margins.Based on the nature of an institution’s leveragedlending activities, the institution should estab-lish limits for the proportion of individual trans-actions and the total portfolio that are supportedby enterprise value. Regardless of the methodol-ogy used, the assumptions underlying enterprisevalue 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 theborrower’s industry and condition.

2010.2.3.1.7 Pipeline Management

Market disruptions can substantially impede theability of an underwriter to consummate syndi-cations or otherwise sell down exposures, whichmay result in material losses. Accordingly,financial institutions should have strong riskmanagement and controls over transactions inthe pipeline, including amounts to be held andthose to be distributed. A financial institutionshould be able to differentiate transactionsaccording 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 appetitefor underwriting risk that considers the poten-tial effects on earnings, capital, liquidity, andother risks that result from pipeline exposures.

• Written policies and procedures for definingand managing distribution failures and‘‘hung’’ deals, which are identified by aninability to sell down the exposure within areasonable period (generally 90 days fromtransaction closing). The financial institution’sboard of directors and management shouldestablish clear expectations for the dispositionof pipeline transactions that are not soldaccording to their original distribution plan.Such transactions that are subsequently reclas-sified as hold-to-maturity should also bereported to management and the board ofdirectors.

• Guidelines for conducting periodic stress testson pipeline exposures to quantify the potentialimpact 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 regularreports of variances to management, includingthe amount and timing of syndication anddistribution variances and reporting ofrecourse sales to achieve distribution.

• Reports that include individual and aggregatetransaction information that accurately riskrates 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 (thatis, borrower, counterparty, and aggregate holdlevels), and limits on the underwriting riskthat will be undertaken for amounts intendedfor distribution.

• Policies and procedures that identify accept-able accounting methodologies and controlsin both functional as well as dysfunctionalmarkets, and that direct prompt recognition oflosses in accordance with generally acceptedaccounting principles.

• Policies and procedures addressing the use ofhedging to reduce pipeline and hold expo-sures, which should address acceptable typesof hedges and the terms considered necessaryfor providing a net credit exposure afterhedging.

• Plans and provisions addressing contingentliquidity 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, includingleveraged loans. A financial institution’s man-agement should receive comprehensive reportsabout the characteristics and trends in suchexposures at least quarterly, and summariesshould be provided to the institution’s board ofdirectors. Policies and procedures should iden-tify the fields to be populated and captured by afinancial institution’s Management InformationSystems, which should yield accurate and timelyreporting to management and the board of direc-tors that may include the following:

• Individual and portfolio exposures within andacross all business lines and legal vehicles,including the pipeline.

• Risk-rating distribution and migration analy-sis, including maintenance of a list of thoseborrowers who have been removed from theleveraged portfolio due to improvements intheir financial characteristics and overall riskprofile.

• 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, andcharge-offs.

• Amount of impaired assets and the nature ofimpairment (that is, permanent, or tempo-rary), and the amount of the ALLL attribut-able to leveraged lending.

• The aggregate level of policy exceptions andthe performance of that portfolio.

• Exposures by collateral type, including unse-cured transactions and those where enterprisevalue will be the source of repayment forleveraged loans. Reporting should also con-sider the implications of defaults that triggerpari passu (in a fair way) treatment for alllenders and, thus, dilute the secondary supportfrom the sale of collateral.

• Secondary-market-pricing data and tradingvolume, when available.

• Exposures and performance by deal sponsors.Deals introduced by sponsors may, in somecases, be considered exposure to related bor-rowers. An institution should identify, aggre-gate, and monitor potential related exposures.

• Gross and net exposures, hedge counterpartyconcentrations, and policy exceptions.

• Actual versus projected distribution of thesyndicated pipeline, with regular reports ofexcess levels over the hold targets for thesyndication inventory. Pipeline definitionsshould clearly identify the type of exposure.This includes committed exposures that havenot been accepted by the borrower, commit-ments accepted but not closed, and fundedand unfunded commitments that have closedbut have not been distributed.

• Total and segmented leveraged lending expo-sures, including subordinated debt and equityholdings, alongside established limits. Reportsshould provide a detailed and comprehensiveview of global exposures, including situationswhen an institution has indirect exposure toan obligor or is holding a previously soldposition as collateral or as a reference asset ina derivative.

• Borrower and counterparty leveraged lendingreporting should consider exposures bookedin other business units throughout the institu-tion, including indirect exposures such asdefault swaps and total return swaps, namingthe distributed paper as a covered or refer-enced asset or collateral exposure throughrepo transactions. Additionally, the institutionshould consider positions held in available-for-sale or traded portfolios or through struc-tured investment vehicles owned or sponsoredby the originating institution or its subsidi-aries or affiliates.

2010.2.3.1.9 Risk RatingLeveraged 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. 9i

The risk rating of leveraged loans involvesthe use of realistic repayment assumptions todetermine a borrower’s ability to de-lever to asustainable level within a reasonable period. Forexample, supervisors commonly assume that theability to fully amortize senior secured debt or

9i. 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

Management Manual of Examination Policies, ‘‘Loan

Appraisal and Classification.’’



the ability to repay at least 50 percent of totaldebt over a five- to seven-year period providesevidence of adequate repayment capacity. If theprojected capacity to pay down debt from cashflow is nominal with refinancing the only viableoption, the credit will usually be adversely ratedeven if it has been recently underwritten. Incases when leveraged loan transactions have noreasonable or realistic prospects to de-lever, asubstandard rating is likely. Furthermore, whenassessing debt service capacity, extensions andrestructures should be scrutinized to ensure thatthe institution is not merely masking repaymentcapacity problems by extending or restructuringthe loan.

If the primary source of repayment becomesinadequate, the agencies believe that it wouldgenerally be inappropriate for an institution toconsider enterprise value as a secondary sourceof repayment unless that value is well sup-ported. Evidence of well-supported value mayinclude binding purchase and sale agreementswith qualified third parties or thorough assetvaluations that fully consider the effect of theborrower’s distressed circumstances and poten-tial changes in business and market conditions.For such borrowers, when a portion of the loanmay not be protected by pledged assets or awell-supported enterprise value, examiners gen-erally will rate that portion doubtful or loss andplace the loan on nonaccrual status.

2010.2.3.1.10 Credit Analysis

Effective underwriting and management ofleveraged lending risk is highly dependent onthe quality of analysis employed during theapproval process as well as ongoing monitoring.A financial institution’s policies should addressthe need for a comprehensive assessment offinancial, business, industry, and managementrisks including, whether

• cash-flow analyses rely on overly optimisticor 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 cashneeds, and ability to meet debt maturities;

• projections exhibit an adequate margin forunanticipated merger-related integration costs;

• projections are stress tested for one or more

downside scenarios, including a covenantbreach;

• transactions are reviewed at least quarterly todetermine variance from plan, the related riskimplications, and the accuracy of risk ratingsand accrual status. From inception, the creditfile should contain a chronological rationalefor and analysis of all substantive changes tothe borrower’s operating plan and variancefrom expected financial performance;

• enterprise and collateral valuations are inde-pendently derived or validated outside of theorigination function, are timely, and considerpotential value erosion;

• collateral liquidation and asset sale estimatesare based on current market conditions andtrends;

• potential collateral shortfalls are identified andfactored 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 ofnew equity; and

• the borrower is adequately protected frominterest rate and foreign exchange risk.

2010.2.3.1.11 Problem-CreditManagement

A financial institution should formulate indi-vidual action plans when working with borrow-ers experiencing diminished operating cashflows, depreciated collateral values, or othersignificant plan variances. Weak initial under-writing of transactions, coupled with poor struc-ture and limited covenants, may make problem-credit discussions and eventual restructuringsmore difficult for an institution as well as resultin less favorable outcomes.

A financial institution should formulate creditpolicies that define expectations for the manage-ment of adversely rated and other high-risk bor-rowers whose performance departs significantlyfrom planned cash flows, asset sales, collateralvalues, or other important targets. These poli-cies should stress the need for workout plansthat contain quantifiable objectives and mea-sureable time frames. Actions may includeworking with the borrower for an orderly resolu-tion while preserving the institution’s interests,sale of the credit in the secondary market, orliquidation of collateral. Problem credits shouldbe reviewed regularly for risk rating accuracy,accrual status, recognition of impairmentthrough specific allocations, and charge-offs.



2010.2.3.1.12 Deal Sponsors

A financial institution that relies on sponsorsupport as a secondary source of repaymentshould develop guidelines for evaluating thequalifications of financial sponsors and shouldimplement processes to regularly monitor asponsor’s financial condition. Deal sponsorsmay provide valuable support to borrowers suchas strategic planning, management, and othertangible and intangible benefits. Sponsors mayalso provide sources of financial support forborrowers that fail to achieve projections. Gen-erally, a financial institution rates a borrowerbased on an analysis of the borrower’s stand-alone financial condition. However, a financialinstitution may consider support from a sponsorin assigning internal risk ratings when the insti-tution can document the sponsor’s history ofdemonstrated support as well as the economicincentive, capacity, and stated intent to continueto support the transaction. However, even withdocumented capacity and a history of support,the sponsor’s potential contributions may notmitigate supervisory concerns absent a docu-mented commitment of continued support. Anevaluation of a sponsor’s financial supportshould 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 capitalcontributed at inception

• documentation of degree of support (forexample, a guarantee, comfort letter, or verbalassurance)

• consideration of the sponsor’s contractualinvestment limitations

• to the extent feasible, a periodic review of thesponsor’s financial statements and trends, andan analysis of its liquidity, including the abil-ity to fund multiple deals

• consideration of the sponsor’s dividend andcapital contribution practices

• the likelihood of the sponsor supporting aparticular borrower compared to other dealsin the sponsor’s portfolio

• guidelines for evaluating the qualifications ofa sponsor and a process to regularly monitorthe sponsor’s performance

2010.2.3.1.13 Credit Review

A financial institution should have a strong andindependent credit-review function that demon-

strates the ability to identify portfolio risks anddocumented authority to escalate inappropriaterisks and other findings to its senior manage-ment. Due to the elevated risks inherent in lever-aged lending, and depending on the relative sizeof a financial institution’s leveraged lendingbusiness, the institution’s credit-review functionshould assess the performance of the leveragedportfolio more frequently and in greater depththan other segments in the loan portfolio. Suchassessments should be performed by individualswith the expertise and experience for these typesof loans and the borrower’s industry. Portfolioreviews should generally be conducted at leastannually. For many financial institutions, therisk characteristics of leveraged portfolios, suchas high reliance on enterprise value, concentra-tions, adverse risk rating trends, or portfolioperformance, may dictate reviews that are morefrequent.

A financial institution should staff its internalcredit-review function appropriately and ensurethat the function has sufficient resources toensure timely, independent, and accurate assess-ments of leveraged lending transactions.Reviews should evaluate the level of risk, riskrating integrity, valuation methodologies, andthe quality of risk management. Internal creditreviews should include the review of the institu-tion’s leveraged lending practices, policies, andprocedures to ensure that they are consistentwith regulatory guidance.

2010.2.3.1.14 Stress Testing

A financial institution should develop andimplement guidelines for conducting periodicportfolio stress tests on loans originated to holdas well as loans originated to distribute, andsensitivity analyses to quantify the potentialimpact of changing economic and market condi-tions on its asset quality, earnings, liquidity, andcapital. 9j The sophistication of stress testing

9j. 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,



practices and sensitivity analyses should be con-sistent with the size, complexity, and risk char-acteristics of the institution’s leveraged loanportfolio. To the extent a financial institution isrequired to conduct enterprise-wide stress tests,the leveraged portfolio should be included inany such tests.

2010.2.3.1.15 Conflicts of Interest

A financial institution should develop appropri-ate policies and procedures to address and toprevent potential conflicts of interest when ithas equity and lending positions. For example,an institution may be reluctant to use an aggres-sive collection strategy with a problem borrowerbecause of the potential impact on the value ofan institution’s equity interest. A financial insti-tution may encounter pressure to provide finan-cial or other privileged client information thatcould benefit an affiliated equity investor. Suchconflicts also may occur when the underwritingfinancial institution serves as financial advisorto the seller and simultaneously offers financingto multiple buyers (that is, stapled financing).Similarly, there may be conflicting interestsamong the different lines of business within afinancial institution or between the financialinstitution and its affiliates. When these situa-tions occur, potential conflicts of interest arisebetween the financial institution and its custom-ers. Policies and procedures should clearlydefine potential conflicts of interest, identifyappropriate risk-management controls and pro-cedures, enable employees to report potentialconflicts of interest to management for actionwithout fear of retribution, and ensure compli-ance with applicable laws. Further, managementshould have an established training program foremployees on appropriate practices to follow toavoid conflicts of interest and provide for report-ing, tracking, and resolution of any conflicts ofinterest 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 tomeet its legal responsibilities in underwriting

and distributing transactions can damage itsmarket 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 andperformance issues, may also see its reputationdamaged.

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 andlaws and regulations are adhered to, an institu-tion’s independent compliance function shouldperiodically review the institution’s leveragedlending activity. This guidance is consistent withthe principles of safety and soundness and otheragency guidance related to commercial lending.

In particular, because leveraged transactionsoften involve a variety of types of debt and bankproducts, a financial institution should ensurethat its policies incorporate safeguards to pre-vent violations of anti-tying regulations. Section106(b) of the Bank Holding Company ActAmendments of 1970 9k prohibits certain formsof product tying by financial institutions andtheir affiliates. The intent behind Section 106(b)is to prevent financial institutions from usingtheir market power over certain products toobtain an unfair competitive advantage in otherproducts.

In addition, equity interests and certain debtinstruments used in leveraged transactions mayconstitute ‘‘securities’’ for the purposes of fed-eral securities laws. When securities areinvolved, an institution should ensure compli-ance with applicable securities laws, includingdisclosure and other regulatory requirements.An institution should also establish policies andprocedures to appropriately manage the internaldissemination of material, nonpublic informa-tion about transactions in which it plays a role.

2010.2.4 CREDIT-RISKMANAGEMENT GUIDANCE FORHOME EQUITY LENDING

On May 16, 2005, the federal bank and thriftregulatory agencies collectively issued the fol-lowing interagency guidance. The guidance isintended to promote sound credit-risk manage-ment practices at banking organizations10 that77 Fed. Reg. 62417 (Oct. 15, 2012) (to be codified at 12 CFR

part 325, subpart C).

9k. 12 USC 1972.

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

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



have home equity lending programs, includingopen-end home equity lines of credit (HELOCs)and closed-end home equity loans (HELs).Banking organizations’ credit-risk managementpractices for home equity lending need to keeppace with the rapid growth in home equity lend-ing and should emphasize compliance withsound underwriting standards and practices.

The risk factors listed below, combined withan inherent vulnerability to rising interest rates,suggest that banking organizations need to fullyrecognize the risk embedded in their homeequity portfolios. Following are the specificproduct, risk-management, and underwritingrisk 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’sassets, 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 underwritinghome equity loans;

5. greater use of automated valuation models(AVMs) and other collateral-evaluation toolsfor the development of appraisals andevaluations

6. an increase in the number of transactionsgenerated through a loan broker or otherthird party

Home equity lending can be conducted in asafe and sound manner if pursued with theappropriate risk-management structure, includ-ing adequate allowances for loan and leaselosses and appropriate capital levels. Soundpractices call for fully articulated policies thataddress marketing, underwriting standards,collateral-valuation management, individual-account and portfolio management, andservicing.

Banking organizations should ensure thatrisk-management practices keep pace with thegrowth and changing risk profile of home equityportfolios. Management should actively assess aportfolio’s vulnerability to changes in consum-ers’ ability to pay and the potential for declinesin home values. Active portfolio management isespecially important for banking organizations

that project or have already experienced signifi-cant growth or concentrations, particularly inhigher-risk products such as high-LTV, ‘‘lowdoc’’ or ‘‘no doc,’’ interest-only, or third-party-generated loans. (See SR-05-11.)

2010.2.4.1 Credit-Risk ManagementSystems

2010.2.4.1.1 Product Development andMarketing

In the development of any new product offering,product change, or marketing initiative, manage-ment should have a review and approval processthat is sufficiently broad to ensure compliancewith the banking organization’s internal policiesand applicable laws and regulations11 and toevaluate the credit, interest-rate, operational,compliance, reputation, and legal risks. In par-ticular, risk-management personnel should beinvolved in product development, including anevaluation of the targeted population and theproduct(s) being offered. For example, materialchanges in the targeted market, originationsource, or pricing could have a significantimpact on credit quality and should receivesenior management approval.

When HELOCs or HELs are marketed orclosed by a third party, banking organizationsshould have standards that provide assurancethat the third party also complies with applica-ble laws and regulations, including those onmarketing materials, loan documentation, andclosing procedures. (For further details on agentrelationships, see section 2010.2.4.1.3, ‘‘Third-Party Originations.’’) Finally, managementshould have appropriate monitoring tools andmanagement 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 theinterest rate or term.

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.

11. 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.



2010.2.4.1.2 Origination andUnderwriting

All relevant risk factors should be consideredwhen establishing product offerings and under-writing guidelines. Generally, these factorsshould include a borrower’s income and debtlevels, 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, prudentlyunderwritten home equity loans should includean evaluation of a borrower’s capacity toadequately service the debt.12 Given the homeequity products’ long-term nature and the largecredit amount typically extended to a consumer,an evaluation of repayment capacity should con-sider a borrower’s income and debt levels andnot just a credit score.13 Credit scores are basedupon a borrower’s historical financial perfor-mance. While past performance is a good indi-cator of future performance, a significant changein a borrower’s income or debt levels canadversely alter the borrower’s ability to pay.How much verification these underwriting fac-tors require will depend upon the individualloan’s credit risk.

HELOCs generally do not have interest-ratecaps that limit rate increases.14 Rising interestrates could subject a borrower to significantpayment increases, particularly in a low-interest-rate environment. Therefore, underwrit-ing standards for interest-only and variable-rateHELOCs should include an assessment of theborrower’s ability to amortize the fully drawnline over the loan term and to absorb potentialincreases in interest rates.

12. On December 23, 1992, the Federal Reserve

announced the adoption of uniform rules on real estate lend-

ing standards and issued the Interagency Guidelines for Real

Estate Lending Policies. See subsection 2010.2.1. See also 12

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

13. The Interagency Guidelines Establishing Standards for

Safety and Soundness also call for documenting the source of

repayment and assessing the ability of the borrower to repay

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

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

must state in the consumer credit contract the maximum

interest rate that may be imposed during the term of the

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



2010.2.4.1.3 Third-Party Originations

Banking organizations often use third parties,such as mortgage brokers or correspondents, tooriginate loans. When doing so, they shouldhave strong control systems to ensure the qual-ity of originations and compliance with allapplicable laws and regulations, and to helpprevent fraud.

Brokers are firms or individuals, acting onbehalf of either the banking organization or theborrower, who match the borrower’s needs withinstitutions’ 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 donot use their own funds to close loans. Whetherbrokers are allowed to process and perform anyunderwriting will depend on the relationshipbetween the banking organization and the bro-ker. For control purposes, the banking organiza-tion should retain appropriate oversight of allcritical loan-processing activities, such as verifi-cation of income and employment and indepen-dence in the appraisal and evaluation function.

Correspondents are financial companies thatusually close and fund loans in their own nameand subsequently sell them to a lender. Bankingorganizations commonly obtain loans throughcorrespondents and, in some cases, delegatethe underwriting function to the correspondent.In delegated underwriting relationships, a bank-ing organization grants approval to a correspon-dent financial company to process, underwrite,and close loans according to the delegator’sprocessing and underwriting requirements andis committed to purchase those loans. Thedelegating banking organization should havesystems and controls to provide assurance thatthe correspondent is appropriately managed, isfinancially sound, and provides mortgages thatmeet the banking organization’s prescribedunderwriting guidelines and that comply withapplicable consumer protection laws and regula-tions. A quality-control unit or function inthe delegating banking organization shouldclosely monitor the quality of loans that thecorrespondent underwrites. Monitoring activi-ties should include post-purchase underwritingreviews and ongoing portfolio-performance-management activities.

Both brokers and correspondents are compen-sated based upon mortgage-origination volumeand, accordingly, have an incentive to produceand 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, oncea relationship is established, the banking organi-zation should have adequate audit proceduresand controls to verify that the third parties arenot being paid to generate incomplete or fraudu-lent mortgage applications or are not otherwisereceiving referral or unearned income or feescontrary to RESPA prohibitions.15 Monitoringthe quality of loans by origination source, anduncovering such problems as early paymentdefaults and incomplete packages, enables man-agement to know if third-party originators areproducing quality loans. If ongoing credit ordocumentation problems are discovered, thebanking organization should take appropriateaction against the third party, which couldinclude terminating its relationship with thethird party.

2010.2.4.1.4 Collateral-ValuationManagement

Competition, cost pressures, and advancementsin technology have prompted banking organiza-tions to streamline their appraisal and evaluationprocesses. These changes, coupled with bankingorganizations underwriting to higher LTVs, haveheightened the importance of strong collateral-valuation management policies, procedures, andprocesses.

Banking organizations should have appropri-ate collateral-valuation policies and proceduresthat ensure compliance with the FederalReserve’s appraisal regulations16 and the Inter-agency Appraisal and Evaluation Guidelines(the guidelines).17 In addition, the banking orga-nization should—

1. establish criteria for determining the appro-priate valuation methodology for a particulartransaction, based on the risk in the transac-tion and loan portfolio (For example, higher-

15. In addition, a banking organization that purchases loanssubject to TILA’s rules for HELs with high rates or highclosing costs (loans covered by HOEPA) can incur assigneeliability unless the banking organization can reasonably showthat it could not determine the transaction was a loan coveredby HOEPA. Also, the nature of its relationship with brokersand correspondents may have implications for liability underECOA, and for reporting responsibilities under HMDA.

16. 12 C.F.R. 208, subpart E, and 12 C.F.R. 225, subpartG.

17. See SR-94-55, dated October 27, 1994. These revisedguidelines include the June 1994 amendments. See also sec-tion 2231.0.15, appendix A.



risk transactions or nonhomogeneous prop-erty types should be supported by more-thorough valuations. The banking organi-zation should also set criteria for determiningthe extent to which an inspection of the col-lateral is necessary.)

2. ensure that an expected or estimated value ofthe property is not communicated to anappraiser or individual performing anevaluation

3. implement policies and controls to preclude‘‘value shopping’’ (Use of several valuationtools may return different values for the sameproperty. These differences can result in sys-tematic overvaluation of properties if thevaluation choice becomes driven by the high-est property value. If several different valua-tion tools or AVMs are used for the sameproperty, the banking organization should ad-here to a policy for selecting the most reli-able method, rather than the highest value.)

4. require sufficient documentation to supportthe collateral valuation in the appraisal orevaluation

2010.2.4.1.5 AVMs

When AVMs are used to support evaluations orappraisals, the banking organization should vali-date the models on a periodic basis to mitigatethe potential valuation uncertainty in the model.As part of the validation process, the bankingorganization should document the validation’sanalysis, assumptions, and conclusions. Thevalidation 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 processshould cover properties representative of thegeographic area and property type for which thetool is used.

Many AVM vendors, when providing a value,will also provide a ‘‘confidence score,’’ whichusually relates to the accuracy of the valueprovided. Confidence scores, however, come inmany different formats and are calculated basedon differing scoring systems. Banking organiza-tions that use AVMs should have an understand-ing of how the model works as well as what theconfidence scores mean. Confidence levelsshould be established by the banking organiza-tion that are appropriate for the risk in a giventransaction or group of transactions.

When tax-assessment valuations are used as a

basis for the collateral valuation, the bankingorganization should be able to demonstrate anddocument the correlation between the assess-ment value of the taxing authority and the prop-erty’s market value as part of the validationprocess.

2010.2.4.1.6 Account Management

Since HELOCs often have long-term, interest-only payment features, banking organizationsshould have risk-management techniques thatidentify higher-risk accounts and adversechanges in account risk profiles, therebyenabling management to implement timely pre-ventive action (e.g., freezing or reducing lines).Further, a banking organization should haverisk-management procedures to evaluate andapprove additional credit on an existing line orextending the interest-only period. Account-management practices should be appropriate forthe size of the portfolio and the risks associatedwith the types of home equity lending.

Effective account-management practices forlarge portfolios or portfolios with high-risk char-acteristics include—

1. periodically refreshing credit-risk scores onall customers;

2. using behavioral scoring and analysis of indi-vidual borrower characteristics to identifypotential 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 thosewho rely on the line to keep paymentscurrent;

5. monitoring home values by geographic area;and

6. obtaining updated information on the collat-eral’s value when significant market factorsindicate a potential decline in home values,or when the borrower’s payment perfor-mance deteriorates and greater reliance isplaced on the collateral.

The frequency of these actions should becommensurate with the risk in the portfolio.Banking organizations should conduct annualcredit reviews of HELOC accounts to determinewhether the line of credit should be continued,based on the borrower’s current financialcondition.18

18. Under the Federal Reserve’s risk-based capital guide-lines, an unused HELOC commitment with an original matu-



When appropriate, banking organizationsshould refuse to extend additional credit orreduce the credit limit of a HELOC, bearing inmind that under Regulation Z such steps can betaken only in limited circumstances. Theseinclude, for example, when the value of thecollateral declines significantly below theappraised value for purposes of the HELOC,default of a material obligation under the loanagreement, or deterioration in the borrower’sfinancial circumstances.19 In order to freeze orreduce credit lines due to deterioration in aborrower’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, thebanking organization must have a reasonablebelief that the borrower will be unable to fulfillthe plan’s payment obligations.

Account-management practices that do notadequately control authorizations and providefor timely repayment of over-limit amounts maysignificantly increase a portfolio’s credit risk.Authorizations of over-limit home equity linesof credit should be restricted and subject toappropriate policies and controls. A bankingorganization’s practices should require over-limit borrowers to repay in a timely manner theamount that exceeds established credit limits.Management information systems should besufficient to enable management to identify,measure, monitor, and control the unique risksassociated with over-limit accounts.

2010.2.4.1.7 Portfolio Management

Banking organizations should implement aneffective portfolio credit-risk management pro-cess for their home equity portfolios thatincludes 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 leastannually. Before implementing any changes topolicies or underwriting standards, managementshould assess the potential effect on the bankingorganization’s overall risk profile, which wouldinclude the effect on concentrations, profitabil-ity, and delinquency and loss rates. The accu-racy of these estimates should be tested bycomparing them with actual experience.

2010.2.4.1.7.2 Portfolio Objectives and RiskDiversification

Effective portfolio management should clearlycommunicate portfolio objectives, such asgrowth targets, utilization, rate-of-returnhurdles, and default and loss expectations. Forbanking organizations with significant concen-trations of HELs or HELOCs, limits should beestablished and monitored for key portfolio seg-ments, such as geographic area, loan type, andhigher-risk products. When appropriate, consid-eration should be given to the use of risk miti-gants, such as private mortgage insurance, poolinsurance, or securitization. As the portfolioapproaches concentration limits, the bankingorganization should analyze the situation suffi-ciently to enable the banking organization’sboard of directors and senior management tomake a well-informed decision to either raiseconcentration limits or pursue a different courseof action.

Effective portfolio management requires anunderstanding of the various risk characteristicsof the home equity portfolio. To gain this under-standing, a banking organization should analyzethe portfolio by segment, using criteria such asproduct type, credit-risk score, DTI, LTV, prop-erty type, geographic area, collateral-valuationmethod, lien position, size of credit relative toprior liens, and documentation type (such as‘‘no doc’’ or ‘‘low doc’’).

2010.2.4.1.7.3 Management InformationSystems

By maintaining adequate credit MIS, a bankingorganization can segment loan portfolios andaccurately assess key risk characteristics. TheMIS should also provide management with suf-ficient information to identify, monitor, mea-sure, and control home equity concentrations.

rity of one year or more may be allocated a zero percentconversion factor if the banking organization conducts at leastan annual credit review and is able to unconditionally cancelthe commitment (i.e., prohibit additional extensions of credit,reduce the credit line, and terminate the line) to the full extentpermitted 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.

19. Regulation Z does not permit these actions to be takenin circumstances other than those specified in the regulation.See 12 C.F.R. 226.5b(f)(3)(vi)(A)–(F).



Banking organizations should periodicallyassess the adequacy of their MIS in light ofgrowth and changes in their appetite for risk.For banking organizations with significant con-centrations of HELs or HELOCs, MIS shouldinclude, at a minimum, reports and analysis ofthe following:

1. production and portfolio trends by product,loan structure, originator channel, creditscore, LTV, DTI, lien position, documenta-tion type, market, and property type

2. delinquency and loss-distribution trends byproduct and originator channel with someaccompanying analysis of significant under-writing characteristics (such as credit score,LTV, DTI)

3. vintage tracking4. 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 foridentifying, approving, tracking, and analyzingunderwriting exceptions. Reporting systems thatcapture and track information on exceptions,both by transaction and by relevant portfoliosegments, facilitate the management of a portfo-lio’s credit risk. The aggregate data is useful tomanagement in assessing portfolio risk profilesand monitoring the level of adherence to policyand underwriting standards by various origina-tion channels. Analysis of the information mayalso be helpful in identifying correlationsbetween certain types of exceptions and delin-quencies and losses.

2010.2.4.1.7.5 High-LTV Monitoring

To clarify the real estate lending standards regu-lations and interagency guidelines, the agenciesissued Guidance on High Loan-To-Value(HLTV) Residential Real Estate Lending (theHLTV guidance) in October 1999. The HLTVguidance clarified the Interagency Real EstateLending Guidelines and the supervisory loan-to-value limits for loans on one- to four-familyresidential properties. Banking organizations are

expected to ensure compliance with the supervi-sory loan-to-value limits of the Interagency RealEstate Lending Guidelines. The HLTV guidanceoutlines controls that the banking organizationsshould have in place when engaging in HLTVlending. 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 tothe banking organization’s board of directors.Specifically, banking organizations arereminded 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-LTVone-to four-family residential loans shouldnot exceed 100 percent of the banking orga-nization’s total capital.20 Within that limit,high-LTV loans for properties other thanone- to four-family residential propertiesshould 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 seniorliens. All loans secured by the property andheld by the banking organization are reportedas an exception if the combined LTV of aloan and all senior liens on an owner-occupied one- to four-family residentialproperty equals or exceeds 90 percent and ifthere is no additional credit enhancement inthe form of either mortgage insurance orreadily marketable collateral.

3. For the LTV calculation, the loan amount isthe legally binding commitment (that is, theentire amount that the banking organizationis legally committed to lend over the life ofthe loan).

4. All real–estate secured loans in excess ofsupervisory LTV limits should be aggregatedand included in a quarterly report for thebanking organization’s board of directors.

Certain insurance products help banking or-ganizations mitigate the credit risks of HLTV

20. For purposes of the Interagency Real Estate LendingStandards Guidelines, high-LTV one- to four-family residen-tial property loans include (1) a loan for raw land zoned forone- to four-family residential use with an LTV ratio greaterthan 65 percent; (2) a residential land development loan orimproved lot loan with an LTV greater than 75 percent; (3) aresidential construction loan with an LTV ratio greater than85 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 anowner-occupied residential property with an LTV equal to orexceeding 90 percent without mortgage insurance, readilymarketable collateral, or other acceptable collateral.



residential loans. Insurance policies that cover a‘‘pool’’ of loans can be an efficient and effectivecredit-risk management tool. But if a policy hasa coverage limit, the coverage may be exhaustedbefore all loans in the pool mature or pay off.The Federal Reserve considers pool insurance tobe a sufficient credit enhancement to remove theHLTV designation in the following circum-stances: (1) the policy is issued by an acceptablemortgage insurance company, (2) it reduces theLTV for each loan to less than 90 percent, and(3) it is effective over the life of each loan in thepool.

2010.2.4.1.7.6 Stress Testing for Portfolios

Banking organizations with home equity con-centrations as well as higher-risk portfolios areencouraged to perform sensitivity analyses onkey portfolio segments. This type of analysisidentifies possible events that could increaserisk within a portfolio segment or for the port-folio as a whole. Banking organizations shouldconsider stress tests that incorporate interest-rate increases and declines in home values.Since these events often occur simultaneously,the agencies recommend testing for these eventstogether. Banking organizations should alsoperiodically analyze markets in key geographicareas, including identified ‘‘soft’’ markets. Man-agement should consider developing contin-gency strategies for scenarios and outcomes thatextend credit risk beyond internally establishedrisk tolerances. These contingency plans mightinclude increased monitoring, tightening under-writing, limiting growth, and selling loans orportfolio segments.

2010.2.4.1.8 Operations, Servicing, andCollections

Effective procedures and controls should bemaintained for such support functions as per-fecting liens, collecting outstanding loan docu-ments, obtaining insurance coverage (includingflood insurance), and paying property taxes.Credit-risk management should oversee thesesupport functions to ensure that operational risksare properly controlled.

2010.2.4.1.8.1 Lien Recording

Banking organizations should take appropriatemeasures to safeguard their lien position. Theyshould verify the amount and priority of anysenior liens prior to closing the loan. This infor-

mation is necessary to determine the loan’s LTVratio and to assess the credit support of thecollateral. Senior liens include first mortgages,outstanding liens for unpaid taxes, outstandingmechanic’s liens, and recorded judgments onthe borrower.

2010.2.4.1.8.2 Problem-Loan Workouts andLoss-Mitigation Strategies

Banking organizations should have establishedpolicies and procedures for problem loan work-outs and loss-mitigation strategies. Policiesshould be in accordance with the requirementsof the FFIEC’s Uniform Retail Credit Classifi-cation and Account Management Policy, issuedJune 2000 (see SR-00-8 and section 2241.0) andshould, at a minimum, address the following:

1. circumstances and qualifying requirementsfor various workout programs includingextensions, re-ages, modifications, andre-writes (Qualifying criteria should includean analysis of a borrower’s financial capacityto service the debt under the new terms.)

2. circumstances and qualifying criteria forloss-mitigating strategies, includingforeclosure

3. appropriate MIS to track and monitor theeffectiveness of workout programs, includingtracking the performance of all categories ofworkout loans (For large portfolios, vintagedelinquency and loss tracking also should beincluded.)

While banking organizations are encouragedto work with borrowers on a case-by-case basis,a banking organization should not use workoutstrategies to defer losses. Banking organizationsshould ensure that credits in workout programsare evaluated separately for the allowance forloan and lease losses (ALLL), because suchcredits tend to have higher loss rates than otherportfolio segments.

2010.2.4.1.9 Secondary-Market Activities

More banking organizations are issuing HELOCmortgage-backed securities (that is, securitizingHELOCs). Although such secondary-marketactivities can enhance credit availability and abanking organization’s profitability, they alsopose certain risk-management challenges. A



banking organization’s risk-management sys-tems should address the risks of HELOCsecuritizations.21

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 governsthe classification of consumer loans and estab-lishes general classification thresholds that arebased on delinquency. Banking organizationsand the Federal Reserve’s examiners have thediscretion to classify entire retail portfolios, orsegments thereof, when underwriting weak-nesses or delinquencies are pervasive and pres-ent an excessive level of credit risk. Portfoliosof high-LTV loans to borrowers who exhibitinadequate capacity to repay the debt within areasonable time may be subject to classification.

Banking organizations should establishappropriate ALLL and hold capital commensu-rate with the riskiness of their portfolios. Indetermining the ALLL adequacy, a bankingorganization should consider how the interest-only and draw features of HELOCs during thelines’ revolving period could affect the losscurves for its HELOC portfolio. Those bankingorganizations engaging in programmatic sub-prime home equity lending or banking organiza-tions that have higher-risk products are expectedto recognize the elevated risk of the activitywhen assessing capital and ALLL adequacy.22

2010.2.5 OVERSIGHT OFCONCENTRATIONS INCOMMERCIAL REAL ESTATELENDING AND SOUNDRISK-MANAGEMENT LENDING

As part of a bank holding company inspection,the examiner should make an assessment of the

parent company’s supervision and control overits subsidiary lending activities, which includesan overall assessment of the banking organiza-tion’s credit-risk concentrations, including therisk concentrations in commercial real estatelending. (See also section 2010.2.) Bankingorganizations, including bank holding compa-nies, are responsible for establishing the neces-sary and appropriate management oversight oftheir bank and nonbank subsidiaries by adminis-tering, monitoring, and assuring adherence tothe organization’s lending policies and practicesfor controlling ‘‘concentration risk.’’ Bankingorganizations should therefore have adequatemanagement information systems (including theappropriate accounting and internal controlsystems) in place to accomplish their supervi-sory oversight and to control such creditconcentrations.

The following guidance, Concentrations inCommercial Real Estate (CRE) Lending, SoundRisk-Management Practices (the guidance) wasissued on December 6, 2006 (effective onDecember 12, 2006).23 The guidance was devel-oped to reinforce sound risk-management prac-tices for institutions (includes banking organiza-tions) with high and increasing concentrationsof commercial real estate loans on their balancesheets. An institution’s strong risk-managementpractices and its maintenance of appropriate lev-els of capital are important elements of a soundCRE lending program, particularly when aninstitution has a concentration in CRE or a CRElending strategy leading to a concentration.However, institutions needing to improve theirrisk-management processes may have been pro-vided the opportunity for some flexibility on thetime frame for complying with the guidance.This time frame will be commensurate with thelevel and nature of CRE concentration risk, thequality 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

21. 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).

22. 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.

23. 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.



December 6, 2006, and SR-07-01 and itsattachments.) See also SR-15-17, “InteragencyStatement on Prudent Risk Management forCommercial Real Estate Lending” and itsattachment and the Board’s December 18, 2015,press release.

2010.2.5.1 Scope of the CREConcentration Guidance

The guidance focuses on those CRE loans forwhich the cash flow from the real estate is theprimary source of repayment rather than loansto a borrower for which real estate collateral istaken as a secondary source of repayment orthrough an abundance of caution. For the pur-poses of this guidance, CRE loans include thoseloans with risk profiles sensitive to the conditionof the general CRE market (for example, marketdemand, changes in capitalization rates, vacancyrates, or rents). CRE loans are land developmentand construction loans (including one- to four-family residential and commercial constructionloans) and other land loans. CRE loans alsoinclude loans secured by multifamily property,and nonfarm nonresidential property where theprimary source of repayment is derived fromrental income associated with the property (thatis, loans for which 50 percent or more of thesource of repayment comes from third-party,nonaffiliated, rental income) or the proceeds ofthe sale, refinancing, or permanent financing ofthe property. Loans to real estate investmenttrusts and unsecured loans to developers alsoshould be considered CRE loans for purposes ofthis guidance if their performance is closelylinked to performance of the CRE markets. Thescope of the guidance does not include loanssecured by nonfarm nonresidential propertieswhere the primary source of repayment is thecash flow from the ongoing operations andactivities conducted by the party, or affiliate ofthe party, who owns the property. Rather thandefining a CRE concentration, the guidance’s‘‘Supervisory Oversight’’ section describes thecriteria that the Federal Reserve will use ashigh-level indicators to identify banks poten-tially exposed to CRE concentration risk.

2010.2.5.2 CRE ConcentrationAssessments

Banks that are actively involved in CRE lendingshould perform ongoing risk assessments toidentify CRE concentrations. The risk assess-ment should identify potential concentrations bystratifying the CRE portfolio into segments that

have common risk characteristics or sensitivitiesto economic, financial, or business develop-ments. A bank’s CRE portfolio stratificationshould be reasonable and supportable. The CREportfolio should not be divided into multiplesegments simply to avoid the appearance ofconcentration risk.

The Federal Reserve recognizes that riskcharacteristics vary among CRE loans securedby different property types. A manageable levelof CRE concentration risk will vary by bankdepending on the portfolio risk characteristics,the quality of risk-management processes, andcapital levels. Therefore, the guidance does notestablish a CRE concentration limit that appliesto all banks. Rather, banks are encouraged toidentify and monitor credit concentrations andto establish internal concentration limits, and allconcentrations should be reported to seniormanagement and the board of directors on aperiodic basis. Depending on the results of therisk assessment, the bank may need to enhanceits risk-management systems.

2010.2.5.3 CRE Risk Management

The sophistication of a bank’s CRE risk-management processes should be appropriate tothe size of the portfolio, as well as the level andnature of concentrations and the associated riskto the bank. Banks should address the followingkey elements in establishing a risk-managementframework that effectively identifies, monitors,and controls CRE concentration risk:

1. board and management oversight2. portfolio management3. management information systems4. market analysis5. credit underwriting standards6. portfolio stress testing and sensitivity

analysis7. credit-risk review function

2010.2.5.3.1 Board and ManagementOversight of CRE Concentration Risk

A bank’s board of directors has ultimate respon-sibility for the level of risk assumed by thebank. If the bank has significant CRE concentra-tion risk, its strategic plan should address therationale for its CRE levels in relation to itsoverall growth objectives, financial targets, andcapital plan. In addition, the Federal Reserve’sreal estate lending regulations require that each



bank adopt and maintain a written policy thatestablishes appropriate limits and standards forall extensions of credit that are secured by lienson or interests in real estate, including CREloans. Therefore, the board of directors or adesignated committee thereof should—

1. establish policy guidelines and approve anoverall CRE lending strategy regarding thelevel and nature of CRE exposures accept-able to the bank, including any specific com-mitments to particular borrowers or propertytypes, such as multifamily housing;

2. ensure that management implements proce-dures and controls to effectively adhere toand monitor compliance with the bank’slending policies and strategies;

3. review information that identifies and quanti-fies the nature and level of risk presented byCRE concentrations, including reports thatdescribe changes in CRE market conditionsin which the bank lends; and

4. periodically review and approve CRE riskexposure limits and appropriate sublimits(for example, by nature of concentration) toconform to any changes in the bank’s strate-gies and to respond to changes in marketconditions.

2010.2.5.3.2 CRE Portfolio Management

Banks with CRE concentrations should managenot only the risk of individual loans but alsoportfolio risk. Even when individual CRE loansare prudently underwritten, concentrations ofloans that are similarly affected by cyclicalchanges in the CRE market can expose a bankto an unacceptable level of risk if not properlymanaged. Management regularly should evalu-ate the degree of correlation between relatedreal estate sectors and establish internal lendingguidelines and concentration limits that controlthe bank’s overall risk exposure.

Management should develop appropriatestrategies for managing CRE concentration lev-els, including a contingency plan to reduce ormitigate concentrations in the event of adverseCRE market conditions. Loan participations,whole loan sales, and securitizations are a fewexamples of strategies for actively managingconcentration levels without curtailing neworiginations. If the contingency plan includesselling or securitizing CRE loans, managementshould assess periodically the marketability of

the portfolio. This should include an evaluationof the bank’s ability to access the secondarymarket and a comparison of its underwritingstandards with those that exist in the secondarymarket.

2010.2.5.3.3 CRE ManagementInformation Systems

A strong management information system(MIS) is key to effective portfolio management.The sophistication of the MIS will necessarilyvary with the size and complexity of the CREportfolio and level and nature of concentrationrisk. The MIS should provide management withsufficient information to identify, measure,monitor, and manage CRE concentration risk.This includes meaningful information on CREportfolio characteristics that is relevant to thebank’s lending strategy, underwriting standards,and risk tolerances. A bank should periodicallyassess the adequacy of the MIS in light ofgrowth in CRE loans and changes in the CREportfolio’s size, risk profile, and complexity.

Banks are encouraged to stratify the CREportfolio by property type, geographic market,tenant concentrations, tenant industries, devel-oper concentrations, and risk rating. Other use-ful stratifications may include loan structure (forexample, 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 newlyunderwritten credit facilities, and affiliated loans(for example, loans to tenants). A bank shouldalso be able to identify and aggregate exposuresto a borrower, including its credit exposure relat-ing to derivatives.

Management reporting should be timely andin a format that clearly indicates changes in theportfolio’s risk profile, including risk-ratingmigrations. In addition, management reportingshould include a well-defined process throughwhich management reviews and evaluates con-centration and risk-management reports, as wellas special ad hoc analyses in response to poten-tial market events that could affect the CRE loanportfolio.

2010.2.5.3.4 Market Analysis

Market analysis should provide the bank’s man-agement and board of directors with informationto assess whether its CRE lending strategy andpolicies continue to be appropriate in light ofchanges in CRE market conditions. A bankshould perform periodic market analyses for the



various property types and geographic marketsrepresented in its portfolio.

Market analysis is particularly important as abank considers decisions about entering newmarkets, pursuing new lending activities, orexpanding in existing markets. Market informa-tion also may be useful for developing sensitiv-ity analysis or stress tests to assess portfoliorisk.

Sources of market information may includepublished research data, real estate appraisersand 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 varyby its market share and exposure, as well as theavailability of market data. While a bank operat-ing in nonmetropolitan markets may have accessto fewer sources of detailed market data than abank operating in large, metropolitan markets, abank should be able to demonstrate that it has anunderstanding of the economic and businessfactors influencing its lending markets.

2010.2.5.3.5 Credit UnderwritingStandards

A bank’s lending policies should reflect thelevel of risk that is acceptable to its board ofdirectors and should provide clear and measur-able underwriting standards that enable thebank’s lending staff to evaluate all relevantcredit factors. When a bank has a CRE concen-tration, the establishment of sound lending poli-cies becomes even more critical. In establishingits policies, a bank should consider both internaland external factors, such as its market position,historical experience, present and prospectivetrade area, probable future loan and fundingtrends, staff capabilities, and technologyresources. Consistent with the Federal Reserve’sreal estate lending guidelines, CRE lending poli-cies should address the following underwritingstandards:

1. maximum loan amount by type of property2. loan terms

3. pricing structures

4. collateral valuation24

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 permitexceptions to underwriting standards only on alimited basis. When a bank does permit anexception, it should document how the transac-tion does not conform to the bank’s policy orunderwriting standards, obtain appropriate man-agement approvals, and provide reports to theboard of directors or designated committeedetailing the number, nature, justifications, andtrends for exceptions. Exceptions to both thebank’s internal lending standards and the Fed-eral Reserve’s supervisory LTV limits25 shouldbe monitored and reported on a regular basis.Further, banks would analyze trends in excep-tions to ensure that risk remains within thebank’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 proceduresgoverning loan disbursements to ensure that thebank’s minimum borrower equity requirementsare maintained throughout the development andconstruction periods. Prudent controls shouldinclude an inspection process, documentationon construction progress, tracking pre-soldunits, pre-leasing activity, and exception moni-toring and reporting.

2010.2.5.3.6 CRE Portfolio Stress Testingand Sensitivity Analysis

A bank with CRE concentrations should per-form portfolio-level stress tests or sensitivityanalysis to quantify the impact of changing eco-nomic conditions on asset quality, earnings, andcapital. Further, a bank should consider the sen-sitivity of portfolio segments with common riskcharacteristics to potential market conditions.The sophistication of stress testing practices andsensitivity analysis should be consistent withthe size, complexity, and risk characteristics ofthe CRE loan portfolio. For example, well-

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

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

25. 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.



margined and seasoned performing loans onmultifamily housing normally would requiresignificantly less robust stress testing than mostacquisition, development, and constructionloans.

Portfolio stress testing and sensitivity analy-sis may not necessarily require the use of asophisticated portfolio model. Depending on therisk characteristics of the CRE portfolio, stresstesting may be as simple as analyzing the poten-tial effect of stressed loss rates on the CREportfolio, capital, and earnings. The analysisshould focus on the more vulnerable segmentsof a bank’s CRE portfolio, taking into consider-ation the prevailing market environment and thebank’s business strategy.

2010.2.5.3.7 Credit-Risk Review Function

A strong credit-risk review function is criticalfor a bank’s self-assessment of emerging risks.An effective, accurate, and timely risk-ratingsystem provides a foundation for the bank’scredit-risk review function to assess credit qual-ity and, ultimately, to identify problem loans.Risk ratings should be risk sensitive, objective,and appropriate for the types of CREloans underwritten by the bank. Further, riskratings should be reviewed regularly forappropriateness.

2010.2.5.4 Supervisory Oversight OfCRE Concentration Risk

As part of its ongoing supervisory monitoringprocesses, the Federal Reserve will use certaincriteria to identify banks that are potentiallyexposed to significant CRE concentration risk.A bank that has experienced rapid growth inCRE lending, has notable exposure to a specifictype of CRE, or is approaching or exceeds thefollowing supervisory criteria may be identifiedfor further supervisory analysis of the level andnature of its CRE concentration risk:

1. total reported loans for construction, landdevelopment, and other land26 represent100 percent or more of the bank’s total capi-tal27 or

2. total commercial real estate loans asdefined in this guidance28 represent300 percent or more of the bank’s totalcapital, and the outstanding balance of thebank’s commercial real estate loan portfo-lio has increased by 50 percent or moreduring the prior 36 months.

The Federal Reserve will use the criteria as apreliminary step to identify banks that may haveCRE concentration risk. Because regulatoryreports capture a broad range of CRE loans withvarying risk characteristics, the supervisorymonitoring criteria do not constitute limits on abank’s lending activity but rather serve as high-level indicators to identify banks potentiallyexposed to CRE concentration risk. Nor do thecriteria constitute a ‘‘safe harbor’’ for banks ifother risk indicators are present, regardless oftheir measurements under (1) and (2).

2010.2.5.4.1 Evaluation of CREConcentrations

The effectiveness of a bank’s risk-managementpractices will be a key component of the super-visory evaluation of the bank’s CRE concentra-tions. Examiners will engage in a dialogue withthe bank’s management to assess CRE exposurelevels and risk-management practices. Banksthat have experienced recent, significant growthin CRE lending will receive closer supervisoryreview than those that have demonstrated a suc-cessful track record of managing the risks inCRE concentrations.

In evaluating CRE concentrations, the Fed-eral Reserve will consider the bank’s own analy-sis of its CRE portfolio, including considerationof factors such as—

1. portfolio diversification across property types2. geographic dispersion of CRE loans3. underwriting standards4. level of pre-sold units or other types of take-

out commitments on construction loans5. portfolio liquidity (ability to sell or securitize

exposures on the secondary market)

While consideration of these factors shouldnot change the method of identifying a creditconcentration, these factors may mitigate therisk posed by the concentration.

26. For commercial banks as reported in the Call Report

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

27. For purposes of this guidance, the term total capitalmeans 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.

28. For commercial banks as reported in the Call Report

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



2010.2.5.4.2 Assessment of CapitalAdequacy for CRE Concentration Risk

The Federal Reserve’s existing capital adequacyguidelines note that a bank should hold capitalcommensurate with the level and nature of therisks to which it is exposed. Accordingly, bankswith CRE concentrations are reminded that theircapital levels should be commensurate with therisk profile of their CRE portfolios. In assessingthe adequacy of a bank’s capital, the FederalReserve will consider the level and nature ofinherent risk in the CRE portfolio as well asmanagement expertise, historical performance,underwriting standards, risk-management prac-tices, market conditions, and any loan lossreserves allocated for CRE concentration risk. Abank with inadequate capital to serve as a bufferagainst unexpected losses from a CRE concen-tration should develop a plan for reducing itsCRE concentrations or for maintaining capitalappropriate to the level and nature of its CREconcentration risk.

2010.2.6 GUIDANCE ON PRIVATESTUDENT LOANS WITHGRADUATED REPAYMENT TERMSAT ORIGINATION

On January 29, 2015, interagency 28a

guidance 28b was issued to provide financialinstitutions with principles applicable to privatestudent loans that have graduated repaymentterms. Financial institutions that originate pri-vate student loans may offer borrowers gradu-ated repayment terms in addition to fixed amor-tizing terms at the time of loan origination.Graduated repayment terms are structured toprovide for lower initial monthly payments thatgradually increase. Refer to SR-15-2/CA-15-1and its attachment.

Although most student loan agreementsinclude a grace period 28c to help with the post-education transition, the agencies and SLC rec-ognize that students leaving higher educationprograms may prefer more flexibility to transi-

tion into the labor market because of a numberof factors, such as competitive job markets,traditionally low entry-level salaries, and higherstudent debt loads. Graduated repayment termsmay align borrowers’ income levels with loanrepayment requirements, provide flexibility torepay the debt sooner if borrowers’ incomesincrease more quickly than projected, and mayhelp long-term probability of full repayment.

Financial institutions that originate privatestudent loans with graduated repayment termsshould 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 timingand the amount of payments to facilitate aborrower’s understanding of the loan’s termsand features.

2010.2.6.1 Principles for Private StudentLoans with Graduated Repayment Termsat Origination

Financial institutions should consider the fol-lowing principles in their policies and proce-dures for underwriting private student loanswith graduated repayment terms at origin-ation: 28d

• Ensure orderly repayment. Private studentloans should have defined repayment periodsand promote orderly repayment over the lifeof the loans. Graduated repayment termsshould ensure timely loan repayment and beappropriately calibrated according to reason-able industry and market standards based onthe amount of debt outstanding. Graduatedrepayment terms should avoid negative amor-tization or balloon payments.

• Avoid payment shock. 28e Graduated repay-ment terms should result in monthly paymentsthat a borrower can meet in a sustained man-ner over the life of the loan. Graduatedincreases in a borrower’s monthly paymentshould begin early in the repayment periodand phase in the amortization of the principal

28a. 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.

28b. In implementing this guidance, the agencies will

examine financial institutions consistent with their respective

authorities.

28c. A grace period is the allotted amount of time during

which borrowers are not expected to make payments on

student loans after initially leaving higher education programs

or dropping below half-time enrollment status.

28d. 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.

28e. Payment shock occurs when a borrower experiences a

significant increase in the amount of the monthly payment

after a reset date.



balance to limit payment shock to the bor-rower.

• Align payment terms with a borrower’s

income. Graduated repayment terms shouldbe based on reasonable assumptions about theability to repay of the borrower and cosigner,if any. Lender underwriting should include anassessment of a borrower’s (and, if applica-ble, a cosigner’s) ability to repay the highestamortizing payment over the term of the loan.Graduated repayment terms should not bestructured in a way that could mask delin-quencies or defer losses.

• Provide borrowers with clear disclosures.

Financial institutions that offer private studentloans with graduated repayment terms shouldprovide borrowers with disclosures in compli-ance with all applicable laws and regulations.For example, the Truth in Lending Act, asimplemented by Regulation Z, includes spe-cific private student loan disclosure contentrequirements. 28f Ensuring that disclosuresclearly communicate the timing and theamount 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. 28g Private student loans withgraduated repayment terms must comply withall applicable consumer protection laws.These include, but are not limited to, theElectronic Fund Transfer Act, the EqualCredit Opportunity Act, federal and state pro-hibitions against unfair, deceptive, or abusiveacts or practices (such as section 5 of theFederal Trade Commission Act and sections1031 and 1036 of the Dodd-Frank Wall StreetReform and Consumer Protection Act), theTruth in Lending Act, and the regulationsissued pursuant to those laws.

• Contact borrowers before reset dates. Beforeoriginating private students loans with gradu-ated repayment terms, financial institutionsshould develop processes for contacting bor-rowers before the start of the repaymentperiod and before each payment reset date.These contacts can help establish student debtas a priority in borrowers’ paymenthierarchies 28h and aid borrowers in respond-

ing effectively to payment increases and otherpotential repayment challenges.

2010.2.7 LOAN PARTICIPATIONS,THE AGREEMENTS ANDPARTICIPANTS

This subsection provides supervisory andaccounting guidance for examiners to use intheir inspection (or examination) and review ofa bank holding company’s (BHC’s) or bank’suse, purchase, or sale of loan participationagreements.29 BHCs should manage and controlaggregate credit and other risk exposures on aconsolidated basis while recognizing legal dis-tinctions and possible obstacles to asset move-ments within the parent company or its subsidi-aries. Additional guidance, research, andinformation on loan participations and loan par-ticipation agreements will be developed andconsidered for future issuance andimplementation.

A loan participation is an agreement thattransfers a stated ownership interest in a loan toone or more other BHCs or subsidiaries, orother entities. The transfer represents an owner-ship interest in an individual financial asset. Thelead BHC (or lead subsidiary) retains a partialinterest in the loan, holds all loan documenta-tion in its own name, services the loan, anddeals directly with the customer for the benefitof all participants. The lead BHC or lead subsid-iary should ensure that comprehensive participa-tion agreements with originating institutions arein place for each loan facility before they con-sider purchasing any participating interest.

Many BHCs and their subsidiaries purchaseloans or participate in loans originated by oth-ers. In some cases, such transactions are con-ducted with BHC affiliates, groups of BHCs orchain banks, or other subsidiaries. Alternatively,a purchasing BHC or subsidiary may also wishto supplement its loan portfolio when loandemand is weak. In still other cases, a BHC orsubsidiary may purchase or participate in a loanto accommodate another unrelated bank withwhich it has established an ongoing businessrelationship.

Purchasing or selling loans, if done properly,can have a legitimate role in a BHC’s or bank’soverall asset and liability management and cancontribute to the efficient functioning of the

28f. 12 CFR 1026.46 and 12 CFR 1026.47.

28g. Reporting standards include, but are not limited to,

quarterly Consolidated Reports of Condition and Income.

28h. Payment hierarchy refers to the prioritization of a

borrower’s payment obligations.29. As determined by the Board, it is permissible for a

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

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

(2)).



financial system. In addition, these activitieshelp a BHC or bank diversify its risks andimprove its liquidity.

2010.2.7.1 Board Policies on LoanParticipations

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) therequirements for entering into a loan participa-tion agreement, (2) limits for the aggregateamount of loans purchased from and sold to anoutside source, (3) limits of all loans purchasedand sold, (4) limits for the aggregate amount ofloans to particular industries, (5) comprehensiveparticipation agreements with originating BHCsor banks, (6) complete analysis and documenta-tion of the credit quality of obligations pur-chased, (7) an analysis of the value and lienstatus of the collateral, (8) appraisal guidelines,(9) the maintenance of full independent creditinformation on the borrower throughout theterm of the loan, (10) guidelines for the timelytransfer of all financial and nonfinancial creditinformation to participant BHCs or banks, and(11) collection procedures.

2010.2.7.2 Loan Participation Agreement

A loan participation agreement may enable asmaller lead BHC or lead subsidiary, acting astransferor, to originate a large loan in excess ofits legal lending limit. Participants having anownership interest are able to offset low localloan demand or invest in large loans without theburden of servicing the loan or incurring origi-nation costs. A loan participation agreementmay also allow the originating BHC or subsidi-ary to facilitate and grant a larger loan withoutcausing it to have a concentration of credit (i.e.,enabling risk diversification) or an impairmentof its liquidity position. The participation agree-ment should contain provisions that require theoriginator to transfer, in a timely manner, allfinancial and nonfinancial credit information tothe participant banks upon the loan’s originationand throughout the term of the loan. The agree-ment should specify the allocation of payments,losses, and expenses. It should also state that aparticipant has the right to perform its ownindependent review of the transaction. Theagreement 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 agreementcould be viewed as an unsafe and unsoundbanking practice.

2010.2.7.3 Accounting for LoanParticipations

A loan participation agreement usually is struc-tured to allow the participation transaction toreceive sale treatment of a portion of the loan bythe originating BHC or its subsidiary eventhough the participation agreement may restrictthe purchaser when reselling its interest in theloan, subject to certain conditions.30 Sale treat-ment is achieved by structuring the loan partici-pation agreement so that interests sold to apurchaser meet the definition of a ‘‘participatinginterest’’ and the transaction satisfies all condi-tions for transfer of control over the interests. Ingeneral, FAS 166 (paragraph 8B) briefly definesa participating interest as a portion of a financialasset that

1. conveys proportionate ownership rights withequal priority to each participating interestholder.

2. involves no recourse (other than standardrepresentations and warranties) to, or subor-dination by, any participating interest holder.

3. does not entitle any participating interestholder to receive cash before any other par-ticipating interest holder.

A transfer of a participating interest in anentire financial asset in which the transferorsurrenders control over those interests is to beaccounted for as a sale if and only if all thefollowing conditions are met:

30. 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).



1. The transferred financial assets have beenisolated from the transferor—put presump-tively beyond the reach of the transferor andits creditors, even in bankruptcy or otherreceivership.31

2. Each purchaser has the right to pledge orexchange the interests it received, and nocondition both constrains the purchaser fromtaking advantage of its right to pledge orexchange and provides more than a trivialbenefit to the transferor.

3. The transferor does not maintain effectivecontrol over the interests.32

31. Transferred financial assets are isolated in bankruptcy

or other receivership only if the transferred financial assets

would be beyond the reach of the powers of a bankruptcy

trustee or other receiver for the transferor or any of its

consolidated affiliates included in the financial statements

being presented.

32. Examples of a 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

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.



2010.2.7.4 Structuring the LoanParticipation Agreement

The written participation agreement should con-sider contingent events such as a defaultingborrower, the lead BHC or lead subsidiarybecoming insolvent, or a party to the participantarrangement that is not performing as expected.The agreement should clearly state the limita-tions the originator or participants impose oneach other and any rights that the parties retain.The participation agreement should clearlyinclude

• the obligation of the lead BHC or lead subsid-iary to furnish timely credit information andto notify the parties of significant changes inthe borrower’s status;

• a requirement that the lead BHC or lead sub-sidiary consult with the participants prior toany proposed change to the loan, guarantee,or security agreements, or taking any actionwhen the borrower defaults;

• the lead BHC’s or lead subsidiary’s and par-ticipants’ specific rights if the borrowerdefaults;

• the resolution procedures to be followed whenthe 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 subsidiaryand the participants upon events such as insol-vency, breach of duty, negligence, or misap-propriation by one of the parties to theagreement.

Some participation agreements may allocatepayments using a method other than a pro ratasharing based on each participant’s ownershipinterest. The first principal payment could beapplied based on the participant’s ownershipinterest while the remaining payments would beapplied according to the lead BHC’s or leadsubsidiary’s ownership interest. In this situation,the participation agreement should specify thatif a borrower defaults, the participants wouldshare subsequent payments and collections inproportion to their ownership interest at the timeof default.33

A participation agreement may provide thatthe originating lender allow a participating BHCor 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 cuttingoff or restricting the flow of interest at the calldate.34 In this situation, the originating lenderhas 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 securedborrowing.

2010.2.7.5 Independent Credit Analysis

A BHC or subsidiary that acquires a loan par-ticipation should regularly perform a rigorouscredit analysis on its loan participation as if ithad originated the loan. Due to the indirectrelationship that a participant has with a bor-rower, it may be difficult for the participant toreceive timely credit information to allow it toconduct a comprehensive credit analysis of thetransaction. However, the participant should notrely solely on the originator’s credit analysis. Itshould gather all available relevant credit infor-mation, including the details on the collateral’svalue (for example, values determined by anindependent appraisal or an evaluation), lienstatus, loan agreements, and the loan’s otherparticipation agreements that existed prior tomaking its commitment to acquire the loan par-ticipation. A participant also should reach anagreement with the loan originator (transferor)that it will provide ongoing, complete, andtimely credit information about the borrower. Itis important for the participants to maintaincurrent and complete records on their loan par-ticipations. The absence of such informationmay indicate that the originator did not performthe necessary due diligence prior to making itsdecision to acquire the loan participation. Dur-ing the life of the loan participation, the origina-tor should monitor the loan’s servicing andrepayment status.

2010.2.7.6 Sales of Loan Participations inthe Secondary Market

If a BHC or a subsidiary has a concentration inloan participations, it may be possible for it to

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

34. The cash flows from a loan participation agreement,

except servicing fees, should be divided in proportion to the

third parties’ participating interests.



sell its participating interests in the secondarymarket to reduce its dependence on an assetgroup. If the BHC or a subsidiary is not largeenough to participate in the secondary market,an alternative might be to sell loans withoutrecourse to another subsidiary or correspondentbank that also desires to diversify its loanportfolio.

2010.2.7.7 Sale of Loan ParticipationsWith or Without the Right of Recourse

The parties to a participation agreement (thosehaving a participating ownership interest) gener-ally may have no recourse to the transferor or toeach other even though the transferor (e.g., theoriginating lender) continues to service the loan.No participant’s interest should be subordinateto another. Some loan participation agreements,however, may give the seller a contractual rightto repurchase the participated loan interest forpurposes of working out or modifying the sale.When the seller has the right to repurchase theparticipation, it may provide the seller with acall option on a specific loan participation asset.If the seller’s right to repurchase precludes theseller from recognizing the transaction as a sale,the transaction should be accounted for as asecured borrowing.

2010.2.7.8 Sales of 100 PercentParticipations

Some loan participation agreements may bestructured so that the transferor sells the entireunderlying loan amount (100 percent) to theagreement’s participants. If participation agree-ments are not structured properly they can poseunnecessary and increased risks (for example,legal, compliance, or reputational risks) to theoriginator and the participants. The originatorwould have no ownership in the loan. Suchagreements should therefore clearly state thatthe loan participants are participating in the loanand that they are not investing in a businessenterprise. The policies of a BHC or subsidiaryengaged in such loan participation agreementsshould focus on safety and soundness concernsthat include

• the program’s objectives• the plan of distribution• the credit requirements that pertain to the

borrower—the originator should structure100 percent loan participation programs onlyfor borrowers who meet its credit require-ments

• the program participant’s accessibility to theborrower’s financial information (as autho-rized by the borrower)—the originator shouldallow potential loan participants to obtain andreview appropriate credit and other informa-tion that would enable them to make aninformed credit decision.

2010.2.7.9 Participation TransactionsBetween Affiliates

BHCs or their subsidiaries should not relax theircredit standards when participation agreementsinvolve their affiliates. Such agreements must bestructured to comply with sections 23A and 23Bof the Federal Reserve Act (FRA) and theBoard’s Regulation W. The Federal Reserve hasdetermined that in certain very limited circum-stances the purchase or sale of a participationagreement may be exempt from theseprovisions.

2010.2.7.9.1 Transfer of Low-QualityAssets

In general, a bank cannot purchase a low-qualityasset, including a loan participation from anaffiliate. Section 23A of the FRA provides alimited exception to the general rule prohibitingthe purchase of low-quality assets if the bankperforms an independent credit evaluation andcommits to the purchase of the asset before theaffiliate acquires the asset.35 Section 223.15 ofthe Board’s Regulation W provides an excep-tion from the prohibition on the purchase of alow-quality asset by a member bank from anaffiliate for certain loan renewals. The ruleallows a member bank that purchased a loanparticipation from an affiliate to renew its par-ticipation in the loan, or provide additional fund-ing under the existing participation, even if theunderlying loan had become a low-quality asset,so long as certain criteria were met. Theserenewals or additional credit extensions mayenable both the affiliate and the participatingmember bank to avoid or minimize potentiallosses. The exception is available only if (1) theunderlying loan was not a low-quality asset atthe time the member bank purchased its partici-pation and (2) the proposed transaction would

35. 12 U.S.C. 371c(a)(3).



not increase the member bank’s proportionalshare of the credit facility. The member bankmust also obtain the prior approval of its entireboard of directors (or its delegees) and it mustgive a 20-day post-consummation notice to itsappropriate federal banking agency. A memberbank is permitted to increase its proportionateshare in a restructured loan by 5 percent (or by ahigher percentage with the prior approval of thebank’s appropriate federal banking agency). Thescope of the exemption includes renewals ofparticipations in loans originated by any affiliateof the member bank (not just affiliated deposi-tory institutions).

2010.2.7.10 Concentrations of CreditInvolving Loan Participations

BHCs or their subsidiaries should avoid pur-chasing loans that generate unacceptable creditconcentrations. Such concentrations may arisesolely from the BHC’s or subsidiary’s pur-chases, or they may arise when loans or pur-chased participations are aggregated with loansoriginated and retained by the purchaser. Theextent of contingent liabilities, holdbacks,reserve requirements, and the manner in whichloans will be handled and serviced should beclearly defined. In addition, loans purchasedfrom another source should be evaluated in thesame manner as originated loans. Guidelinesshould be established for the type and frequencyof credit and other information the BHC or itssubsidiary needs to obtain from the originator tokeep itself continually updated on the status ofthe credit. Guidelines should also be establishedfor supplying complete and regularly updatedcredit information to the purchasers of loansoriginated and sold by the BHC or its subsidiary.

2010.2.7.11 Loan Participations andEnvironmental 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 indirectlyliable via their lending activities for the costsresulting from cleaning up hazardous substancecontamination. BHCs and their subsidiariesneed to be careful that their actions making,administering, and collecting loans—includingassessing and controlling environmentalliability—cannot be construed as taking anactive role in the management or day-to-day

operations of a borrower’s business. Suchactions could lead to potential liability under theComprehensive Environmental Response, Com-pensation, and Liability Act (CERCLA). BHCsor their subsidiaries that originate loans to bor-rowers through loan participation agreementscould be transferring environmental risk andliability to the holders of participations, thusmaking them susceptible to such losses. Theoriginator should establish and follow policiesand procedures designed to control environmen-tal risks. See the Commercial Bank ExaminationManual, section 2140.1 (the ‘‘EnvironmentalLiability’’ subsection) for a more detailed dis-cussion on ways banks can protect themselvesas 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 thereare significant problems with the managementof the BHC’s or a subsidiary’s loan participa-tion portfolio:

1. the absence of formal loan participationpolicies.

2. the absence of any formal participationagreement.

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 theloan portfolio.

6. missing loan participation agreements anddocumentation which should denote therights and responsibilities of all participants.

7. the existence of numerous disputes or dis-agreements among the participants regardingthe receipt of payment(s) in accordance withthe participation agreements, documentationrequirements, or any other significant aspectsof the entity’s loan participation transactions.

8. the originator is making loan payments toloan participation acquirers without receiv-ing reimbursement by the original borrower.


Loan Administration

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



adequate in relation to the responsibilities ithas for the supervision of its credit-extendingsubsidiaries and whether those policies areconsistent with safe and sound lendingpractices.

2. To determine if internal and external factors(for example, the size and financial conditionof the credit-extending subsidiary, the sizeand expertise of its staff, avoidance of orcontrol over credit concentrations, marketconditions, and statutory and regulatory com-pliance) are considered in formulating andmonitoring the organization’s loan policiesand strategic plan.

3. To determine if the loan policy is beingmonitored and complied with.

4. To establish whether the loan policy ensuressound assessments of the value of real estateand other collateral.

Lending Standards for Commercial Loans

1. To focus on and evaluate the strength of thecredit-risk management process.

2. To determine whether the bank holdingcompany has formal credit policies that(1) provide clear guidance on its appetitefor credit risk and (2) support sound lendingdecisions.

3. To determine whether experienced creditprofessionals who are independent of linelending functions provide adequate internalcontrol 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 beingconsidered, and that the information is in aclear and understandable format.

5. To evaluate whether forward-looking analy-sis tools are being adequately and appropri-ately used as part of the loan-approvalprocess.

6. To determine whether credit-risk manage-ment information systems provide adequateinformation to management and lenders.

7. To incorporate the examiner’s evaluation ofthe bank holding company’s adherence tosound practices into the overall assessmentof credit-risk management.

8. To be alert to indications of insufficientlyrigorous risk assessment at banking organi-zations, particularly inadequate stress test-ing and excessive reliance on strong eco-

nomic conditions and robust financialmarkets to support a borrower’s capacity toservice its debts.

9. To be attentive in reviewing a banking orga-nization’s assessment and monitoring ofcredit risk to ensure that undue reliance onfavorable conditions does not lead todelayed recognition of emerging weak-nesses in some loans.

10. To ascertain whether the banking organiza-tion has relied, to a significant and undueextent, on favorable assumptions about bor-rowers or the economy and financial mar-kets. If so, to carefully consider downgrad-ing, under the applicable supervisory ratingframework, a banking organization’s risk-management, management, and/or asset-quality ratings and, if deemed sufficientlysignificant to the banking organization, itscapital adequacy rating.

11. To determine if the banking organization’sloan-review activities or other internal con-trol and risk-management processes havebeen weakened by staff turnover, failure tocommit sufficient resources, inadequatetraining, and reduced scope or by less-thorough internal loan reviews. To incorpo-rate such findings into the determination ofsupervisory ratings.

Leveraged Lending

1. Risk-Management Framework, Definition,and Policy Expectations. To determinea. whether the institution has established a

sound definition of leveraged lendingthat is appropriate for the types of lever-aged loans that are underwritten and if itcan be applied across all business lines;

b. whether it has adjusted (if necessary) itsrisk appetite and limit structure (includ-ing pipeline limits and overall portfoliolimits) to conform with the institution’sdefinition of leveraged lending andwhether it has the necessary reporting inplace 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 lendingstandards both for transactions that itintends to hold as well as transactionsthat are underwritten to distribute.

d. if the institution’s risk-managementstructure has strong and effective pro-cesses and controls and if they are appro-priate based on its leveraged lendingactivity.



2. Participations Purchased. To ensure thatthe institution applies the same standards ofprudence and credit assessment techniquesand in-house limits that would apply as if ithad originated the loan(s).

3. Underwriting Standards. To assess theeffectiveness of the institution’s underwrit-ing policy standards for leveraged lendingto determine whether theya. 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 areoriginated to be held and to loans thatare originated to distribute; and

d. fully reflect the underwriting standardslisted in the guidance, including:

i. sound business premise and sustain-able capital structure for each trans-action

ii. capacity to repay and ability tode-lever to a sustainable level over areasonable period

iii. appropriate depth and breadth of duediligence

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’sindustry and condition;

b. whether the assumptions are clearlydocumented, well supported, and under-stood by the institution’s appropriatedecision makers and risk-oversight units

c. whether enterprise valuations are per-formed by qualified persons independentof an institution’s origination function

d. whether an institution has policies andprovides for appropriate loan to valueratios, discount rates and collateral mar-gins for loans dependent on enterprisevalue or illiquid and hard-to-value collat-eral.

5. Pipeline Management. To find out if thereare strong risk-management standards andcontrols over transactions in and to the pipe-line and if those standards are applied uni-formly to transactions held in the portfolioand those that are distributed.

6. Reporting and Analytics.

a. To determine if individual and portfolioexposures within and across all businesslines and legal vehicles are captured and

reported in the appropriate amount ofdetail to senior management and theboard.

b. To determine if the necessary risk infor-mation (as outlined in the guidance)about leveraged lending exposures (port-folio holds and pipeline exposures) arecaptured in reports that are distributedtimely and that adequate information isdistributed to senior management and theinstitution’s board of directors at leastquarterly.

7. Risk Rating. To verify that leveraged loansare risk rated based on the borrower’s abil-ity to repay and de-lever to a sustainablelevel.

8. Credit Analysis.

a. To test transactions to determine ifunderwriting practices are effective andcomprehensive.

b. To determine if individual leveragedlending exposures contain a comprehen-sive assessment of financial, business,industry, and management risks based onthe elements of the guidance.

9. Problem Credit Management.

a. To ascertain whether the institution for-mulates individual action plans andexpectations

b. To evaluate workout plans to confirmthat they contain quantifiable objectivesand measureable time frames

c. To determine if problem credits are regu-larly reviewed for risk-rating accuracy,accrual status, impairment status, andcharge off.

10. Deal Sponsors

a. To determine if the institution has guide-lines for evaluating deal sponsors thatare based on the sponsor’s ability andwillingness to support the transactionwhere sponsors are viewed as a sourceof repayment.

11. Credit Review

a. To ensure that the institution regularlyconducts an independent credit review ofthe leveraged lending portfolio more fre-quently and in greater depth than othersegments of the portfolio generally atleast annually. For firms making signifi-cant changes to policies, underwritingstandards, procedures etc., ensure that acredit review is scheduled to test compli-ance with changes.

b. To ensure that credit review personnel



have the expertise and experience toevaluate leveraged loans.

12. Stress Testing.

a. To determine if the institution is con-ducting periodic loan- and portfoliostress tests on leveraged loan portfoliosor if the portfolio has been incorporatedinto enterprise-wide stress testing prac-tices.

b. To verify the effectiveness of the institu-tion’s periodic portfolio stress tests (inaccordance with stress testing guidance)in identifying what effect economic andmarket events could have on the institu-tion’s financial condition and leveragedlending transactions.

13. Conflict of Interest. To determine

a. if policies identify and if there are proce-dures to address transactions in whichthe institution holds both an equity andlending positions;

b. the adequacy and effectiveness of con-trols and training programs that aim tocurb any potential conflicts of intereststhat result from leveraged lending.

14. Reputational Risk.

a. To determine if the institution has suf-fered reputational damage by failing tomeet its legal responsibilities in under-writing and syndicating leveraged loantransactions into the wider financial mar-ket.

Credit-Risk Management for Home EquityLending

1. To determine if the banking organization hasan appropriate review and approval processfor new product offerings, product changes,and marketing initiatives.

2. To ascertain whether the banking organiza-tion has appropriate control procedures forthird parties that generate loans on its behalfand if the control procedures comply withthe laws and regulations that are applicableto the organization.

3. To determine if the banking organization hasgiven full recognition to the risks embeddedin its home equity lending.

4. To determine whether the banking organiza-tion’s risk-management practices have keptpace with the growth and changing risk pro-file of its home equity portfolios and whetherunderwriting standards have eased.

5. To determine whether the loan policy—

a. ensures prudent underwriting standardsfor home equity lending, including stan-dards to ensure that a thorough evaluationof a borrower’s capacity to service thedebt is conducted (that is, the bankingorganization is not relying solely on theborrower’s credit score);

b. provides risk-management safeguards forpotential declines in home values;

c. ensures that the standards for interest-onlyand variable-rate home equity lines ofcredit (HELOCs) include an assessmentof a borrower’s ability to (1) amortize thefully drawn line of credit over the loanterm and (2) absorb potential increases ininterest rates; and

d. provides appropriate collateral-valuationpolicies and procedures and provides forthe use and validation of automated valua-tion models.

Loan Participations, the Agreements andParticipants

1. To ascertain if the BHC engages in the pur-chase or sale of loans via loan participationagreements.

2. To determine if the BHC’s lending policy

a. places limits on the amount of loan par-ticipations originated, purchased, or soldbased on any one source or in theaggregate;

b. has set credit standards for the BHC’sborrowers requesting loans as well asthird parties acquiring loan participationsfrom the bank as originator;

c. requires the same credit standards for loanparticipations as it does for other loans;

d. sets the amount of contingent liability,holdback (retained ownership), and themanner in which the loan should be ser-viced; or

e. requires complete loan documentation forloan participations.

3. To assess the impact of any concentrations ofcredit to a borrower, or in the aggregate, thatarise from loans involved in loan participa-tion agreements.

4. To determine if there are any informal repur-chase agreements that exist between loanparticipation acquirers that are designed tocircumvent the originating BHC’s or its sub-sidiary’s legal lending limits, disguise delin-quencies, and avoid adverse classifications.

5. To determine whether the BHC’s financialcondition is compromised by assessing theimpact of the BHC’s loan participations with



its affiliates.6. To ascertain whether loan participation trans-

actions with affiliates are in compliance withsections 23A and 23B of the Federal ReserveAct and the Board’s Regulation W.

7. To determine if there are disputes betweenthe BHC or its subsidiaries as originator ofloan participations and its participants.

8. To determine if any loan participations havebeen adversely classified by examiners,including examiners from other supervisoryagencies (includes loan participations heldby the other institutions).


Loan Administration

1. Obtain an organizational chart and deter-mine the various levels of responsibilityand job functions of individuals involvedwith the lending function.

2. Obtain and review the BHC’s loan policy;determine if the policy contains the appro-priate components, as summarized in thissection. Determine how the policy is com-municated to subsidiaries. Also determinewhether the loan policy reflects the Decem-ber 1992 uniform interagency real estatelending standards and guidelines as theyapply to subsidiary depository institutions.

3. Obtain a copy of the most recent manage-ment reports concerning the quality of loansand other aspects of the loan portfolio(delinquency list, concentrations, yieldanalysis, loan-distribution lists, watch loanreports, charge-off reports, participationlistings, internal and external audit reports,etc.). Determine the scope and sufficiencyof the work performed by any committeesrelated to the lending function. Determine ifthe information provided to the directorateand senior management is sufficient forthem to make judgments about the qualityof the portfolio and to determine appropri-ate corrective action.

4. Determine if an internal process has beenestablished for the review and approval ofloans that do not conform to internal lend-ing policy. Establish whether such loans aresupported by written documentation thatclearly states all the relevant credit factorsthat culminated in the underwriting deci-sion. Determine if exception loans of a sig-nificant size are reported to the board ofdirectors of the subsidiary or to the holdingcompany.

5. Review internal and external audit reports

and bank examination reports for criticalcomments concerning loan-policy excep-tions and administration. Determinewhether action was taken in response to anyidentified exceptions. Determine who isresponsible for follow-up and what the timeframes are; seek rationale if no action wastaken or if the action taken was half-hearted.

6. Review the organization’s financial state-ments, the bank Call Reports, and the BHCFR Y-series reports submitted to the Fed-eral Reserve. Determine whether reportingis accurate and disclosure is sufficient toindicate the organization’s financial posi-tion and the nature of its loan portfolios,including nonaccrual loans.

7. When reviewing lending policies, ascertainwhether—a. the loan policies facilitate extensions of

credit to sound borrowers and facilitatethe workout of problem loans, and

b. the loan policies control and reduce con-centration risk by placing emphasis oneffective internal policies, systems, andcontrols to monitor the risk.

8. Through interviews with, or review ofreports submitted by, the internal auditor,lending officers, loan-review personnel, andsenior management, (1) evaluate the effec-tiveness of the BHC’s self-monitoring ofadherence to loan policy, (2) determine howchanges to the loan policy occur, (3) deter-mine how loans made in contradiction tothe loan policy are explained, and (4) deter-mine the various circumstances involvinglevels of approval and what specific consid-eration occurs at these levels.

9. Presuming the inspection is concurrent witha bank’s primary regulator, coordinate, on arandom basis, the selection of loans subjectto classification. Determine whether theyconform 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 anequivalent page of the inspection report,evaluate the BHC’s oversight regardingeffective lending policy and procedures.

Lending Standards for Commercial Loans

1. Review formal credit policies for cleararticulation of current lending standards,



including—

a. a description of the characteristics ofacceptable loans and (if applicable)‘‘guidance’’ minimum financial ratios,

b. standards for the types of covenants to beimposed for specific loan types, and

c. the treatment and reporting of policyexceptions, both for individual loans andthe entire portfolio.

2. Evaluate the role played by independentcredit staff in loan approvals and, in particu-lar, whether these credit professionals areadequately experienced, are independent ofline lending functions, and have authority toreject loans either because of specific excep-tions to policy or because the loan does notmeet the institution’s credit-risk appetite.

3. Review written policies and determine oper-ating practice in preparing loan-approvaldocuments to evaluate whether sufficientinformation is provided on the characteristicsand risks of loans being considered, andwhether such information is provided clearlyand can be easily understood.

4. Based on written policies and review of oper-ating practice, evaluate whether loans beingconsidered are evaluated not only on thebasis of the borrower’s current performancebut on the basis of forward-looking analysisof the borrower.

a. Determine whether financial projectionsor other forward-looking tools are an inte-gral part of the preapproval analysis andloan-approval documents.

b. Determine the extent to which alternativeor ‘‘downside’’ scenarios are identified,considered, and analyzed in the loan-approval process.

5. Review credit-risk management informationsystems and reports to determine whetherthey provide adequate information to man-agement and lenders about—

a. the composition of the institution’s cur-rent portfolio or exposure, to allow forconsideration of whether proposed loansmight affect this composition sufficientlyto be inconsistent with the institution’srisk appetite, and

b. data sources, analytical tools, and otherinformation to support credit analysis.

6. When appropriate, coordinate or conduct suf-ficient loan reviews and transaction testing inthe lending function to accurately determinethe quality of loan portfolios and other creditexposures. If deficiencies in lending prac-

tices or credit discipline are indicated as aresult of the preexamination risk assessment,the inspection, or bank or other examina-tions, arrange for the commitment of suffi-cient supervisory resources to conductin-depth reviews, including transaction test-ing, that are adequate to ensure that the Fed-eral Reserve achieves a full understanding ofthe nature, scope, and implications of thedeficiencies.

7. When reviewing loans, lending policies, andlending practices—a. observe and analyze loan-pricing policies

and practices to determine whether theinstitution may be unduly weighting theshort-term benefit of retaining or attract-ing new customers through price conces-sions, while not giving sufficient consi-deration to potential longer-termconsequences;

b. be alert for indications of insufficientlyrigorous risk assessment, in particular(1) excessive reliance on strong economicconditions and robust financial markets tosupport the capacity of borrowers to ser-vice their debts and (2) inadequate stresstesting;

c. be attentive in reviewing an institution’sassessment and monitoring of credit riskto ensure that undue reliance on favorableconditions does not lead that institution todelay recognition of emerging weaknessesin some loans or to lessen staff resourcesassigned to internal loan review;36 and

d. give careful consideration to downgrad-ing, under the applicable supervisory rat-ing framework, a banking organization’srisk-management, management, and/orasset-quality ratings and its capitaladequacy rating (if sufficiently signifi-cant) when there is significant and unduereliance on favorable assumptions aboutborrowers or the economy and financialmarkets, or when that reliance has slowedthe recognition of loan problems.

8. Discuss matters of concern with the seniormanagement and the board of directors of thebank holding company and report those areasof concern on core page 1, ‘‘Examiner’sComments and Matters Requiring SpecialBoard Attention.’’

36. 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.



Leveraged Lending

Overview

Complete or update the Leveraged LendingInternal Control Questionnaire if selected forimplementation.

1. Based on an evaluation of internal controls,determine the scope of the inspection. Thescope should include exposures relatedthrough common ownership, guarantors, orsponsors. Also include direct and indirectleveraged 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 apolicy review and transaction testingapproach to determine the effectiveness ofthe institution’s leveraged lending controlprocess.

If the institution is found to lack robust risk-management processes and controls aroundleveraged lending that reinforces the institu-tion’s risk profile, a supervisory finding ofunsafe and unsound banking practices should beconsidered.

3. Applicability/Risk Management Frameworka. At the start of the inspection, ascertain

whether the institution has adopted anappropriate risk-management frameworkfor leveraged lending that includesrobust policies, procedures, and risk lim-its that have been approved by the boardof directors.

b. Implementation of this guidance shouldbe consistent with the size and risk pro-file of the institution.

c. All aspects of the guidance should beapplied to institutions that originate anddistribute leveraged loans.

d. The section on Participations Purchasedshould be applied to banking organiza-tions that have limited involvement inleveraged lending; community banksoverall may not be materially affected bythe guidance.

4. Definition of Leveraged Lendinga. Determine if the institution has a written

policy for leveraged lending and if thatpolicy contains criteria for definingleveraged lending that are appropriatefor the institution and consistent with theguidance standards.

b. Determine if the institution’s definition

includes related exposures and direct andindirect exposures.

5. General Policy Expectationsa. Review the policy for the key risk ele-

ments referred to in the guidance (Seethe section on General Policy Expecta-tions in the guidance and in the InternalControl Questionnaire). Determine if thepolicy includes the following elements:• Risk Appetite that clearly defines the

amount of leveraged lending the insti-tution is willing to underwrite and iswilling to retain.

• Limit Framework for aggregate port-folio held on balance sheet, singleobligors and transactions, aggregatepipeline exposure, industry and geo-graphic concentrations. For institutionswith significant underwriting expo-sure, determine if limits have beenestablished for stress losses, flex terms,economic capital, or earnings at riskassociated with leveraged loans.

• Allowance for loan and lease losses(ALLL) and capital adequacy analysisthat reflect the risk of leveraged lend-ing activities.

• Credit approval and underwritingauthorities.

• Guidelines for senior managementoversight and timely reporting tosenior management and the board ofdirectors.

• Expected risk adjusted returns.

• Minimum underwriting standards.

• Underwriting practices for originationand secondary loan acquisition.

6. Participations Purchased

a. Ascertain if the institution participatingor purchasing into a leveraged loan has aclear understanding of the credit and therisks involved and also has a clear under-standing of its rights and responsibilitiesunder the participation agreement.

b. Determine if the institution has con-ducted its own independent underwritingof participations and has applied thesame standards of prudence, creditassessment techniques, and in-house lim-its as if the institution had originated theloan(s).

c. Verify that the institution has receivedcopies of all participation documents andany other documents relevant to thecredit transaction(s).



7. Underwriting Standardsa. Determine if the institution employs

similar and consistent underwriting stan-dards for leveraged loans it plans to holdor 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 forleveraged lending.

• Evaluate the underwriting policies andstandards and determine if they con-tain the elements found in guidance(Refer to the section on UnderwritingStandards in the guidance and in theInternal Control Questionnaire):

8. Valuation Standards

a. Confirm that the institution has policiesand procedures in place for estimatingenterprise value or for valuing otherilliquid collateral. If enterprise value isrelied on as a secondary source of repay-ment, determine the following:

• If one or a combination of the threemethods referred to in the guidance isused (asset, income, or market valua-tion).

• If the underlying assumptions and theresulting values are well documented,supportable, and credible (Refer to theValuations Standards section of theguidance and the Internal ControlQuestionnaire).

• If enterprise value was calculated byqualified persons independent of theorigination function.

• If stress tests of key enterprise valuevariables and assumptions (such ascash flow earnings and sales multiples)are conducted.

• That firms have policies that providefor appropriate loan-to-value ratios,discount rates and collateral margins.

• If the institution has established limitsfor the proportion of individual trans-actions and the total portfolio that aresupported by enterprise value.

9. Pipeline Management

a. Determine if the institution has strongrisk management and controls that areextended to deals in the pipeline,whether those deals are intended forhold, 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 forstress testing pipeline deals.

• Ascertain if management reports showthat transactions can be differentiatedbased on their key characteristics,tenor, and investor class (pro-rata andinstitutional), structure, and key bor-rower characteristics (for example,industry).

• Determine if there are clearly articu-lated rationales for the effectiveness ofhedging 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 (seethe section on Pipeline Management inthe guidance and in the Internal Con-trol Questionnaire).

10. Reporting and Analyticsa. Ascertain if the institution’s risk-

management framework includes anintensive and frequent review and moni-toring process.

b. Establish whether management receivescomprehensive reports about the charac-teristics and trends of the institution’sleveraged-lending portfolio at least quar-terly and if summaries are provided tothe board of directors.

c. Find out if internal reports provide adetailed and comprehensive view ofglobal exposures, including situationswhen an institution has an indirect expo-sure to an obligor or is holding a previ-ously sold position as collateral or as areference asset in a derivative. Borrowerand counterparty leveraged lendingreporting should aggregate total expo-sure and consider exposures bookedacross business lines or legal entities.

d. Verify that internal policies identify thedata fields to be populated and capturedby the institution’s MIS and whether thereports are accurate, timely, and if theinformation is provided to managementand the board of directors.

e. Confirm that MIS reporting on the lever-aged lending portfolio contains the appli-cable measures listed in the guidance.(Refer to the section on Reporting andAnalytics in the guidance and in theInternal Control Questionnaire.)

11. Credit Analysisa. 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 determineif they fit the institutions definition of aleveraged loan.

c. Determine if individual credits were ana-lyzed in conjunction with the parametersin the guidance. (Refer to the section onCredit Analysis in the guidance and inthe Internal Control Questionnaire).

d. Verify that there are guidelines for evalu-ating deal sponsors and their willingnessand ability to support the credit.

e. Confirm that sponsors are used as a sec-ondary and not a primary source ofrepayment.

f. Assess the credit agreement to determineif it contains language for:• Material dilution, sale, or exchange of

collateral or cash flow producingassets 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 othercredit information to participants andinvestors.

• Acceptable collateral types, loan tovalue guidelines and appropriate col-lateral valuation methodologies

12. Internal Risk Ratinga. Determine if individual loans are risk

rated based on the borrower’s demon-strated ability to repay the loan andde-lever over a reasonable period oftime.• Confirm that the institution has evi-

dence of adequate repayment capacity,for example borrowers demonstratethe ability to fully amortize senior debtor repay at least 50 percent of totaldebt over a 5–7 year period. Ensurethat extensions or other restructuringare not masking an inability to repay.

• Consider adversely rating credits thatdo not show the capacity to pay downdebt from cash flow or if refinancing isthe only option for repayment.

• Consider a substandard rating if thereare no reasonable or realistic prospectsfor repayment or de-levering.

13. Deal Sponsorsa. If a deal sponsor is relied on as a second-

ary source of repayment, determine ifmanagement 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 sectionon Deal Sponsors in the guidance and inthe Internal Control Questionnaire).

14. Credit Review/Problem Credit Management

a. Assess credit review staff’s expertiserelative to leveraged lending.

b. Verify that the institution conducts fre-quent internal credit review ofleveraged-lending portfolio that is doneindependently of the origination func-tion. Portfolio reviews should generallybe conducted no less than annually.

c. Evaluate the institution’s procedures fordealing with problem credits including ifwork out plans contain quantifiableobjectives and measurable time frames.

15. Stress Testing

a. Determine if the institution has devel-oped stress tests for leveraged loans or ifthe loans are included in the existingstress testing protocol.

16. Conflicts of Interest/Reputational Risk/Compliance

a. Confirm that the institution is meeting itslegal responsibilities by underwritingand distributing transactions that do notresult in undue reputational risk.

b. Determine if potential conflicts of inter-est exist if the institution has both equityand lending positions in a particulartransaction. Confirm that policies andprocedures are in place to handle con-flicts of interest.

c. Ascertain whether the institution’s com-pliance function periodically reviews theinstitution’s leveraged-lending activity.

d. Ascertain whether the institution’s poli-cies incorporate safeguards to preventviolations of anti-tying regulations.

e. When securities are involved, determinehow the institution ensures compliancewith applicable securities laws, includ-ing disclosure and other regulatoryrequirements.

f. Ascertain what plans and provisionshave been developed to ensure compli-ance with the Board’s Regulation W (12CFR part 223).



Credit-Risk Management for Home Equity

Lending

1. Review the credit policies for home equitylending to determine if the underwritingstandards address all relevant risk factors(that is, an analysis of a borrower’s incomeand debt levels, credit score, and credithistory versus the loan’s size, the collateralvalue (including valuation methodology),the lien position, and the property type andlocation.

2. Determine whether the banking organiza-tion’s underwriting standards include—

a. a properly documented evaluation ofthe borrower’s financial capacity toadequately service the debt and

b. an adequately documented evaluation ofthe borrower’s ability to (1) amortize thefully drawn line of credit over the loanterm and (2) absorb potential increasesin interest rates for interest-only andvariable-rate HELOCs.

3. Assess the reasonableness and adequacy ofthe analyses and methodologies underlyingthe banking organization’s evaluation ofborrowers.

4. If the organization uses third parties tooriginate 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 internalcontrols for delegated underwriting areadequate;

c. whether the banking organization retainsappropriate oversight of all critical loan-processing activities, such as verificationof income and employment and the inde-pendence of the appraisal and evaluationfunction;

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 thatmeet the banking organization’s pre-scribed underwriting guidelines, andadheres to applicable consumer protec-tion laws and regulations;

e. if the banking organization has a quality-control unit or function that closelymonitors (monitoring activities shouldinclude post-purchase underwritingreviews and ongoing portfolio-performance-management activities) the

quality of loans that the third partyunderwrites; and

f. whether the banking organization hasadequate audit procedures and controlsto verify that third parties are not beingpaid to generate incomplete or fraudu-lent mortgage applications or are nototherwise receiving referral or unearnedincome or fees contrary to RESPAprohibitions.

5. Evaluate the adequacy of the banking orga-nization’s collateral-valuation policies andprocedures. Ascertain whether theorganization—a. establishes criteria for determining the

appropriate valuation methodology for aparticular transaction (based on the riskin the transaction and loan portfolio);

b. sets criteria for determining when aphysical inspection of the collateral isnecessary;

c. ensures that an expected or estimatedvalue 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 theappraisal or evaluation.

6. If the banking organization uses automatedvaluation models (AVMs) to support evalu-ations or appraisals, find out if theorganization—a. periodically validates the models, to

mitigate the potential valuation uncer-tainty in the model;

b. adequately documents the validation’sanalysis, assumptions, and conclusions;

c. back-tests a representative sample ofevaluations and appraisals supportingloans outstanding; and

d. evaluates the reasonableness andadequacy of its procedures for validatingAVMs.

7. If tax-assessment valuations are used as abasis for collateral valuation, ascertainwhether the banking organization is able todemonstrate and document the correlationbetween the assessment value of the taxingauthority and the property’s market value,as part of the validation process.

8. Review the risk- and account-managementprocedures. Verify that the procedures areappropriate for the size of the bankingorganization’s loan portfolio, as well asfor the risks associated with the types ofhome equity lending conducted by the



organization.

9. If the banking organization has large homeequity loan portfolios or portfolios withhigh-risk characteristics, determine if theorganization—

a. periodically refreshes credit-risk scoreson all customers;

b. uses behavioral scoring and analysis ofindividual borrower characteristics toidentify potential problem accounts;

c. periodically assesses utilization rates;

d. periodically assesses payment patterns,including borrowers who make onlyminimum payments over a period oftime or those who rely on the credit lineto keep payments current;

e. monitors home values by geographicarea; and

f. obtains updated information on the colla-teral’s value when significant marketfactors indicate a potential decline inhome values, or when the borrower’spayment performance deteriorates andgreater reliance is placed on thecollateral.

Determine that the frequency of theseactions is commensurate with the risk in theportfolio.

10. Verify that annual credit reviews of homeequity line of credit (HELOC) accounts areconducted. Verify if the reviews of HELOCaccounts determine whether the line ofcredit should be continued, based on theborrower’s current financial condition.

11. Determine that authorizations of over-limithome equity lines of credit are restrictedand subject to appropriate policies andcontrols.

a. Verify that the banking organizationrequires over-limit borrowers to repay,in a timely manner, the amount thatexceeds established credit limits.

b. Evaluate the sufficiency of managementinformation systems (MIS) that enablemanagement to identify, measure, moni-tor, and control the risks associated withover-limit accounts.

12. Verify that the organization’s real estatelending policies are consistent with safe andsound banking practices and that its boardof directors reviews and approves the poli-cies at least annually.

13. Determine whether the MIS—

a. allows for the segmentation of the loanportfolios;

b. accurately assesses key risk characteris-tics; and

c. provides management with sufficientinformation to identify, monitor, mea-sure, and control home equity concentra-tions.

14. Determine whether management periodi-cally assesses the adequacy of its MIS, inlight of growth and changes in the bankingorganization’s risk appetite.

15. If the banking organization has significantconcentrations of home equity loans (HELs)or HELOCs, determine if the MIS includes,at a minimum, reports and analysis of thefollowing:

a. production and portfolio trends by prod-uct, loan structure, originator channel,credit score, loan to value (LTV), debt toincome (DTI), lien position, documenta-tion type, market, and property type

b. the delinquency and loss-distributiontrends by product and originator chan-nel, with some accompanying analysisof 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 andproperty type, to identify areas of rapidlyappreciating or depreciating housingvalues

16. Determine whether the banking organiza-tion accurately tracks the volume of high-LTV (HLTV) loans, including HLTV homeequity and residential mortgages, and if theorganization reports the aggregate of theseloans to its board of directors.

17. Determine whether loans in excess of thesupervisory LTV limits are identified ashigh-LTV loans in the banking organiza-tion’s records. Determine whether the orga-nization reports, on a quarterly basis, thedollar value of such loans to its board ofdirectors.

18. Find out whether the organization has pur-chased insurance products to help mitigatethe credit risks of its HLTV residentialloans. If a policy has a coverage limit,determine whether the coverage may beexhausted before all loans in the poolmature or pay off.

19. Determine whether the organization’scredit-risk management function overseesthe 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 procedureshave been established for home equityproblem-loan workouts and loss-mitigationstrategies.

Loan Participations, the Agreements andParticipants

These inspection procedures are designed toensure that originated loans that were trans-ferred via loan participation agreements or cer-tificates to state member banks, bank holdingcompanies, nonbank affiliates, or other third par-ties were carefully evaluated. The proceduresinstruct examiners to determine if the assettransfers were carried out to avoid or circum-vent classification and to determine the effect ofthe transfers on the BHC’s financial conditionor that of its subsidiaries. In addition, the proce-dures are designed to ensure that the primaryregulator of another financial institutioninvolved in the asset transfer of any low-qualityassets is notified.

1. Review the board of directors’ or their des-ignated committees’ policies and proce-dures governing how loan participationagreements and activities are created, trans-acted, and administered. Refer to section2010.2.7 for the minimum items that shouldbe included in board-approved policies onloan participation activities.

2. Determine if managerial reports providesufficient information relative to the sizeand risk profile of the loan participationportfolio and evaluate the accuracy andtimeliness of reports produced for the boardand senior management.

3. For loan participations held (either in wholeor in part) with another lending institution,review, if applicable,

• the participation certificates and agree-ments, on a test basis, to determine if thecontractual terms are being adhered to;

• loan documentation to determine if itmeets the BHC’s (or its subsidiary’s)underwriting procedures (that is, thedocumentation for loan participationsshould meet the same standards as the

documentation for other loans the respec-tive entity originates);

• the transfer of loans immediately beforethe date of the inspection to determine ifthe loan was either nonperforming orclassified and if the transfer was made toavoid possible criticism during the cur-rent inspection; and

• losses to determine if they are shared on apro rata or other basis according to theterms of the participation agreement.

4. Check participation certificates or agree-ments and records to determine whether theparties share in the risks and contractualpayments on a pro rata or other basis.

5. Determine if loans are purchased on arecourse basis and that loans are sold on anonrecourse basis.

6. Ascertain that the BHC (or its subsidiaries)do not buy back or pay interest on defaultedloans in contradiction of the underlying par-ticipation agreement.

7. Compare the volume of outstanding origi-nated or purchased loans that were issued inthe form of loan participations with the totaloutstanding loan portfolio.

8. Determine if the BHC (or its subsidiaries)has sufficient expertise to properly evaluatethe volume of loans originated or purchasedand sold as loan participations.

9. Based on the terms of the loan participationagreements, review the originator’s distri-bution of the borrower’s payments receivedto those entities or persons owning interestsin the loan participations. Ascertain if theagreement’s recourse provisions mayrequire accounting for the transactions as asecured borrowing rather than as a sale.

10. Determine if loans are sold primarily toaccommodate credit overline needs of cus-tomers or to generate fee income.

11. Determine if loans are purchased or sold toaffiliates or other companies; if so, deter-mine whether the purchasing companiesrequest and are given sufficient informationto properly evaluate the credit. (Section23A of the Federal Reserve Act and theBoard’s Regulation W prohibit transfers oflow-quality assets between affiliates.) Seesections 2020.0, 2020.1, 2020.2.

12. Investigate any situations in which assetswere transferred before the date ofinspection:a. Determine if any were transferred to

avoid possible criticism during theinspection.

b. Determine whether any of the loan par-ticipations transferred were nonperform-



ing at the time of transfer, classified dur-ing the previous examination, ortransferred for any other reason that maycause the loans to be considered of ques-tionable quality.

13. Review the BHC’s policies and proceduresto determine whether loan participationspurchased are required to be given an inde-pendent, complete, and adequate creditevaluation. Review asset participations soldto affiliates to determine if the asset pur-chases were supported by an arm’s-lengthand independent credit evaluation.

14. Determine that any assets purchased by theBHC (or its subsidiaries) were properlyrecorded at fair market value at the time ofpurchase.

15. Determine that transactions involving trans-fers of low-quality assets to the parent hold-ing company or a nonbank affiliate areproperly reflected at fair market value onthe books of both the bank and the holdingcompany affiliate.

16. If poor-quality assets were transferred bythe BHC to another financial institution forwhich the Federal Reserve is not the pri-mary regulator, prepare a memorandum tobe submitted to the Reserve Bank supervi-sory personnel. The Reserve Bank’s appro-priate staff will then inform the local officeof the primary federal regulator of the otherinstitution involved in the transfer. Thememorandum should include the followinginformation, 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. Ascertainwhether the bank manages not only therisk from individual participation loansbut also portfolio risk.

17. Find out if management develops appropri-ate strategies for managing concentrationlevels, 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 alsowhole loan sales). Find out if the BHC’s (orits subsidiaries’) contingency plan includesselling 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 thesecondary market.

19. Verify whether the BHC (or its subsidi-aries) compare its underwriting standardsfor loan participations with those that existin the secondary market.

2010.2.10 INTERNAL CONTROLQUESTIONNAIRE

Applicability/Risk-ManagementFramework

1. Has the institution adopted a risk-management framework around leveragedlending 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 asound business premise, have an appro-priate capital structure, reasonable cashflow, and balance sheet leverage?

c. A definition of leveraged lending thatcan be applied across all business lines?

d. Well-defined underwriting standards thatdefine acceptable leverage levels andamortization 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 leveragedloans 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 leveragedloans; participating in leveraged loans, orboth?

Definition of Leveraged Lending

1. Has the institution developed an appropri-ate written definition for leveraged lendingand incorporated it into the leveraged lend-



ing policy?

2. Is the policy definition consistent with theamounts and types of leveraged loans thatthe 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 containthe following elements:

a. A clear statement of the amounts ofleveraged lending that it is willing tounderwrite and the amount(s) it is will-ing to hold in its own portfolio?

b. A limit framework that establishes limitsor guidelines around the following asapplicable: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 trackingprovisions?

c. Procedures for insuring that leveragedlending risks are appropriately reflectedin the institution’s level of allowance forloan and lease losses (ALLL) and capitaladequacy analysis?

d. Credit and underwriting approvalauthorities, including the procedures forapproving and documenting changes toapproved transaction structures andterms?

e. Guidelines for appropriate oversight bysenior management, including adequateand timely reporting to the board ofdirectors?

f. Expected risk-adjusted returns for lever-aged transactions?

g. Minimum underwriting standards andunderwriting practices for primary loanorigination and secondary loan acquisi-tion?

Participations Purchased

1. Has the institution, with respect to participa-tions purchased, done its own independentunderwriting of its portion of the transac-tion and has it adequately identified itsrisks?

2. Has the institution received copies of alldocumentation relevant to the transaction?

3. Is there evidence that the institution hasreviewed the participation agreement andhas a clear understanding of its rights andresponsibilities under the agreement?

Underwriting Standards

1. Is the institution using similar underwritingstandards for leveraged loans it plans tohold as well as for leveraged loans it plansto distribute?

2. Are the institution’s underwriting standardsclear, written, and measurable?

3. Do underwriting standards require:

• A sound business premise for each trans-action and that the borrower’s capitalstructure is sustainable?

• A determination and documentation ofthe borrower’s capacity to repay andability to de-lever to a sustainable levelover a reasonable period?

• Standards for evaluating various types ofcollateral?

• Standards for evaluating risk-adjustedreturns?

• The acceptable degree of reliance onenterprise value and other intangibleassets for loan repayment?

• Expectations for the degree of supportexpected to be provided by sponsors?

• A prohibition on material dilution, sale,or exchange of collateral or cash flowproducing assets without lenderapproval?

• A credit agreement that contains finan-cial covenants, reporting covenants, andcompliance monitoring? Does the loancontain covenant-lite and PIK toggleloan structures? If so, does the borrowerhave the ability to repay the loan underthe contractual terms?

• Guidelines for acceptable collateraltypes, loan-to value-guidelines, andacceptable collateral valuation method-ologies?

• Loan agreements that provide for thedistribution of financial information toparticipants and investors?



Valuation Standards

1. Does the institution have policies for valu-ing illiquid, intangible, or hard to valuecollateral that include appropriate LTVratios, discount rates, and collateral mar-gins?

2. Is the institution relying on enterprise valueto confirm a secondary source of repay-ment?a. Has the institution documented its valua-

tion approach to calculating enterprisevalue?

b. Has the valuation been performed byqualified persons independent of theorigination function?

c. Has one or a combination of three meth-ods been used for determining enterprisevalue, asset valuation, income valuation,or market valuation?

d. If the income method is used, is it basedon capitalized cash flow or discountedcash flow?

e. Has the institution confirmed proxy mea-sures such as multiples of cash flowearnings or sales by performing its owndiscounted cash flow analysis?

f. Are stress tests of key variables andassumptions used in determining enter-prise value (such as cash flow earningsand 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 aresupported by enterprise value?

Pipeline Management

1. Do strong risk-management controls coverall transactions in the pipeline, includingamounts planned for hold and those markedfor distribution?

2. Does the institution have the capability todifferentiate transactions based on their keycharacteristics, tenor, and investor class(pro-rata and institutional), structure, andkey 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 potentialeffects 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-dayperiod?– Have transactions reclassified as hold-

to-maturity been reported to manage-ment and the board of directors?

• Guidelines for conducting periodic stresstests of pipeline exposures?

• Controls to monitor expected vs. actualperformance?

• Reports that show individual and aggre-gate transaction information, risk ratingsand concentrations?

• Limits on hold levels per borrower,counterparty, and aggregate hold levels?

• Limits on the amounts intended for dis-tribution?

• Policies and procedures for acceptableaccounting methods, including promptrecognition of losses?

• Policies and procedures around accept-able hedging practices if applicable?

• Plans to address contingent liabilities andcompliance with Sections 23A and 23Bof the Federal Reserve Act and Regula-tion W?

Reporting and Analytics

1. Does management receive quarterly com-prehensive reports about the characteristicsand trends of the institution’s leveragedlending portfolio? Are summaries providedto the board of directors?

2. Do internal policies identify the data fieldsto be populated and captured by the institu-tion’s MIS? Are the reports accurate andtimely?

3. As dictated by the size and complexity ofthe leveraged lending portfolio, does MISreporting on the leveraged lending portfolioinclude the following:a. Individual and portfolio exposures

within and across all business lines andlegal vehicles including the pipeline?

b. Risk-rating distribution and migrationanalysis?

c. A list of borrowers who have beenremoved from the leveraged-lendingportfolio due to improvements in theirfinancial characteristics and risk profile?Is the removal from the profile concur-rent with a refinance, restructure or someother modification in the loan agree-ment?



d. Industry mix and maturity profile?

e. Metrics derived from probability ofdefault and loss-given default?

f. Portfolio performance measures includ-ing covenant breaches, restructurings,delinquencies, nonperforming assetamounts, and charge offs?

g. Amount and nature of impaired assetsand the amount of ALLL attributable toleveraged lending?

h. The level of policy exceptions in theportfolio?

i. Exposures by collateral type, includingunsecured transactions when enterprisevalues 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 levelsof the pipeline with reports of excesslevels of exposure over hold targets?

o. Types of exposure in the pipeline: com-mitted exposures not accepted by theborrower; exposures committed andaccepted but not closed; funded andunfunded commitments closed but notdistributed?

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 theinstitution is holding a previously soldposition as collateral or as a referenceasset in a derivative)?

q. Exposures booked in other business unitsthroughout the institution that are relatedto a leveraged loan or borrower? (Forexample, default swaps or total returnswaps naming the distributed paper as acovered or referenced asset or as collat-eral exposure through repo transactions).

r. Positions held in leveraged loans inavailable for sale or traded portfolios orheld in structured-investment vehiclesowned or operated by the originatinginstitution or its subsidiaries or affiliates?

Internal Risk Rating

1. Does the institution have evidence ofadequate repayment capacity? For example,do borrowers demonstrate the ability tofully amortize senior debt or repay at least50 percent of total debt over a five to seven-year period?

2. Are there extensions or other restructuringthat are masking an inability to repay?

3. Has the primary source of repaymentbecome inadequate? Is enterprise valuebeing relied on as a secondary source ofrepayment? Is enterprise value well sup-ported with binding purchase and saleagreements with qualified third parties?Does enterprise value consider theborrower’s distressed circumstances?

Credit Analysis

1. Does transaction testing of individual lever-aged lending credits contain the followingelements 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 measuresto determine operating cash needs andcash needed to meet debt maturities?Analyze liquidity based on industry per-formance metrics?

c. Projections—There is adequate marginfor unanticipated merger-related integra-tion costs?

d. Stress tests—Projections are stress testedfor one or more downside scenarios,including a covenant breach?

e. Variances from plan—Transactions arereviewed at least quarterly to determinevariance from plan; does the credit filecontain a chronological rationale for andanalysis of all changes to the operatingplan and variances from the expectedfinancial performance?

f. Enterprise Value—Were enterprise val-ues independently derived and validatedoutside of the origination function? Werevalues calculated timely and did theyconsider value erosion?

g. Collateral shortfalls—Have shortfallsbeen identified and factored into the riskrating?

h. Collateral liquidation and asset sales—Are any liquidations and sales based oncurrent market conditions and trends?



i. Contingency plans—Are there contin-gency analyses to anticipate changingconditions in debt or equity markets? Dothe exposures rely on refinancing or theissuance of new equity?

j. Interest Rate Risk and Foreign ExchangeRisk—Have these risks been addressedin the analysis? Are mitigants in place?

Problem Credit Management

1. Has the institution formulated and estab-lished procedures for dealing with problemcredits?

2. Do work out plans contain quantifiableobjectives and measurable time frames?

3. Are problem credits regularly reviewed forrisk-rating accuracy, accrual status, recogni-tion of impairment through specific alloca-tions and charge-offs.

Deal Sponsors

1. Has the institution developed guidelines forevaluating the willingness and ability ofsponsors to support the credit exposure anda 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 primarysource of repayment?

b. If the sponsor has a historical pattern ofsupporting investments, financially orotherwise?

c. If the degree of support has been docu-mented via a guarantee, comfort level, orverbal assurance?

d. If there has been a periodic review of thesponsor’s financial statements, an analy-sis of liquidity, and an analysis of thesponsor’s ability to support multipledeals?

e. If consideration has been given to thesponsor’s dividend and capital contribu-tion practices and the likelihood that thesponsor will support the borrower ascompared to other deals in the sponsor’sportfolio?

Credit Review

1. Does the institution conduct an internalcredit 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 andability to identify risks in the leveragedlending portfolio?

Stress Testing

1. Has the institution developed and imple-mented guidelines for conducting periodicportfolio stress tests on loans originated tohold and on loans originated to distribute?

2. Has the institution conducted periodic loanand leveraged lending portfolio level stresstests?

3. If applicable, has the leveraged-lendingportfolio been included in enterprise widestress tests?

4. Does stress testing of leveraged creditsinclude sensitivity analyses to quantify thepotential impact of changing economic andmarket conditions on the institution’s assetquality, earnings, liquidity, and capital?

Reputational Risk

1. Does the institution have procedures, safe-guards, actions, training, and staff remind-ers about the potential reputational riskassociated with poorly underwritten origi-nated leveraged loans?

2. Has there been any failure or apparent fail-ure by the institution to meet its legalresponsibilities in underwriting and distrib-uting transactions that could damage itsreputation or its ability to compete?

Conflicts of Interest

1. Has the institution developed appropriatepolicies and procedures to address and toprevent potential conflicts of interest whenit has both equity and lending positions?

2. Do policies and procedures: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 managementswithout fear of retribution?

d. Ensure compliance with applicable laws?



3. Has management:a. Established a training program for

employees on appropriate practices tofollow to avoid conflicts of interest?

b. Provided for reporting, tracking, andresolution 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-tyingregulations?

3. How does the institution ensure compliancewith applicable securities laws, includingdisclosure and other regulatory require-ments when equity interests and certain debtinstruments have been used in leveragedtransactions that may constitute ‘‘securi-ties’’ under federal securities laws?

4. Have plans and provisions been developedto ensure compliance with sections 23A and23B of the Federal Reserve Act and Regula-tion W?

2010.2.11 APPENDIX I - EXAMINERLOAN-SAMPLING REQUIREMENTSFOR CREDIT-EXTENDING NONBANKSUBSIDIARIES OF BHCS WITH$10-50 BILLION IN TOTALCONSOLIDATED ASSETS

This guidance sets forth loan sampling expecta-tions for the Federal Reserve’s examination ofstate member bank (SMB) and the inspection ofcredit-extending nonbank subsidiaries of bankholding companies (BHCs) with $10-50 billionin total consolidated assets. Examiners will havethe flexibility, depending upon the structure andsize of subsidiary SMBs or credit-extendingnonbank subsidiaries of BHCs, to utilize theguidance applicable to smaller organizationswhen the subsidiary’s total assets are below $10billion. This guidance clarifies expectations forthe assessment of material37 retail credit port-folios for these institutions. The guidance thatfollows has been solely adapted to BHC credit-extending nonbank subsidiaries.

A thorough review of a BHC’s credit-extending nonbank subsidiary’s loan and leaseportfolio remains a fundamental element of theFederal Reserve’s inspection program for theseorganizations. Such credit reviews are a primarymeans for examiners to (1) evaluate the effec-tiveness of a BHC’s credit-extending nonbankinternal loan review program and internal grad-ing systems for determining the reliability ofinternal reporting of classified credits, (2) assesscompliance 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 fromtheir credit review to identify the overall the-matic credit-risk management issues, to assessasset quality, to assist in the assessment of theadequacy of the allowance for loan and leaselosses (ALLL), and to inform their analysis ofcapital 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 objectiveshould provide coverage of material exposures,including those in the retail segments.38 ReserveBanks should plan on conducting at least twoloan quality reviews during the annual supervi-sory cycle of the BHC’s credit-extending non-bank subsidiaries with $10−50 billion in totalconsolidated assets.

Each review should focus on one or morematerial commercial loan segment exposuresusing the comparable FR Y-9C Report loantypes and, in total over the annual cycle, shouldcover the four highest concentrations for com-mercial credits in terms of total risk-based capi-tal for any FR Y-9C Report loan type fromSchedule HC-C. Loan segments that generatesubstantial revenues are generally likely to entailhigher risk. To the extent that examiners candetermine that a loan category contributes25 percent or more to annual revenues,39 exam-iners should sample these segments. Examiners

37. 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.

38. 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.

39. 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.



should also sample other loan segments thatthey or the bank’s internal loan review haveidentified as exhibiting high-risk characteristics.Such risk characteristics include liberal under-writing, high levels of policy exceptions, high-delinquency trends, rapid growth, new lendingproducts, concentrations and concentrations toindustry, or significant levels of classified cred-its. In addition to these risk-focused samples, asample of loans to insiders must be reviewed.40

Annual loan sampling coverage by examinersshould take into consideration the severity ofthe asset quality component rating, the effective-ness of the internal loan review program, theresults of internal loan portfolio stress testing,and current asset quality financial trends.

During the inspection scoping phase, ReserveBank staff should analyze the results of recentloan review reports or audits prepared for aninstitution’s internal use and the Reserve Bank’smost current assessment of credit-risk manage-ment to help establish the size and compositionof loans to be selected for review. A nonbanksubsidiary’s internal loan review programshould achieve substantial coverage beyond theexaminers’ annual judgmental sample of mate-rial loan portfolios. Examiners should reviewthe findings and recommendations of the non-bank subsidiary’s internal loan review programto help identify areas of risk. In selecting loansfrom each segment of the loan portfolio toreview, examiners should include a selection ofthe largest loans, problem loans (past due90 days or more, nonaccrual, restructured, orinternally classified loans), and newly origi-nated loans. Examiners should ensure thesample selection includes robust coverage ofclassified credits. At a minimum, loans selectedfor review from commercial loan segmentsshould represent 10 percent of the committeddollar amount of credit exposure within the loansegment.

Sample sizes should be increased beyond the10 percent minimum, based on examiner judg-ment, for segments when the inspection scopingprocess or the internal loan review program hasidentified

1. deficiencies with credit-risk managementand administration practices,

2. unusually high loan growth,3. credit quality or collateral values that have

been adversely affected since the priorreview by volatile local or national eco-nomic conditions, or

4. unreliable internal credit-risk grading.

Conversely, sample sizes should be based on the10 percent minimum if

1. previous inspections concluded that internalloan review and credit-risk identification iseffective,

2. internal loan review has reviewed a loansegment within the last 12 months andnoted no material weaknesses, and

3. the inspection scoping process reveals nosignificant credit-risk management issues.

In general, the lower range of 10 percent sam-pling of each segment or the entire commercialportfolio would be acceptable when all aspectsof credit risk indicate low and stable risk.

Examiners should determine classificationamounts for retail credits using the UniformRetail Classification Guidance (SR letter 00-8,“Revised Uniform Retail Credit Classificationand Account Management Policy”). Annually,examiners should focus on one or more materialretail loan segment exposures as divided by thecomparable FR Y-9C Report loan type. Examin-ers should determine the appropriate sample ofretail loans from material segments based onrisk to be tested for compliance with internalcredit administration policies and underwritingstandards. While there is no minimum coverageexpectation for retail portfolios or segments, thegoal of sampling is to assist examiners in mak-ing an informed assessment of all aspects ofretail credit-risk management. If applicable,examiners should evaluate and test secondarymarket origination and servicing practices andquality assurance programs. Examiners shouldalso sample other retail loan segments, asneeded, from segments the examiners or inter-nal loan review identify as exhibiting high-riskcharacteristics such as liberal underwriting,high-delinquency trends, rapid growth, newlending products, or significant levels of classi-fied credits.

2010.2.11.2 Documentation of LoanSampling Analysis and Methodology

Examiners should discuss their analysis andobjectives for achieving loan sampling coveragewith Board staff during the annual supervisoryplanning process. Upon reaching a consensuswith Board staff, the analysis and methodology

40. Federal Reserve examiners must test and evaluate

Regulation O compliance annually.



should be retained in workpapers and docu-mented in the supervisory plan. Further, examin-ers should document their loan sample selectionmethods in scoping memoranda and in the con-fidential section of the report of inspection. Therequired workpaper documentation of the com-mercial loan coverage calculation should bebased on total loan commitments and shouldgenerally exclude loans reviewed outside of theReserve Bank’s supervisory plan when adetailed analysis of the loans by an examinerand an assessment of credit-risk managementwere not performed. Review of syndicated loansand participations, such as those from theShared National Credits (SNCs) annual review,should only be included in the coverage ratio ifReserve Bank staff reviewed the credit-riskmanagement aspects of the credit (for example,adherence to underwriting policies) and thesefindings are included in the examiner’s assess-ment of overall credit-risk management prac-tices. Examiners should continue to follow theSNC grading guidance.41

2010.2.11.3 Follow-Up Expectations forInspections with Adverse Findings

Examiners should generally consider a credit-extending nonbank subsidiary’s internal risk-rating system to be less reliable when examinerdowngrades42 or internal loan review down-grades equal 10 percent of the total number ofloans reviewed, or 5 percent of the total dollaramount of loans and commitments reviewed.When a credit-extending nonbank subsidiary’srisk-rating system is determined to be unreli-able, examiners may need to expand samplingto better evaluate the effect of rating differenceson the entity’s ALLL and capital. In such situa-tions, examiners should direct the BHC and itscredit-extending nonbank subsidiary to take cor-rective action to validate its internal ratings andto evaluate whether the ALLL or capital shouldbe increased. The Reserve Bank will follow-upwith the BHC and its nonbank subsidiary toassess progress on corrective action and verifysatisfactory completion. The timeframe forfollow-up should correspond with the timeframeduring which actions are to be completed.43 Allfollow-up actions on adverse findings should bediscussed with Board staff.

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

gram.”

42. 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.

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

ations for the Communications of Supervisory Findings.”



Supervision of Subsidiaries(Investments) Section 2010.3

The System’s ability to evaluate the effective-ness of a company’s supervision and control ofsubsidiary investment activities can be strength-ened not only by evaluating the parent’s role inlight of efficiency and operating performance,but also by evaluating the quality of control andsupervision. In order to assess quality there mustbe a standard or measuring block against whicha company’s policies can be evaluated. By es-tablishing the minimum areas that a company’spolicies should address with respect to subsidi-ary investments, a standard is created which canevaluate the quality of company’s control andsupervision of that activity. The examiner needsto make a qualitative assessment of the parent’ssupervision and control of subsidiary invest-ment activities.


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.


1. Determine whether the management hasdeveloped a flow chart on investment authoriza-tion procedures sufficiently detailed to assurethat the execution of transactions precludes theability 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 priorapproval of new activities and investments innew instruments is granted.3. Determine whether the boards of directors

and the management of subsidiaries appear tobe sufficiently involved in their respective rolesto 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 involvementin various investment activities.5. Evaluate the reasonableness of investment

activity initiated to achieve corporate objectivesin 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 atsubsidiaries.7. Evaluate policy directives regarding the

appropriateness of accounting practices in re-gard to transactions involving investment partic-ipations, swaps, other transfers of investmentsas well as specialized investment activities.8. Evaluate whether investment policies ade-

quately provide for the maintenance of a stableincome stream at bank subsidiaries as well asthe 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 assuringthat investment policies and directives are ad-hered to at each corporate level.


Supervision of Subsidiaries(Consolidated Planning Process) Section 2010.4

This section emphasizes the importance of inte-grating subsidiaries into a consolidated plan, theessential elements of the planning process, andthe ultimate accountability of the board of direc-tors of the holding company. As a minimum, theparent’s consolidated plan should include thefollowing ten elements:1. All plans should address a long-range

goal or focus, intermediate term objectives, andshort-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 aservice or customer orientation and marketshare emphasis. These plans provide the entireorganization with a consistent direction andfacilitate changes in the organization arisingfrom environmental changes. Intermediate goalsgenerally are narrower in scope. Short-termbudgets are generally developed at the subsidi-ary level; however, they are subject to reviewand revision by the parent in an effortto maintain consistency throughout theorganization.2. The planning process should be formal-

ized.A long-range focus, intermediate term ob-jectives, and budgets should be written andadopted by the parent’s board of directors toinsure 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 inconsistentwith a long-term goal of increasing marketshare, or short-term compensation plans may bedisfunctional 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 goalsand objectives should be periodically reviewed,preferably, annually, by the BHC’s board ofdirectors. A consolidated plan should reduceunnecessary internal competition.5. A consolidated plan should facilitate the

allocation of resources throughout the organiza-tion. This is particularly important when theparent is providing most, or all, of the short-term funds and long-term capital. As the parenthas an awareness of all subsidiaries, it can betterallocate funds and personnel to areas where theywill 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, flexibilityshould exist for contingency plans.7. Methods should be determined, in the

plan, to monitor and evaluate compliance withthe plan.8. The consolidated plan should have a mea-

surable aspect to determine whether budgets,objectives, and goals are being met.If they arenot met, determination as to the controllabilityof variances should be ascertained.9. Plans and goals must continually be eval-

uated to determine whether accomplishing thegoal results in the desired and expected out-come.For example, the desired outcome may beto increase net income by granting loans withhigher interest rates and above normal risk. Thegranting of such loans may result in a need toincrease 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 plansare too rigid, they may become disfunctional ifthe environment changes and actually constrainan organization’s ability to react. On the otherhand, flexible goals and plans should enhancean organization’s ability to compete by provid-ing the entire organization with a fluid consis-tent direction.


1. To determine if the board of directors atthe 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 andbeneficial.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 flowingfrom the management and financial reportingsystems of the organization.


1. Evaluate the participation by the board ofdirectors of the parent company in giving over-all direction to the organization.2. Obtain and evaluate descriptions of all im-


portant management and financial policies, pro-cedures, and practices.3. Determine if contradictions or ‘‘conflicts’’

between expressed and unexpressed strategiesand between long-term and short-term goalsexist. Also determine that goals are consistentwith concern over safety and soundness.4. Determine whether the planning process is

sufficiently flexible and if contingency plansexist.

5. Spell out the lines of authority associatedwith 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


Supervision of Subsidiaries(Environmental Liability) Section 2010.5

2010.5.1 BACKGROUNDINFORMATION ONENVIRONMENTAL LIABILITY

Banking organizations are increasingly becom-ing exposed to liability associated with theclean-up of hazardous substance contaminationpursuant to, the Comprehensive EnvironmentalResponse, Compensation and Liability Act(‘‘CERCLA’’), the federal superfund statute. Itwas enacted in response to the growing problemof improper handling and disposal of hazardoussubstances. CERCLA authorizes the Environ-mental Protection Agency (‘‘EPA’’) to clean-uphazardous waste sites and to recover costs asso-ciated with the clean-up from entities specifiedin the statute. The superfund statute is theprimary federal law dealing with hazardoussubstance contamination. However, there arenumerous other federal statutes, as well as statestatutes, that establish environmental liabilitythat could place banking organizations at risk.For example, underground storage tanks are alsocovered by separate federal legislation.1

While the superfund statute was enacted adecade ago, it has been only since the mid-1980s that court actions have resulted in somebanking organizations being held liable for theclean-up of hazardous substance contamination.In this connection, recent court decisions havehad a wide array of interpretations as to whetherbanking organizations are owners or operatorsof contaminated facilities, and thereby liableunder 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 tobanking organizations, indicate which personsor entities are subject to liability for clean-upcosts of hazardous substance contamination.These include ‘‘. . . the owner and operator of avessel or a facility, (or) any person who at thetime of disposal of any hazardous substanceowned or operated any facility at which suchhazardous substances were disposed of. . . .’’ 2 Aperson or entity that transports or arranges totransport hazardous substances can also be heldliable for cleaning-up contamination under thesuperfund statute.

The liability imposed by the superfund statuteis strict liability which means the governmentdoes not have to prove that the owners or opera-tors had knowledge of or caused the hazardoussubstance contamination. Moreover, liability isjoint and several, which allows the governmentto seek recovery of the entire cost of theclean-up from any individual party that is liablefor those clean-up costs under CERCLA. In thisconnection, CERCLA does not limit the bring-ing of such actions to the EPA, but permits suchactions 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 ‘‘. . . aperson, who, without participating in the man-agement of a vessel or facility, holds indicia ofownership primarily to protect his security inter-est in the vessel or facility.’’3 However, thisexception has not provided banking organiza-tions with an effective ‘‘safe harbor’’ becauserecent court decisions have worked to limit theapplication of this exemption. Specifically,courts have held that actions by lenders to pro-tect their security interests may result in thebanking organization ‘‘participating in the man-agement’’ of a vessel or facility, thereby voidingthe exemption. Additionally, once the title to aforeclosed property passes to the banking orga-nization, courts have held that the exemption nolonger applies and that the banking organizationis liable under the superfund statute as an‘‘owner’’ of the property. Under some circum-stances, CERCLA may exempt landowners whoacquire property without the knowledge of pre-existing conditions (the so-called ‘‘innocentlandowner defense’’). However, the courts haveapplied a stringent standard to qualify for thisdefense. Because little guidance is provided bythe statute as to what constitutes the appropriatetiming and degree of ‘‘due diligence’’ to suc-cessfully employ this defense, banking organi-zations should exercise caution before relyingon it.

2010.5.2 OVERVIEW OFENVIRONMENTAL 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)..


erated or handled hazardous substances, or other-wise having been associated with the aftermathof subsequent contamination. The following dis-cussion highlights some common environmentalhazards, 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 solventsin the manufacturing process or as waste prod-ucts. For years, these types of hazardous sub-stances were disposed of in land fills, or justdumped on industrial sites. Hazardous sub-stances are also found in many other lines ofbusiness. The following examples demonstratethe 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 lawnchemicals).

• Trucking firms (local and long haul transport-ers of hazardous substances such as fuel orchemicals).

The real estate industry has taken the brunt ofthe adverse affects of hazardous waste contami-nation. In addition to having land contaminatedwith toxic substances, construction methods formajor construction projects, such as commercialbuildings, have utilized materials that have beensubsequently determined to be hazardous, re-sulting in significant declines in their value. Forexample, asbestos was commonly used in com-mercial construction from the 1950’s to the late1970’s. Asbestos has since been found to be ahealth hazard and now must meet certain federaland, in many instances, state requirements forcostly removal or abatement (enclosing or other-wise sealing off).Another common source of hazardous sub-

stance contamination is underground storagetanks. Leaks in these tanks not only contaminatethe surrounding ground, but often flow intoground water and travel far away from the orig-inal contamination site. As contaminationspreads to other sites, clean-up costs escalate.

2010.5.3 IMPACT ON BANKINGORGANIZATIONS

Banking organizations may encounter lossesarising from environmental liability in severalways. The greatest risk to banking organiza-tions, resulting from the superfund statute andother environmental liability statutes, is the pos-sibility of being held solely liable for costlyenvironmental clean-ups such as hazardous sub-stance contamination. If a banking organizationis found to be a responsible party underCERCLA, the banking organization may finditself responsible for cleaning-up a contami-nated site at a cost that far exceeds any outstand-ing loan balance. This risk of loss results froman 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 anyclean-up. Of course, the banking organizationmay attempt to recover such costs from theborrower, or the owner if different than theborrower, provided that the borrower or ownercontinues in existence and is solvent. Bankingorganizations may be held liable for theclean-up of hazardous substance contaminationin situations where the banking organization:

• Takes title to property pursuant to foreclosure;• Involves the banking organization’s personnelor 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 infurther contamination;

• Acts in a fiduciary capacity, including man-agement involvement in the day-to-dayoperations of industrial or commercial con-cerns, and purchasing or selling contaminatedproperty;

• Owns existing, or acquires (by merger or ac-quisition), subsidiaries involved in activitiesthat might result in a finding of environmentalliability;

• 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 officewhere a service station having undergroundstorage tanks once operated. Also, premisesor other real estate owned could be contami-nated by asbestos requiring costly clean-up orabatement.

A more common situation encountered bybanking organizations has been where real prop-

Supervision of Subsidiaries (Environmental Liability) 2010.5


erty collateral is found to be contaminated byhazardous 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 thenecessary funds to remove contaminated materi-als. In making its determination whether to fore-close, the banking organization must estimatethe potential clean-up costs. In many cases thisestimated cost has been found to be well inexcess of the outstanding loan balance, and thebanking organization has elected to abandon itssecurity interest in the property and write off theloan. This situation occurs regardless of the factthat the superfund statute provides a securedcreditor exemption. Some courts have notextended this exemption to situations wherebanking organizations have taken title to a prop-erty pursuant to foreclosure. These rulings havebeen based on a strict reading of the statute thatprovides 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 hazardoussubstances) deteriorates markedly as a result ofbeing required to clean up hazardous substancecontamination. Banking organizations must beaware that significant clean-up costs borne bythe borrower could threaten the borrower’s sol-vency and jeopardize the banking organization’sultimate collection of outstanding loans to thatborrower, regardless of the fact that no realproperty collateral is involved. Therefore, ulti-mate collection of loans to fund operations, or toacquire manufacturing or transportation equip-ment can be jeopardized by the borrower’s gen-erating or handling of hazardous substances inan improper manner. Further, some bankruptcycourts have required clean-up of hazardous sub-stance contamination prior to distribution of adebtor’s estate to secured creditors.Borrowers may have existing subsidiaries or

may be involved in merger and acquisitionactivity that may place the borrower at risk forthe activities of others that result in environmen-tal liability. Some courts have held that for thepurposes of determining liability under the super-fund statute, the corporate veil may not protectparent companies that participate in the day-to-day operations of their subsidiaries from envi-ronmental liability and court imposed clean-upcosts. Additionally, borrowers can be held liablefor contamination which occurred prior to theirowning or using real estate.

2010.5.4 PROTECTION AGAINSTENVIRONMENTAL LIABILITY

Banking organizations have numerous ways toidentify and minimize their exposure to environ-mental liability. Because environmental liabilityis relatively recent, procedures used to safe-guard against such liability are evolving. Thefollowing discussion briefly describes methodscurrently 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 theirexposure to potential environmental liability.Loan policies and procedures should addressmethods for identifying potential environmentalproblems relating to credit requests as well asexisting loans. The loan policy should describean appropriate degree of due diligence investi-gation required for credit requests. Borrowers inhigh-risk industries or localities should be heldto a more stringent due diligence investigationthan borrowers in low-risk industries or locali-ties. In addition to establishing procedures forgranting credit, procedures should be developedand applied to portfolio analysis, credit monitor-ing, loan workout situations, and—prior to tak-ing title to real property—foreclosures. Bankingorganizations may avoid or mitigate potentialenvironmental liability by having sound policiesand procedures designed to identify, assess andcontrol environmental liability.At the same time, banking organizations must

be careful that any lending policies and proce-dures, but especially those undertaken to assessand control environmental liability, cannot beconstrued as taking an active role in participat-ing in the management or day-to-day operationsof the borrower’s business. Activities whichcould be considered active participation in themanagement of the borrower’s business, andtherefore subject the bank to potential liability,include, but are not limited to:

• having bank employees as members of theborrower’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 importantwhen the banking organization is actively in-volved in loan workouts or debt restructuring.


BHC Supervision Manual June 1996Page 3

The first step in identifying and minimizingenvironmental risk is for banking organiza-tions to perform environmental reviews. Suchreviews may be performed by loan officers orothers, and typically identify past practices anduses of the facility and property, evaluate regu-latory compliance, if applicable, and identifypotential future problems. This is accomplishedby interviewing persons familiar with presentand past uses of the facility and property,reviewing relevant records and documents, andvisiting and inspecting the site.Where the environmental review reveals pos-

sible hazardous substance contamination, anenvironmental assessment or audit may be re-quired. Environmental assessments are made bypersonnel trained in identifying potential envi-ronmental hazards and provide a more thoroughreview and inspection of the facility and prop-erty. Environmental audits differ markedly fromenvironmental assessments in that independentenvironmental engineers are employed to inves-tigate, in greater detail, those factors listed pre-viously, and actually test for hazardous sub-stance contamination. Such testing mightrequire collecting and analyzing air samples,surface soil samples, subsurface soil samples, ordrilling wells to sample ground water.Other measures used by some banking orga-

nizations to assist in identifying and minimizingenvironmental liability include: obtaining in-demnities from borrowers for any clean-up costsincurred by the banking organization, andincluding affirmative covenants in loan agree-ments (and attendant default provisions) requir-ing the borrower to comply with all applicableenvironmental regulations. Although these mea-sures may provide some aid in identifying andminimizing potential environmental liability,they are not a substitute for environmentalreviews, assessments and audits, because theireffectiveness is dependent upon the financialstrength of the borrower.

2010.5.5 CONCLUSION

Potential environmental liability can touch on agreat number of loans to borrowers in manyindustries or localities. Moreover, nonlendingactivities as well as corporate affiliations canlead to environmental liability depending uponthe nature of the these activities and the degreeof participation that the parent exercises in theoperations 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 courtordered clean-ups. Additionally, the bankingorganization’s ability to collect the loans itmakes may be hampered by significant declinesin collateral value, or the inability of aborrower to meet debt payments after payingfor costly clean-ups of hazardous substancecontamination.Banking organizations must understand the

nature of environmental liability arising fromhazardous substance contamination. Addition-ally, they should take prudential steps to identifyand minimize their potential environmental lia-bility. Indeed, the common thread to environ-mental liability is the existence of hazardoussubstances, not types of borrowers, lines of busi-ness, or real property.


1. To determine whether adequate safeguardsand controls have been established to limitexposure to potential environmental liability.2. To determine whether the banking organi-

zation has identified specific credits and anylending and other banking and nonbankingactivities that expose the organization to envi-ronmental liability.


1. Review loan policies and procedures andestablish whether these and other adequate safe-guards and controls have been established toavoid or mitigate potential environmental liabil-ity.4 In performing this task, ascertain whether:

a. an environmental policy statement hasbeen adopted;

b. training programs are being conductedso that lending personnel are aware of environ-mental liability issues and are able to identifyborrowers with potential problems;

c. guidelines and procedures have beenestablished for dealing with new borrowers andreal property offered as collateral.

d. the lending policies and procedures andother safeguards, including those to assess andcontrol 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.



2. When reviewing individual credits deter-mine whether the loan policy has been compliedwith in regard to a borrower’s activities orindustry that is associated with hazardous sub-stances or environmental liability.3. Ascertain whether appropriate periodic

analysis of potential environmental liability isconducted.

Such analysis should be more rigorous asthe risk of hazardous substance contaminationincreases. The following are examples of typesof analyses and procedures that should be pro-gressively considered as the risk of environmen-tal liability increases:

• Environmental review—screening of theborrower’s activities by lending personnelor 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, areview of company records for past use ordisposal of hazardous materials, and areview of any relevant Environmental Pro-tection Agency records.

• Environmental assessment—structuredanalysis by aqualifiedindividual that iden-tifies the borrower’s past practices, regula-tory compliance, and potential futureproblems. This analysis would includereviewing relevant documents, visiting andinspecting the site, and, in some cases, per-forming limited tests.

• Environmental audit—a professional envi-ronmental engineer performs a similar

structured analysis as previously indicatedfor ‘‘environmental assessments,’’ however,more comprehensive testing might involvecollecting and analyzing air samples, sur-face soil samples, subsurface soil samples,or drilling wells to sample ground water.

4. Determine whether existing loans arereviewed internally to identify credits havingpotential environmental problems.5. Review recordkeeping procedures and

determine whether there is documentation as tothe due diligence efforts taken at the time ofmaking loans or acquiring real property.6. Review loan agreements to determine if

warranties, representations, and indemnifica-tions have been included in loan agreementsdesigned to protect the banking organizationfrom losses stemming from hazardous substancecontamination. (Although such provisions pro-vide some protection for the lender, these agree-ments are not binding against the government orthird parties. Such contractual protections areonly as secure as the borrower’s financialstrength.)7. For situations involving potential environ-

mental liability arising from a banking organiza-tion’s nonlending activities, verify that similarpolicies and procedures are in place.5

5. A banking organization’s policies and procedures relat-ing to environmental liability should apply to nonlendingsituations where appropriate. For example, banking organiza-tions engaged in trust activities or contemplating a merger oracquisition should evaluate the possibility of existing or sub-sequent environmental liability arising from these activities.



Supervision of Subsidiaries (Financial Institution SubsidiaryRetail Sales of Nondeposit Investment Products) Section 2010.6


Effective July 2009, this section has beenrevised to delete a cancelled SR letter reference.

2010.6.05 INTERAGENCYSTATEMENT OVERVIEW

The Board of Governors of the Federal ReserveSystem, along with the other federal bankingregulators, issued an interagency statement onFebruary 15, 1994, that provides comprehensiveguidance on retail sales of nondeposit invest-ment products occurring on or from depositoryinstitution premises. The interagency statementunifies pronouncements previously issued by thebanking agencies that addressed various aspectsof retail sales programs involving mutual funds,annuities, and other nondeposit investmentproducts.

The interagency statement applies to alldepository institutions, including state memberbanks and the U.S. branches and agencies offoreign banks, supervised by the FederalReserve. The policy statement does not applydirectly to bank holding companies. However,the board of directors and management of bankholding companies should consider and admin-ister the provisions of the statement with regardto the holding company’s supervision of itsbanking and thrift subsidiaries that offer suchproducts to retail customers. Reserve Bankexaminers will continue to review nondepositinvestment product sales activities duringexaminations of institutions engaging in suchactivities on their premises, either directly orthrough a third party or an affiliate. The reviewprocess will consist of, at a minimum, an assess-ment of whether the interagency statement isbeing followed, particularly with regard to thenature and sufficiency of an institution’s disclo-sures, the separation of functions, and the train-ing of personnel involved with the sales ofmutual funds and other nondeposit products.(See SR-94-11.)

The interagency policy statement was furtherclarified by a September 12, 1995, joint interpre-tation (SR-95-46). Section numbers have beenadded for reference.

2010.6.1 INTERAGENCY STATEMENTON RETAIL SALES OF NONDEPOSITINVESTMENT PRODUCTS

Insured depository institutions have expandedtheir activities in recommending or selling suchproducts. Many depository institutions are pro-viding these services at the retail level, directlyor through various types of arrangements withthird parties.

Sales activities for nondeposit investmentproducts should ensure that customers for theseproducts are clearly and fully informed of thenature and risks associated with these products.In particular, where nondeposit investment prod-ucts are recommended or sold to retail custom-ers, depository institutions should ensure thatcustomers are fully informed that the products—

• are not insured by the FDIC;• are not deposits or other obligations of the

institution and are not guaranteed by the insti-tution; and

• are subject to investment risks, including pos-sible loss of the principal invested.

Moreover, sales activities involving theseinvestment products should be designed to mini-mize the possibility of customer confusion andto safeguard the institution from liability underthe applicable antifraud provisions of the fed-eral securities laws, which, among other things,prohibit materially misleading or inaccuraterepresentations in connection with the sale ofsecurities.

The four federal banking agencies—theBoard of Governors of the Federal Reserve Sys-tem, the Federal Deposit Insurance Corporation,the Office of the Comptroller of the Currency,and the Office of Thrift Supervision—issuedthe statement to provide uniform guidance todepository institutions engaging in theseactivities.1

1. Each of the four banking agencies has in the past issuedguidelines addressing various aspects of the retail sale ofnondeposit investment products, which are superseded by thisstatement. Some of the banking agencies had adopted addi-tional guidelines covering the sale of certain specific types ofinstruments by depository institutions, i.e., obligations of theinstitution itself or of an affiliate of the institution.


2010.6.1.1 Scope

This statement applies when retail recommenda-tions or sales of nondeposit investment productsare made by—

• employees of the depository institution;• employees of a third party, which may or may

not be affiliated with the institution,2 occur-ring on the premises of the institution (includ-ing telephone sales or recommendations byemployees or from the institution’s premisesand sales or recommendations initiated bymail from its premises); and

• sales resulting from a referral of retail custom-ers by the institution to a third party when thedepository institution receives a benefit forthe referral.

Retail sales include (but are not limited to)sales to individuals by depository institutionpersonnel or third-party personnel conducted inor adjacent to the institution’s lobby area. Salesof government or municipal securities awayfrom the lobby area are not subject to the inter-agency statement. The statement also applies tosales activities of an affiliated standalonebroker–dealer resulting from a referral of retailcustomers from the depository institution to thebroker–dealer.

These guidelines generally do not apply tothe sale of nondeposit investment products tononretail customers, such as sales to fiduciaryaccounts administered by an institution.3 Thedisclosures provided by the interagency state-ment, however, should be provided to customersof fiduciary accounts where the customer directsinvestments, such as self-directed IRA accounts.Such disclosures need not be made to customers

acting as professional money managers. Fidu-ciary accounts administered by an affiliated trustcompany on the depository institution’s prem-ises should be treated as fiduciary accounts ofthe institution. However, as part of its fiduciaryresponsibility, an institution should take appro-priate steps to avoid potential customer confu-sion when providing nondeposit investmentproducts to the institution’s fiduciary customers.

2010.6.1.2 Adoption of Policies andProcedures

2010.6.1.2.1 Program Management

A depository institution involved in the activi-ties described above for the sale of nondepositinvestment products to its retail customersshould adopt a written statement that addressesthe risks associated with the sales program andcontains a summary of policies and proceduresoutlining the features of the institution’s pro-gram and addressing, at a minimum, the con-cerns described in this statement. The writtenstatement should address the scope of activitiesof any third party involved as well as the proce-dures for monitoring compliance by third partiesin accordance with the guidelines below. Thescope and level of detail of the statement shouldappropriately reflect the level of the institution’sinvolvement in the sale or recommendation ofnondeposit investment products. The institu-tion’s statement should be adopted and reviewedperiodically by its board of directors. Deposi-tory institutions are encouraged to consultwith legal counsel with regard to the implemen-tation of a nondeposit investment product salesprogram.

The institution’s policies and proceduresshould include the following:

Compliance procedures. The procedures forensuring compliance with applicable laws andregulations and consistency with the provisionsof this statement.

Supervision of personnel involved in sales.A designation by senior managers of specificindividuals to exercise supervisory responsibil-ity for each activity outlined in the institution’spolicies and procedures.

Types of products sold. The criteria governingthe selection and review of each type of productsold or recommended.

Permissible use of customer information. Theprocedures for the use of information regardingthe institution’s customers for any purpose in

2. This statement does not apply to the subsidiaries ofinsured state nonmember banks, which are subject to separateprovisions, contained in 12 C.F.R. 337.4, relating to securitiesactivities. For OTS-regulated institutions that conduct sales ofnondeposit investment products through a subsidiary, theseguidelines apply to the subsidiary. 12 C.F.R. 545.74 alsoapplies to such sales. Branches and agencies of U.S. foreignbanks should follow these guidelines with respect to theirnondeposit investment sales programs.

3. Restrictions on a national bank’s use as fiduciary of thebank’s brokerage service or other entity with which the bankhas a conflict of interest, including purchases of the bank’sproprietary and other products, are set out in 12 C.F.R. 9.12.Similar restrictions on transactions between funds held by afederal savings association as fiduciary and any person ororganization with whom there exists an interest that mightaffect the best judgment of the association acting in its fidu-ciary capacity are set out in 12 C.F.R. 550.10.

Supervision of Subsidiaries (Financial Institution Subsidiary Retail Sales of Nondeposit Investment Products) 2010.6


connection with the retail sale of nondepositinvestment products.

Designation of employees to sell investment

products. A description of the responsibilities ofthose personnel authorized to sell nondepositinvestment products and of other personnel whomay have contact with retail customers concern-ing the sales program, and a description of anyappropriate and inappropriate referral activitiesand the training requirements and compensationarrangements for each class of personnel.

2010.6.1.2.2 Arrangements with ThirdParties

If a depository institution directly or indirectly,including through a subsidiary or service corpo-ration, engages in activities as described aboveunder which a third party sells or recommendsnondeposit investment products, the institutionshould, prior to entering into the arrangement,conduct an appropriate review of the third party.The institution should have a written agreementwith the third party that is approved by theinstitution’s board of directors. Compliance withthe agreement should be periodically monitoredby the institution’s senior management. At aminimum, the written agreement should—

• describe the duties and responsibilities of eachparty, including a description of permissibleactivities by the third party on the institution’spremises; terms as to the use of the institu-tion’s space, personnel, and equipment; andcompensation arrangements for personnel ofthe institution and the third party;

• specify that the third party will comply withall applicable laws and regulations, and willact consistently with the provisions of thisstatement and, in particular, with the provi-sions relating to customer disclosures;

• authorize the institution to monitor the thirdparty and periodically review and verify thatthe third party and its sales representativesare complying with its agreement with theinstitution;

• authorize the institution and the appropriatebanking agency to have access to such recordsof the third party as are necessary or appropri-ate to evaluate such compliance;

• require the third party to indemnify the insti-tution for potential liability resulting fromactions of the third party with regard to theinvestment product sales program; and

• provide for written employment contracts, sat-isfactory to the institution, for personnel who

are employees of both the institution and thethird party.

2010.6.1.3 General Guidelines

2010.6.1.3.1 Disclosures and Advertising

The banking agencies believe that recommend-ing or selling nondeposit investment products toretail customers should occur in a manner thatensures that the products are clearly differenti-ated from insured deposits. Conspicuous andeasy-to-comprehend disclosures concerning thenature of nondeposit investment products andthe risk inherent in investing in these productsare one of the most important ways of ensuringthat the differences between nondeposit prod-ucts and insured deposits are understood.

2010.6.1.3.1.1 Content and Form ofDisclosure

Disclosures with respect to the sale or recom-mendation of these products should, at a mini-mum, specify that the product is—

• not insured by the FDIC;• not a deposit or other obligation of, or guaran-

teed by, the depository institution; and• subject to investment risks, including possible

loss of the principal amount invested.

The written disclosures described aboveshould be conspicuous and presented in a clearand concise manner. Depository institutions mayprovide any additional disclosures that furtherclarify the risks involved with particular nonde-posit investment products.

2010.6.1.3.1.2 Timing of Disclosure

The minimum disclosures should be provided tothe customer—

• orally during any sales presentation;• orally when investment advice concerning

nondeposit investment products is provided;• orally and in writing prior to or at the time an

investment account is opened to purchasethese products; and

• in advertisements and other promotionalmaterials, as described below.



A statement, signed by the customer, shouldbe obtained at the time such an account isopened, acknowledging that the customer hasreceived and understands the disclosures. Third-party vendors not affiliated with the depositoryinstitution need not make the minimum disclo-sures on confirmations and account statementsthat contain the name of the depository institu-tion as long as the name of the depository insti-tution is there only incidentally and with a validbusiness purpose, and as long as it is clear onthe face of the document that the broker–dealer,and not the depository institution, has sold thenondeposit investment products. For investmentaccounts established prior to the issuance ofthese guidelines, the institution should considerobtaining such a signed statement at the time ofthe next transaction.

Confirmations and account statements forsuch products should contain at least the mini-mum disclosures if the confirmations or accountstatements contain the name or the logo of thedepository institution or an affiliate.4 If a cus-tomer’s periodic deposit account statementincludes account information concerning thecustomer’s nondeposit investment products, theinformation concerning these products shouldbe clearly separate from the information con-cerning the deposit account and should be intro-duced with the minimum disclosures and theidentity of the entity conducting the nondeposittransaction.

2010.6.1.3.1.3 Advertisements and OtherPromotional Material

Advertisements and other promotional and salesmaterial, written or otherwise, about nondepositinvestment products sold to retail customersshould conspicuously include at least the mini-mum disclosures discussed above and must notsuggest or convey any inaccurate or misleadingimpression about the nature of the product or itslack of FDIC insurance. The minimum disclo-sures should also be emphasized in telemarket-ing contacts. A shorter version of the minimumdisclosures is permitted in advertisements. Thetext of an acceptable logo-format disclosurewould include the following statements:

• not FDIC-insured• no bank guarantee• may lose value

The logo format should be boxed, set in bold-face type, and displayed in a conspicuous man-ner. Radio broadcasts of 30 seconds or less,electronic signs, and signs, such as banners andposters, when used only as location indicators,need not contain the minimum disclosures. Anythird-party advertising or promotional materialshould clearly identify the company selling thenondeposit investment product and should notsuggest that the depository institution is theseller. If brochures, signs, or other written mate-rial contain information about both FDIC-insured deposits and nondeposit investmentproducts, these materials should clearly segre-gate information about nondeposit investmentproducts from the information about deposits.

2010.6.1.3.1.4 Additional Disclosures

Where applicable, the depository institutionshould disclose the existence of an advisory orother material relationship between the insti-tution or an affiliate of the institution and aninvestment company whose shares are sold bythe institution and any material relationshipbetween the institution and an affiliate involvedin providing nondeposit investment products. Inaddition, where applicable, the existence of anyfees, penalties, or surrender charges should bedisclosed. These additional disclosures shouldbe made prior to or at the time an investmentaccount is opened to purchase these products. Ifsales activities include any written or oral repre-sentations concerning insurance coverage pro-vided by any entity other than the FDIC, e.g.,the Securities Investor Protection Corporation(SIPC), a state insurance fund, or a privateinsurance company, then clear and accuratewritten or oral explanations of the coveragemust also be provided to customers when therepresentations concerning insurance coverageare made, in order to minimize possible confu-sion with FDIC insurance. Such representationsshould not suggest or imply that any alternativeinsurance coverage is the same as or similar toFDIC insurance.

Because of the possibility of customer confu-sion, a nondeposit investment product must nothave a name that is identical to the name of thedepository institution. Recommending or sellinga nondeposit investment product with a namesimilar to that of the depository institutionshould only occur pursuant to a sales program

4. These disclosures should be made in addition to anyother confirmation disclosures that are required by law orregulation, e.g., 12 C.F.R. 12 and 344, and 12 C.F.R.208.8(k)(3).



designed to minimize the risk of customerconfusion. The institution should take appro-priate steps to ensure that the issuer of theproduct has complied with any applicablerequirements established by the Securities andExchange Commission regarding the use ofsimilar names.

2010.6.1.3.2 Setting and Circumstances

Selling or recommending nondeposit invest-ment products on the premises of a depositoryinstitution may give the impression that theproducts are FDIC-insured or are obligations ofthe depository institution. To minimize cus-tomer confusion with deposit products, sales orrecommendations of nondeposit investmentproducts on the premises of a depository institu-tion should be conducted in a physical locationdistinct from the area where retail deposits aretaken. Signs or other means should be used todistinguish the investment sales area from theretail deposit-taking area of the institution.However, in the limited situation where physicalconsiderations prevent sales of nondeposit prod-ucts from being conducted in a distinct area, theinstitution has a heightened responsibility toensure appropriate measures are in place tominimize customer confusion.

In no case, however, should tellers and otheremployees, while located in the routine deposit-taking area, such as the teller window, makegeneral or specific investment recommendationsregarding nondeposit investment products,qualify a customer as eligible to purchase suchproducts, or accept orders for such products,even if unsolicited. Tellers and other employeeswho are not authorized to sell nondeposit invest-ment products may refer customers to individu-als who are specifically designated and trainedto assist customers interested in the purchase ofsuch products.

2010.6.1.3.3 Qualifications and Training

The depository institution should ensure that itspersonnel who are authorized to sell nondepositinvestment products or to provide investmentadvice with respect to such products are ade-quately trained with regard to the specific prod-ucts being sold or recommended. Trainingshould not be limited to sales methods, butshould impart a thorough knowledge of theproducts involved, of applicable legal restric-tions, and of customer-protection requirements.If depository institution personnel sell or recom-

mend securities, the training should be thesubstantive equivalent of that required for per-sonnel qualified to sell securities as registeredrepresentatives.5 Depository institution person-nel with supervisory responsibilities shouldreceive training appropriate to that position.Training should also be provided to employeesof the depository institution who have directcontact with customers to ensure a basic under-standing of the institution’s sales activities andthe policy of limiting the involvement ofemployees who are not authorized to sell invest-ment products to customer referrals. Trainingshould be updated periodically and should occuron an ongoing basis.

Depository institutions should investigate thebackgrounds of employees hired for their non-deposit investment products sales programs,including checking for possible disciplinaryactions by securities and other regulators if theemployees have previous investment industryexperience.

2010.6.1.3.4 Suitability and SalesPractices

Depository institution personnel involved inselling nondeposit investment products mustadhere to fair and reasonable sales practices andbe subject to effective management and compli-ance reviews with regard to such practices. Inthis regard, if depository institution personnelrecommend nondeposit investment products tocustomers, they should have reasonable groundsfor believing that the specific product recom-mended is suitable for the particular customeron the basis of information disclosed by thecustomer. Personnel should make reasonableefforts to obtain information directly from thecustomer regarding, at a minimum, the cus-tomer’s financial and tax status, investmentobjectives, and other information that may beuseful or reasonable in making investmentrecommendations to that customer. This infor-mation should be documented and updatedperiodically.

5. Savings associations are not exempt from the definitionsof ‘‘broker’’ and ‘‘dealer’’ in sections 3(a)(4) and 3(a)(5) ofthe Securities Exchange Act of 1934; therefore, all securitiessales personnel in savings associations must be registeredrepresentatives.



2010.6.1.3.5 Compensation

Depository institution employees, includingtellers, may receive a one-time nominal feeof a fixed dollar amount for each customerreferral for nondeposit investment products.The payment of this referral fee should notdepend on whether the referral results in atransaction.

Personnel who are authorized to sell nonde-posit investment products may receive incentivecompensation, such as commissions, for trans-actions entered into by customers. However,incentive compensation programs must not bestructured in such a way as to result in unsuit-able recommendations or sales being made tocustomers.

Depository institution compliance and auditpersonnel should not receive incentive compen-sation directly related to results of the nonde-posit investment sales program.

2010.6.1.3.6 Compliance

Depository institutions should develop andimplement policies and procedures to ensurethat nondeposit investment product sales activi-ties are conducted in compliance with applica-ble laws and regulations, the institution’s inter-nal policies and procedures, and in a mannerconsistent with this statement. Compliance pro-cedures should identify any potential conflictsof interest and how such conflicts should beaddressed. The compliance procedures shouldalso provide for a system to monitor customercomplaints and their resolution. Where applica-ble, compliance procedures also should call forverification that third-party sales are being con-ducted in a manner consistent with the govern-ing agreement with the depository institution.

The compliance function should be conductedindependently of nondeposit investment productsales and management activities. Compliancepersonnel should determine the scope andfrequency of their own review, and findingsof compliance reviews should be periodicallyreported directly to the institution’s board ofdirectors, or to a designated committee of theboard. Appropriate procedures for the non-deposit investment product program shouldalso be incorporated into the institution’s auditprogram.

2010.6.1.4 Supervision by BankingAgencies

The federal banking agencies will continue toreview a depository institution’s policies andprocedures governing recommendations andsales of nondeposit investment products, as wellas management’s implementation and compli-ance with such policies and all other applicablerequirements. The banking agencies will moni-tor compliance with the institution’s policiesand procedures by third parties that participatein the sale of these products. The failure of adepository institution to establish and observeappropriate policies and procedures consistentwith this statement in connection with salesactivities involving nondeposit investment prod-ucts will be subject to criticism and appropriatecorrective action.

2010.6.2 SUPPLEMENTARY FEDERALRESERVE SUPERVISORY ANDEXAMINATION GUIDANCEPERTAINING TO THE SALE OFUNINSURED NONDEPOSITINVESTMENT PRODUCTS

The above guidelines contained in the Inter-agency Statement on Retail Sales of NondepositInvestment Products apply to retail recommen-dations or sales of nondeposit investment prod-ucts made by—

• employees of a banking organization,• employees of an affiliated or unaffiliated third

party occurring on the premises of the bank-ing organization (including telephone sales,investment recommendations by employees,and sales or recommendations initiated bymail from its premises), and

• a referral of retail customers by the institutionto a third party when the depository institutionreceives a benefit for the referral.

The following examination procedures areintended to determine if the bank’s policies andprocedures provide for an operating environ-ment that is designed to ensure customer protec-tions in all facets of the sales program. Further-more, examiners are expected to assess thebank’s ability to conduct such sales activities ina safe and sound manner.

These procedures apply when reviewing thenondeposit investment product retail salesactivities conducted by state member banks orthe state-licensed U.S. branches or agencies offoreign banks. They also apply to such activities



conducted by a bank holding company nonbanksubsidiary on the premises of a bank.6

The Rules of Fair Practice of the FinancialIndustry Regulatory Authority (FINRA) governsales of securities by its member broker–dealers.In addition, the federal securities laws prohibitmaterially misleading or inaccurate representa-tions in connection with the offer or sale ofsecurities7 and require that sales of registeredsecurities be accompanied by a prospectus thatcomplies with Securities and Exchange Com-mission (SEC) disclosure requirements.

In view of the existence of these securitiesrules and laws that are applicable to broker–dealers subject to supervision by the SEC andthe FINRA, examiners should note that theexamination procedures contained herein havebeen tailored to avoid duplication of examina-tion efforts by relying on the most recent exami-nation results or sales-practice review conductedby the FINRA and provided to the third party.To the extent that no such FINRA examinationsor reviews have been completed within thelast two years, Reserve Banks should consultwith Board staff to determine an appropriateexamination/inspection scope before proceedingfurther.

Notwithstanding Reserve System use ofFINRA results of sales-practice reviews, exam-iners should still complete the balance of theseexamination procedures, particularly those per-taining to the separation of sales of nondepositinvestment products from the deposit-takingactivities of the bank. Examiners should deter-mine whether the institution has adequate poli-cies and procedures to govern the conduct of thesales activities on a bank’s premises and, inparticular, whether sales of nondeposit invest-ment products are distinguished from thedeposit-taking activities of the bank throughdisclosure and physical means that are designedto prevent customer confusion.

Although the interagency statement does notapply to sales of nondeposit investment prod-ucts to nonretail customers, such as fiduciary

customers, examiners should apply these exami-nation procedures when retail customers aredirected to the bank’s trust department wherethey may purchase nondeposit investmentproducts simply by completing a customeragreement.

For additional information on the subject ofretail sales of nondeposit investment products,examiners and other interested parties may findit helpful to refer to ‘‘Retail Investment Sales—Guidelines for Banks,’’ February 1994 (industryguidelines), published collectively by six banktrade associations and available from the Ameri-can Bankers Association, 1120 ConnecticutAvenue, N.W., Washington, D.C. 20036.

2010.6.2.1 Program Management

Banking organizations must adopt policies andprocedures governing nondeposit investmentproduct retail sales programs. Such policies andprocedures should be in place before the com-mencement of the retail sale of nondepositinvestment products on bank premises.

The board of directors of a banking organiza-tion is responsible for ensuring that retail salesof nondeposit investment products comply withthe interagency statement (see section 2010.6.1)and all applicable state and federal laws andregulations. Therefore, the board or a designatedcommittee of the board should adopt writtenpolicies that address the risks and managementof such sales programs. Policies and proceduresshould reflect the size, complexity, and volumeof the institution’s activities or, when applica-ble, address the institution’s arrangements withany third parties selling such products on bankpremises. The banking organization’s policiesand procedures should be reviewed periodicallyby the board of directors or its designated com-mittee to ensure that the policies are consistentwith the institution’s current practices, applica-ble laws, regulations, and guidelines.

As discussed in more detail below, an institu-tion’s policies and procedures for nondepositinvestment products should, at a minimum,address disclosure and advertising, physicalseparation of investment sales from deposit-taking activities, compliance and audit, suitabil-ity, and other sales practices and related risksassociated with such activities. In addition, poli-cies and procedures should address the follow-ing areas.

6. The interagency statement and the majority of theseexamination procedures apply to all depository institutions.Many of the procedures, however, may not apply directly tothe inspection of bank holding companies. Some proceduresmay be applicable to bank holding companies from the per-spective of inspecting a bank holding company with regard toits responsibility to supervise its depository institution andholding company nonbank subsidiaries. Depository institutionexamination procedures and bank holding company inspec-tion procedures have been included in this section to keepbank holding company examiners fully informed.

7. See, for example, section 10(b) of the SecuritiesExchange Act (15 U.S.C. 78j(b)) and rule 10b-5 (17 C.F.R.240.10b-5) thereunder.



2010.6.2.1.1 Types of Products Sold

When evaluating nondeposit investment prod-ucts, management should consider what prod-ucts best meet the needs of customers. Policiesshould outline the criteria and procedures thatwill be used to select and periodically reviewnondeposit investment products that are recom-mended or sold on a depository institution’spremises. Institutions should periodically reviewproducts offered to ensure that they meet theircustomers’ needs.

2010.6.2.1.2 Use of Identical or SimilarNames

Because of the possibility of customer confu-sion, a nondeposit investment product must nothave a name that is identical to the name of abank or its affiliates. However, a bank may sell anondeposit investment product with a namesimilar to the bank’s as long as the sales pro-gram addresses the even greater risk that cus-tomers may regard the product as an insureddeposit or other obligation of the bank. More-over, the bank should review the issuer’s dis-closure documents for compliance with SECrequirements, which call for a thorough explana-tion of the relationship between the bank andthe mutual fund.

The Federal Reserve applies a stricter ruleunder Regulation Y (12 C.F.R. 225.125) when abank holding company (as opposed to a bank)or nonbank subsidiary acts as an investmentadviser to a mutual fund. In such a case, thefund may not have a name that is identical to,similar to, or a variation of the name of the bankholding company or a subsidiary bank.

2010.6.2.1.3 Permissible Use ofCustomer Information

Banking organizations should adopt policies andprocedures regarding the use of confidential cus-tomer information for any purpose in connec-tion with the sale of nondeposit investmentproducts. The industry guidelines permit banksto share with third parties only limited customerinformation, such as name, address, telephonenumber, and types of products owned. It doesnot permit the sharing of more confidentialinformation, such as specific or aggregate dollaramounts of investments, net worth, etc., without

the customer’s prior acknowledgment and writ-ten consent.

2010.6.2.1.4 Arrangements with ThirdParties

A majority of all nondeposit investment prod-ucts sold on bank premises are sold by represen-tatives of third parties. Under such arrange-ments, the third party has access to theinstitution’s customers, while the bank is able tomake nondeposit investment products availableto interested customers without having to com-mit the resources and personnel necessary todirectly sell such products. Third parties includewholly owned subsidiaries of a bank, bank-affiliated broker–dealers, unaffiliated broker–dealers, insurance companies, or other compa-nies in the business of distributing nondepositinvestment products on a retail basis.

A banking institution should conduct a com-prehensive review of an unaffiliated third partybefore entering into any arrangement. Thereview should include an assessment of the thirdparty’s financial status, management experience,reputation, and ability to fulfill its contractualobligations to the bank, including compliancewith the interagency statement.

The interagency statement calls for banks toenter into written agreements with any affiliatedand unaffiliated third parties that sell nondepositinvestment products on a bank’s premises. Suchagreements should be approved by a bank’sboard of directors or its designated committee.Agreements should outline the duties andresponsibilities of each party; describe third-party activities permitted on bank premises;address the sharing or use of confidential cus-tomer information for investment sales activi-ties; and define the terms for use of the institu-tion’s office space, equipment, and personnel. Ifan arrangement includes dual employees, theagreement must provide for written employmentcontracts that specify the duties of such employ-ees and their compensation arrangements.

In addition, a third-party agreement shouldspecify that the third party will comply with allapplicable laws and regulations and will con-duct its activities in a manner consistent withthe interagency statement. The agreementshould authorize the bank to monitor the thirdparty’s compliance with its agreement, andauthorize the institution and Federal Reserveexamination staff to have access to third-partyrecords considered necessary to evaluate suchcompliance. These records should includeexamination results, sales-practice reviews, and



related correspondence provided to the thirdparty by securities regulatory authorities.Finally, an agreement should provide for indem-nification of the bank by an unaffiliated thirdparty for the conduct of its employees inconnection with sales activities.

Notwithstanding the provisions of a third-party agreement, a bank should monitor theconduct of nondeposit investment product salesprograms to ensure that sales of nondepositinvestment products are distinct from other bankactivities and are not conducted in a manner thatcould confuse customers about the lack of insur-ance coverage for such investments.

2010.6.2.1.5 Contingency Planning

Nondeposit investment products are subject toprice fluctuations caused by changes in interestrates, stock market valuations, etc. In the eventof a sudden, sharp drop in the market value ofnondeposit investment products, banking insti-tutions may experience a heavy volume of cus-tomer inquiries, complaints, and redemptions.Management should develop contingency plansto address these situations. A major element ofany contingency plan should be the provision ofcustomer access to information pertaining totheir investments. Other factors to consider incontingency planning include public relationsand the ability of operations staff to handleincreased volumes of transactions.

2010.6.2.2 Disclosures and Advertising

2010.6.2.2.1 Content, Form, and Timingof Disclosure

Nondeposit investment product sales programsshould be conducted in a manner that ensuresthat customers are clearly and fully informed ofthe nature and risks associated with these prod-ucts. In addition, nondeposit investment prod-ucts must be clearly differentiated from insureddeposits. The interagency statement identifiesthe following minimum disclosures that must bemade to customers when providing investmentadvice, making investment recommendations,or effecting nondeposit investment producttransactions:

• They are not insured by the Federal DepositInsurance Corporation (FDIC).

• They are not deposits or other obligations ofthe depository institution and are not guaran-teed by the depository institution.

• They are subject to investment risks, includ-ing the possible loss of the principal invested.

Disclosure is the most important way ofensuring that retail customers understand thedifferences between nondeposit investmentproducts and insured deposits. It is critical thatthe minimum disclosures be presented clearlyand concisely in both oral and written communi-cations. In this regard, the minimum disclosuresshould be provided—

• orally during any sales presentations (includ-ing telemarketing contacts) or when invest-ment advice is given,

• orally and in writing before or at the time aninvestment account to purchase these prod-ucts is opened, and

• in all advertisements and other promotionalmaterials (as discussed further below).

The minimum disclosures may be made on acustomer-account agreement or on a separatedisclosure form. The disclosures must be con-spicuous (highlighted through bolding, boxes,or a larger typeface). Disclosures containeddirectly on a customer-account agreementshould be located on the front of the agreementor adjacent to the customer signature block.

Banking organizations are to obtain a writtenacknowledgment—on the customer-accountagreement or on a separate form—from a cus-tomer confirming that the customer has receivedand understands the minimum disclosures. Fornondeposit investment product accounts estab-lished before the interagency statement, bank-ing organizations should obtain a disclosureacknowledgment from the customer at the timeof the customer’s next purchase transaction. Ifan institution solicits customers by telephone ormail, it should ensure that the customers receivethe written disclosures and an acknowledgmentto be signed and returned to the institution.

Customer-account statements (including com-bined statements for linked accounts) and tradeconfirmations that are provided by the bank oran affiliate should contain the minimum disclo-sures if they display the name or logo of thebank or its affiliate. Statements that provideaccount information about insured deposits andnondeposit investment products should clearlysegregate the information about nondepositinvestment products from the information aboutdeposits to avoid customer confusion.



2010.6.2.2.2 Advertising

The interagency statement provides that adver-tisements in all media forms that identifyspecific investment products must conspicu-ously include the minimum disclosures andmust not suggest or convey any inaccurate ormisleading impressions about the nature of anondeposit investment product. Promotionalmaterial that contains information about bothFDIC-insured products and nondeposit invest-ment products should clearly segregate theinformation about the two product types. Dis-plays of promotional sales materials related tonondeposit investment products in a bank’sretail areas should be grouped separately frommaterial related to insured bank products.

Examiners should review telemarketingscripts to determine whether bank personnel aremaking inquiries about customer investmentobjectives, offering investment advice, or identi-fying particular investment products or types ofproducts. In such cases, the scripts must containthe minimum disclosures. Bank personnel rely-ing on the scripts must be formally authorized tosell nondeposit investment products by theiremployers and must have training that is thesubstantive equivalent of that required for per-sonnel qualified to sell securities as registeredrepresentatives (see the discussion on trainingbelow).

2010.6.2.2.3 Additional Disclosures

A depository institution should apprise cus-tomers of certain material relationships. Forexample, sales personnel should inform acustomer orally and in writing before the saleabout any advisory relationship existing be-tween the bank (or an affiliate) and a mutualfund whose shares are being sold by the depos-itory institution. Similarly, sales personnelshould disclose fees, penalties, or surrendercharges associated with a nondeposit invest-ment product orally and in writing before orat the time the customer purchases the prod-uct. The SEC requires written disclosure ofthis information in the investment product’sprospectus.

If sales activities include any written or oralrepresentations concerning insurance coverageby any entity other than the FDIC (for example,Securities Investor Protection Corporation(SIPC) insurance of broker–dealer accounts, a

state insurance fund, or a private insurancecompany), then clear and accurate explanationsof the coverage must also be provided to cus-tomers at that time to minimize possible con-fusion with FDIC insurance. Such disclosuresshould not suggest that other forms of insuranceare the substantive equivalent to FDIC depositinsurance.

2010.6.2.3 Setting and Circumstances

2010.6.2.3.1 Physical Separation fromDeposit Activities

Selling or recommending nondeposit invest-ment products on the premises of a bankinginstitution may give the impression that theproducts are FDIC-insured or are obligations ofthe bank. To minimize customer confusion withdeposit products, nondeposit investment prod-uct sales activities should be conducted in alocation that is physically distinct from the areaswhere retail deposits are taken. Bank employeeslocated at teller windows may not provideinvestment advice, make investment recommen-dations about investment products, or acceptorders (even unsolicited orders) for nondepositinvestment products.

Examiners must evaluate the particular cir-cumstances of each bank in order to form anopinion about whether nondeposit investmentproduct sales activities are sufficiently separatefrom deposit activities. FDIC insurance signsand promotional material related to FDIC-insured deposits should be removed from theinvestment-product sales area and replaced withsigns indicating that the area is for the sale ofinvestment products. Signs referring to specificinvestments should prominently contain theminimum disclosures. In the limited situationwhere physical constraints prevent nondepositinvestment product sales activities from beingconducted in a distinct and separate area, theinstitution has a heightened responsibility toensure that appropriate measures are taken tominimize customer confusion.

A bank that enters into a third-party broker-age arrangement with a broker or dealer regis-tered under the Securities Exchange Act of 1934(the 1934 Act) will not itself be considered to bea broker subject to registration under the 1934Act if the bank complies with the nine require-ments set forth in section 3(a)(4)(B) of the 1934Act. These requirements include clear identifi-cation of the broker or dealer as the personproviding the brokerage services; clear physicalseparation of deposit-taking activities from bro-



kerage transactions; prohibition of bank employ-ees’ receiving incentive compensation based onbrokerage transactions; limitation of bankemployees to clerical or ministerial functionswith respect to brokerage transactions; and spe-cific disclosures and other requirements. Failureby a bank to comply with these requirementswill not automatically require the bank to regis-ter but brings into question the exemption of thebank from the registration requirements of the1934 Act.

Business cards for designated sales personnelshould clearly indicate that they sell nondepositinvestment products or, if applicable, areemployed by a broker–dealer.

The interagency statement was intended togenerally cover sales made to retail customersin a bank’s lobby. However, some banks mayhave an arrangement whereby retail customerspurchase nondeposit investment products at alocation generally confined to institutional ser-vices (such as the corporate money desk). Insuch cases, the banking institutions should stillensure that retail customers receive the mini-mum disclosures to minimize any possible cus-tomer confusion about nondeposit investmentproducts and insured deposits.

2010.6.2.3.2 Hybrid Instruments andAccounts

In cases in which a depository institution offersaccounts that link traditional bank deposits withnondeposit investment products, such as a cashmanagement account,8 the accounts should beopened at the investment sales area by trainedpersonnel. In light of the hybrid characteristicsof these products, the opportunity for customerconfusion is amplified, so the depository institu-tion must take special care in the account-opening process to ensure that a customer isaccurately informed that—

• funds deposited into a sweep account willonly be FDIC-insured until they are sweptinto a nondeposit investment product accountand

• customer-account statements may disclosebalances for both insured and nondepositproduct accounts.

2010.6.2.4 Designation, Training, andSupervision of Sales Personnel andPersonnel Making Referrals

2010.6.2.4.1 Hiring and Training of SalesPersonnel

Banking organizations hiring sales personnel fornondeposit investment product programs shouldinvestigate the backgrounds of prospectiveemployees. In cases in which candidates foremployment have previous investment industryexperience, the bank should check whether theindividual has been the subject of any disci-plinary actions by securities, state, or otherregulators.

Unregistered bank sales personnel shouldreceive training that is the substantive equiva-lent of that provided to personnel qualified tosell securities as registered representatives.Training should cover the areas of productknowledge, trading practices, regulatoryrequirements and restrictions, and customer-protection issues. In addition, training programsshould cover the institution’s policies and proce-dures regarding sales of nondeposit investmentproducts and should be conducted continually toensure that staff are kept abreast of new prod-ucts and compliance issues.

Bank employees whose sales activities arelimited to mutual funds or variable annuitiesshould receive training equivalent to that ordi-narily needed to pass FINRA’s Series 6 limitedrepresentative examination, which typicallyinvolves approximately 30 to 60 hours of prepa-ration, including about 20 hours of classroomtraining. Bank employees who are authorized tosell additional investment products and securi-ties should receive training that is appropriate topass the NYSE’s Series 7 general securitiesrepresentative examination, which typicallyinvolves 160 to 250 hours of study, including atleast 40 hours of classroom training.

The training of third-party or dual employeesis the responsibility of the third party. Whenentering into an agreement with a third party, abanking organization should be satisfied that thethird party is able to train third-party and dualemployees about compliance with the minimumdisclosures and other requirements of theinteragency statement. The bank should obtainand review copies of third-party training andcompliance materials in order to monitor thethird party’s performance regarding its trainingobligations.

8. A hybrid account may incorporate deposit and broker-age services, credit/debit card features, and automated sweeparrangements.



2010.6.2.4.2 Training of Bank PersonnelWho Make Referrals

Bank employees, such as tellers and platformpersonnel, who are not authorized to provideinvestment advice, make investment recommen-dations, or sell nondeposit investment productsbut who may refer customers to authorizednondeposit investment products sales personnel,should receive training regarding the strict limi-tations on their activities. In general, bank per-sonnel who are not authorized to sell nondepositinvestment products are not permitted to dis-cuss general or specific investment products,prequalify prospective customers as to financialstatus and investment history and objectives,open new accounts, or take orders on a solicitedor unsolicited basis. Such personnel may con-tact customers for the purposes of—

• determining whether the customer wishes toreceive investment information;

• inquiring whether the customer wishes todiscuss investments with an authorized salesrepresentative; and

• arranging appointments to meet with autho-rized bank sales personnel or third-partybroker–dealer registered sales personnel.

The minimum disclosure guidelines do notapply to referrals made by personnel not autho-rized to sell nondeposit investment products ifthe referral does not provide investment advice,identify specific investment products, or makeinvestment recommendations.

2010.6.2.4.3 Supervision of Personnel

Banking institution policies and proceduresshould designate, by title or name, the indi-viduals responsible for supervising nondepositinvestment product sales activities, as well asreferral activities initiated by bank employeesnot authorized to sell these products. Personnelassigned responsibility for management of salesprograms for these products should have super-visory experience and training equivalent to thatrequired of a general securities principal asrequired by the FINRA for broker–dealers.Supervisory personnel should be responsible forthe institution’s compliance with policies andprocedures on nondeposit investment products,applicable laws and regulations, and the inter-agency statement. When sales of these products

are conducted by a third party, supervisory per-sonnel should be responsible for monitoringcompliance with the agreement between thebank and the third party, as well as compliancewith the interagency statement, particularly theguideline calling for nondeposit investmentproduct sales to be separate and distinct fromthe deposit activities of the bank.

2010.6.2.5 Suitability and Sales Practices

2010.6.2.5.1 Suitability ofRecommendations

Suitability refers to the matching of customerfinancial means and investment objectives witha suitable product. If customers are placed intounsuitable investments, the resulting loss of con-sumer confidence could have detrimental effectson an institution’s reputation. Many first-timeinvestors may not fully understand the risksassociated with nondeposit investment productsand may assume that the banking institution isresponsible for the preservation of the principalof their investment.

Banking institutions that sell nondepositinvestment products directly to customersshould develop detailed policies and proce-dures addressing the suitability of investmentrecommendations and related record-keepingrequirements. Sales personnel who recommendnondeposit investment products to customersshould have reasonable grounds for believingthat the products recommended are suitablefor the particular customer on the basis of infor-mation provided by the customer. A reasonableeffort must be made to obtain, record, andupdate information concerning the customer’sfinancial profile (such as tax status, otherinvestments, income), investment objectives,and other information necessary to makerecommendations.

In determining whether sales personnel aremeeting their suitability responsibilities, exam-iners should review the practices for conform-ance with the banking institution’s policies andprocedures. The examiner’s review shouldinclude a sample of customer files to determinethe extent of customer information collected,recorded, and updated (for subsequent pur-chases), and whether investment recom-mendations appear unsuitable in light of suchinformation.

Nondeposit investment product sales pro-grams conducted by third-party broker–dealersare subject to FINRA’s suitability and other



sales-practice rules. To avoid duplicatingFINRA examination efforts, examiners shouldrely on FINRA’s most recent sales-practicereview of the third party, when available. Tothe extent that no such FINRA review hasbeen completed within the last two years,Reserve Banks should consult with Board staffto determine an appropriate examination scopefor suitability compliance before proceedingfurther.

2010.6.2.5.2 Sales Practices

The banking organization should have policiesand procedures that address undesirable prac-tices by sales personnel intended to generateadditional commission income through thechurning or switching of accounts from oneproduct to another.

2010.6.2.5.3 Customer Complaints

The banking organization should have policiesand procedures for handling customer com-plaints related to nondeposit investment prod-ucts. The process should provide for the record-ing and tracking of all complaints and requireperiodic reviews of complaints by compliancepersonnel. The merits and circumstances of eachcomplaint (including all documentation relatingto the transaction) should be considered whendetermining the proper form of resolution.Reasonable timeframes should be establishedfor addressing complaints.

2010.6.2.6 Compensation

Incentive compensation programs specificallyrelated to the sale of nondeposit investmentproducts may include sales commissions,limited fees for referring prospective cus-tomers to an authorized sales representative, andnonmonetary compensation (prizes, awards, andgifts). Compensation that is paid by unaffili-ated third parties (such as mutual fund distribu-tors) to banking organization staff must beapproved in writing by bank management; beconsistent with the bank’s written internal codeof conduct relating to the acceptance ofremuneration from third parties; and beconsistent with the proscriptions of the BankBribery Act (18 U.S.C. 215) and the bankingagencies’ implementing guidelines to that act(see 52Federal Register 39277, October 21,

1987). Compensation policies should establishappropriate limits on the extent of compensa-tion that may be paid to banking organizationstaff by unaffiliated third parties.

Incentive compensation programs must notbe structured in such a way as to result inunsuitable investment recommendations or salesto customers. In addition, if sales personnel sellboth deposit and nondeposit products, similarfinancial incentives should be in place for salesof both types of products. A compensation pro-gram that offers significantly higher remunera-tion for selling a specific product (for example,a proprietary mutual fund) may be inappropriateif it results in unsuitable recommendations tocustomers. A compensation program that isintended to provide remuneration for a group ofbank employees (such as a branch or depart-ment) is permissible as long as the program isbased on the overall performance of the groupin meeting bank objectives regarding a broadvariety of bank services and products, and is notbased principally on the volume of sales onnondeposit investment products.

Individual bank employees, such as tellers,may receive a one-time nominal fee of a fixeddollar amount for referring customers to autho-rized sales personnel to discuss nondepositinvestment products. However, the payment ofthe fee should not depend on whether the refer-ral results in a transaction. Nonmonetary com-pensation to bank employees for referrals shouldbe similarly structured.

Auditors and compliance personnel shouldnot participate in incentive compensation pro-grams directly related to the results of non-deposit investment product sales programs.

2010.6.2.7 Compliance

Institutions must develop and maintain writtenpolicies and procedures that effectively monitorand assess compliance with the interagencystatement and other applicable laws and regula-tions and ensure appropriate follow-up to cor-rect identified deficiencies. Compliance pro-grams should be independent of sales activitieswith respect to scheduling, compensation, andperformance evaluations. Compliance personnelshould periodically report compliance findingsto the institution’s board of directors or a desig-nated committee of the board as part of theboard’s ongoing oversight of nondeposit invest-ment product activities. Compliance personnel

Supervision of Subsidiaries (Financial Institution Subsidiary Retail Sales of Nondeposit Investment Products)2010.6


should have appropriate training and experiencewith nondeposit investment product sales pro-grams, applicable laws and regulations, and theinteragency statement.

Banking organizations should institute com-pliance programs for nondeposit investmentproducts that are similar to those of securitiesbroker–dealers. This includes a review of newaccounts and a periodic review of transactionsin existing accounts to identify any potentialabusive practices, such as unsuitable recommen-dations or churning or switching practices.Compliance personnel should also oversee theprompt resolution of customer complaints andreview complaint logs for questionable salespractices. Compliance personnel should useMIS reports on early redemptions and salespatterns for specific sales representatives andproducts to identify any potentially abusivepractices. In addition, referral activities of bankpersonnel should be reviewed to ensure thatthey are conducted in a manner that conforms tothe guidelines in the interagency statement.

When nondeposit investment products aresold by third parties on bank premises, thebank’s compliance program should provide foroversight of the third party’s compliance withits agreement with the bank, including conform-ance to the disclosure and separate facilitiesguidelines of the interagency statement. Theresults of such oversight should be reported tothe board of directors or to a designated commit-tee of the board. Management should promptlyobtain the third party’s commitment to correctidentified problems. Proper follow-up by thebank’s compliance personnel should verify thethird party’s corrective actions.

2010.6.2.8 Audit

Audit personnel should be responsible forassessing the effectiveness of the depositoryinstitution’s compliance function and overallmanagement of the nondeposit investment prod-uct sales program. The scope and frequency ofaudit’s review of nondeposit investment productactivities will depend on the complexity andsales volume of a sales program, and whetherthere are any indications of potential or actualproblems. Audits should cover all of the issuesdiscussed in the interagency statement. Internalaudit staff should be familiar with nondepositinvestment products and receive ongoing train-ing. Audit personnel should report their findings

to the board of directors or a designated commit-tee of the board, and proper follow-up should beperformed. Audit activities with respect to thirdparties should include a review of their compli-ance function and the effectiveness of the bank’soversight of the third party’s activities.

2010.6.2.9 Joint Interpretations of theInteragency Statement

In response to a banking association’s inquiry,the banking supervisory agencies issued on Sep-tember 12, 1995, joint interpretations regardingthe February 1994 Interagency Statement onRetail Sales of Nondeposit Investment Productsby banking and thrift organizations, previouslydiscussed. The agencies also authorized the useof alternative abbreviated minimum disclosuresfor advertisements. The alternative minimumdisclosures need not be made at all in certaintypes of advertisements. The use of abbreviateddisclosures offers an optional alternative to thelonger disclosures prescribed by the interagencystatement.

2010.6.2.9.1 Disclosure Matters

The agencies agreed that there are limited situa-tions in which the disclosure guidelines neednot apply or where a shorter logo format may beused in lieu of the longer written disclosurescalled for by the interagency statement.

The interagency statement disclosures do notneed to be provided in the following situations:

• radio broadcasts of 30 seconds or less• electronic signs9

• signs, such as banners and posters, when usedonly as location indicators

Additionally, third-party vendors not affili-ated with the depository institution need notmake the interagency statement disclosures onnondeposit investment product confirmationsand in account statements that may incidentally,with a valid business purpose, contain the nameof the depository institution.

The banking agencies have been askedwhether shorter, logo-format disclosures may beused in visual media, such as television broad-casts, ATM screens, billboards, signs, and post-

9. ‘‘ Electronic signs’’ may include billboard-type signsthat are electronic, time and temperature signs, and ticker-tapesigns. Electronic signs would not include media such astelevision, online services, or ATMs.



ers, and in written advertisements and promo-tional materials, such as brochures. The text ofan acceptable logo-format disclosure wouldinclude the following statements:

• not FDIC-insured

• no bank guarantee

• may lose value

The logo-format disclosures would be boxed,set in boldface type, and displayed in a con-spicuous manner. The full disclosures prescribedby the interagency statement should continue tobe provided in written acknowledgment formsthat are signed by customers. An example of anacceptable logo disclosure is—

NOTFDIC-INSURED

May lose

value

No bankguarantee

2010.6.2.9.2 Joint Interpretations onRetail Sales of Nondeposit InvestmentProducts

The banking agencies’ joint statement alsoaddressed the following:

• Sales from lobby area presumed retail. Retailsales include (but are not limited to) sales toindividuals by depository institution person-nel or third-party personnel conducted in oradjacent to a depository institution’s lobbyarea. Sales activities occurring in anotherlocation of a depository institution may alsobe retail sales activities covered by the inter-agency statement depending on the facts andcircumstances.

• Government or municipal securities dealers

or desks. Sales of government and muni-cipal securities made in a depository institu-tion’s dealer department that is located awayfrom the lobby area are not subject to theinteragency statement. Such departments arealready regulated by the banking agencies andare subject to the statutory requirements forregistration of government and municipalsecurities brokers and dealers. Further, suchbrokers and dealers are subject to sales-practice and other regulations of the Depart-

ment of the Treasury, the SEC, and designatedsecurities self-regulatory organizations.

• Fiduciary accounts, affiliated trust com-

panies, and custodian accounts. Theinteragency statement generally does notapply to fiduciary accounts administered by adepository institution. However, for fiduciaryaccounts in which the customer directs invest-ments, such as self-directed individual retire-ment accounts, the disclosures prescribed bythe interagency statement should be provided.Nevertheless, disclosures need not be made tocustomers acting as professional moneymanagers. Fiduciary accounts administered byan affiliated trust company on the depositoryinstitution’s premises would be treated thesame way as the fiduciary accounts of theinstitution.

With respect to custodian accounts main-tained by a depository institution, the inter-agency statement does not apply to traditionalcustodial activities, for example, collectinginterest and dividend payments for securitiesheld in the accounts or handling the deliveryor collection of securities or funds in connec-tion with a transaction.

• Affiliated standalone broker–dealers. Thestatement applies specifically to sales of non-deposit investment products on the premisesof a depository institution, for example, when-ever sales occur in the lobby area. The state-ment also applies to sales activities of anaffiliated standalone broker–dealer resultingfrom a referral of retail customers by thedepository institution to the broker–dealer.

2010.6.3 INSPECTION/EXAMINATIONOBJECTIVES

1. To determine that the banking organizationhas taken appropriate measures to ensure thatretail customers clearly understand the differ-ences between insured deposits and non-deposit investment products and receive theminimum disclosures both orally during salespresentations (including telemarketing) andin writing.

2. To assess the adequacy of the institution’spolicies and procedures, sales practices, andoversight by management and the board ofdirectors to ensure an operating environmentthat fosters customer protection in all facetsof the sales program.

3. To ensure that the sales program is con-



ducted in a safe and sound manner that is incompliance with the interagency statement,Federal Reserve guidelines, regulations, andapplicable laws.

4. To assess the effectiveness of the institu-tion’s compliance and audit programs fornondeposit investment product operations.

5. To obtain commitments for corrective actionwhen policies, procedures, practices, or man-agement oversight is deficient or the institu-tion has failed to comply with the inter-agency statement or applicable laws andregulations.

2010.6.4 INSPECTION/EXAMINATIONPROCEDURES

2010.6.4.1 Scope of the Procedures

These procedures are based on the guidelinesoutlined in the interagency statement. Theinteragency statement applies to all bankingorganizations, including state member banksand the U.S. branches and agencies of foreignbanks supervised by the Federal Reserve.

These examination procedures are intended tobe used when examining a state member bank(or a state-licensed U.S. branch or agency of aforeign bank) that engages directly in the retailsale of nondeposit investment products.

This set of examination procedures is alsomeant to be used in conjunction with otherprocedures in this manual when examining anonbank subsidiary that sells nondeposit invest-ment products on bank premises. See the follow-ing sections for related examination procedures:

• Section 3130.1: Section 4(c)(8) of the BHCAct—Investment or Financial Advisers

• Section 3230.0: Section 4(c)(8) of the BHCAct—Securities Brokerage

• Section 3600.27: Providing Administrativeand Certain Other Services to Mutual Funds

Program Management and Organization

1. Evaluate the institution’s structure andreporting lines (legal and functional) forits retail nondeposit investment productsoperations. Determine whether retail salesof nondeposit investment products are beingmade directly by employees of the deposi-tory institution or through an affiliated or

unaffiliated third party. Identify the princi-pals responsible for the management of thenondeposit investment products sales pro-gram. Review their backgrounds, qualifica-tions, and tenure with the institution.

2. Determine the role of the board of directorsof each legal entity involved in the sale ofnondeposit investment products in authoriz-ing and controlling nondeposit investmentproducts activities on bank premises. Evalu-ate the adequacy of MIS reports relied onby the board (or a designated committee)and senior management to manage theseactivities.

3. Describe the membership and responsibili-ties of management or board committeesfor nondeposit investment product retailsales programs. Review the minutes main-tained by these committees for informationrelated to the conduct of retail nondepositinvestment product sales programs.

4. Review and evaluate the institution’s poli-cies and procedures, objectives, and budgetfor nondeposit investment products activi-ties. In so doing, consider the following:a. who prepared the materialb. how it fits into the institution’s overall

strategic objectivesc. whether the goals and objectives are

realisticd. whether actual results are routinely com-

pared to plans and budgets5. Determine how policies and procedures for

nondeposit investment products activitiesare developed and at what level in the insti-tution they are formally approved. Reviewthe policies and procedures to see that theyare consistent with the interagency state-ment and address the following matters:a. disclosure and advertisingb. physical separation from deposit-taking

activitiesc. compliance programs and internal auditd. hiring, training, supervision, and com-

pensation practices for sales staff andpersonnel making referrals

e. types of products offered, selectioncriteria

f. restrictions on a mutual fund’s use ofnames similar or identical to that of thebank holding company or its subsidiarybanks

g. suitability and sales practicesh. use of customer informationi. transactions with affiliated partiesj. role of third parties, if applicable

6. Determine how management oversees com-



pliance with the policies and procedures initem 5.

7. Review the product selection and develop-ment process to ensure that it considerscustomer needs and investment objectives.

8. Determine if the depository institution iscovered by blanket bond insurance applica-ble to nondeposit investment product retailsales activities.

9. If the institution sells proprietary nonde-posit investment products and performsrelated back-office operations, review—a. the work flow and position responsibili-

ties within the sales and operations func-tion, and

b. available flow charts, job descriptions,and policies and procedures.After discussions with management,

conduct a walk-through, tracing the pathof a typical transaction. Evaluate theeffectiveness and efficiency of the workflow and the overall operation.

10. Determine whether the institution hasestablished any contingency plans for han-dling adverse events affecting nondepositinvestment product programs, such as asudden market downturn or period of heavyredemptions.

11. Review the institution’s earnings and evalu-ate the—a. profitability of nondeposit investment

products activities, including any invest-ment advisory fees it may receive, and

b. income and expense from the sales,investment advisory, and proprietaryfund management activities related tonondeposit investment products, as apercentage of non-interest income andexpense.

Disclosures and Advertising

The interagency statement identifies certainminimum disclosures that must be made to cus-tomers. The disclosures must state that non-deposit investment products—

• are not insured by the FDIC;• are not deposits or other obligations of the

institution and are not guaranteed by the insti-tution; and

• are subject to investment risks, including thepossible loss of the principal invested.

12. Determine whether the minimum disclo-sures are being provided orally to custom-ers during sales presentations (including

telemarketing contacts) or when givinginvestment advice on specific investmentproducts.

13. Determine if the customer-account agree-ment (or a separate disclosure form)presents the minimum disclosures clearlyand conspicuously. The disclosures shouldbe prominent (highlighted through bold-ing, boxes, or a larger typeface) and shouldbe located on the front of the customer-account agreement or adjacent to the cus-tomer signature block.

14. Determine whether customers sign anacknowledgment that they have receivedand understand the minimum disclosures.The acknowledgment can be on thecustomer-account agreement or it can be ona separate disclosure form. Determine ifcustomers who opened accounts before theinteragency statement was issued receivethe written minimum disclosures andacknowledge receipt at the time of theirnext transaction. Review a sample of cus-tomer accounts to determine whether cus-tomers received the minimum oral andwritten disclosures.

15. When sales confirmations or account state-ments provided by the bank or an affiliatebear the name or logo of the bank or anaffiliate, determine whether the minimumdisclosures are conspicuously displayed onthe front of the documents.

16. Review advertisements and promotionalmaterial that identify specific nondepositinvestment products to determine whetherthey conspicuously display the minimumdisclosures or the abbreviated logo-formatdisclosures. Any materials that containinformation about insured deposits and non-deposit investment products should clearlysegregate the information about investmentproducts from the information aboutdeposits.

17. Review telemarketing material used tosolicit new business. To the extent thatemployees identify specific products, seekcustomer investment objectives, makeinvestment recommendations, or giveinvestment advice, determine whether—a. the minimum disclosures are included in

the script;b. bank employees engaged in telemarket-

ing activities are authorized by the bankto recommend or sell nondeposit invest-ment products, and whether their train-



ing is the substantive equivalent of thatrequired for securities registered repre-sentatives; and

c. the material contains any statements thatmay be misleading or confusing to cus-tomers regarding the uninsured nature ofnondeposit investment products.

18. When nondeposit investment products aresold by employees of an affiliated broker–dealer, determine if any written or oral rep-resentations concerning insurance coverageprovided by SIPC, a state insurance fund, ora private insurance company are clear andaccurate and do not suggest that they are thesubstantive equivalent to FDIC insuranceavailable for certain deposit products.

19. When the bank or its bank holding com-pany (or affiliate) acts as an investmentadviser to or has some other material rela-tionship with a mutual fund whose sharesare sold by the bank, determine whether—a. oral and written disclosure of the rela-

tionship is made before the purchase ofthe shares;

b. bank-advised mutual funds do not havenames identical to the bank’s;

c. bank-advised mutual funds with namessimilar to the bank’s are sold pursuant toa sales program designed to minimizethe risk of customer confusion; and

d. mutual funds advised by bank holdingcompanies do not have names identicalto, similar to, or a variation of the nameof the holding company or its subsidiarybank.

20. Determine whether disclosure of any salescharges, fees, penalties, or surrendercharges relating to nondeposit investmentproducts is made orally and in writingbefore the purchase of these products.

Third-Party Agreements

21. When sales of nondeposit investment prod-ucts are conducted by employees or repre-sentatives of a third party, review all con-tractual agreements between the bank andthe third party to determine whether theycover the following:a. duties and responsibilities of each partyb. third-party compliance with all applica-

ble laws and regulations and the inter-agency statement

c. authorization for the institution to over-

see and verify compliance by the thirdparty

d. provision for access to relevant recordsto the appropriate bank supervisoryauthorities

e. written employment contracts for dualemployees

f. indemnification of the institution by thethird party for the conduct of its employ-ees in connection with nondepositinvestment product sales activities

g. policies regarding the use of confidentialcustomer information for any purpose inconnection with sales of nondepositinvestment products.

22. Obtain and review the most recent FINRAexamination results for the third party fromthe bank or the third-party broker–dealer.Also obtain and review examination-relatedcorrespondence and any disciplinary mat-ters between the broker–dealer and theFINRA or SEC. Review the institution’sprogress in addressing any investment rec-ommendations or deficiencies noted in theexamination results or other material.

23. Where any retail sales facilities of the insti-tution are leased to an affiliated third partythat sells nondeposit investment products—

a. assess whether the lease was negotiatedon an arm’s-length basis and on termscomparable to similar lease agreementsin the local market and

b. review any intercompany relationshipsfor compliance with sections 23A and23B of the Federal Reserve Act.

Settings and Circumstances

24. Determine whether the sale of nondepositinvestment products is conducted in aphysical location distinct from deposit-taking activities of the bank. In so doing—

a. verify that nondeposit investment prod-ucts are not sold from teller windows;

b. determine if signs or other means areused to distinguish the nondepositinvestment products sales area from theretail deposit-taking area of theinstitution; and

c. determine whether space limitations pre-clude having a separate investment-products sales area. If so, note how theinstitution clearly distinguishes nonde-posit investment products from insuredbank products or obligations.



Qualifications and Training

25. Determine whether employees of adepository institution are providing invest-ment advice, making investment recom-mendations, or selling nondeposit invest-ment products directly to retail customers.If so, determine whether—a. the depository institution has performed

background checks andb. sales personnel have received training

that is the substantive equivalent tothat provided to a securities registeredrepresentative.

26. Review the training program provided toemployees of the depository institution whoare authorized to provide investmentadvice, make investment recommendations,or sell nondeposit investment products.Assess whether the program addresses thefollowing subject matters:a. general overview of U.S. financial

marketsb. detailed information concerning specific

product lines being offered for salec. generally accepted trading practices for

the products available for saled. general overview of federal securities

laws and regulations (antifraud anddisclosure)

e. banking regulations and guidelines appli-cable to sales activities (such as anti-tying prohibitions, the interagency state-ment, supervisory letters on sales ofspecific investment products, etc.)

f. policies and procedures specific to theinstitution

g. appropriate sales practices, includingsuitability of investment recommenda-tions and disclosure obligations

h. appropriate use of customer lists andconfidential customer information

27. Determine whether the institution has anycontinuing-education program or periodicseminars on new products or compliance.

28. Determine whether supervisors of banksales personnel receive special trainingpertaining to their supervisory responsibili-ties that is the substantive equivalent oftraining required for supervisors (GeneralSecurities Principals) of registeredrepresentatives.

29. Review the training of bank employees whoare not authorized to sell nondeposit invest-ment products but who make referrals, suchas tellers, customer service representatives,and others. In so doing, determine whethersuch employees have been provided train-

ing in appropriate referral practices, includ-ing the limits on their activities.

Suitability and Sales Practices

The following procedures on suitability andsales practices are applicable when conductingan examination of a depository institution whoseemployees offer investment advice, makeinvestment recommendations, or sell nondepositinvestment products. Examinations involvingregistered broker–dealers should rely on theFINRA’s review of sales practices or its exami-nation to assess the organization’s compliancewith suitability requirements.

30. Determine whether depository institutionpersonnel recommend nondeposit invest-ment products to customers. If so, deter-mine whether sales personnel obtain,record, and update the followinginformation:a. ageb. tax statusc. current investments and overall financial

profile, including an estimate of networth*

d. investment objectives*e. other personal information deemed

necessary to offer reasonable investmentadvice*

31. Review a representative sample of cus-tomer accounts that were opened at severaldifferent branch locations. Assess whethercustomer suitability information is obtainedand whether investments appear unsuitablein light of such information.

32. Review customer complaints involving suit-ability of investment recommendations.Determine whether the bank’s original rec-ommendations appear unsuitable in the con-text of the information available at the timeof sale. Note how suitability complaints areresolved.

Compensation

33. If employees of the depository institutionprovide investment advice, make invest-ment recommendations, or sell nondeposit

* Not necessary when money market mutual funds arebeing recommended.



investment products, determine whether—a. any incentive compensation plan avail-

able to nondeposit investment productsales personnel strongly favors propri-etary or other specific products; if so,determine how the institution ensuresthat customers are not placed into unsuit-able investments, and

b. compliance and audit personnel areexcluded from incentive compensationprograms directly related to the results ofnondeposit investment product sales.

34. Determine whether fees paid to bankemployees for referrals to depository insti-tution sales personnel or third-party salesstaff are based on a one-time, nominal feeof a fixed dollar amount and are not depen-dent on a successful sale.

35. Determine if the bank’s compensation poli-cies address remuneration of bank employ-ees by third parties and if these policies areincorporated into the bank’s code of con-duct. In so doing, determine whether thebank’s policies were approved by the boardof directors and are consistent with the pro-scriptions of the Bank Bribery Act and theinteragency guidelines adopted thereunder.

Compliance and Audit

36. Review and assess the depository institu-tion’s compliance program for nondepositinvestment product sales activities. In sodoing, consider the following:a. frequency and scopeb. workpapersc. degree of independence from the sales

programd. follow-up on material findingse. centralization of findings from all com-

pliance areasf. role of the board of directors in review-

ing findings37. Review the criteria used to evaluate bank

sales personnel for compliance with the

institution’s policies and procedures, spe-cifically those policies relating to disclosureand suitability.

38. Determine whether compliance personnelapprove or review new accounts, periodi-cally review transactions in accounts, andreview sales and referral activities of bankpersonnel.

39. Review the customer complaint process andthe associated complaint log to determine ifcomplaints are addressed on a timely basis.

40. Review progress in addressing identifiedcompliance problems.

41. Evaluate the experience, training, and quali-fications of compliance personnel.

42. Review the scope of audits and determineif the following areas were adequatelyaddressed:a. disclosure and advertisingb. physical separation of nondeposit

investment product sales activitiesc. complianced. sales practices and suitabilitye. product selection and developmentf. use of confidential customer information

by bank and third-party sales personnelg. third-party compliance with its agree-

ment with the institutionh. personnel training and background

checksi. operations (clearing, cash receipts and

disbursements, accounting, redemptions,etc.), if applicable

43. Obtain all internal and external audit reportsregarding the institution’s nondepositinvestment product activities performedover the past year (including management’sresponses). Review for exceptions, recom-mendations, and follow-up actions. Ascer-tain if significant exceptions were presentedto the institution’s audit committee or boardof directors for their review.

44. For external audits, obtain a copy of theengagement letter and comment on theadequacy of the firm’s audit review.



Supervision of Subsidiaries (Sharing of Facilities and Staffby Banking Organizations) Section 2010.8

A banking organization should be able to readilydetermine for which entity within the bank hold-ing company an individual is employed, andmembers of a banking organization’s staff mustbe able to identify which subsidiary of the hold-ing company employs them. The distinction isimportant because complex banking organiza-tions must take steps to ensure that their officialsand employees have both the corporate andlegal authority to carry out their duties, andbecause the organization’s personnel shouldonly be performing activities that are permittedby law to be carried out by the holding companyor its particular subsidiaries.

2010.8.1 IDENTIFICATION OFFACILITIES AND STAFF

Generally, unless there are statutory restrictionsor the Federal Reserve or other regulators haveissued explicit written proscriptions, such asthose concerning mutual fund sales on bankpremises, there is no fundamental legal prohibi-tion on the entities of a banking organizationsharing or using unmarked contiguous facilitiesand, in some instances, sharing officials andemployees. There are, however, concerns aboutsafety and soundness and conflicts of interest.These may arise when a banking organizationdoes not take appropriate actions to define anddifferentiate the functions and responsibilities ofeach of its entities and staff.

Good corporate governance requires that abanking organization be able to readily identifythe authority and responsibilities of its officialsand employees at each of its entities, especiallywhere the entities share facilities or use contigu-ous offices that are not clearly marked to indi-cate the identity of the different entities. This isnecessary to ensure that—

1. an official or employee who makes a com-mitment to a counterparty on behalf of theorganization has both the corporate and legalauthority to do so,

2. the counterparty understands with whom it isdealing, and

3. each entity is in compliance with any legalrestrictions under which it operates.

To accomplish the goal of ready identifica-tion, a banking organization should maintainwell-defined job descriptions for each categoryof its staff at each entity. When officials andemployees of one entity have responsibilities for

other entities, particularly in shared facilities,the staff’s responsibilities should be clearlydefined and, when appropriate, disclosed ormade clear to customers and the public in gen-eral. This procedure clarifies for both the publicand the regulators for which entity officials oremployees are carrying out their duties andresponsibilities. Also, this clarifies whether anentity is operating within the scope of its char-ter, license, or other legal restrictions. Finally, abanking organization should establish and main-tain appropriate internal controls designed toensure the separation of the functions of thelegal entities, when required, as well as havean adequate audit program to monitor suchactivities.

If officials and employees have responsibili-ties for other offices or affiliates of the bankingorganization, particularly those that share facili-ties, these responsibilities should be clearlydefined and, when appropriate, disclosed ormade clear to customers and the public in gen-eral. This procedure clarifies for which entityemployees are carrying out their duties. Further-more, in establishing employee responsibilities,management should ensure that they are withinthe scope of the entity’s license or charter.

2010.8.2 EXAMINER GUIDANCE ONSHARING FACILITIES AND STAFF

Examiners should continue to be fully aware ofthe issues and potential problems involved inthe sharing of staff and the sharing or use ofunmarked contiguous facilities by the differententities of a banking organization with variedactivities. At a minimum, examiners shouldcheck to see that a banking organization main-tains clear records indicating the duties andresponsibilities of the officials and employees ateach of its entities. They should also take stepsto check whether, in situations when an officialor employee may perform duties for more thanone entity in a shared facility, the banking orga-nization has adequate policies and controls inplace to ensure that its staff have the corporateand legal capacity to commit the organization toits counterparties and that the duties are carriedout in conformance with the statutory restric-tions applicable to each of the entities. SeeSR-95-34 (SUP).


Supervision of Subsidiaries(Required Absences from Sensitive Positions) Section 2010.9

One of the many basic tenets of internal controlis that a banking organization (bank holdingcompany, state member bank, and foreign bank-ing organization) needs to ensure that itsemployees in sensitive positions are absent fromtheir duties for a minimum of two consecutiveweeks. Such a requirement enhances the viabil-ity of a sound internal control environmentbecause most frauds or embezzlements requirethe continuous presence of the wrongdoer.

In brief, this section contains a statementemphasizing the need for banking organizationsto conduct an assessment of significant riskareas before developing a policy on requiredabsences from sensitive positions. After makingthis assessment, the organization should requirethat employees in sensitive key positions, suchas trading and wire transfer, not be allowed totransact or otherwise carry out, either physicallyor through electronic access, their assignedduties for a minimum of two consecutive weeksper year. The prescribed period of absenceshould, under all circumstances, be sufficient toallow all pending transactions to clear. It shouldalso require that an individual’s daily work beprocessed by another employee during theemployee’s absence. (See SR-96-37.)

2010.9.1 STATEMENT ON REQUIREDABSENCES FROM SENSITIVEPOSITIONS

A comprehensive system of internal controls isessential for a financial institution to safeguardits assets and capital, and to avoid undue reputa-tional and legal risk. Senior management isresponsible 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 fraudand abuse, these acts are more easily perpetratedwhen proper segregation and rotation of dutiesdo not exist. As a result, the Federal Reserve isreemphasizing the following prudent bankingpractices that should be incorporated into abanking organization’s internal control proce-dures. These practices are designed to enhancethe viability of a sound internal control environ-ment, as most internal frauds or embezzlementsnecessitate the constant presence of the offenderto prevent the detection of illegal activities.

When developing comprehensive internalcontrol procedures, each banking organizationshould first make a critical assessment of itssignificant areas and sensitive positions. This

assessment should consider all employees, butshould focus more on those with authority toexecute transactions, signing authority andaccess to the books and records of the bankingorganization, as well as those employees whocan influence or cause such activities to occur.Particular attention should be paid to areasengaged 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 areasand activities, it would be expected that a mini-mum absence of two consecutive weeks peryear be required of employees in sensitive posi-tions. The prescribed period of absence should,under all circumstances, be sufficient to allowall pending transactions to clear and to providefor an independent monitoring of the trans-actions that the absent employee is responsiblefor initiating or processing. This practice couldbe implemented through a requirement thataffected employees take vacation or leave, therotation of assignments in lieu of required vaca-tion, or a combination of both so the prescribedlevel of absence is attained. Some banking orga-nizations, particularly smaller ones, might con-sider compensating controls such as continuousrotation of assignments in lieu of requiredabsences to avoid placing an undue burden onthe banking organization or its employees.

For the policy to be effective, individualshaving electronic access to systems and recordsfrom remote locations must be denied thisaccess during their absence. Similarly, indirectaccess can be controlled by not allowing othersto take and carry out instructions from theabsent employee. Of primary importance is therequirement that an individual’s daily work beprocessed by another employee during his orher absence; this process is essential to bring tothe forefront any unusual activity of the absentemployee.

Exceptions to the required-absence policymay be necessary from time to time. However,management should exercise the appropriatediscretion and properly document any waiversthat are granted. Internal auditing should bemade aware of individuals who receive waiversand the circumstances necessitating theexceptions.

If a banking organization’s internal controlprocedures do not now include the above prac-tices, they should be promptly amended. After


the procedures have been enhanced, they shouldbe disseminated to all employees, and the docu-mentation regarding their receipt and acknowl-edgment maintained. Additionally, adherence tothe procedures should be included in the appro-priate audit schedules, and the auditors shouldbe cognizant of potential electronic access orother circumventing opportunities.

The development and implementation of pro-cedures on required absences from sensitivepositions is just one element of an adequatecontrol environment. Each banking organizationshould take all measures to establish appropriatepolicies, limits, and verification procedures foran effective overall risk-management system.


1. To determine whether a critical assessmenthas been performed of a banking organiza-tion’s significant areas and sensitive posi-tions.

2. To ascertain that sound internal controlsexist, including policies and procedures thatprovide assurances that employees in sensi-tive positions are absent from their duties fora minimum of two consecutive weeks peryear.

3. To ascertain whether the banking organiza-tion has taken all measures to establishappropriate policies, limits, and verificationprocedures 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 othercircumventing actions by employees.


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

2. Ascertain if employees assigned to sensitivepositions are required to be absent for aminimum of two weeks per year while—a. pending sensitive transactions are moni-

tored while they clear, andb. daily work is monitored and processed by

another employee during the regularlyassigned employee’s absence.

3. Determine if required internal control proce-dures for minimum absences (for example,rotation of assignments, vacation or leave, ora combination of both) are being used insensitive operations such as trading, trust,wire transfer, reconciliation, or other sensi-tive back-office responsibilities.

4. Ascertain if appropriate policies, limits, andverification procedures have been establishedand maintained for an effective overall risk-managment system.

5. Determine whether the bankingorganization—a. prohibits others from taking and carry-

ing out instructions from the absentemployees, and

b. prevents remote electronic access to sys-tems and records involving sensitive trans-actions during the regularly assignedemployee’s required minimum two-weekabsence.

6. Ascertain that the banking organizationdocuments waivers from the two-week mini-mum absence policies and proceduresinvolving sensitive positions.

7. Determine that the appropriate audit sched-ules and the audits include a review of suchprocedures, including potential electronicaccess or other circumventing actions byemployees.

Supervision of Subsidiaries (Required Absences from Sensitive Positions) 2010.9


Supervision of Subsidiaries(Internal Loan Review) Section 2010.10

Internal loan review is an activity which pro-vides management with information about thequality of loans and effectiveness of a bankingorganization’s lending policies and procedures.The objectives of loan-review procedures are toidentify, in a timely manner, existing or emerg-ing credit-quality problems and to determinewhether internal lending policies are beingadhered to.

The size and complexity of a bank holdingcompany will dictate the need for and structureof internal loan review. One-bank holdingcompanies with no significant credit-extendingnonbank subsidiaries will normally establishinternal loan-review procedures within the sub-sidiary bank. In these cases, there is no need toevaluate the loan-review procedures during theinspection.

For larger multibank companies or those withsignificant credit-extending nonbank subsidi-aries, internal loan review is usually centralizedat the parent company level. In some cases, acentralized loan-review function could operatein the lead bank and cover all affiliates withinthe organization. However, since parent com-pany directors and senior management are ulti-mately accountable for the organization’s assetquality, an evaluation of the internal loan-reviewfunction should be conducted as part of theinspection process no matter where the opera-tions are technically located within the corpo-rate structure. Since a subsidiary bank’s primaryregulator will normally want to evaluate theloan-review process as it relates to the respec-tive bank, a coordination of efforts would beappropriate. This should be handled on an adhoc basis, as deemed necessary by the holdingcompany’s examiner-in-charge, to avoid unnec-essary duplication of efforts without com-promising the independence of the appraisalprocess.

Internal loan-review procedures may takevarious forms, from senior officers’ review ofjunior-officer loans to the formation of an inde-pendent department staffed by loan-reviewanalysts. An effective system will identifydeteriorations in credits, loans that do not com-ply with written loan policies, and loans withtechnical exceptions.

The loan-review program should be delegatedto a qualified and adequate staff. The reviewshould be systematic in scope and frequency.All related extensions of credit should be identi-fied and analyzed together. A minimum creditsize should be established that allows for anefficient review while providing adequate cover-

age. The process should also tie problem loansor technical exceptions to the particular loanofficer to allow senior management to evaluateindividual performance. Loans should bereviewed shortly after origination to determinetheir initial quality, technical exceptions, andcompliance 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 effectiveloan-review procedure will incorporate an earlywarning system of ‘‘red flags,’’ such as over-drafts, adverse published reports, and deteriorat-ing financial statements. Loan officers shouldalso be encouraged to inform the organization’sinternal loan-review unit of developing loanproblems, and they should be discouraged fromwithholding problem loans or adverse informa-tion from the review process.

The loan-review process should be indepen-dent of the loan-approval function, with writtenfindings reported to a board or senior manage-ment committee that is not directly involved inlending. Follow-up and monitoring of problemcredits should be instituted. The loan officershould be responsible for reporting on any cor-rective actions taken. The maintenance ofadequate internal controls within the lendingprocess, in particular for loan review or creditaudit, is critical for maintaining proper incen-tives for banking organization staff to be rigor-ous and disciplined in their credit-analysis andlending decisions. A banking organization’scredit analyses, loan terms and structures, creditdecisions, and internal rating assignments havehistorically been reviewed in detail by experi-enced and independent loan-review staff. Suchloan reviews have provided both motivation forbetter credit discipline within an institutionand greater comfort for examiners—andmanagement—that internal policies are beingfollowed and that the banking organization con-tinues to adhere to sound lending practice.

For larger multibank organizations, loan-review procedures are usually centralized andadministered 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 allother affiliates in the organization. The parentcompany directors and senior management areultimately accountable for supervision of theentire organization’s asset quality. Therefore, it


should be the System’s responsibility to evalu-ate top management’s loan-review policies andprocedures as they relate to the subsidiaries,both bank and nonbank, no matter where thefunction is technically established within thecorporate structure. The holding companyexaminer-in-charge should attempt to coordi-nate efforts and cooperate with the respectivebanks’ primary supervisors to avoid unneces-sary duplication, without compromising theindependence of the appraisal process.

During favorable economic and financialmarkets, relatively low levels of problem loansand credit losses may increase pressure withinbanking organizations to reduce the resourcescommitted to loan-review functions. Thesereductions 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 byreducing loan-review resources, but some bank-ing organizations may reduce the scope anddepth of loan-review activities beyond levelsthat are prudent over the longer horizon. Ifreduced too far, the integrity of the lendingprocess and the discipline of identifying unreal-istic assumptions and discerning problem loansin a timely fashion may deteriorate. This may beespecially true when a large proportion of lend-ers may not have had direct lending experienceduring a credit cycle when there was aneconomic and financial market downturn. SeeSR-99-23.

If supervisors and examiners find that thereare weaknesses in the internal loan-review func-tion and in activities or other internal controland risk-management processes (for example,staff turnover, failure to commit sufficientresources, inadequate adherence to establishedinternal controls, or inadequate training), suchfindings should be discussed with the seniormanagement of the parent bank holding com-pany or other management at a corporate-widelevel and, if determined to be a major concern,presented as comments on the ‘‘Examiner’sComments and Matters Requiring Special BoardAttention’’ 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 whenassigning supervisory ratings.

Shell one-bank holding companies will nothave or need a loan-review program emanatingfrom the parent company level. Loan review

will normally function within the subsidiarybank and be supervised by bank directors andmanagement.


1. Review the operations of the bank holdingcompany to determine whether there is aninternal loan-review program. If not, oneshould be implemented.

2. Determine whether the loan-review programis independent from the loan-approvalfunction.

3. Determine if the loan-review staff is suffi-ciently qualified and whether its size isadequate.

4. Determine whether the scope and frequencyof the loan-review procedure is adequate toensure that problems are being identified.

5. Determine that findings from the loan-reviewprocess are being properly reported andreceive adequate follow-up attention.


1. Review the holding company’s operations todetermine what types of internal loan-reviewprocedures are being performed and whetheran internal loan-review program exists.

2. If no internal loan-review program exists,determine whether the size, complexity, andfinancial condition of the organization war-rants implementation of a formal loan-reviewprocess.

3. Review the organizational structure of theloan-review function to ensure its indepen-dence from the loan-approval processes.

4. Review the reporting process for internalloan-review findings to determine whether adirector committee or independent seniormanagement committee is being appropri-ately advised of the findings. Determinewhether adequate follow-up procedures arein place.

5. Through loan reviews, transaction testing,and discussions with loan-review manage-ment, evaluate the quality, effectiveness andadequacy of the internal loan-review staffand 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 selectingloans and the manner in which they are ana-lyzed and graded. Determine whether theseprocedures are adequate.

Internal Loan Review 2010.10


7. Determine if loan-review activities or otherinternal control and risk-management pro-cesses have been weakened by turnover ofinternal loan-review staff; a failure to com-mit sufficient resources; inadequate internalcontrols; inadequate training; or the absenceof 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 corepage 1, ‘‘Examiner’s Comments and MattersRequiring 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 ofthe review procedure is established andwhether this provides adequate coverage.

Internal Loan Review 2010.10


Supervision of Subsidiaries (Private-BankingFunctions and Activities) Section 2010.11


Effective July 2012, this section has been revisedto reference the Financial Crimes EnforcementNetwork’s regulations and those of the Office ofForeign Assets Control, issued by the U.S.Department of the Treasury (31 C.F.R. 1020).

2010.11.1 OVERVIEW OF PRIVATEBANKING AND ITS ASSOCIATEDACTIVITIES

The role of bank regulators in supervisingprivate-banking activities is (1) to evaluate man-agement’s ability to measure and control therisks associated with such activities and (2) todetermine if the proper internal control and auditinfrastructures are in place to support effectivecompliance with relevant laws and regulations.In this regard, the supervisors may determinethat certain risks have not been identified oradequately managed by the institution, a poten-tially unsafe and unsound banking practice.

Private-banking functions may be performedin a specific department of a commercial bankor nonbank subsidiary of a commercial bank, abank holding company (including a financialholding company), an Edge corporation or itsforeign subsidiaries, a branch or agency of aforeign banking organization, or within multipleareas of an institution. Private banking may bethe sole business of an institution. Regardless ofhow an institution is organized or where it islocated, the results of the private-bankingreview should be reflected in the entity’s overallsupervisory assessment.1

This section provides examiners with guid-ance for reviewing private-banking activities atall types and sizes of banking organizations,including financial institutions. It is intended tosupplement, not replace, existing guidance onthe inspection or examination of private-bankingactivities and to broaden the examiner’s reviewof general risk-management policies and prac-

tices governing private-banking activities. Inaddition to providing an overview of privatebanking, the general types of customers, and thevarious products and services typically pro-vided, the ‘‘Functional Review’’ subsectiondescribes the critical functions that constitute aprivate-banking operation and identifies certainsafe and sound banking practices. These criticalfunctions are supervision and organization, riskmanagement, fiduciary standards, operationalcontrols, management information systems,audit, and compliance. Included in the risk-management portion is a discussion of the basic‘‘customer-due-diligence’’ (CDD) principle thatis the foundation for the safe and sound opera-tion of a private-banking business. See the CDDrules at 31 C.F.R. 1020. The ‘‘Preparation forInspection’’ subsection assists in defining theinspection scope and provides a list of corerequests to be made in the first-day letter. Addi-tional inspection and examination guidance canbe found in this manual, the Federal FinancialInstitutions Examination Council’s (FFIEC)Bank Secrecy Act/Anti–Money Laundering(BSA/AML) Examination Manual, the FederalReserve System’s Trading and Capital-MarketsActivities 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 theframework for risk-focused supervision of largecomplex institutions), all aspects of the private-banking review should be coordinated with therest of the inspection to eliminate unnecessaryduplication of effort. Furthermore, this sectionhas introduced the review of trust activities andfiduciary services, critical components of mostprivate-banking operations, as part of the over-all private-banking review. Although the prod-uct nature of these activities differs from that ofproducts 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 informationsystems, audit, compliance, and financialcondition/business profile) should be reviewedacross product lines.

Private banking offers the personal and dis-crete delivery of a wide variety of financialservices 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.


corporate interests. A private-banking operationtypically offers its customers an all-inclusivemoney-management relationship, includinginvestment portfolio management, financial-planning advice, offshore facilities, custodialservices, funds transfer, lending services, over-draft privileges, hold mail, letter-of-creditfinancing, and bill-paying services. As the afflu-ent market grows, both in the United States andglobally, competition to serve it is becomingmore intense. Consequently, the private-bankingmarketplace includes banks, nonbanks, andother types of banking organizations and finan-cial institutions. Private-banking products, ser-vices, technologies, and distribution channelsare still evolving. A range of private-bankingproducts and services may be offered to custom-ers throughout an institution’s global network ofaffiliated entities—including branches, subsidi-aries, and representative offices—in many dif-ferent regions of the world, including offshoresecrecy jurisdictions.

Typically, private-banking customers are highnet worth individuals or institutional investorswho have minimum investible assets of $1 mil-lion or more. Institutions often differentiatedomestic from international private banking,and they may further segregate the internationalfunction on the basis of the geographic locationof their international client base. Internationalprivate-banking clients may be wealthy indi-viduals who live in politically unstable nationsand 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 itis for the domestic customer. Private-bankingaccounts may, for example, be opened in thename of an individual, a commercial business, alaw firm, an investment adviser, a trust, a per-sonal investment company (PIC), or an offshoremutual fund.

In 2001, the USA Patriot Act (the Patriot Act)established new and enhanced measures to pre-vent, detect, and prosecute money launderingand terrorist financing. In general, these mea-sures were enacted through amendments to theBank Secrecy Act (BSA). The measures directlyaffecting banking organizations are imple-mented primarily through regulations issued bythe U.S. Department of the Treasury (31 C.F.R.1020).2 Section 326 of the Patriot Act (see the

BSA at 31 U.S.C. 5318(l)) requires financialinstitutions (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 recordsand documentation on customers. Institutionsare to develop and use identity verification pro-cedures to ensure the identity of their customers.Bank holding companies, as a matter of safetyand soundness, should take appropriate mea-sures to ensure that their financial institutionsubsidiaries are in compliance with the cus-tomer identification program (CIP) rule.

The CIP rule (see 31 C.F.R. 1020.220 and 12C.F.R. 326.8(b)) applies only to a bank, not to abank holding company solely because it owns abank. Also, a nonbank subsidiary of a bankholding company is not subject to the CIP rulefor banks solely as a result of being affiliatedwith a bank in a holding company structure.Even though this rule is not applicable to bankholding companies and their nonbank subsidi-aries (or to savings and loan holding companiesand their non–savings association subsidiaries),bank holding companies should, as a matter ofsafety and soundness, take appropriate measuresthroughout the organization to ensure that eachof their entities is in compliance with any appli-cable CIP rule. New accounts must receiveappropriate due diligence, and a holding com-pany should generally protect the consolidatedorganization from any risks associated withmoney laundering and financial crime. The bankholding company may still be subject to otherCIP rules if it has ownership in a functionallyregulated entity, for example, a securitiesbroker-dealer. (See 31 C.F.R. 1023.220 and1026.220)

The CIPs are to include measures to—

1. require that certain information be obtainedat account opening (for individuals, the infor-mation would generally include their name,address, tax identification number, and dateof birth);

2. verify the identity of new account holderswithin a reasonable time period;

3. ensure that a banking organization has a rea-sonable belief that it knows each customer’sidentity;

4. maintain records of the information used toverify 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


5. compare the names of new customers againstgovernment 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 complianceprogram.

The FFIEC BSA/AML Examination Manualprovides the interagency BSA examination pro-cedures that should be used to evaluate bankingorganizations’ compliance with the regulation.The scope of the examination or inspection canbe tailored to the reliability of the banking orga-nization’s compliance-management system andto the level of risk that the organization assumes.Relevant interagency guidance (in a frequently-asked-question format) has been issued toaddress the customer identification programrules. (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 ormarketer, commonly known as a relationshipmanager (RM), as the primary point of contactwith the institution. The RM is generallycharged with understanding and anticipating theneeds of his or her wealthy clients, and thenrecommending services and products for them.The number of accounts an RM handles varies,depending on the portfolio size or net worth ofthe particular accounts. RMs strive to provide ahigh level of support, service, and investmentopportunities to their clients and tend to main-tain strong, long-term client relationships. Fre-quently, RMs take accounts with them to otherprivate-banking institutions if they changeemployment. Historically, initial and ongoingdue diligence of private-banking clients is notalways well documented in the institution’s filesbecause of RM turnover and confidentialityconcerns.

Clients may choose to delegate a great deal ofauthority and discretion over their financialaffairs to RMs. Given the close relationshipbetween clients and their account officers, anintegral part of the inspection process is assess-ing the adequacy of managerial oversight of thenature and volume of transactions conductedwithin the private-banking department or withother departments of the financial institution, aswell as determining the adequacy and integrityof the RM’s procedures. Policy guidelines andmanagement supervision should provide param-eters for evaluating the appropriateness of allproducts, especially those involving market risk.Moreover, because of the discretion given toRMs, management should develop effective pro-

cedures to review the activity of client accountsin order to protect the client from any unauthor-ized activity. In addition, ongoing monitoring ofaccount activity should be conducted to detectactivity 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 useof leveraging and arbitrage is becoming moreevident in the private-banking business. Exam-iners should be alert to the totality of the clientrelationship product by product, in light ofincreasing client awareness and use of deriva-tives, emerging-market products, foreignexchange, and margined accounts.

2010.11.1.1 Products and Services

2010.11.1.1.1 Personal InvestmentCompanies, Offshore Trusts, andToken-Name Accounts

Private-banking services almost always involvea high level of confidentiality for clients andtheir account information. Consequently, it isnot unusual for private bankers to help theirclients achieve their financial-planning, estate-planning, and confidentiality goals through off-shore vehicles such as personal investmentcompanies (PICs), trusts, or more exoticarrangements, such as hedge fund partnerships.While these vehicles may be used for legitimatereasons, without careful scrutiny, they may cam-ouflage illegal activities. Private bankers shouldbe committed to using sound judgment andenforcing prudent banking practices, especiallywhen they are assisting clients in establishingoffshore vehicles or token-name accounts.

Through their global network of affiliatedentities, private banks often form PICs for theirclients. These ‘‘shell’’ companies, which areincorporated in offshore secrecy jurisdictionssuch 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 byopening accounts in the PIC’s name. The ‘‘ben-eficial owners’’ of the shell corporations aretypically foreign nationals. The banking institu-tion should know and be able to document thatit knows the beneficial owners of such corpora-tions and that it has performed the appropriatedue diligence to support these efforts. Emphasisshould be placed on verifying the source or



origin of the customer’s wealth. Similarly, off-shore trusts established in these jurisdictionsshould identify grantors of the trusts and sourcesof the grantors’ wealth. Anonymous relation-ships or relationships in which the RM does notknow and document the beneficial owner shouldnot be permitted.

PICs are typically passive personal invest-ment vehicles. However, foreign nationals haveestablished PICs as operating accounts for busi-ness entities they control in their home coun-tries. Accordingly, financial institutions shoulduse extra care when dealing with beneficialowners of PICs and associated trusts; these vehi-cles can be used to conceal illegal activities.

2010.11.1.1.2 Deposit-Taking Activities ofSubsidiary Institutions

A client’s private-banking relationship fre-quently begins with a deposit account and thenexpands into other products. In fact, many insti-tutions require private-banking customers toestablish a deposit account before maintainingany other accounts. Deposit accounts serve asconduits for a client’s money flows. To distin-guish private-banking accounts from retailaccounts, institutions usually require signifi-cantly higher minimum account balances andassess higher fees. The private-banking functionor institution should have account-opening pro-cedures and documentation requirements thatmust be fulfilled before a deposit account can beopened. (These standards are described in detailin the ‘‘Functional Review’’ subsection.)

Most private banks offer a broad spectrum ofdeposit products, including multicurrencydeposit accounts that are used by clients whoengage in foreign-exchange, securities, andderivatives transactions. The client’s transactionactivity, such as wire transfers, check writing,and cash deposits and withdrawals, is conductedthrough deposit accounts (including currentaccounts). It is very important that the transac-tion activity into and out of these depositaccounts (including internal transfers betweenaffiliated deposit accounts) be closely monitoredfor suspicious transactions that are inconsistentwith the client’s profile of usual transactions.

Suspicious transactions could warrant the fil-ing of a Suspicious Activity Report (SAR). Abank holding company or any nonbank subsidi-ary thereof, or a foreign bank that is subject tothe Bank Holding Company Act (or any non-

bank subsidiary of such a foreign bank operat-ing in the United States), is required to file aSAR in accordance with the provision of section208.62 of the Federal Reserve Board’s Regula-tion H (12 C.F.R. 208.62) when suspicioustransactions or activities are initially discoveredand warrant or require reporting. See the report-ing requirements discussed in subsection2010.11.2.2.1.1 and the expanded examinationprocedures for private banking in the FFIEC’sBSA/AML Examination Manual.

2010.11.1.1.3 Investment Management

In private banking, investment managementusually consists of two types of accounts:(1) discretionary accounts in which portfoliomanagers make the investment decisions on thebasis of recommendations from the bank’sinvestment research resources and (2) nondis-cretionary (investment advisory) accounts inwhich 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’swritten approval. Discretionary accounts consistof a mixture of instruments bearing varyingdegrees of market, credit, and liquidity risk thatshould be appropriate to the client’s investmentobjectives and risk appetite. Both account typesare governed under separate agreementsbetween the client and the institution.

Unlike depository accounts, securities andother instruments held in the client’s investmentaccounts are not reflected on the balance sheetof the institution because they belong to theclient. These managed assets are usuallyaccounted for on a separate ledger that is segre-gated according to the customer who owns theassets.

2010.11.1.1.4 Credit

Private-banking clients may request extensionsof credit on either a secured or an unsecuredbasis. Loans backed by cash collateral or man-aged assets held by the private-banking functionare quite common, especially in internationalprivate banking. Private-banking clients maypledge a wide range of their assets, includingcash, mortgages, marketable securities, land, orbuildings, to securitize their loans. Managementshould demonstrate an understanding of the pur-pose of the credit, the source of repayment, theloan tenor, and the collateral used in the financ-ing. When lending to individuals with high net



worths, whether on a secured or an unsecuredbasis, the creditworthiness determination is bol-stered by a thorough and well-structuredcustomer-due-diligence process. If that processis not thorough, collateral derived from illicitactivities may be subject to governmentforfeiture.

Borrowing mechanisms are sometimes estab-lished to afford nonresident-alien customers theability to keep financial assets in the UnitedStates and to use such assets (via collateralizedborrowing arrangements) to provide operatingcapital for businesses they own and operate intheir home countries. Such arrangements enablethese customers to keep the existence of thesefinancial assets secret from their home-countryauthorities and others, while they continue touse the funds (via collateralized borrowings) tofund their businesses at home.

Private bankers need to maintain in theUnited States adequate CDD information onsuch nonresident-alien customers and their pri-mary business interests. A well-documentedCDD 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 Officeof Foreign Assets Control (OFAC), and writtenand appropriately documented Call Reports pre-pared by the RM.

While these lending mechanisms may be usedfor legitimate reasons, management needs todetermine whether the arrangements are beingused primarily to obfuscate the beneficial own-ership of collateral assets, making it difficult forthe customer’s home-country government toidentify who owns the assets. If so, managementneeds to further determine whether the practicevaries from both the appropriate standards ofinternational cooperation for transparency issuesand with prudent banking practices, and if so,whether the institution is exposed to elevatedlegal risk.

2010.11.1.1.5 Payable-Through Accounts

Another product that may be available inprivate-banking operations is payable-throughaccounts (PTAs). PTAs are transaction depositaccounts through which U.S. banking entities(‘‘payable-through banks’’) extend check-writing privileges to the customers of a foreignbank. The foreign bank (‘‘master accountholder’’) opens a master checking account withthe U.S. bank and uses this account to provideits customers with access to the U.S. bankingsystem. The master account is divided into

‘‘subaccounts,’’ each in the name of one of theforeign bank’s customers. The foreign bankextends signature authority on its masteraccount to its own customers, who may not beknown to the U.S. bank. Consequently, the U.S.bank may have customers who have not beensubject to the same account-opening require-ments imposed on its U.S. account holders.These subaccount customers are able to writechecks and make deposits at the U.S. bankingentity. The number of subaccounts permittedunder this arrangement may be virtuallyunlimited.

U.S. banking entities engage in PTAs primar-ily because they attract dollar deposits from thedomestic market of their foreign correspondentswithout changing the primary bank-customerrelationship; PTAs also provide substantial feeincome. Generally, PTAs at U.S. banking enti-ties have the following characteristics: they arecarried on the U.S. banking entity’s books as acorrespondent bank account, their transactionvolume is high, checks passing through theaccount contain wording similar to ‘‘payablethrough XYZ bank,’’ and the signatures appear-ing on checks are not those of authorized offi-cers of the foreign bank. See the expandedexamination procedures for PTAs in theFFIEC’s BSA/AML Examination Manual.

2010.11.1.1.6 Personal Trust and Estates

In trust and estate accounts, an institution offersmanagement services for a client’s assets. Whendealing with trusts under will, or ‘‘testamentarytrusts,’’ the institution may receive an estateappointment (executor) and a trustee appoint-ment if the will provided for the trust from theprobate. These accounts are fully funded atorigination with no opportunity for an outsideparty to add to the account, and all activities aresubject to review by the probate or surrogates’court. On the other hand, with living trusts, or‘‘grantor trusts,’’ the customer (grantor) maycontinually add to and, in some instances, hascontrol over the corpus of the account. Trustsand estates require experienced attorneys,money managers, and generally well-roundedprofessionals to set up and maintain theaccounts. In certain cases, bankers may need tomanage a customer’s closely held business orsole proprietorship. In the case of offshore trustfacilities, recent changes in U.S. law haveimposed additional obligations on those banks



that function as trustees or corporate manage-ment for offshore trusts and PICs.

A critical element in offering personal trustand estate services is the fiduciary responsibilityof the institutions to their customers. Thisresponsibility requires that institutions alwaysact in the best interest of the clients pursuant tothe trust documentation, perhaps even to thedetriment of the bank. In these accounts, thebank is the fiduciary and the trust officer servesas a representative of the institution. Fiduciariesare held to higher standards of conduct thanother bankers. Proper administration of trustsand estates includes strict controls over assets,prudent investment and management of assets,and meticulous recordkeeping. See theexpanded 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-bankingcustomers include securities safekeeping, receiptand 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 thebank or from outside investment advisers. Thecustomer or a designated financial adviserretains full control of the investment manage-ment of the property subject to the custodian-ship. Sales and purchases of assets are made byinstruction 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 itfails to act properly according to the custodyagreement. Therefore, procedures for properadministration should be established andreviewed.

An escrow account is a form of custodyaccount in which the institution agrees to holdcash or securities as a middleman, or a thirdparty. The customer, for example, an attorney ora travel agency, gives the institution funds tohold until the ultimate receiver of the funds‘‘performs’’ in accordance with the writtenescrow agreement, at which time the institutionreleases the funds to the designated party.

2010.11.1.1.8 Funds Transfer

Funds transfer, another service offered byprivate-banking functions, may involve thetransfer of funds between third parties as part ofbill-paying and investment services on the basisof customer instructions. The adequacy of con-trols over funds-transfer instructions that areinitiated electronically or telephonically isextremely important. Funds-transfer requests arequickly processed and, as required by law,funds-transfer personnel may have limitedknowledge of the customers or the purpose ofthe transactions. Therefore, strong controls andadequate 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, andElectronic-Mail Only

Hold-mail, no-mail, or electronic-mail-onlyaccounts are often provided to private-bankingcustomers who elect to have bank statementsand other documents maintained at the institu-tion or e- mailed to them, rather than mailed totheir residence. Agreements for hold-mailaccounts should be in place, and the agreementsshould indicate that it was the customer’s choiceto have the statements retained at the bank andthat the customer will pick up his or her mail atleast annually. Variations of hold-mail servicesinclude delivery of mail to a prearranged loca-tion (such as another branch of the bank) byspecial courier or the bank’s pouch system.

2010.11.1.1.10 Bill-Paying Services

Bill-paying services are often provided toprivate-banking customers for a fee. If this ser-vice is provided, an agreement between the bankand the customer should exist. Typically, a cus-tomer may request that the bank debit a depositaccount for credit card bills, utilities, rent, mort-gage payments, or other monthly consumercharges. In addition, the increased use of theInternet has given rise to the electronic-mail-only account, whereby customers elect to havestatements, notices, etc., sent to them only bye-mail.

2010.11.2 FUNCTIONAL REVIEW

When discussing the functional aspects of aprivate-banking operation, functional refers to



managerial processes and procedures, such asreporting lines, quality of supervision (includinginvolvement of the board of directors), informa-tion flows, policies and procedures, risk-management policies and methodologies, segre-gation of duties, management informationsystems, operational controls (including BSA/AML monitoring), and audit coverage. Theexaminer should be able to draw sound conclu-sions about the quality and culture of manage-ment and stated private-banking policies afterreviewing the functional areas described below.Specifically, the institution’s risk-identificationprocess and risk appetite should be carefullydefined and assessed. Additionally, the effective-ness of the overall control environment main-tained by management should be evaluated byan internal or external audit. The effectivenessof the following functional areas is critical toany private-banking operation, regardless of itssize or product offerings.

2010.11.2.1 Supervision and Organization

As part of the examiner’s appraisal of anorganization, the quality of supervision ofprivate-banking activities is evaluated. The ap-praisal of management covers the full range offunctions and activities related to the operationof the private bank. The discharge ofresponsibilities by bank directors should be ef-fected through an organizational plan that ac-commodates the volume and business serviceshandled, local business practices and the bank’scompetition, and the growth and developmentof 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-rangeplan for the institution, and should be consistentwith any enterprise-wide risk-managementprogram.

Both the directors and management haveimportant roles in formulating policies andestablishing programs for private-banking prod-ucts, operations, internal controls, and audits.However, management alone must implementpolicies and programs within the organizationalframework instituted by the board of directors.

2010.11.2.2 Risk Management

Sound risk-management processes and stronginternal controls are critical to safe and soundbanking generally and to private-banking activi-ties in particular. Management’s role in ensuring

the integrity of these processes has becomeincreasingly important as new products andtechnologies are introduced. Similarly, theclient-selection, documentation, approval, andaccount-monitoring processes should adhere tosound and well-identified practices.

The quality of risk-management practices andinternal controls is given significant weight inthe evaluation of management and the overallcondition of private-banking operations. Abank’s failure to establish and maintain a risk-management framework that effectively identi-fies, measures, monitors, and controls the risksassociated with products and services should beconsidered unsafe and unsound conduct. Fur-thermore, well-defined management practicesshould indicate the types of clients that theinstitution will and will not accept and shouldestablish multiple and segregated levels ofauthorization for accepting new clients. Institu-tions that follow sound practices will be betterpositioned to design and deliver products andservices that match their clients’ legitimateneeds, while reducing the likelihood that unsuit-able clients might enter their client account base.Deficiencies noted in this area are weighted incontext of the relative risk they pose to theinstitution and are appropriately reflected in theappraisal of management.

The private-banking function is exposed to anumber of risks, including reputational, fidu-ciary, legal, credit, operational, and market. Abrief description of some of the different typesof risks follows:

1. Reputational risk is the potential that nega-tive publicity regarding an institution’s busi-ness practices and clients, whether true ornot, could cause a decline in the customerbase, costly litigation, or revenue reductions.

2. Fiduciary risk refers to the risk of loss due tothe institution’s failure to exercise loyalty;safeguard assets; and, for trusts, to use assetsproductively and according to the appropri-ate standard of care. This risk generallyexists in an institution to the extent that itexercises discretion in managing assets onbehalf of a customer.

3. Legal risk arises from the potential of unen-forceable contracts, client lawsuits, oradverse judgments to disrupt or otherwisenegatively affect the operations or conditionof a banking organization. One key dimen-sion of legal risk is supervisory action thatcould result in costly fines or other punitive



measures being levied against an institutionfor compliance breakdowns.

4. Credit risk arises from the potential that aborrower or counterparty will fail to performon an obligation.

5. Operational risk arises from the potentialthat inadequate information systems, opera-tional problems, breaches in internal con-trols, fraud, or unforeseen catastrophes willresult in unexpected losses.

Although effective management of all of theabove risks is critical for an institution, certainaspects of reputational, legal, and fiduciary risksare often unique to a private-banking function.In this regard, the following customer-due-diligence policies and practices are essential inthe management of reputational and legal risksin the private-banking functions. (In addition,sound fiduciary practices and conflicts-of-interest issues that a private-banking operationmay face in acting as fiduciary are described inthe subsection on fiduciary standards.)

2010.11.2.2.1 Customer-Due-DiligencePolicy and Procedures

Sound customer-due-diligence (CDD) policiesand procedures are essential to minimize therisks inherent in private banking. The policiesand procedures should clearly describe the tar-get client base in terms such as ‘‘minimuminvestable net worth’’ and ‘‘types of productssought,’’ as well as specifically indicate the typeof clientele the institution will or will not accept.Policies and procedures should be designed toensure that effective due diligence is performedon all potential clients, that client files are bol-stered with additional CDD information on anongoing basis, and that activity in clientaccounts is monitored for transactions that areinconsistent with the client profile and may con-stitute unlawful activities, such as money laun-dering. The client’s identity, background, andthe nature of his or her transactions should bedocumented and approved by the back officebefore opening an account or accepting clientmonies. Certain high-risk clients like foreignpoliticians or money exchange houses shouldhave additional documentation to mitigate theirhigher risk. See 31 C.F.R. 1020, subpart F, fordue diligence rules.

Money laundering is associated with a broadrange of illicit activities: the ultimate intention

is to disguise the money’s true source—fromthe initial placement of illegally derived cashproceeds to the layers of financial transactionsthat disguise the audit trail—and make the fundsappear legitimate. Under U.S. money-launderingstatutes, a bank employee can be held person-ally liable if he or she is deemed to engage in‘‘willful blindness.’’ This condition occurs whenthe employee fails to make reasonable inquiriesto satisfy suspicions about client accountactivities.

Since the key element of an effective CDDpolicy is a comprehensive knowledge of theclient, the bank’s policies and procedures shouldclearly reflect the controls needed to ensure thepolicy is fully implemented. CDD policiesshould clearly delineate the accountability andauthority for opening accounts and for determin-ing if effective CDD practices have been per-formed on each client. In addition, policiesshould delineate documentation standards andaccountability for gathering client informationfrom referrals among departments or areaswithin the institution as well as from accountsbrought to the institution by new RMs.

In carrying out prudent CDD practices onpotential private-banking customers, manage-ment should document efforts to obtain andcorroborate critical background information.Private-banking employees abroad often havelocal contacts who can assist in corroboratinginformation received from the customer. Theinformation listed below should be corroboratedby a reliable, independent source, whenpossible:

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 varietyof methods, such as—a. visiting the residence, office, factory, or

farm (with the RM recording the resultsof the visit or conversations in a memo-randum);

b. checking the information against the tele-phone directory; the client’s residence, asindicated on his or her national ID card; amortgage or bank statement or utility orproperty tax bill; or the electoral or taxrolls;

c. obtaining a reference from the client’sgovernment or known employer or fromanother bank;

d. checking with a credit bureau or profes-sional corroboration organization; or

e. any other method verified by the RM.2. Sufficient business information about the



customer should be gathered so that the RMunderstands the profile of the customer’scommercial transactions. This informationshould include a description of the nature ofthe customer’s business operations or meansof generating income, primary trade or busi-ness areas, and major clients and their geo-graphic locations, as well as the primarybusiness 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 farmb. a reliable third party who has a business

relationship with the customerc. financial statementsd. Dun and Bradstreet reportse. newspaper or magazine articlesf. Lexis/Nexis reports on the customer or

customer’s businessg. ‘‘Who’s Who’’ reports from the home

countryh. private investigations

3. Although it is often not possible to get proofof a client’s wealth, an RM can use his or hergood judgment to derive a reasonable esti-mate of the individual’s net worth.

4. As part of the ongoing CDD process, the RMshould document in memos or ‘‘call reports’’the substance of discussions that take placeduring frequent visits with the client. Addi-tional information about a client’s wealth,business, or other interests provides insightinto potential marketing opportunities for theRM and the bank, and updates and strength-ens the CDD profile.

As a rule, most private banks make it a policynot to accept walk-in clients. If an exception ismade, procedures for the necessary documenta-tion and approvals supporting the exceptionshould be in place. Similarly, other exceptionsto policy and procedures should readily identifythe specific exception and the required due-diligence and approval process for overridingexisting procedures.

In most instances, all CDD information anddocumentation should be maintained and avail-able for examination and inspection at the loca-tion where the account is located or where thefinancial services are rendered. If the bank main-tains centralized customer files in locations otherthan where the account is located or the finan-cial services are rendered, complete customerinformation, identification, and documentationmust be made available at the location wherethe account is located or where the financialservices are rendered within 48 hours of a Fed-eral Reserve examiner’s request. Off-site stor-

age of CDD information will be allowed only ifthe bank has adopted, as part of its customer-due-diligence program, specific proceduresdesigned to ensure that (1) the accounts aresubject to ongoing Office of Foreign AssetsControl screening that is equivalent to thescreening afforded other accounts, (2) theaccounts are subject to the same degree ofreview for suspicious activity, and (3) the bankdemonstrates that the appropriate review of theinformation and documentation is being per-formed by personnel at the offshore location.

CDD procedures should be no different whenthe institution deals with a financial adviser orother type of intermediary acting on behalf of aclient. To perform its CDD responsibilities whendealing with a financial adviser, the institutionshould identify the beneficial owner of theaccount (usually the intermediary’s client, but inrare cases, it is the intermediary itself) and per-form its CDD analysis with respect to that ben-eficial owner. The imposition of an intermediarybetween the institution and counterparty shouldnot lessen the institution’s CDD responsibilities.

The purpose of all private-banking relation-ships should also be readily identified. Incomingcustomer funds may be used for various pur-poses, such as establishing deposit accounts,funding investments, or establishing trusts. Thebank’s CDD procedures should allow for thecollection of sufficient information to develop atransaction or client profile for each customer,which will be used in analyzing client transac-tions. Internal systems should be developed formonitoring and identifying transactions that maybe inconsistent with the transaction or clientprofile 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 SuspiciousActivity Reports (SARs) is an important compo-nent of a bank’s CDD program. Since 1996, thefederal financial institution supervisory agenciesand the Department of the Treasury’s FinancialCrimes Enforcement Network (FinCEN) haverequired banking organizations to report knownor suspected violations of law as well as suspi-cious transactions on a SAR. See the Board’sSAR regulation (Regulation H, section 208.62[12 C.F.R. 208.62] and Regulation Y, section



225.4(f) [12 C.F.R. 225.4(f)]).3 Law enforce-ment agencies use the information reported onthe form to initiate investigations, and FederalReserve staff use the SAR information in theirexamination and oversight of supervisedinstitutions.

A member bank and a BHC are required tofile a SAR with the appropriate federal lawenforcement agencies and the Department of theTreasury. A SAR must be prepared in accor-dance with the form’s instructions. The com-pleted SAR is to be sent to FinCEN when aninstitution 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; or4. 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 amember bank must promptly notify its board ofdirectors or a committee thereof.

A SAR must be filed within 30 calendar daysafter the date of initial detection of the facts thatmay constitute a basis for filing a SAR. If nosuspect was identified on the date of detectionof the incident requiring the filing, a memberbank may delay filing a SAR for an additional30 calendar days in order to identify the suspect.Reporting may not be delayed more than 60calendar days after the date of initial detectionof 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 enforcementauthority and the Board by telephone, in addi-tion to its timely filing of a SAR.

A banking organization’s internal systems forcapturing suspicious activities should provideessential information about the nature and vol-ume of activities passing through customeraccounts. 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 ensurethat the institution’s approach to SARs is proac-tive and that well-established procedures coverthe SAR process. Accountability should existwithin the organization for the analysis andfollow-up of internally identified suspiciousactivity; this analysis should conclude with adecision on the appropriateness of filing a SAR.See the core procedures concerning suspicious-activity-reporting requirements in the FFIECBSA/AML Examination Manual.

2010.11.2.2.2 Credit-UnderwritingStandards

The underwriting standards for private-bankingloans to high net worth individuals should beconsistent with prudent lending standards. Thesame credit policies and procedures that areapplicable to any other type of lending arrange-ment should extend to these loans. At a mini-mum, sound policies and procedures shouldaddress 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 underwhich credit is granted, repayment terms, maxi-mum tenor, loan authority, collections andcharge-offs, and prohibition against capitaliza-tion of interest.

An extension of credit based solely on col-lateral, even if the collateral is cash, does notensure repayment. While the collateral en-hances the bank’s position, it should not substi-tute for regular credit analyses and prudentlending practices. If collateral is derived fromillegal activities, it is subject to forfeiturethrough the seizure of assets by a governmentagency. The bank should perform its due dili-gence by adequately and reasonably ascertain-ing and documenting that the funds of itsprivate-banking customers were derived fromlegitimate means. Banks should also verify thatthe use of the loan proceeds is for legitimatepurposes.

In addition, bank policies should explicitlydescribe the terms under which ‘‘margin loans,’’loans collateralized by securities, are made andshould ensure that they conform to applicableregulations. Management should review andapprove daily MIS reports. The risk of marketdeterioration in the value of the underlying col-lateral may subject the lender to loss if thecollateral must be liquidated to repay the loan.In the event of a ‘‘margin call,’’ any shortageshould 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.



from other sources pursuant to the terms of themargin agreement.

In addition, policies should address the accep-tance of collateral held at another location, suchas an affiliated entity, but pledged to the private-banking function. Under these circumstances,management of the private-banking functionshould, at a minimum, receive frequent reportsdetailing the collateral type and current valua-tion. In addition, management of the private-banking function should be informed of anychanges 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 proficientstaff; and development of effective policies, pro-cedures, and controls. In managing its fiduciaryrisk, the bank must ensure that it carries out thefollowing fiduciary duties:

1. Duty of loyalty. Trustees are obligated tomake all decisions based exclusively on thebest interests of trust customers. Except aspermitted by law, trustees cannot place them-selves in a position in which their interestsmight conflict with those of the trustbeneficiaries.

2. Avoidance of conflicts of interest. Conflictsof interest arise in any transaction in whichthe fiduciary simultaneously represents theinterests of multiple parties (including itsown interests) that may be adverse to oneanother. Institutions should have detailedpolicies and procedures regarding potentialconflicts of interest. All potential conflictsidentified should be brought to the attentionof management and the trust committee, withappropriate action taken. Conflicts of interestmay arise throughout an institution. Careshould be taken by fiduciary business lines,in particular, to manage conflicts of interestbetween fiduciary business lines and otherbusiness lines (including other fiduciary busi-ness lines). Consequently, managementthroughout the institution should receivetraining in these matters. For more informa-tion on the supervision of fiduciary activities,see section 3120.0 in this manual and section4200.0 in the Commercial Bank ExaminationManual.

3. Duty to prudently manage discretionary trustand agency assets. Since 1994, the majorityof states have adopted laws concerning theprudent investor rule (PIR) with respect to

the investment of funds in a fiduciary capac-ity. PIR is a standard of review that imposesan obligation to prudently manage the port-folio as a whole, focusing on the process ofportfolio management, rather than on the out-come of individual investment decisions.Although this rule only governs trusts, thestandard is traditionally applied to allaccounts for which the institution is manag-ing funds.

2010.11.2.4 Operational Controls

To minimize any operational risks associatedwith private-banking activities, management isresponsible for establishing an effective internalcontrol infrastructure and reliable managementinformation systems. Critical operational con-trols over any private-banking activity includethe establishment of written policies and proce-dures, segregation of duties, and comprehensivemanagement reporting. Throughout this section,specific guidelines and inspection proceduresfor assessing internal controls over differentprivate-banking activities are provided. Listedbelow are some of those guidelines that coverspecific private-banking services.

2010.11.2.4.1 Segregation of Duties

Banking organizations should have guidelineson the segregation of employees’ duties in orderto prevent the unauthorized waiver of documen-tation requirements, poorly documented refer-rals, and overlooked suspicious activities. Inde-pendent oversight by the back office helps toensure compliance with account-opening proce-dures and CDD documentation. Control-conscious institutions may use independentunits, such as compliance, risk management, orsenior management, to fill this function in lieuof the back office. The audit and compliancefunctions of the private-banking entity shouldbe similarly independent so that they can oper-ate autonomously from line management.

2010.11.2.4.2 Inactive and DormantAccounts

Management should be aware that banking lawsin most states prohibit banks from offering ser-vices that allow deposit accounts to be inactive



for prolonged periods of time (generally, 12 ormore months with no externally generatedaccount-balance activity). These regulations arebased on the presumption that inactive and dor-mant accounts may be subject to manipulationand abuse by insiders. Policies and proceduresshould delineate when inactivity occurs andwhen inactive accounts should be converted todormant status. Effective controls over dormantaccounts should include a specified timebetween the last customer-originated activityand its classification as dormant, the segregationof signature cards for dormant accounts, dualcontrol of records, and the blocking of theaccount so that entries cannot be posted to theaccount without review by more than one mem-ber of senior management.

2010.11.2.4.3 Pass-Through Accounts andOmnibus Accounts

Pass-through accounts (PTAs) extend checking-account privileges to the customers of a foreignbank; several risks are involved in providingthese accounts. In particular, if the U.S. bankingentity does not exercise the same due diligenceand customer vetting for PTAs as it does fordomestic account relationships, the use of PTAsmay facilitate unsafe and unsound banking prac-tices or illegal activities, including money laun-dering. Additionally, if accounts at U.S. bankingentities are used for illegal purposes, the entitiescould be exposed to reputational risk and risk offinancial loss as a result of asset seizures andforfeitures brought by law enforcement authori-ties. It is recommended that U.S. banking enti-ties terminate a payable-through arrangementwith a foreign bank in situations in which(1) adequate information about the ultimateusers of PTAs cannot be obtained, (2) the for-eign bank cannot be relied on to identify andmonitor the transactions of its own customers,or (3) the U.S. banking entity is unable to ensurethat its payable-through accounts are not beingused for money laundering or other illicit pur-poses.

Omnibus, or general clearing, accounts mayalso exist in the private-banking system. Theymay be used to accommodate client fundsbefore an account opening to expedite a newrelationship, or they may fund products such asmutual funds in which client deposit accountsmay not be required. However, these accountscould circumvent an audit trail of client transac-

tions. Examiners should carefully review abank’s use of such accounts and the adequacy ofits controls on their appropriate use. Generally,client monies should flow through client depositaccounts, which should function as the soleconduit and paper trail for client transactions.

2010.11.2.4.4 Hold-Mail, No-Mail, andE-Mail-Only Controls

Controls over hold-mail, no-mail, and e-mail-only accounts are critical because the clientshave relinquished their ability to detect unau-thorized transactions in their accounts in atimely manner. Accounts with high volume orsignificant 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 anindependent party.

2010.11.2.4.5 Funds Transfer—TrackingTransaction Flows

One way that institutions can improve their cus-tomer knowledge is by tracking the transactionflows into and out of customer accounts andpayable-through subaccounts. Tracking shouldinclude funds-transfer activities. Policies andprocedures to detect unusual or suspiciousactivities should identify the types of activitiesthat would prompt staff to investigate the cus-tomer’s activities and should provide guidanceon the appropriate action required for suspiciousactivity. The following is a checklist to guidebank personnel in identifying some potentialabuses:

1. indications of frequent overrides of estab-lished approval authority or other internalcontrols

2. intentional circumvention of approvalauthority by splitting transactions

3. wire transfers to and from known secrecyjurisdictions

4. frequent or large wire transfers for personswho have no account relationship with thebank, or funds being transferred into and outof an omnibus or general clearing accountinstead of the client’s deposit account

5. wire transfers involving cash amounts inexcess of $10,000

6. inadequate control of password access

7. customer complaints or frequent errorconditions



2010.11.2.4.6 Custody—Detection of‘‘Free Riding’’

Custody departments should monitor accountactivity to detect instances of ‘‘free-riding,’’ thepractice of offering the purchase of securitieswithout sufficient capital and then using theproceeds of the sale of the same securities tocover the initial purchase. Free-riding poses sig-nificant risk to the institution and typicallyoccurs without the bank’s prior knowledge.Free-riding also violates margin rules (Regula-tions T, U, and X) governing the extension ofcredit in connection with securities transactions.(See SR-93-13 and section 2187.0.)

2010.11.2.5 Management InformationSystems

Management information systems (MIS) shouldaccumulate, interpret, and communicate infor-mation on (1) the private-banking assets undermanagement, (2) profitability, (3) business andtransaction activities, and (4) inherent risks. Theform and content of MIS for private-bankingactivities will be a function of the size andcomplexity of the private-banking organization.Accurate, informative, and timely reports thatperform the following functions may be pre-pared and reviewed by RMs and seniormanagement:

1. aggregate the assets under managementaccording to customer, product or service,geographic area, and business unit

2. attribute revenue according to customer andproduct type

3. identify customer accounts that are related toor affiliated with one another through com-mon ownership or common control

4. identify and aggregate customer accounts bysource of referral

5. identify beneficial ownership of trust, PIC,and similar accounts

To monitor and report transaction activity and todetect suspicious transactions, managementreports may be developed to—

1. monitor a specific transaction criterion, suchas a minimum dollar amount or volume oractivity level;

2. monitor a certain type of transaction, such asone with a particular pattern;

3. monitor individual customer accounts forvariations from established transaction andactivity profiles based on what is usual or

expected for that customer; and4. monitor specific transactions for BSA and

SAR compliance.

In addition, reports prepared for private-bankingcustomers should be accurate, timely, and infor-mative. Regular reports and statements preparedfor private-banking customers shouldadequately 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 rolein building new and more direct channels ofinformation between the institution and itsprivate-banking customers. Active andsophisticated customers are increasing theirdemand for data relevant to their investmentneeds, which is fostering the creation of onlineinformation services. Online information cansatisfy customers’ desire for convenience, real-time access to information, and a seamlessdelivery of information.

2010.11.2.6 Audit

An effective audit function is vital to ensuringthe strength of a private bank’s internal controls.As a matter of practice, internal and externalauditors should be independently verifying andconfirming 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 auditfunction are the strong qualifications and exper-tise of the internal audit staff and a sound risk-assessment process for determining the scopeand frequency of specific audits. The audit pro-cess should be risk-focused and should ulti-mately determine the risk rating of businesslines and client CDD procedures. Compliancewith CDD policies and procedures and thedetailed testing of files for CDD documentationare also key elements of the audit function.Finally, examiners should review and evaluatemanagement’s responsiveness to criticisms bythe audit function.

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 havea distinct compliance department with the cen-tralized role of ensuring compliance institution-wide, including private-banking activities. Thisarrangement is strongly preferable to a situationin which an institution delegates compliance tospecific functions, which may result in the man-agement of private-banking operations beingresponsible 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 toensuring compliance with various laws andregulations such as the Bank Secrecy Act andthose promulgated by the Office of ForeignAssets Control, compliance may perform itsown internal investigations and due diligence onemployees, customers, and third parties withwhom the bank has contracted in a consulting orreferral capacity and whose behavior, activities,and transactions appear to be unusual or suspi-cious. Institutions may also find it beneficial forcompliance to review and authorize account-opening documentation and CDD adequacy fornew accounts. The role of compliance is a con-trol function, but it should not be a substitute forregular and frequent internal audit coverage ofthe private-banking function. Following is adescription of certain regulations that may bemonitored by the compliance function.

2010.11.2.7.1 Office of Foreign AssetsControl

The Office of Foreign Assets Control (OFAC) ofthe U.S. Department of the Treasury administersand enforces economic and trade sanctionsbased on U.S. foreign policy and national secu-rity goals. Sanctions are imposed against tar-geted foreign countries, terrorists, internationalnarcotics traffickers, and those engaged inactivities related to the proliferation of weaponsof mass destruction. See 31 C.F.R. subtitle B,chapter V, part 501. OFAC acts under presiden-tial wartime and national emergency powers, aswell as under authority granted by specific legis-lation, to impose controls on transactions andfreeze foreign assets under U.S. jurisdiction.Many of the sanctions are based on UnitedNations and other international mandates, aremultilateral in scope, and involve close coopera-tion with allied governments. Under the Interna-

tional Emergency Economic Powers Act, thePresident can impose sanctions, such as tradeembargoes, the freezing of assets, and importsurcharges, on certain foreign countries and the‘‘specially designated nationals’’ of thosecountries.

A ‘‘specially designated national’’ is a personor entity who acts on behalf of one of thecountries under economic sanction by theUnited States. Dealing with such nationals isprohibited. Moreover, their assets or accounts inthe United States are frozen. In certain cases,the Treasury Department can issue a license to adesignated national. This license can then bepresented by the customer to the institution,allowing the institution to debit his or heraccount. The license can be either general orspecific.

OFAC screening may be difficult when trans-actions are conducted through PICs, tokennames, numbered accounts, or other vehiclesthat shield true identities. Management mustensure that accounts maintained in a name otherthan that of the beneficial owner are subject tothe same level of filtering for OFAC speciallydesignated nationals and blocked foreign coun-tries as other accounts. That is, the OFACscreening process must include the account’sbeneficial ownership as well as the officialaccount name.

Any violation of regulations implementingdesignated national sanctions subjects the viola-tor to criminal prosecution, including prisonsentences and fines to corporations and indi-viduals, per incident. Any funds frozen becauseof OFAC orders should be placed in a blockedaccount. Release of those funds cannot occurwithout a license from the Treasury Department.

2010.11.2.7.2 Bank Secrecy Act

Guidelines for compliance with the BankSecrecy Act (BSA) can be found in the FFIECBSA/AML Examination Manual. See also thequestion-and-answer format interpretations (SR-05-9) of the U.S. Department of the Treasury’sregulation (31 C.F.R. 1010) for banking organi-zations, which is based on section 326 of thePatriot Act. In addition, the procedures for con-ducting BSA examinations of foreign offices ofU.S. banks are detailed in the FFIEC BSA/AMLExamination Manual. The SAR filing require-ments for nonbank subsidiaries of bank holdingcompanies and state member banks are also setforth in SR-10-8.



2010.11.3 PREPARATION FORINSPECTION

The following subsections provide examinerswith guidance on preparing for the on-siteinspection of private-banking operations,including determination of the inspection scopeand drafting of the first-day-letter questionnairethat is provided to the institution.

2010.11.3.1 Pre-Inspection Review

To prepare the examiners for their assignmentsand to determine the appropriate staffing andscope of the inspection, the following guidelinesshould be followed during the pre-inspectionplanning process:

1. Review the prior report of inspection andworkpapers for the inspection scope; struc-ture and type of private-banking activitiesconducted; and findings, conclusions, andrecommendations of the prior inspection.The prior inspection report and inspectionplan should also provide insight to key con-tacts at the institution and to the time frameof the prior private-banking review.

2. Obtain relevant correspondence sent sincethe prior inspection, such as management’sresponse to the report of inspection, anyapplications submitted to the FederalReserve, and any supervisory action.

3. Research press releases and published newsstories about the institution and its private-banking activities.

4. Review internal and external audit reportsand any internal risk assessments performedby the institution on its private-bankingactivities. Such reports should include anassessment of the internal controls and riskprofile of the private-banking function.

5. Contact the institution’s management toascertain what changes have occurred sincethe last inspection or are planned in the nearfuture. For example, examiners should deter-mine if there have been changes to the strate-gic plan; senior management; or the leveland type of private-banking activities, prod-ucts, and services offered. If there is no men-tion of private banking in the prior inspectionreport, management should be asked at thistime if they have commenced or plan tocommence any private-banking activities.

6. Follow these inspection procedures and alsoconsider the core examination procedures inthe FFIEC BSA/AML Examination Manualin order to establish the base scope for the

inspection of private-banking activities.Review and follow the expanded proceduresfor private banking and any other expandedprocedures that are deemed necessary.

2010.11.3.2 Inspection Staffing andScope

Once the inspection scope has been establishedand before beginning the new inspection, theexaminer-in-charge and key administrators ofthe inspection team should meet to discuss theprivate-banking inspection scope, the assign-ments of the functional areas of private banking,and the supplemental reviews of specificprivate-banking products and services. If thebank’s business lines and services overlap and ifits customer base and personnel are sharedthroughout the organization, examiners may beforced to go beyond a rudimentary review ofprivate-banking operations. They will probablyneed to focus on the policies, practices, andrisks within the different divisions of a particu-lar institution and throughout the institution’sglobal network of affiliated entities.

2010.11.3.3 Reflection of OrganizationalStructure

The review of private-banking activities shouldbe conducted on the basis of the bank holdingcompany’s organizational structure. Thesestructures may vary considerably depending onthe size and sophistication of the institution, itscountry of origin and the other geographic mar-kets in which it competes, and the objectivesand strategies of its management and board ofdirectors. To the extent possible, examinersshould understand the level of consolidatedprivate-banking activities an institution con-ducts in the United States and abroad. Thisbroad view is needed to maintain the ‘‘big pic-ture’’ impact of private banking for a particularinstitution.

For bank holding company inspections,examiners must consider the provisions of theGramm-Leach Bliley Act, which amended sec-tion 5(c) of the Bank Holding Company Act,that concern examinations and inspections. Inparticular, examiners must adhere to those statu-tory provisions that pertain to the inspections ofbank 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 oftesting of private-banking practices shouldreflect the degree of risk assumed, prior examfindings on the implementation of policies andprocedures, the effectiveness of controls, and anassessment of the adequacy of the internal auditand compliance functions. If initial inquiriesinto the institution’s internal audit and otherassessment practices raise doubts about theinternal system’s effectiveness, expanded analy-sis and review are required—and examinersshould perform more transaction testing. Exam-iners will usually need to follow the core exami-nation procedures in the FFIEC BSA/AMLExamination Manual, as well as the expandedprocedures for private banking. Other expandedprocedures should be followed if circumstancesdictate.

2010.11.3.5 First-Day Letter

As part of the inspection preparation, examinersshould customize the first-day-letter question-naire to reflect the structure and type of private-banking activities of the institution and thescope of the exam. The following is a list ofrequests regarding private banking that examin-ers should consider including in the first-dayletter. Responses to these items should bereviewed in conjunction with responses to theBSA, fiduciary, audit, and internal control inqui-ries:

1. organizational chart for the private bank onboth a functional and legal-entity basis

2. business or strategic plan3. income and expense statements for the prior

fiscal year and current year to date, withprojections for the remainder of the currentand the next fiscal year, and income byproduct division and marketing region

4. balance-sheet and total assets under man-agement (list the most active and profitableaccounts by type, customer domicile, andresponsible account officer)

5. most recent audits for private-bankingactivities

6. copies of audit committee minutes7. copy of the CDD and SAR policies and

procedures8. list of all new business initiatives intro-

duced last year and this year, relevant new-product-approval documentation thataddresses the evaluation of the unique char-acteristics and risk associated with the newactivity or product, and an assessment ofthe risk-management oversight and controlinfrastructures in place to manage the risks

9. list of all accounts in which an intermediaryis acting on behalf of clients of the privatebank, for example, as financial advisers ormoney 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 aggregatingclient holdings and activities across busi-ness units throughout the organization

12. explanation of how related accounts, suchas common control and family link, areidentified

13. name of a contact person for information oncompensation, training, and recruiting pro-grams for relationship managers

14. list of all personal investment companyaccounts

15. list of reports that senior managementreceives regularly on private-bankingactivities

16. description and sample of the managementinformation reports that monitor accountactivity

17. description of how senior managementmonitors compliance with global policiesfor worldwide operations, particularly foroffices operating in secrecy jurisdictions

18. appropriate additional items from the coreand expanded procedures for private bank-ing, as set forth in the FFIEC BSA/AMLExamination Manual, as well as any otheritems from the expanded procedures thatare needed to gauge the adequacy of theBSA/AML program for private-bankingactivities.


1. To determine if the policies, practices, proce-dures, and internal controls regardingprivate-banking activities are adequate forthe risks involved.

2. To determine if the institution’s officers and



employees are operating in conformancewith established guidelines for conductingprivate-banking activities.

3. To assess the financial condition and income-generation results of the private-bankingactivities.

4. To determine the scope and adequacy of theaudit function for private-banking activities.

5. To determine compliance with applicablelaws and regulations for private banking.

6. To initiate corrective action when policies,practices, procedures, or internal controls aredeficient, or when violations of laws or regu-lations are found.


The examiner-in-charge should supplement thefollowing procedures, as appropriate, with theexamination procedures for private banking, asset forth in the FFIEC BSA/AML ExaminationManual.

2010.11.5.1 Private-BankingPre-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 arudimentary review of private-bankingoperations if the institution’s businesslines and services overlap and if its cus-tomer base and personnel are sharedthroughout the organization. Examinerswill probably need to focus on the poli-cies, practices, and risks within the differ-ent divisions of each particular institutionand throughout each institution’s globalnetwork of affiliated entities.);

b. examiner assignments of the functionalareas of private banking; and

c. the supplemental reviews of specificprivate-banking products and services.

2. Review the prior report of inspection and theprevious inspection workpapers; descriptionof the inspection scope; structure and type ofprivate-banking activities conducted; andfindings, conclusions, and recommendationsof the prior inspection. The prior inspectionreport and inspection plan should also pro-vide information and insight on key contactsat the institution and on the time frame of theprior 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 FederalReserve, and any supervisory actions.

4. Research press releases and published newsstories about the institution and its private-banking activities.

5. Review internal and external audit reportsand any internal risk assessments performedby the institution’s internal or external audi-tors on its private-banking activities. Reviewinformation on any assessments of the inter-nal controls and risk profile of the private-banking function.

6. Contact management at the institution toascertain what changes in private-bankingservices have occurred since the last inspec-tion or if there are any planned in the nearfuture.a. Determine if the previous inspection or

examination report(s) mention privatebanking; if not, ask management if theyhave commenced or plan to commenceany private-banking activities within anypart of the bank holding companyorganization.

b. Determine if there have been any changesto the strategic plan; senior management;or the level and type of private-bankingactivities, products, and services offered.

c. During the entire inspection of private-banking activities, be alert to the totalityof the client relationship, product by prod-uct, in light of increasing client awarenessand use of derivatives, emerging-marketproducts, foreign exchange, and marginedaccounts.

2010.11.5.2 Full-Inspection Phase

1. After reviewing the private-banking func-tional areas, draw sound conclusions aboutthe quality and culture of management andstated private-banking policies.

2. Evaluate the adequacy of risk-managementpolicies and practices governing private-banking activities.

3. Assess the organization of the private-banking function and evaluate the quality ofmanagement’s supervision of private-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 tothe operation of the private-bankingactivities; and

b. discharge of responsibilities by the insti-tution’s directors through a long-rangeorganizational plan that accommodatesthe volume and business serviceshandled, local business practices and theinstitution’s competition, and the growthand development of the institution’sprivate-banking business.

4. Determine if management has effective pro-cedures for conducting ongoing reviews ofclient-account activity to detect, and protectthe client from, any unauthorized activityand any account activity that is inconsistentwith the client’s profile (for example, fre-quent or sizeable unexplained transfersflowing through the account).

5. Determine if the bank holding company hasinitiated and maintained controls and proce-dures that require each subsidiary private-banking institution to have account-openingprocedures and documentation require-ments that must be satisfied before anaccount can be opened.

6. Determine if the bank holding companyrequires its subsidiary institutions to main-tain and adhere to well-structured CCDprocedures.

7. Determine if the bank holding company hasproper controls and procedures to ensureeach institution’s proper administration oftrust and estates, including strict controlsover assets, prudent investment and man-agement of assets, and meticulous record-keeping. Review previous trust examinationreports 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 holdingcompany should ensure that each institutionhas established and currently maintains pro-cedures for the proper administration ofcustody services, including the regularreview of the services on a preset schedule.

9. Determine whether subsidiary institutionsare required to and actually maintain strongcontrols and supervision over fundstransfers.

10. Ascertain if institution management andstaff are required to perform due diligence,that is, to verify and document that thefunds of its private-banking customers werederived through legitimate means, andwhen extending credit, to verify that the useof loan proceeds was legitimate.

11. Review the institution’s use of depositaccounts.a. Assess the adequacy of the institution’s

controls and whether they are appropri-ately used.

b. Determine if client monies flow throughclient deposit accounts and whether theaccounts function as the sole conduit andpaper trail for client transactions.

12. Determine and ensure that each institution’sapproach to Suspicious Activity Reports(SARs) is proactive and that the bank hold-ing company and each institution have well-established procedures covering the SARprocess. Establish whether there is account-ability within the organization for the analy-sis and follow-up of internally identifiedsuspicious activity (this analysis includes asound decision on whether the bank holdingcompany or an institution needs to file, or isrequired by regulation to file, a SAR).



Fees Involving Investments of Fiduciary Assets in Mutual Fundsand Potential Conflicts of Interest Section 2010.12

Banking organizations, including trust institu-tions, are increasingly encountering variousdirect or indirect financial incentives to placetrust assets with particular mutual funds. Suchincentives include the payment of fees to bank-ing organizations for using nonaffiliated fundfamilies as well as other incentives for usingthose mutual funds that are managed by theinstitution or an affiliate. The payment of suchfees, referred to variously as shareholder, subac-counting, or administrative service fees, may bestructured as payments to reimburse the institu-tion for performing standard recordkeeping andaccounting functions for the institution’s fidu-ciary accounts. Those functions may consist ofmaintaining shareholder subaccounts andrecords, transmitting mutual fund communica-tions as necessary, and arranging mutual fundtransactions. These fees are typically based on apercentage or basis point amount of the dollarvalue of assets invested, or on transaction vol-ume. Another form of compensation may con-sist of a lump-sum payment based on assetstransferred into a mutual fund.

In all cases, decisions to place fiduciary assetsin particular investments must be consistentwith the underlying trust documents and mustbe undertaken in the best interests of the trustbeneficiary. The primary supervisory concern isthat an institution may fail to act in the bestinterest of beneficiaries if it stands to benefitindependently from a particular investment. Asa result, an institution may expose itself to anincreased risk of legal action by account benefi-ciaries, as well as to potential violations of lawor regulation.

In recent years, nearly every state legislaturehas modified its laws explicitly to allow fiducia-ries to accept fees from mutual funds undercertain conditions. As for the permissibility ofother financial incentives, guidance under appli-cable law may be less clear. Conditions involv-ing fee payments under state law often includecompliance with standards of prudence, quality,and appropriateness for the account, and a deter-mination of the ‘‘reasonableness’’ of the feesreceived by the institution. The Office of theComptroller of the Currency (OCC) has alsoadopted these general standards for nationalbanks.1 The Employee Retirement Income Secu-

rity Act of 1974 (ERISA), however, generallyprohibits fee arrangements between fiduciariesand third parties, such as mutual fund providers,with limited exceptions.2 ERISA requirementssupersede state laws and guidelines put forth bythe bank regulatory agencies.

Similar conflict-of-interest concerns areraised by the investment of fiduciary-accountassets in mutual funds for which the institutionor an affiliate acts as investment adviser(referred to as ‘‘proprietary’’ funds). In this case,the institution receives a financial benefit frommanagement fees generated by the mutual fundinvestments. This activity can be expected tobecome more prevalent as banking organiza-tions more actively offer proprietary mutualfunds.3 See SR-99-7.

2010.12.1 DUE-DILIGENCE REVIEWNEEDED BEFORE ENTERING INTOFEE ARRANGEMENTS

Although many state laws now explicitly autho-rize certain fee arrangements in conjunctionwith the investment of trust assets in mutualfunds, institutions nonetheless face heightenedlegal and compliance risks from activities inwhich a conflict of interest exists, particularly ifproper fiduciary standards are not observed anddocumented. Even when the institution does notexercise investment discretion, disclosure orother requirements may apply. Therefore, insti-tutions should ensure that they perform anddocument an appropriate level of due diligencebefore entering into any fee arrangements simi-lar to those described earlier or placing fiduciaryassets in proprietary mutual funds. The follow-ing measures should be included in this process:

1. Reasoned legal opinion.The institutionshould obtain a reasoned opinion of counselthat addresses the conflict of interest inherentin the receipt of fees or other forms of com-

1. In general, national banks may make these investmentsand receive such fees if applicable law authorizes the practiceand if the investment is prudent and appropriate for fiduciaryaccounts and consistent with established state law fiduciaryrequirements. This includes a ‘‘reasonableness’’ test for anyfees 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 Board interpretation of Regulation Y addresses invest-ment of fiduciary-account assets in mutual funds for whichthe trustee bank’s holding company acts as investmentadviser. In general, such investments are prohibited unlessspecifically authorized by the trust instrument, court order, orstate law. See 12 C.F.R. 225.125.


pensation from mutual fund providers in con-nection with the investment of fiduciaryassets. 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 wellas any applicable disclosure requirements orreasonableness standard for fees set forth inthe law.

2. Establishment of policies and procedures.The institution should establish written poli-cies and procedures governing the accep-tance of fees or other compensation frommutual fund providers as well as the use ofproprietary mutual funds. The policies mustbe reviewed and approved by the institu-tion’s board of directors or its designatedcommittee. Policies and procedures should,at a minimum, address the following issues:(1) designation of decision-making author-ity; (2) analysis and documentation of invest-ment decisions; (3) compliance with applica-ble laws, regulations, and sound fiduciaryprinciples, including any disclosure require-ments or ‘‘reasonableness’’ standards forfees; and (4) staff training and methods formonitoring compliance with policies andprocedures by internal or external audit staff.

3. Analysis and documentation of investmentdecisions.When fees or other compensationare received in connection with fiduciary-account investments over which the institu-tion has investment discretion or when suchinvestments are made in the institution’s pro-prietary mutual funds, the institution shouldfully document its analysis supporting theinvestment decision. This analysis should beperformed on a regular, ongoing basis andwould typically include factors such as his-torical performance comparisons with simi-lar mutual funds, management fees andexpense ratios, and ratings by recognizedmutual fund rating services. The institutionshould also document its assessment that theinvestment is, and continues to be, (1) appro-priate for the individual account, (2) in thebest interest of account beneficiaries, and(3) in compliance with the provisions of the‘‘prudent investor’’ or ‘‘prudent man rules,’’as appropriate.


1. To determine that the institution has per-

formed ongoing due-diligence reviews whenit is receiving fees or other compensation forinvesting fiduciary assets in mutual funds orinvesting such assets in proprietary mutualfunds.

2. To determine that the institution maintainsfull ongoing documentation of investmentdecisions and performance, and obtains legalopinions regarding its compliance with appli-cable laws and fiduciary standards, as well aspotential conflicts of interest that may arisefrom its receiving fees or other compensationfor investing fiduciary assets in mutual funds,including proprietary funds.


1. Determine if a written legal opinion is on filethat focuses on conflicts of interest that mayarise from the receipt of fees and other com-pensation from mutual fund providers forinvesting fiduciary assets, and from theinvestment of these assets in proprietarymutual funds. Ascertain whether the legalopinion addresses the investment’s permissi-bility, including its resulting compensationand any disclosure requirements under appli-cable state or federal laws, the trust instru-ment, or a court order.

2. Verify that the institution’s board of directorshas approved written policies and proceduresgoverning the acceptance of fees and othercompensation from mutual fund providersfor placing investments with their firms andfor the use of proprietary funds. Ascertainthat the policies and procedures, at aminimum—a. determine what group or individual has

decision-making authority;b. analyze and document supporting invest-

ment decisions;c. require compliance with applicable laws,

regulations, and sound fiduciary prin-ciples, including disclosure requirementsor reasonableness standards for fees; and

d. address staff training and methods formonitoring compliance with policies andprocedures by internal and external auditstaff.

3. When fees and other compensation are beingreceived in connection with fiduciary-account investments (those in which theinstitution has authorized discretionaryinvestment authority) or when such assetsare involved in proprietary mutual funds,ascertain whether there is full documentationof the institution’s analysis supporting its

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


investment decisions on a regular, ongoingbasis. Ascertain that the documentationincludes—a. historical performance comparisons with

other mutual funds, engagement fees andexpense ratios, and ratings by recognizedmutual fund rating agencies;

b. an assessment that the investments are,and continue to be, appropriate for theindividual account and in the best inter-ests of its account beneficiaries; and

c. evidence of continued compliance withthe provisions of the ‘‘prudent investor’’or ‘‘prudent man rules.’’

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


Supervision of Subsidiaries (Establishing Accounts for ForeignGovernments, Embassies, and Political Figures) Section 2010.13

On June 15, 2004, an interagency advisory con-cerning the embassy banking business andrelated banking matters was issued by the fed-eral banking and thrift agencies1 in coordinationwith the U.S. Department of the Treasury’sFinancial Crimes Enforcement Network. Thepurpose of the advisory is to provide generalguidance to financial institutions regarding thetreatment of accounts for foreign governments,foreign embassies, and senior foreign politicalfigures.

The joint interagency statement advises finan-cial institutions2 that the decision to accept orreject an embassy or foreign governmentaccount is theirs alone to make. Financial insti-tutions should be aware, however, that there arevarying degrees of risk associated with suchaccounts, depending on the customer and thenature of the services provided. Financial insti-tutions should take appropriate steps to managesuch risks, consistent with sound practices andapplicable anti-money-laundering laws andregulations. The advisory also encourages finan-cial institutions to direct questions aboutembassy banking to their primary federal bankregulators. See SR letter 04-10, “BankingAccounts for Foreign Governments, Embassies,and Political Figures.”

On March 24, 2011, another interagencyadvisory was issued to supplement the 2004interagency advisory. The 2011 advisory pro-vides information to financial institutions pro-viding account services to foreign embassies,consulates, and missions (“foreign missions”) ina manner that fulfills the needs of those foreigngovernments while complying with the provi-sions of the Bank Secrecy Act (BSA). It advisesthat financial institutions are expected to demon-strate the capacity to conduct appropriate riskassessments and implement the requisite con-trols and oversight systems to effectively man-age the risk identified in these relationships withforeign missions. The 2011 advisory also con-firms that it is the financial institution’s decisionto accept or reject a foreign mission account.See SR letter 11-6, “Guidance on AcceptingAccounts from Foreign Embassies, Consulates

and Missions.” See also the FFIEC BankSecrecy 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 ADVISORYON ACCEPTING ACCOUNTS FORFOREIGN GOVERNMENTS,EMBASSIES, AND POLITICALFIGURES

The 2004 and 2011 interagency advisoriesanswer questions on whether financial institu-tions should do business with foreign embassiesand whether institutions should establishaccount services for foreign governments, for-eign embassies, and senior foreign political fig-ures. As it would with any new account, aninstitution should evaluate whether or not toaccept a new account for a foreign government,embassy, or political figure. That decisionshould be made by the institution’s manage-ment, under standards and guidelinesestablished by the board of directors, and shouldbe based on the institution’s own businessobjectives, its assessment of the risks associatedwith particular accounts or lines of business,and its capacity to manage those risks. Theagencies will not, in the absence of extraordi-nary circumstances, direct or encourage anyinstitution to open, close, or refuse a particularaccount or relationship.

Providing financial services to foreign gov-ernments and embassies and to senior foreignpolitical figures can, depending on the nature ofthe customer and the services provided, involvevarying degrees of risk. Such services can rangefrom account relationships that enable anembassy to handle the payment of operationalexpenses—for example, payroll, rent, andutilities—to ancillary services or accounts pro-vided to embassy staff or foreign-governmentofficials. Each of these relationships potentiallyposes different levels of risk. Institutions areexpected to assess the risks involved in any suchrelationships and to take steps to ensure boththat such risks are appropriately managed andthat the institution can do so in full compliancewith its obligations under the BSA, as amendedby the USA PATRIOT Act, and the regulationspromulgated 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 2017Page 1

When an institution elects to establish finan-cial relationships with foreign governments,embassies, or senior foreign political figures, theagencies, consistent with their usual practice ofrisk-based supervision, will make their ownassessment of the risks involved in such busi-ness. As is the case with all accounts, the institu-tion should expect appropriate scrutiny byexaminers that is commensurate with the levelof risk presented by the account relationship. Asin any case where higher risks are presented, theinstitution should expect an increased level ofreview by examiners to ensure that the institu-tion has in place controls and compliance over-sight systems that are adequate to monitor andmanage such risks, as well as personnel trainedin the management of such risks and in therequirements of applicable laws and regulations.

Institutions that have or are considering tak-ing on relationships with foreign governments,embassies, or political figures should ensure thatsuch customers are aware of the requirements ofU.S. laws and regulations to which the institu-tion is subject. Institutions should, to the maxi-mum extent feasible, seek to structure suchrelationships in order to conform them to con-ventional U.S. domestic banking relationshipsso as to reduce the risks that might be presentedby such relationships.

2010.13.2 RISK MITIGATION ANDSUPERVISORY EXPECTATIONS FORFOREIGN MISSIONS

A financial institution should manage the risksassociated 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 tomanage its risk in a number of ways. A financialinstitution 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 acustomer relationship, a financial institutionshould assess the risks posed such as the volumeof activity, number of accounts, and countryrisk.

A financial institution may also mitigate riskby entering into a written agreement with theforeign mission that clearly defines the terms ofuse for the account(s) setting forth availableservices, acceptable transactions, and accesslimitations. Similarly, the financial institutioncould offer limited purpose accounts, such asthose used to facilitate operational expense pay-ments (e.g., payroll, rent and utilities, routinemaintenance), which are generally consideredlower risk and allow the foreign mission tocarry out its customary functions in the UnitedStates. Account monitoring to ensure compli-ance with account limitations and the terms ofany service agreements is essential to mitigaterisks associated with these accounts.

A financial institution may also provide ancil-lary services or accounts to foreign missionpersonnel and their families. As with foreignmission accounts, written agreements, whichclearly define the terms of use for these types ofservices or accounts, may assist in mitigatingthe varying degrees of risk.

As with any type of accountholder, the agen-cies expect financial institutions to demonstratethe capacity to conduct appropriate risk assess-ments and implement the requisite controls andoversight systems to effectively manage varyingdegrees of risks in financial relationships withforeign missions. The agencies, consistent withtheir usual practice of risk-based supervision,will evaluate the risks associated with theaccount relationship and mitigating controlsimplemented. The agencies will not direct orrequire any financial institution to close orrefuse a particular account or relationship,except in extraordinary circumstances (forexample, when violations of law are identifiedthat warrant an administrative enforcementaction).

Supervision of Subsidiaries (Establishing Accounts for Foreign Governments, Embassies, and Political Figures) 2010.13

BHC Supervision Manual September 2017Page 2

Bank Holding Company, Supervision Manual, Section 2000-2010

Documents

Transcript of Bank Holding Company, Supervision Manual, Section 2000-2010