Legal Risk Section 2070 - Federal ReserveSection 2070.1 An institution’s trading and...

Legal RiskSection 2070.1

An institution’s trading and capital-marketsactivities can lead to significant legal risks.Failure to correctly document transactions canresult in legal disputes with counterparties overthe terms of the agreement. Even if adequatelydocumented, agreements may prove to be unen-forceable if the counterparty does not have theauthority to enter into the transaction or if theterms of the agreement are not in accordancewith applicable law. Alternatively, the agree-ment may be challenged on the grounds that thetransaction is not suitable for the counterparty,given its level of financial sophistication, finan-cial condition, or investment objectives, or onthe grounds that the risks of the transaction werenot accurately and completely disclosed to theinvestor.

As part of sound risk management, institu-tions should take steps to guard themselvesagainst legal risk. Active involvement of theinstitution’s legal counsel is an important ele-ment in ensuring that the institution has ade-quately considered and addressed legal risk. Aninstitution’s policies and procedures shouldinclude appropriate review by in-house or out-side counsel as an integral part of the institu-tion’s trading and capital-markets activities,including new-product development, creditapproval, and documentation of transactions.While some issues, such as the legality of a typeof transaction, may be addressed on a jurisdiction-wide basis, other issues, such as the enforceabil-ity of multibranch netting agreements coveringseveral jurisdictions, may require review ofindividual contracts.

An institution should have established proce-dures to ensure adequate legal review. Forexample, review by legal counsel may berequired as part of the product-development orcredit-approval process. Legal review is alsonecessary for an institution to establish the typesof agreements to be used in documenting trans-actions, including any modifications to standard-ized agreements that the institution considersappropriate. The institution should also ensurethat prior legal opinions are reviewed periodi-cally to determine if they are still valid.

DOCUMENTATION

If the terms of a transaction are not adequatelydocumented, there is a risk that the transaction

will prove unenforceable. Many trading activi-ties, such as securities trading, commonly takeplace without a signed agreement, as each indi-vidual transaction generally settles within a veryshort time after the trade. The trade confirma-tions generally provide sufficient documentationfor these transactions, which settle in accor-dance with market conventions. Other tradingactivities involving longer-term, more complextransactions may necessitate more comprehen-sive and detailed documentation. Such documen-tation ensures that the institution and its coun-terparty agree on the terms applicable to thetransaction. In addition, documentation satisfiesother legal requirements, such as the ‘‘statutes offrauds’’ that may apply in many jurisdictions.Statutes of frauds generally require signed, writ-ten agreements for certain classes of contracts,such as agreements with a duration of more thanone year (including both longer-term transac-tions such as swaps and master or nettingagreements for transactions of any duration).Some states, such as New York, have providedlimited exceptions from their statutes of fraudsfor certain financial contracts when other sup-porting evidence, such as confirmations or taperecordings, is available.

In the over-the-counter (OTC) derivativesmarkets, the prevailing practice has been forinstitutions to enter into master agreements witheach counterparty. Master agreements are alsobecoming common for other types of transac-tions, such as repurchase agreements. Each mas-ter agreement identifies the type of products andspecific legal entities or branches of the institu-tion and counterparty that it will cover. Enteringinto a master agreement may help to clarify thateach subsequent transaction with the counter-party will be made subject to uniform terms andconditions. In addition, a master agreement thatincludes netting provisions may reduce theinstitution’s overall credit exposure to thecounterparty.

An institution should specify its documenta-tion requirements for transactions and its proce-dures for ensuring that documentation is consis-tent with orally agreed-on terms. Transactionsentered into orally, with documents to follow,should be confirmed as soon as possible. Docu-mentation policies should address the terms thatwill be covered by confirmations for specifictypes of transactions and what transactions are

Trading and Capital-Markets Activities Manual September 2002

covered by a master agreement; policies shouldspecify when additional documentation beyondthe confirmation is necessary. When masteragreements are used, policies should cover thepermissible types of master agreements. Appro-priate controls should be in place to ensure thatthe confirmations and agreements used satisfythe institution’s policies. Additional issues re-lated to the enforceability of the netting provi-sions of master agreements are discussed belowin ‘‘ Enforceability Issues.’’

Trigger Events

Special attention should be given to the defini-tion of ‘‘ trigger events,’’ which provide forpayment from one counterparty to another orpermit a counterparty to close out a transactionor series of transactions. In the ordinary courseof events, contractual disputes can be resolvedby parties who wish to continue to enter intotransactions with one another, but these disputescan become intractable if serious market disrup-tions occur. Indeed, the 1998 Russian marketcrisis raised calls for the establishment of aninternational dispute-resolution tribunal to handlethe large volume of disputed transactions whenthe Russian government announced its debtmoratorium and restructuring.

Trigger events need to be clearly and pre-cisely defined. In the Russian crisis, the triggerevents in some master agreements did not includea rescheduling of or moratorium on the paymentof sovereign debt. Even when sovereign debt iscovered by the master agreement, it may beappropriate to specify that not only debt directlyissued by the sovereign, but also debt issuedthrough governmental departments and agenciesor through other capital-raising vehicles, fallswithin the scope of the trigger event. Moreover,when a trigger event has occurred, but thecontract expires before the expiration of a cureperiod or before the completion of a debtrestructuring, the nondefaulting party can losethe protection of the contract absent clear pro-visions to the contrary.

The occurrence of trigger events also maygive rise to disputes regarding the appropriatesettlement rate at which to close out contracts. Itmay be difficult to argue in favor of substitutesettlement rates that were not referenced as apricing source in the original documentation.However, original pricing sources may not be

available or may be artificially maintained atnonmarket rates by a government seeking topreserve its currency.

Contracts also should be clear as to whethercross-default provisions allow or require theclose-out of other contracts between the parties.Finally, close-out provisions should be reviewedto determine what conditions need to be metbefore the contract can be finally closed out.Formalities in some contracts may delay theclose-out period significantly, further injuring anondefaulting counterparty.

Netting

To reduce settlement, credit, and liquidity risks,institutions increasingly use netting agreementsor master agreements that include netting pro-visions. ‘‘ Netting’’ is the process of combiningthe payment or contractual obligations of two ormore parties into a single net payment or obli-gation. Institutions may have bilateral nettingagreements covering the daily settlement ofpayments such as those related to check-clearingor foreign-exchange transactions. Bilateral mas-ter agreements with netting provisions maycover OTC derivatives or other types of trans-actions, such as repurchase agreements.

The Commodity Futures Trading Commis-sion (CFTC) has exempted a broad range ofOTC derivatives from the Commodity ExchangeAct, eliminating the risk that instruments meet-ing certain conditions would be found to beillegal off-exchange futures under U.S. law. Theexemption nevertheless limits the use of multi-lateral netting and similar arrangements forreducing credit and settlement risk, and reservesthe CFTC’s enforcement authority with respectto fraud and market manipulation.1

The CFTC’s exemption provides significantcomfort with respect to the legality of most OTCderivative instruments within the United States.The risk that a transaction will be unenforceablebecause it is illegal may be higher in otherjurisdictions, however. Jurisdictions outside theUnited States also may have licensing or otherrequirements that must be met before certainOTC derivatives or other trading activities canbe legally conducted.

1. See 17 CFR 35. Instruments covered by the CFTC’sexemption are also excluded from the coverage of statebucket-shop and gambling laws.

2070.1 Legal Risk

September 2002 Trading and Capital-Markets Activities Manual

Master Agreements

Master agreements generally provide for routinetransaction and payment netting and for close-out netting in the event of a default. Under thetransaction- and payment-netting provisions ofsuch an agreement, all payments for the samedate in the same currency for all covered trans-actions are netted, resulting in one payment ineach currency for any date on which paymentsare made under the agreement. Close-out nettingprovisions, on the other hand, generally aretriggered by certain default events, such as afailure to make payments or insolvency. Suchevents may give the nondefaulting party theright to require early termination and close-outof the agreement. Under close-out netting, thepositive and negative current replacement val-ues for each transaction under the agreement arenetted for the nondefaulting counterparty toobtain a single sum, either positive or negative.If the sum of the netting is positive (that is, thetransactions under the agreement, taken as awhole, have a positive value to the nondefault-ing counterparty), then the defaulting counter-party owes that sum to the nondefaultingcounterparty.

The results may differ if the net is negative,that is, the contracts have a positive value to thedefaulting counterparty. Some master agree-ments include so-called walk-away clauses,under which a nondefaulting counterparty is notrequired to pay the defaulting counterparty forthe positive value of the netting to the defaultingcounterparty. The current trend, however, hasbeen to require payments of any positive netvalue to either party, regardless of whether theparty defaulted. Revisions to the Basel CapitalAccord have reinforced this trend by not recog-nizing netting agreements that include a walk-away clause, as discussed more fully below.

Enforceability Issues

The effectiveness of netting in reducing riskdepends on both the adequacy and enforceabil-ity of the legal arrangements in place. Theunenforceability of a netting agreement mayexpose an institution to significant losses if itrelies on the netting agreement to manage itscredit risk or for capital purposes.

A major concern for market participants hasbeen the enforceability in bankruptcy of theclose-out netting provisions of master agree-

ments covering multiple derivative transactions.When a bank has undertaken a number ofcontracts with a particular counterparty that aresubject to a master agreement, the bank runs therisk that, in the event of the counterparty’sfailure, the receiver for the counterparty willrefuse to recognize the validity of the nettingprovisions. In such an event, the receiver could‘‘ cherry pick,’’ that is, repudiate individual con-tracts under which the counterparty was obli-gated to pay the bank while demanding paymenton those contracts on which the bank wasobligated to pay the counterparty. The FinancialInstitutions Reform, Recovery, and EnforcementAct of 1990 (FIRREA) and amendments to theBankruptcy Code, as well as the payment sys-tem risk-reduction provisions of the FederalDeposit Insurance Corporation Improvement Act(FDICIA), have significantly reduced this riskfor financial institutions in the United States.2The enforceability of close-out netting remains asignificant risk in dealing with non-U.S. coun-terparties that are chartered or located in juris-dictions where the legal status of netting agree-ments may be less well settled. Significantissues concerning enforcement and collectionunder netting agreements also arise when thecounterparty is an uninsured branch of a foreignbank chartered in a state, such as New York, thathas adopted a ‘‘ ring-fencing’’ statute providingfor the separate liquidation of such branches.

In evaluating the enforceability of a nettingcontract, an institution needs to consider anumber of factors. First, the institution needs todetermine the legal entity that is its counter-party. For example, if the bank is engaging intransactions with a U.S. branch of a foreignbank, the relevant legal entity generally wouldbe the foreign bank itself. Some master agree-ments, however, are designed to permit nettingof transactions with multiple legal entities. Afurther consideration is the geographic coverageof the agreement. In some instances, bank coun-terparties have structured their netting agree-ments to cover transactions entered into betweenmultiple branches of the counterparties in avariety of countries, thereby potentially subject-ing the agreements to a variety of legal regimes.Finally, the range of transactions to be coveredin a single agreement is an important consider-

2. Risks related to netting enforceability have not beencompletely eliminated in the United States. Validation ofnetting under FDICIA is limited to netting among entities thatmay be considered to be ‘‘fi nancial institutions.’’

Legal Risk 2070.1


ation. While there is an incentive to cover abroad range of contracts to achieve a greaterreduction of credit risk, overinclusion may becounterproductive if contracts that could jeop-ardize the enforceability of the entire agreementare included. Some institutions deal with thisrisk by having separate agreements for particu-lar products, such as currency contracts, orseparate master agreements covered by an over-all ‘‘ master master agreement.’’

Regardless of the scope of a master agree-ment, clarity is an important factor in ensuringthe enforceability of netting provisions. Theagreement should clearly specify the types ofdeals to be netted, mechanisms for valuation andnetting, locations covered, and the office throughwhich netting will be done.

Reliance on Netting Agreements

While netting agreements have the potential tosubstantially reduce credit risk to a counterparty,an institution should not rely on a nettingagreement for credit-risk-management purposesunless it has adequate assurances that the agree-ment would be legally enforceable in the eventof a legal challenge. Further, netting will berecognized for capital purposes only if the bankhas satisfied the requirements set forth in theBasel Capital Accord (the accord). To meetthese requirements, the netting contract or agree-ment with a counterparty must create a singlelegal obligation, covering all transactions to benetted, such that the bank would have either aclaim to receive or an obligation to pay only thenet amount of the individual transactions if acounterparty fails to perform because of default,bankruptcy, liquidation, or other similar circum-stances.3 Netting contracts that include a walk-away clause are not recognized for capital pur-poses under the accord.

To demonstrate that a netting contract meetsthe requirements of the accord, the bank mustobtain written and reasoned legal opinions that,in the event of a legal challenge, the relevantcourts and administrative authorities would findthe bank’s exposure to be the net amount under—

• the law of the jurisdiction in which the coun-terparty is chartered and, if a foreign branch ofa counterparty is involved, then also under thelaw of the jurisdiction in which the branch islocated;

• the law that governs the individual transac-tions; and

• the law that governs any contract or agree-ment necessary to effect the netting.4

Under the accord, the bank also must haveprocedures in place to ensure that the legalcharacteristics of netting arrangements are regu-larly reviewed in light of possible changes inrelevant law. To help determine whether to relyon a netting arrangement, many institutionshave procedures for internally assessing or ‘‘ scor-ing’’ legal opinions from relevant jurisdictions.These legal opinions may be prepared by out-side or in-house counsel. A generic industry orstandardized legal opinion may be used to sup-port reliance on a netting agreement for aparticular jurisdiction. The institution shouldhave procedures for review of the terms ofindividual netting agreements, however, toensure that the agreement does not raise issues,such as enforceability of the underlying trans-actions, choice of law, and severability, that arenot covered by the general opinion.

Institutions also rely on netting arrangementsin managing credit risk to counterparties. Insti-tutions may rely on a netting agreement forinternal risk-management purposes only if theyhave obtained adequate assurances on the legalenforceability of the agreement in the event of alegal challenge. Such assurances generally wouldbe obtained by acquiring legal opinions thatmeet the requirements of the accord.

Multibranch Agreements

A multibranch master netting agreement coverstransactions entered into between multiplebranches of an institution or its counterparty thatare located in a variety of countries. Theseagreements may cover branches of the institu-

3. The agreement may cover transactions excluded fromthe risk-based capital calculations, such as exchange-ratecontracts with an original maturity of 14 calendar days or lessor instruments traded on exchanges requiring daily margin.The institution may consistently choose either to include orexclude the mark-to-market values of such transactions whendetermining net exposure.

4. A netting contract generally must be found to beenforceable in all of the relevant jurisdictions in order for aninstitution to rely on netting under the contract for capitalpurposes. For those jurisdictions in which the enforceability ofnetting may be in doubt, however, an institution may be able,in appropriate circumstances, to rely on opinions that thechoice of governing law made by the counterparties to theagreement will be respected.

2070.1 Legal Risk


tion or counterparty located in jurisdictionswhere multibranch netting is not enforceable,creating the risk that including these branchesmay render the entire netting agreement unen-forceable for all transactions. To rely on anetting agreement for transactions in any juris-diction, an institution must obtain legal opinionsthat conclude (1) that transactions with branchesin user-unfriendly jurisdictions are severableand (2) that the multibranch master agreementwould be enforceable, despite the inclusion ofthese branches.

Currently, the risk-based capital rules do notspecify how the net exposure should be calcu-lated when a branch in a netting-unfriendlyjurisdiction is included in a multibranch masternetting agreement. In the meantime, institutionsare using different practices, which are underreview with the goal of providing additionalguidance. Some institutions include the amountowed by branches of the counterparty in netting-unfriendly jurisdictions when calculating theglobal net exposure. Others completely severthese amounts from calculations, as if transac-tions with these branches were not subject to thenetting agreement. With respect to transactionwith branches in netting-unfriendly jurisdic-tions, some institutions add on the amounts theyowe in such jurisdictions (which are liabilities)to account for the risk of double payment,5while other institutions add on the amountsowed to them in such jurisdictions (which areassets). The approach an institution uses shouldreflect the specifics of the legal opinions itreceives concerning the severability of transac-tions in netting-unfriendly jurisdictions.

Collateral Agreements

Financial institutions are increasingly using col-lateral agreements in connection with OTCderivatives transactions to limit their exposureto the credit risk of a counterparty. Dependingon the counterparties’ relative credit strength,requirements for posting collateral may bemutual or imposed on only one of the counter-parties. Under most agreements, posting of col-

lateral is not required until the level of exposurehas reached a certain threshold.

While collateral may be a useful tool forreducing credit exposure, a financial institutionshould not rely on collateral to manage its creditrisk to a counterparty and for risk-based capitalpurposes, unless it has adequate assurances thatits claim on the collateral will be legally enforce-able in the event the counterparty defaults,particularly for collateral provided by a foreigncounterparty or held by an intermediary outsideof the United States. To rely on collateralarrangements where such cross-border issuesarise, a financial institution generally shouldobtain written and reasoned legal opinions that(1) the collateral arrangement is enforceable inall relevant jurisdictions, including the jurisdic-tion in which the collateral is located, and (2) thecollateral will be available to cover all transac-tions covered by the netting agreement in theevent of the counterparty’s default.

Operational Issues

The effectiveness of netting in reducing risksalso depends on how the arrangements areimplemented. The institution should have pro-cedures to ensure that the operational implemen-tation of a netting agreement is consistent withits provisions.

Netting agreements also may require thatsome of a financial institution’s systems beadapted. For example, the interface between thefront-office systems and back-office paymentand receipt functions needs to be coordinated toallow trading activity to take place on a grossbasis while the ultimate processing of paymentsand receipts by the back-office is on a net basis.In particular, an internal netting facility needsto—

• segregate deals to be netted,• compute the net amounts due to each party,• generate trade confirmations on the trade date

for each trade,• generate netted confirmations shortly after the

agreed-on netting cut-off time,• generate net payment and receipt messages,• generate appropriate nostro and accounting

entries, and• provide for the cancellation of any gross

payment or receipt messages in connectionwith the netted trades.

5. The risk of double payment is the risk that the institutionmust make one payment to a counterparty’s main receiverunder a multibranch master agreement and a second paymentto the receiver of the counterparty’s branch in the netting-unfriendly jurisdiction for transactions entered into in thatjurisdiction.

Legal Risk 2070.1


Nondeliverable Forwards

An area of growing concern for legal practitio-ners has been the documentation of nondeliver-able forward (NDF) foreign-exchange transac-tions. The NDF market is a small portion of theforeign-exchange market, but is a large part ofthe market for emerging-country currencies. AnNDF contract uses an indexed value to representthe value of a currency that cannot be delivereddue to exchange restrictions or the lack ofsystems to properly account for the receipt ofthe currency. NDF contracts are settled net in thesettlement currency, which is a hard currencysuch as U.S. dollars or British pounds sterling.

An NDF contract must be explicitly identifiedas such—foreign-exchange contracts are pre-sumed to be deliverable. The index should beclearly defined, especially for countries in whichdual exchange rates exist, that is, the officialgovernment rate versus the unofficial ‘‘ street’’rate.

NDF contracts often provide for cancellationif certain disruption events specified in themaster agreement occur. Disruption events caninclude sovereign events (the nationalization ofkey industries or defaults on government obli-gations), new exchange controls, the inability toobtain valid price quotes with which to deter-mine the indexed value of the contract, ora benchmark-obligation default. Under abenchmark-obligation default, a particular issueis selected and, if that issue defaults during theterm of the contract, the contract is cancelled.Cancellation events should be specificallydescribed in order to minimize disputes aboutwhether an event has occurred. In addition,overly broad disruption events could cause thecancellation of a contract that both counterpar-ties wish to execute.

The International Swaps and DerivativesAssociation (ISDA) has established an NDFproject to develop standard documentation forthese transactions. The ISDA documentationestablishes definitions that are unique to NDFtransactions and provides sample confirmationsthat can be adapted to reflect disruption events.

LEGAL ISSUES

Capacity

If a counterparty does not have the legal author-ity to enter into a transaction, the institution runs

the risk that a legal challenge could result in acourt finding that the contract is ultra vires andtherefore unenforceable. Significant losses inOTC derivatives markets resulted from a findingthat swap agreements with municipal authoritiesin the United Kingdom were ultra vires. Issuesconcerning the authority of municipal and othergovernment units to enter into derivatives con-tracts have been raised in some U.S. jurisdic-tions, as well. Other types of entities, such aspension plans and insurance companies, mayneed specific regulatory approval to engage inderivatives transactions.

A contract may be unenforceable in somecircumstances if the person entering into thecontract on behalf of the counterparty is notauthorized to do so. Many entities, includingcorporations, have placed more extensive restric-tions on the authority of the corporation or itsemployees to enter into certain types of deriva-tives and securities transactions.

To address issues related to counterpartyauthority, an institution’s procedures should pro-vide for an analysis, under the law of thecounterparty’s jurisdiction, of the counterparty’spower to enter into and the authority of a tradingrepresentative of the counterparty to bind thecounterparty to particular transactions. It also iscommon to look at whether boards of directorsor trustees are authorized to enter into specifictypes of transactions. Depending on the proce-dures of the particular institution, issues relatingto counterparty capacity may be addressed in thecontext of the initial credit-approval process orthrough a more general review of classes ofcounterparties.

Suitability

A counterparty on the losing end of a derivativestransaction may claim that a banking organiza-tion recommended or structured an unsuitabletransaction, given the counterparty’s level offinancial sophistication, financial condition, orinvestment objectives, or it may claim that thetransaction and its risks were inaccurately orincompletely disclosed. Banking organizationsthat recommend or structure derivatives transac-tions for clients, especially transactions contain-ing nonstandard terms, should make reasonableefforts to know their counterparties in order toavoid such claims. Moreover, banking organiza-tions should fully explain to counterparty per-sonnel with the requisite knowledge and expe-

2070.1 Legal Risk


rience to evaluate a transaction what the structureand risks of any derivatives transaction are.

Banking organizations should also understandtheir counterparties’ business purpose for enter-ing into derivatives transactions with the insti-tution. Understanding the underlying businessrationale for the transaction allows the institu-tion to evaluate the credit, legal, and reputa-tional risks that may arise if the counterparty hasentered into the transaction to evade taxes, hidelosses, or circumvent legal or regulatoryrestrictions.

New-Product Approval

Legal counsel, either in-house or outside, shouldbe involved in the new-product approval pro-cess. New-product reviews should include prod-ucts being offered for the first time in a newjurisdiction or to a new category of counterpar-ties (for example, a product traditionally mar-

keted to institutional customers being madeavailable to retail customers) and existing prod-ucts that have been significantly modified. Thedefinition of a new product should be consistentwith the size, complexity, and sophistication ofthe institution. Small changes in the paymentformulas or other terms of products can greatlyalter their risk profiles and justify designation asa new product.

The authority of the bank to enter into thenew or modified transaction or market the newproduct in all relevant jurisdictions should beestablished, and any limitations on that authorityfully reviewed. Legal review is also necessaryfor an institution to establish the types of agree-ments to be used in documenting the transac-tion, including any modifications to standard-ized documentation. The institution shouldensure that prior legal opinions and standardagreements are reviewed periodically and thatthey reflect changes in law or the manner inwhich transactions are structured.

Legal Risk 2070.1


Legal RiskExamination Objectives Section 2070.2

1. To determine if the institution’s internal poli-cies and procedures adequately identifypotential legal risks and ensure appropriatelegal review of documentation, counterpar-ties, and products.

2. To determine whether appropriate documen-tation requirements have been establishedand that procedures are in place to ensure thattransactions are documented promptly.

3. To determine whether adequate assurancesof legal enforceability have been obtainedfor netting agreements or collateral arrange-ments relied on for risk-based capital pur-poses or credit-risk management.

4. To determine whether the operational areas

of the bank are effectively implementing theprovisions of netting agreements.

5. To determine whether the unique risks ofnondeliverable forward (NDF) contracts havebeen considered and reflected in the institu-tion’s policies and procedures, if appropriate.

6. To determine whether the institution’s inter-nal policies and procedures adequately addressthe need to review the suitability of transac-tions for a counterparty.

7. To determine whether the institution’s inter-nal policies and procedures adequately addressthe approval of new products, including arequirement for appropriate reviews by legalcounsel.

Trading and Capital-Markets Activities Manual September 2002Page 1

Legal RiskExamination Procedures Section 2070.3

Examiners should use the following guidelinesto assist in their review of the institution’strading activities with respect to legal risk. Thisshould not be considered to be a completechecklist of subjects to be examined.

1. Obtain copies of policies and procedures thatoutline appropriate legal review for newproducts.a. Does the institution require legal review

of new products, including significantrevisions or modifications to existingproducts, as part of the product-reviewprocess?

b. Do the procedures provide for reviewof existing products offered in new juris-dictions or to new classes of counterparties?

2. Obtain copies of policies and proceduresthat outline review requirements for newcounterparties.a. Does the institution require review of new

counterparties to ensure that the counter-party has adequate authority to enter intoproposed transactions?

b. Do the institution’s procedures include anassessment of the suitability of any trans-actions recommended to or structured bythe institution for the counterparty?

c. Do the institution’s procedures ensure fur-ther review of counterparty authority ifnew types of transactions are entered into?

3. Obtain copies of policies and procedures thatestablish documentation requirements.a. Has the institution established documen-

tation requirements for all types of trans-actions in the trading area?

b. When are master agreements required forover-the-counter (OTC) derivative or othertransactions with a counterparty?

c. Does the institution require legal reviewfor new agreement forms, including net-ting agreements and master agreementswith netting provisions?

d. Who has authority to approve the use ofnew agreement forms, including new mas-ter agreement forms or agreement terms?

e. How does the institution ensure that docu-ments are executed in a timely manner fornew counterparties and new products?

f. Does the institution have an adequatedocument-management system to track

completed and pending documentation?How does the institution follow up onoutstanding documentation?

g. What controls does the institution have inplace pending execution of required docu-mentation, for example, legal-approvalrequirements? (Documentation has notbeen executed until it has been signed byappropriate personnel of both parties tothe transaction.)

h. In practice, is required documentationexecuted in a timely manner?

i. Who has the authority to approve excep-t ions to ex is t ing documentat ionrequirements?

j. Do the procedures ensure that documen-tation is reviewed for consistency with theinstitution’s policies?

k. Who reviews documentation?l. Does the institution specify the terms to

be covered by confirmations for differ-ent types of transactions, includingtransactions that are subject to masteragreements?

m. If the institution engages in nondeliver-able forward (NDF) transactions, does thedocumentation address the index to beused and clearly specify that the contractis for a nondeliverable currency? Aredisruption events, if any, specificallydescribed?

4. Obtain copies of policies and proceduresconcerning the review of the enforceabilityof netting agreements and master agreementswith netting provisions.a. Does the institution have procedures to

ensure that legal opinions have beenobtained addressing the enforceability of anetting agreement under the laws of allrelevant jurisdictions before relying onthe netting agreement for capital purposesor in managing credit exposure to thecounterparty?

b. Do the procedures include guidelines fordetermining the relevant jurisdictions forwhich opinions should be obtained? Opin-ions should cover the enforceability ofnetting under (1) the law of the jurisdic-tion in which the counterparty is char-tered, (2) the law of any jurisdiction inwhich a branch of the counterparty that isa party to the agreement is located, (3) the


law that governs any individual trans-action under the netting agreement, and(4) the law that governs the nettingagreement itself.

c. When generic or industry opinions arerelied on, do the procedures of the insti-tution ensure that individual agreementsare reviewed for additional issues thatmight be raised?

d. Does the institution have procedures forevaluating or ‘‘ scoring’’ the legal opinionsit receives concerning the enforceabilityof netting agreements?

e. Who reviews the above opinions? Howdo they communicate their views onthe enforceability of netting under anagreement?

f. Who determines when master nettingagreements will be relied on for risk-based capital and credit-risk-managementpurposes?

g. Who determines whether certain transac-tions should be excluded from the net-ting, such as transactions in connectionwith a branch in a netting-unfriendlyjurisdiction?

h. When the institution nets transactions forcapital purposes, are any transactions thatare not directly covered by a close-outnetting provision of a master agreementincluded? If so, does the institution obtainlegal opinions supporting the inclusion ofsuch transactions? For example, if theinstitution includes in netting calculationsforeign-exchange transactions betweenbranches of the institution or counterpartynot covered by a master agreement, askcounsel if the institution has an agree-ment and legal opinion that support thispractice.

i. Does the institution have procedures toensure that the legal opinions on which itrelies are periodically reviewed?

j. Does the institution have procedures inplace to ensure that existing master agree-ments are regularly monitored to deter-mine whether they meet the requirementsfor recognition under the institution’s net-ting policies?

5. Obtain copies of policies and proceduresconcerning the review of the enforceabilityof collateral arrangements.a. Does the institution have guidelines that

establish when and from what jurisdic-tions legal opinions concerning the

enforceability of collateral arrangementsmust be obtained before the institutionrelies on such arrangements for risk-based capital or credit-risk-managementpurposes?

b. Who reviews the above opinions?c. Who determines when a collateral arrange-

ment may be relied on by the institutionfor credit-risk-management or risk-basedcapital purposes?

d. Do the procedures ensure that legal opin-ions relied on by the institution arereviewed periodically?

6. Obtain samples of master agreements, con-firmations for transactions under such agree-ments, and related legal opinions.a. Does the institution maintain in its files

the master agreements, legal opinions, andrelated documentation and translationsrelied on for netting purposes?

b. Have the master agreements and confir-mations been executed by authorizedpersonnel?

c. Have master agreements been executed bycounterparty personnel that the institutionhas determined are authorized to executesuch agreements?

d. Does the institution maintain records evi-dencing that master agreements andrelated legal opinions have been reviewedin accordance with the institution’s poli-cies and procedures?

7. Obtain copies of the institution’s policies andprocedures concerning the implementation ofnetting agreements.a. Do the procedures ensure that the terms of

netting agreements are accurately andeffectively acted on by the trading, credit,and operations or payments-processingareas of the institution?

b. Does the institution have adequate con-trols over the operational implementationof its master netting agreements?

c. Who determines whether specific transac-tions are to be netted for risk-based capitaland credit-risk-management purposes?

d. When is legal approval for the nettingof particular transactions under a nettingagreement required?

e. How are the relevant details of nettingagreements communicated to the trading,credit, and payments areas?

f. How does each area incorporate relevantnetting information into its systems?

g. What mechanism does the institution have

2070.3 Legal Risk: Examination Procedures

September 2002 Trading and Capital-Markets Activities ManualPage 2

to link netting information with credit-exposure information and to monitornetting information in relation to credit-exposure information?

h. Do periodic settlement amounts reflectpayments or deliveries netted in accor-dance with details of netting agreements?

i. How does the institution calculate its creditexposure to each counterparty under therelevant master netting agreements?

j. If the master agreement includes transac-tions excluded from risk-based capital

calculations, what method does the insti-tution use to calculate net exposure underthe agreement for capital purposes, and isthat method used consistently?

k. If a master agreement includes transac-tions that do not qualify for netting, suchas transactions in a netting-unfriendlyjurisdiction, how does the institution deter-mine what method to use to calculate netexposure under the agreement for capitalpurposes?

Legal Risk: Examination Procedures 2070.3


Financial PerformanceSection 2100.1

The evaluation of financial performance, orprofitability analysis, is a powerful and neces-sary tool for managing a financial institution andis particularly important in the control andoperation of trading activities. Profitability analy-sis identifies the amount and variability of earn-ings, evaluates earnings in relation to the natureand size of risks taken, and enables seniormanagement to judge whether the financial per-formance of business units justifies the riskstaken. Moreover, profitability analysis is oftenused to determine individual or team compen-sation for marketing, trading, and other business-line staff engaged in trading activities. Thefollowing four elements are necessary to effec-tively assess and manage the financial perfor-mance of trading operations:

• valuing or marking positions to market prices• assigning appropriate reserves for activities

and risks• reporting results through appropriate chains of

command• attributing income to various sources and

products

Valuation of the trading portfolio is critical toeffective performance measurement since theaccuracy and integrity of performance reportsare based primarily on the market price or fairvalue of an institution’s holdings and the pro-cess used to determine those prices. The valua-tion process is often complex, as the pricing ofcertain financial instruments can require the useof highly sophisticated pricing models and otherestimators of fair value. The chief financialofficer (CFO) and other senior officers of thebank must receive comprehensive and accurateinformation on capital-markets and tradingactivities to accurately measure financial perfor-mance, assess risks, and make informed busi-ness decisions. Internal profitability reportsshould indicate to the CFO and other seniormanagement the sources of capital-markets andtrading income, and assign profits and losses tothe appropriate business units or products (forexample, foreign exchange, corporate bond trad-ing or interest-rate swaps). To prepare thesereports, an institution should specify its meth-odologies for attributing both earnings and risksto their appropriate sources such as interestincome, bid/offer spreads, customer mark-up,

time decay, or other appropriate factors. Similarmethodologies for allocating reserves shouldalso be established where appropriate.

Proper segregation of duties and clear report-ing lines help ensure the integrity of profitabilityand performance reports. Accordingly, the mea-surement and analysis of financial performanceand the preparation of management reports areusually the responsibility of a financial-controlor other nontrading function. This responsibilityincludes revaluing or marking to market thetrading portfolio and identifying the varioussources of revenue. Some banks have begun toplace operations and some other control staff inthe business line, with separate reporting to thebusiness head. Examiners should satisfy them-selves that duties are adequately segregated andthat the operations staff is sufficiently indepen-dent from trading and risk-taking functions.

VALUATION

The valuation process involves the initial andongoing pricing or ‘‘marking to market’’ ofpositions using either observable market pricesor, for less liquid instruments, fair-value pricingconventions and models. An institution’s writ-ten policies and procedures should detail therange of acceptable practices for the initialpricing, daily mark-to-market, and periodicindependent revaluation of trading positions. Ata minimum, the bank’s policies should specifi-cally define the responsibilities of the partici-pants involved in the trading function (for exam-ple, trading operations, financial-control, andrisk-management staff) to ensure reliable andconsistent financial reporting. Pricing method-ologies should be clearly defined and docu-mented to ensure that they are consistentlyapplied across financial products and businesslines. Proper controls should be in place toensure that pricing feeds are accurate, timely,and not subject to unauthorized revisions.Additionally, the firm should have comprehen-sive policies and procedures specifically forcreating, validating, revising, and reviewing thepricing models used in the valuation process.Inadequate policies and procedures raise doubtsabout the institution’s trading profits and itsability to manage the risks of its trading activities.

Trading and Capital-Markets Activities Manual February 1998Page 1

Initial Pricing

The initial pricing of positions or transactions isgenerally the responsibility of the trader whooriginates the deal, although a marketer willoften be involved in the process. For thoseinstruments that trade in fairly liquid markets,the price is usually based on the quoted bid/offerprice plus an origination ‘‘value-added’’ spreadthat may include, for example, a credit premiumor estimated hedge cost, depending on the char-acteristics of the product. The prices of lessliquid instruments are generally priced at theo-retical market prices, usually determined bypricing models. Regardless of the type of trans-action, an independent control function shouldreview all new-deal pricing for reasonablenessand ensure that pricing mechanics are consistentwith those of existing transactions and approvedmethodologies. Significant differences, as definedin written policies, should be investigated by thecontrol function.

Daily Mark-to-Market Process

Trading accounts should be revalued, or ‘‘markedto market,’’ at least daily to reflect fair value anddetermine the profit or loss on the portfolio forfinancial-reporting and risk-management pur-poses. Trading positions are usually marked tomarket as of the close of business using inde-pendent market quotes. Most institutions areable to determine independent market pricesdaily for most positions, including many exoticand illiquid products. Many complex instru-ments can be valued using the independentmarket prices of various elementary componentsor risk factors. Automatic pricing feeds shouldbe used to update positions whenever feasible.When automatic pricing feeds are not feasible, aseparate control function (for example, themiddle- or back-office function) should be re-sponsible for inputting appropriate pricing dataor parameters into the appropriate accountingand measurement systems, even though tradersmay have some responsibility for determiningthose prices and parameters.

Daily revaluation may not be feasible forsome illiquid instruments, particularly those thatare extremely difficult to model or not widelytraded. Institutions may revalue these types oftransactions less often, possibly weekly or

monthly. In these cases, written policies shouldspecify which types of transactions, if any, areexempt from daily revaluation and how oftenthese transactions must be marked to market.

Independent Price Testing andRevaluation

In addition to the mark-to-market process per-formed daily, banks should perform an indepen-dent review and revaluation of the trading port-folio periodically to verify that trading positionsreflect fair value, check the reasonableness ofpricing inputs, and assess profitability. Thereview must be performed by a control functionthat is independent from the trading func-tion. Usually this independent revaluation pro-cess is performed monthly; however, it may beprudent to independently revalue certain illiquidand harder-to-price transactions, and transac-tions that are not marked to market daily, morefrequently.

The scope of the testing process will differacross institutions depending on the size andsophistication of the trading activities con-ducted. In many institutions, revaluation of anentire portfolio of relatively simple, genericinstruments may be too time consuming to beefficient, and price validation may be conductedon a sampling basis. In contrast, more complextransactions may be revalued in their entirety.Alternatively, an institution may choose torevalue holdings based on materiality (for exam-ple, all transactions over a dollar threshold). Aninstitution’s policies should clearly define thescope of its periodic valuation-testing process,and reasonable justification should be providedfor excluding certain transactions from the test-ing process.

If the value of the portfolios as determined bythe periodic (for example, monthly) independentrevaluation is significantly different from thebook value of these portfolios, further investi-gation is warranted. The materiality thresholdfor investigation should be specifically definedin written policies (such as ‘‘all discrepanciesabove $x thousand must be investigated todetermine the source of the difference’’). Whenthe reason for the discrepancy is discovered, theinstitution should determine whether the finan-cial reports need to be adjusted. Based on themagnitude and pattern of the pricing inconsis-

2100.1 Financial Performance

February 1998 Trading and Capital-Markets Activities ManualPage 2

tencies, changes to the pricing process or pricingmodels may be required.

Results of the month-end valuation processshould be formally documented in sufficientdetail to provide a complete audit trail. Inaddition, a summary of the results of the inde-pendent revaluation should be communicated toappropriate management and control functions.Reports should be generated to inform manage-ment of the results of the periodic price-testingprocess and should include, at a minimum, thescope of the testing process, any material dis-crepancies between the independent valuationsand the reported valuations, and any actionstaken in response to them.

Liquid Instruments and Transactions

For transactions that trade on organizedexchanges or in liquid over-the-counter (OTC)markets, market prices are relatively easy todetermine. Trading positions are simply updatedto reflect observable market prices obtainedfrom either the exchange on which the instru-ment is listed or, in the case of OTC transac-tions, from automated pricing services or asquotes from brokers or dealers that trade theproduct. When observable market prices areavailable for a transaction, two pricing method-ologies are primarily used—bid/offer or midmar-ket. Bid/offer pricing involves assigning thelower of bid or offer prices to a long positionand the higher of bid or offer prices to shortpositions. Midmarket pricing involves assigningthe price that is midway between bid and offerprices. Most institutions use midmarket pricingschemes, although some firms may still usebid/offer pricing for some products or types oftrading. Midmarket pricing is the method rec-ommended by the accounting and reportingsubcommittee of the Group of Thirty’s GlobalDerivatives Study Group, and it is the methodmarket practitioners currently consider the mostsound.

Some institutions may use bid/offer pricingfor some transactions and midmarket pricing forothers. For example, bid/offer pricing may beused for proprietary and arbitrage transactions inwhich the difference between bid and offerprices and the midmarket price is assumed not tobe earned. Midmarket pricing may be used fortransactions in which the firm is a market makerand the bid/offer to midmarket spread is earned.

Also, some organizations may value positionson the conservative side of midmarket by takinga discount or adding a premium to the midmar-ket price to act as a ‘‘holdback reserve.’’ Firmsthat use a conservative midmarket valuationsystem may mark all positions in this manner ormay only value some less liquid positions thisway. Bank policies should clearly specify whichvaluation methodologies are appropriate for dif-ferent types of transactions.

The bid/offer price should be considered alimit on instrument values, net of any reserves.Net instrument values recorded on the books atmarket value should not be below or above themarket’s bid/offer price, as these are the valuesat which a position can be closed. Some insti-tutions have automated programs that use pricesobtained from traders to check whether the fairvalues recorded on the firm’s financial state-ments fall within the bid/offer price. While theseprograms can help ensure appropriate pricingregardless of the specific method used, a firmshould still have a sound, independent dailyrevaluation that does not rely solely on tradersmarking their positions to market.

Whether bid/offer or midmarket pricing isused, banks should use consistent time-of-daycutoffs when valuing transactions. For example,instruments and their related hedges should bepriced as of the same time even if the hedgingitem trades on an exchange with a differentclosing time than the exchange on which thehedged item trades. Also, all instruments in thesame trading portfolio should be valued at thesame time even if they are traded at differentlocations. Price quotes should be current as ofthe time of pricing and should be consistent withother trades that were transacted close to thesame time.

For liquid exchange-traded or OTC products,the monthly revaluation process may simplyentail a comparison of book values withexchange or broker-dealer quotations. In thesecases, it should be known whether the partyproviding the valuation is a counterparty to thetransaction that generated the holding or is beingpaid for providing the valuation as an indepen-dent pricing service. Firms should be aware thatbroker-dealer quotes may not necessarily be thesame values used by that dealer for its internalpurposes and may not be representative of other‘‘market’’ or model-based valuations. Therefore,institutions should satisfy themselves that theexternal valuations provided are appropriate.

Financial Performance 2100.1

Trading and Capital-Markets Activities Manual April 2003Page 3

Illiquid Instruments and Transactions

Illiquid, nontraditional, and user-specific or cus-tomized transactions pose particular pricing chal-lenges because independent third-party pricesare generally unavailable. For illiquid productsthat are traded on organized exchanges, but forwhich trades occur infrequently and availablequotes are often not current, mark-to-marketvaluations based on the illiquid market quotesmay be adjusted by a holdback reserve that iscreated to reflect the product’s reduced liquidity.(See ‘‘Holdback Reserves’’ below.) For illiquidOTC transactions, broker quotes may be avail-able, albeit infrequently. When broker quotesare available, the bank may use several quotes todetermine a final representative valuation. Forexample, the bank may compute a simple aver-age of quotes or eliminate extreme prices andaverage the remaining quotes. In such cases,internal policies should clearly identify the meth-odology to be used.

When the middle or back office is responsiblefor inputting broker quotes directly, the tradersshould also be responsible for reporting theirpositions to the middle- or back-office functionas an added control. Any differences in pricingshould be reconciled. When brokers are respon-sible for inputting data directly, it is crucial thatthe middle or back office verify these data foraccuracy and appropriateness.

For many illiquid or customized transactions,such as highly structured or leveraged instru-ments and more complex, nonstandard notes orsecurities, reliable independent market quotesare usually not available, even infrequently. Insuch instances, other valuation techniques mustbe used to determine a theoretical, end-of-daymarket value. These techniques may involveassuming a constant spread over a reference rateor comparing the transaction in question withsimilar transactions that have readily availableprices (for example, comparable or similar trans-actions with different counterparties). Morelikely, though, pricing models will be used toprice these types of customized transactions.Even when exchange prices exist for a financialinstrument, there may be market anomalies inthe pricing; these anomalies make consistentpricing across the instrument difficult. For exam-ple, timing differences may exist between theclose of the cash market and futures markets,causing a divergence in pricing. In these cases, itmay be appropriate to use theoretical pricing,

and pricing models may again be used for thispurpose.

When conducting the monthly revaluation,the validity of portfolio prices can be tested byreviewing them for historical consistency or bycomparing actual close-out prices or the perfor-mance of hedge positions to model predictions.In some instances, controllers may run parallelpricing models as a check on the valuationsderived by trader models. This method is usu-ally only used for the more exotic, harder-to-price products.

Pricing Models

Pricing models can either be purchased fromvendors or developed internally, and they can bemainframe- or PC-based. Internally developedmodels are either built from scratch or devel-oped using existing customized models thattraders modify and manipulate to incorporatethe specific characteristics of a transaction.

The use of pricing models introduces thepotential for model risk into the valuation pro-cess. Model risk arises when an institution usesmathematical models to value and hedge com-plex financial securities that are in relativelyilliquid markets and for which price-discoverymechanisms are inefficient. In these circum-stances, the models an institution uses may relyon assumptions that are inconsistent with marketrealities; employ erroneous input parameters; orbe calibrated, applied, or implemented incor-rectly. Accordingly, effective policies and pro-cedures related to model development, modelvalidation, and model control are necessary tolimit model risk. At a minimum, policies forcontrolling model risk should address the insti-tution’s process for developing, implementing,and revising pricing models. The responsibili-ties of staff involved in the model-developmentand model-validation process should be clearlydefined.

In some institutions, only one department orgroup may be authorized to develop pricingmodels. In others, model development may beinitiated in any of several areas related totrading. Regardless of the bank function respon-sible for model development and control, insti-tutions should ensure that modeling techniquesand assumptions are consistent with widelyacceptable financial theories and market prac-tices. When modeling activities are conducted in


April 2003 Trading and Capital-Markets Activities ManualPage 4

separate business units or are decentralized,business-unit policies governing model develop-ment and use should be consistent with overallcorporate policies on model-risk management.As part of these policies, institutions shouldensure that models are properly documented.Documentation should be created and main-tained for all models used, and a model-inventory database should be maintained on acorporate-wide or business-line basis.

Before models are authorized for use, theyshould be validated by individuals who are notdirectly involved in the development process ordo not have methodological input to the model.A sound model-validation process rigorouslyand comprehensively evaluates the sensitivity ofmodels to material sources of model risk andidentifies, reviews, and approves new models orenhancements to existing models. Ideally, mod-els should be validated by an independentfinancial-control or risk-management function.Independent model validation is a key control inthe model-development process and should bespecifically addressed in a firm’s policies. Man-agement should be satisfied that the underlyingmethodologies for all models are conceptuallysound, mathematically and statistically correct,and appropriate for the model’s purpose. Amodel should have the same basic mathematicalproperties as the instrument being modeled.Pricing methodologies should be consistentacross business lines. In addition, the technicalexpertise of the model validators should besufficient to ensure that the basic approach of themodel is appropriate.

All model revisions should be performed in acontrolled environment, and changes should beeither made or verified by a control function.When traders are able to make changes tomodels outside of a controlled environment, aninappropriate change may result in inaccuratevaluation. Under no circumstances should trad-ers be able to determine valuations of tradingpositions by making changes to a model unlessthose changes are subject to the same reviewprocess as a new type of transaction. Accord-ingly, written policies should specify whenchanges to models are acceptable and how thoserevisions should be accomplished. Controlsshould be in place to prevent inappropriatechanges to models by traders or other unautho-rized personnel. For example, models can becoded or date-marked so that it is obvious whenchanges are made to those models. Rigorouscontrols on spreadsheet-based models should

ensure their integrity and prevent unauthorizedrevisions. The control function should maintaincopies of all models used by the traders in casethe copies used on the trading floor are corrupted.

Models should be reviewed or reassessed atsome specified frequency, and the most impor-tant or complex models should be reviewed atleast once a year. In addition, models should bereviewed whenever major changes are made tothem. The review process should be performedby a group independent from the traders, such asa control or risk-analysis function. As appropri-ate, model reviews should consider changes inthe types of transactions handled by the model,as well as changes in generally accepted mod-eling conventions and techniques. Model reviewsshould incorporate an investigation of actualversus expected performance and should fullyincorporate an assessment of any hedging activ-ity. Significant deviation in expected versusactual performance and unexplainable volatilityin the profits and losses of trading activities mayindicate that market-defined hedging and pricingrelationships are not being adequately capturedin a model. The model-review process should beclearly defined and documented, and these poli-cies should be communicated to the appropriateparties throughout the organization.

In addition to the periodic scheduled reviews,models should always be reviewed when newproducts are introduced or changes in valuationsare proposed. Model review may also beprompted by a trader who feels that a modelshould be updated to reflect the significantdevelopment or maturing of a market. Themodel-validation and new-product-approvalfunctions should work closely with the modeldeveloper to establish a common understandingof what constitutes a new product that warrantseither model refinements or the development ofan entirely new model. A new product may alsoentail enhancing or modifying an existing prod-uct or introducing an existing product in a newmarket. When a new product warrants a new orrevised model, the model-validation and new-product-approval functions should ensure thatsenior management and the board (or an appro-priate board committee) understand the keyfeatures and risks of the new product and themodel.

In some cases, models may start out as aPC-based spreadsheet model and be subse-quently transformed to a mainframe model.Whenever this occurs, the model should bereviewed and any resulting changes in valuation



should be monitored. Banks should continuallymonitor and compare their actual cash flowswith model projections, and significant discrep-ancies should prompt a model review.

Activities in business lines for which modelshave not yet been reviewed and validated shouldbe subject to special limits designed to minimizerisks, pending review and validation of models.These limits may include dollar limits, Greeklimits, counterparty limits, or some combinationthereof.

The use of vendor models can present specialchallenges, as vendors often claim proprietaryprivilege to avoid disclosing information abouttheir models. However, vendors should provideadequate information on how the model wasconstructed and validated so that managementhas reasonable assurances that the model worksas intended. Institutions should validate vendormodels in addition to their internally generatedmodels.

Pricing-Model Inputs

Pricing models require various types of inputs,including hard data, readily observable param-eters such as spot or futures prices, and bothquantitatively and qualitatively derived assump-tions. All inputs should be subject to controlsthat ensure they are reasonable and consistentacross business lines, products, and geographiclocations. Inputs should be verified through avetting process that validates data integrity—this process is especially important for illiquidproducts for which model risk may be height-ened. Assumptions and inputs regarding expectedfuture volatilities and correlations, and the speci-fication of model-risk factors such as yieldcurves, should be subject to specific control andoversight and to frequent review. Importantconsiderations in each of these areas are asfollows:

• Volatilities. Both historically determined andimplied volatilities should be derived usinggenerally accepted and appropriately docu-mented techniques. Implied volatilities shouldbe reviewed for reasonableness and derivedfrom closely related instruments.

• Correlations. Correlations should be welldocumented and estimated as consistently aspracticable across products and business lines.If an institution relies on broker quotes, itshould have an established methodology for

determining the input to be used from multiplequotes (such as the average or median).

• Risk factors. Pricing models generally decom-pose instruments into elementary components,such as specific interest rates, currencies,commodities, and equity types. Interest ratesand yield curves are particularly importantpricing-model risk factors. Institutions shouldensure that the risk factors and, in particular,the yield curves used in pricing instrumentsare sufficiently robust (have sufficient estima-tion points). Moreover, the same types of yieldcurves (spot, forward, yield-to-maturity) shouldbe used to price similar products.

• Assumptions. The key assumptions underlyingthe model should be validated by examiningwhether the mathematical model is a reason-able representation of the financial instrumentor transaction. Assumptions may be internallyor externally generated. Either source may beappropriate; an institution should determinewhether information derived from its owncustomer base or market-wide information ismore reflective of its risks. In either case, thechoice between the use of internal or externalassumptions should be documented. Assump-tions should be compared with actual portfolioperformance and available market informationand should be updated to reflect changingmarket conditions.

During the periodic revaluation process, manyinstitutions may perform a formal verification ofmodel-pricing inputs, including volatilities, cor-relation matrices, and yield curves.

Pricing-Model Outputs

A model’s output data should be comparedagainst that of comparable models, market prices,or other available benchmarks. Reports pro-duced from model outputs should clearly inter-pret the results for decision makers, explainingany model limitations and summarizing keyassumptions. Management reports should alsoinclude independent reviews of the theory under-lying the model and the results of model stresstests or scenario analyses that may alert decisionmakers to the model’s limitations. Stress testingthe model, or examining some limit scenarios,will provide a range of parameter values forwhich the model produces accurate pricing.Management decision makers need to fully



understand the meaning and limitations of thesemodel outputs.

Models should be subject to rigorous andcomprehensive stress tests; in addition to simu-lating extreme market events, these tests shouldreflect the unique characteristics of the institu-tion’s portfolio. Idiosyncratic risks, such asbasis risk, that are not adequately captured byvalue-at-risk measures should be emphasized inscenario analyses and stress tests. Scenariosshould be reviewed for relevance and appropri-ateness in light of the banking organization’sactivities and risk profile. A range of timehorizons should be used to maximize the com-prehensiveness of the institution’s stress-testingresults.

HOLDBACK RESERVES

Mark-to-market gains and losses on trading andderivatives portfolios are recognized in the unit’sprofits and losses and incorporated into thevalue of trading assets and liabilities. Often abank will ‘‘hold back,’’ or defer, the recognitionof a certain portion of first-day profits on atransaction for some period of time. Holdbackreserves are usually taken to reflect uncertaintyabout the pricing of a transaction or the risksentailed in actively managing the position. Thesereserves are deferred gains that may or may notbe realized, and they are usually not releasedinto income until the close or maturity of thecontract.

Holdback reserves can also be taken to bettermatch trading revenues with expenses. Certaincosts associated with derivatives transactions,such as credit, operational, and administrativecosts, may be incurred over the entire lives ofthe instruments involved. In an effort to matchrevenue with expenses, an institution may defera certain portion of the initial profit or lossgenerated by a transaction and then release thereserve into income over time. By deferring aportion of the profits or losses, holdback reservesmay avoid earnings overstatement and moreaccurately match revenues and expenses.

Reserving methodologies and the types ofreserves created vary among institutions. Evenwithin firms, the reserving concept may not beconsistent across business lines, or the conceptmay not be applied consistently. At a minimum,policies for holdback reserves should define(1) the universe of risks and costs that are to beconsidered when creating holdback reserves,

(2) the methodologies to be used to calculatethem, and (3) acceptable practices for recogniz-ing the reserves into the profits and losses of theinstitution.

General policies for holdback reserves shouldbe developed by a group independent from thebusiness units, such as the financial-control area.This group may also be responsible for devel-oping and implementing the policy. Alterna-tively, individual business lines may be respon-sible for developing an implementation policy.If implementation policies are developed byindividual business lines, the policies should beperiodically reviewed and approved by an inde-pendent operating group. Most importantly, thetraders or business units should not be able todetermine the level of holdback reserves and,hence, be able to determine the fair value oftrading positions. In general, reserving policiesshould be formula-based or have well-specifiedprocedures to limit subjectivity in the determi-nation of fair value. Reserve policies should bereviewed periodically and revised as necessary.

Reserve Adequacy

An insufficient level of holdback reserves maycause current earnings to be overstated. How-ever, excess holdback reserves may cause cur-rent earnings to be understated and subject tomanipulation. Accordingly, institutions shoulddevelop policies detailing acceptable practicesfor the creation, maintenance, and release ofholdback reserves. The level of holdbackreserves should be periodically reviewed forappropriateness and reasonableness by an inde-pendent control function and, if deemed neces-sary, the level should be adjusted to reflectchanging market conditions. Often, the reason-ableness of reserves will be checked in conjunc-tion with the month-end revaluation process.

Creating Reserves

All holdback reserves should be recognized inthe internal reports and financial statements ofthe institution, whether they are represented as‘‘pricing adjustments’’ or as a specified hold-back of a transaction’s profit or loss. Any type ofholdback reserve that is not recorded in thefinancial records should be avoided. Reservesmay be taken either on a transaction-by-transaction basis or on an overall portfolio basis.



Written policies should clearly specify the typesof holdback reserves that are appropriate fordifferent portfolios and transactions.

While holdback reserves may be created for avariety of risks and costs, the following are themost common types:

• Administrative-cost reserves. These reservesare intended to cover the estimated futurecosts of maintaining portfolio positions tomaturity. Administrative-cost reserves are typi-cally determined as a set amount per transac-tion based on historical trends.

• Credit-cost reserves. These reserves providefor the potential change in value associatedwith general credit deterioration in the port-folio and with counterparty defaults. They aretypically calculated by formulas based on thecounterparty credit rating, maturity of thetransaction, collateral, netting arrangements,and other credit factors.

• Servicing-cost reserves. These reserves pro-vide for anticipated operational costs relatedto servicing the existing trading positions.

• Market-risk reserves. These reserves are cre-ated to reflect a potential loss on the open riskposition given adverse market movements andan inability to hedge (or the high cost ofhedging) the position. These reserves includedynamic hedging costs for options.

• Liquidity-risk reserves. These reserves areusually a subjective estimate of potentialliquidity losses (given an assumed change invalue of a position) because of the bank’sinability to obtain bid/offer in the market.They are intended to cover the expected costof liquidating a particular transaction or port-folio or of arranging hedges that would elimi-nate any residual market risk from that trans-action or portfolio.

• Model-risk reserves. These reserves are cre-ated for the expected profit and loss impact ofunforeseen inaccuracies in existing models.For new models, reserves are usually based onan assessment of the level of modelsophistication.

Recording Reserves

Holdback reserves may be separately recordedin the general-ledger accounts of each businessentity, or they may be tracked on a corporate-wide basis. These reserves are usually recorded

on the general-ledger account as a contra tradingasset (as a reduction in unrealized gains), butsome banks record them as a liability. Alterna-tively, reserves for some risks may be recordedas a contra asset, and reserves for other risksrecorded as a liability. Holdback reserves can benetted against ‘‘trading assets,’’ included in‘‘other liabilities,’’ or disclosed separately in thepublished financial statements. Institutions shouldensure that they have clear policies indicatingthe method to be used for portraying reserves inreports and financial statements.

Releasing Reserves

An institution’s policies should clearly indicatethe appropriate procedure for releasing reservesas profits or losses. Holdback reserves created asa means of matching revenues and expenses areusually amortized into income over the lives ofthe individual derivative contracts. Reservesthat are created to reflect the risk that recognizedgains may not be realized because of mispricingor unexpected hedging costs are usually releasedin their entirety at the close or maturity of thecontract, or as the portfolio changes in structure.If reserves are amortized over time, a straight-line amortization schedule may be followed,with reserves being released in equal amountsover the life of the transaction or the life of therisk. Alternatively, individual amortization sched-ules may be determined for each transaction.

INCOME ATTRIBUTION

Profits and losses (P&L’s) from trading accountscan arise from several factors. Firms attempt todetermine the underlying reasons for valuechanges in their trading portfolios by attributingthe profits and losses on each transaction tovarious sources. For example, profits and lossescan be attributed to the ‘‘capture’’ of the bid/offer spread—the primary aim of market mak-ing. Another example is the attribution of profitto ‘‘origination,’’ the difference between the fairvalue of the created instrument and the con-tracted transaction price. Profit and loss can alsoresult from proprietary position taking. Properattribution of trading revenues is crucial tounderstanding the risk profile of trading activi-ties. The ability of an institution to accuratelydetermine the sources of daily P&L on different



types of financial instruments is considered akey control to ensure that trading-portfolio valu-ations are reasonable. The discipline of measur-ing and attributing P&L performance alsoensures that risks are accurately measured andmonitored.

The income-attribution process should be car-ried out by a group independent from the trad-ers; in most larger institutions, attribution is theresponsibility of the risk-management or middle-office function. The designated group is respon-sible for conducting analysis of the institution’stransactions and identifying the various sourcesof trading P&L for each product or businessline. These analyses may cover only certaintypes of transactions, but increasingly they arebeing applied to all products. The income-attribution process should be standardized andconsistently applied across all business units.The goal of income-attribution analyses is toattribute, or ‘‘explain,’’ as much of the dailytrading P&L as possible. A significant level of‘‘unexplained’’ P&L or an unusual pattern ofattribution may indicate that the valuation pro-cess is flawed, implying that the bank’s reportedincome may be either under- or overstated. Itmay also point to unexplained risks that are notadequately identified and estimated.

Explained Profits and Losses

Profits and losses that can be attributed to a risksource are considered ‘‘explained P&L.’’ Insti-tutions that have significant trading activitiesshould ensure they have appropriate methodolo-gies and policies to attribute as much revenue aspracticable. For example, some institutions maydefine first-day profit as the difference betweenthe midmarket or bid/offer price and the price atwhich the transaction was executed. Thisfirst-day profit may then be allocated amongsources such as the sales desk, origination desk,and proprietary trading desk, as well as toholdback reserves. Any balance in the first-dayprofit may then be assigned to the business orproduct line that acquired the position. As theposition is managed over time, subsequent P&Lattributions are made based on the effectivenessof a trading desk’s management of the position.In turn, the trading desk may further attributeP&L to risk sources and other factors such asspread movements, tax sensitivity, time decay,or basis carry. Many trading desks go on to

break out their daily P&L with reference to theactual risks being managed—for example delta,gamma, theta, rho, and vega. Institutions shouldensure that they provide an independent reviewfor the reasonableness of all revenue splits.

Unexplained Profits and Losses

Unexplained profits and losses is defined as thedifference between actual P&L and explainedP&L. If the level of unexplained P&L is con-sidered significant, the control function shouldinvestigate the reason for the discrepancy. Itmay be necessary to make changes to the pricingprocess as a result of the investigation. Forexample, models may be modified or the choiceof pricing inputs, such as volatilities and corre-lations, may be challenged. The level of unex-plained P&L that is considered significant willvary among institutions, with some firms spe-cifically defining a threshold for investigation(for example, ‘‘unexplained P&L above $x thou-sand dollars will be investigated’’). Some insti-tutions permit risk-control units to decide whatis significant on a case-by-case basis. Alterna-tively, management ‘‘triggers,’’ such as contractlimits, may identify particular movements inP&L that should be reviewed.

REPORTS TO MANAGEMENTAND DISCLOSURES TOCUSTOMERS

Reports to Management

An independent control function should preparedaily P&L breakout reports and official month-end P&L breakout reports that are distributed tosenior management. Daily reports that identifythe profits and losses of new deals should beprovided to appropriate management and staff,including trading-desk managers. These reportsshould include P&L explanations by source andrisks for each trading book. New-deal reportsmay also be generated periodically to provideinformation on all new deals transacted duringthe period. This information may include thecustomer names, maturities, notional amounts,portfolio values, holdback reserves, and new-deal profits and losses. At a minimum, seniormanagement should receive the formal month-end P&L explanation reports.



Providing Valuations to Customers

Trading institutions are often asked to providevaluations of transacted products to their cus-tomers. Quotes may be provided on a daily,weekly, monthly, or less frequent basis at thecustomer’s request. Even when valuations arenot requested by the client, sales personnel mayfollow the clients’ positions and notify them ofchanges in the valuation of their positions causedby market movements. Some firms will providequotes for all of the positions in their customers’portfolios—not just the transactions executedwith the firm. Firms may also formally offer togive valuations to certain customers for certainlower-risk products.

Generally, price quotes are taken from thesame systems or models used to generate end-of-day mark-to-market values for the firm’s ownreports and financial records, usually at midmar-ket. Holdback reserves are generally not includedin the valuation given to customers. In all cases,price quotes should be accompanied by infor-mation that describes how the value was derived.

If internally validated models are used to deter-mine a transaction value, this fact should bemade clear, and the underlying valuation assump-tions should be provided.

When making any price quotes, institutionsshould include a disclaimer stating the truenature of any quote—such as ‘‘indication only’’or ‘‘transaction price.’’ Disclosures should statethe characteristics of any valuation provided (forexample, midmarket, indicative, or firm price).In markets that have specific conventions fordetermining valuations, firms should usuallysupply valuations using those conventions unlessotherwise agreed to by the customer.

Although traders and marketers should receiveand review all valuations distributed to custom-ers, customer valuations should be providedprimarily by a back- or middle-office function tomaintain segregation from the front office.Internal auditors may review valuations pro-vided to clients to ensure consistency with thevalues derived from the independent pricingmodels and consistency with internal mark-to-market processes.



Financial PerformanceExamination Objectives Section 2100.2

1. To review the institution’s internal reportingof revenues and expenses to ensure that thesereports are prepared in a manner that accu-rately measures capital-markets and tradingresults and are generally consistent withindustry norms.

2. To review management information reportsfor content, clarity, and consistency. To ensurethat reports contain adequate and accuratefinancial data for sound decision making,particularly by the chief financial officer andother senior management.

3. To assess whether the institution adequatelyattributes income to its proper sources andrisks. To assess whether the allocation meth-odology is sufficient.

4. To review the level of profits, risk positions,and specific types of transactions that resultin revenues or losses (by month or quarter)since the prior examination to ascertain—

a. reasonableness,b. consistency,c. consistency with management’s stated

strategy and budget assumptions,d. the trend in earnings,e. the volatility of earnings, andf. the risk-reward profile of specific products

and business units.5. To review management’s monitoring of

capital-markets and trading volumes.6. To assess whether the institution’s market-

risk-measuring system adequately capturesand reports to senior management the majorrisks of the capital-markets and tradingactivities.

7. To determine the extent that capital-marketsand trading activities contribute to the overallprofitability and risk profile of the institution.

8. To recommend corrective action when poli-cies, procedures, practices, or internal reportsor controls are found to be deficient.


Financial PerformanceExamination Procedures Section 2100.3

These procedures represent a list of processesand activities that may be reviewed during afull-scope examination. The examiner-in-chargewill establish the general scope of examinationand work with the examination staff to tailorspecific areas for review as circumstances war-rant. As part of this process, the examinerreviewing a function or product will analyze andevaluate internal-audit comments and previousexamination workpapers to assist in designingthe scope of examination. In addition, after ageneral review of a particular area to be exam-ined, the examiner should use these procedures,to the extent they are applicable, for furtherguidance. Ultimately, it is the seasoned judg-ment of the examiner and the examiner-in-charge as to which procedures are warranted inexamining any particular activity.

1. Obtain all profitability reports which arerelevant to each business line or group. Foreach line or group, identify the differentsubcategories of income that are used ininternal profit reports.

2. Assess the institution’s methodology forattributing income to its sources. Checkwhether the allocation methodology makessufficient deductions or holdbacks from thebusiness line to account for the efforts ofsales, origination, and proprietary trading,and whether it properly adjusts for hedgingcosts, credit risks, liquidity risks, and otherrisks incurred. An adequate methodologyshould cover each of these factors, but aninstitution need not make separate reservecategories for each risk incurred. However,such institutions should be making efforts toallocate income more precisely among thesedifferent income sources and risks.

3. Review management information reportsfor content, clarity, and consistency. Deter-mine if reports contain adequate financialdata for sound decision making.

4. Review internal trading-income reports toensure that they accurately reflect the earn-ings results of the business line or group.Check whether internal profitability reports

reflect all significant income and expensescontributing to a business line or group’sinternally reported income.

5. Check whether internal reporting practicesare in line with industry norms and identifythe rationale for any significant differences.

6. Check whether amortization and deprecia-tion costs and other overhead costs areappropriately allocated among the appropri-ate business areas.

7. Determine whether reserves for credit riskand other risks are sufficient to cover anyreasonably expectable losses and costs.

8. Review the institution’s progress in imple-menting or updating the methodology forattributing income to the appropriate sources.

9. Analyze the quality of earnings. Review thelevel of profits and specific types of trans-actions that result in revenues or losses (bymonth or quarter) since the prior examina-tion to determine—a. reasonableness,b. consistency,c. consistency with management’s stated

strategy and budgeted levels,d. the trend in earnings,e. the volatility of earnings, andf. the risk/reward profile of specific prod-

ucts or business units.10. Review the volume of transactions and

positions taken by the institution for reason-ableness, and check that the institution has asystem for effectively monitoring its capital-markets and trading volumes.

11. Determine whether the market-risk-measuring system provides the chief finan-cial officer and other senior managementwith a clear vision of the financial institu-tion’s market portfolio and risk profile.

12. Determine the extent that trading activitiescontribute to the overall profitability of theinstitution. Determine how the trend haschanged since the prior examination.

13. Recommend corrective action when meth-odologies, procedures, practices, or internalreports or controls are found to be deficient.


Financial PerformanceInternal Control Questionnaire Section 2100.4

1. How does the institution define tradingincome? Does it cover interest, overhead,and other expenses related to the businessline in that line’s income reports? Do inter-nal income reports accurately reflect theresults of the business line? Is the break-down of business-line income into compo-nents sufficient to identify the main sourcesof profitability and expenses? What varia-tions are there from the general marketpractice for internal reporting of business-line income?

2. What is the methodology for allocatingincome to its sources? Do the allocationsmake sufficient deductions or holdbacks toaccount for the efforts of sales, origination,and proprietary trading? Do they properlyadjust for hedging costs, credit risks, liquid-ity risks, and other risks incurred?

3. What steps is the institution taking toenhance its income-allocation system?

4. How frequently are earnings reported tomiddle and senior management? Are thereports comprehensive enough for the levelof activity? Can they be used for planningand trend analysis? How often and underwhat circumstances are these reports sent tothe chief financial officer, the president, andmembers of the board of directors?

5. Evaluate the sources of earnings. Are earn-ings highly volatile? What economic eventsor market conditions led to this volatility?a. Are there any large, nonrecurring income/

expense items? If so, why?b. Is profitability of the business unit

dependent on income generated fromone particular product? Is profitability of

the business unit overly dependent onincome generated from one particularcustomer or related group of customers?How diverse is the generation of productand customer profitability?

c. Is the institution taking an undue amountof credit risk or market risk to generateits profits? Is the institution ‘‘intermedi-ating’’ in transactions for a credit‘‘spread’’? What is the credit quality ofthe customers in which the institution istaking credit risk in the trading unit?

6. How does the institution monitor and con-trol its business-line and overall volume ofcapital-markets and trading activities?

7. Does the market-risk-measuring systemadequately capture and report to the chieffinancial officer and senior management themajor risks from the capital-markets andtrading activities?

8. Does the market-risk-measuring system pro-vide the chief financial officer and othersenior management with a clear vision ofthe financial institution’s market portfolioand risk profile? How does managementcompare the profitability of business lineswith the underlying market risks?

9. What is the contribution of trading activitiesto the overall profitability of the institution?How has the trend changed since the priorexamination?

10. Evaluate the earnings of new-product ornew-business initiatives. What is the earn-ings performance and risk profile for theseareas? What are management’s goals andplans for these areas?


Capital AdequacySection 2110.1

Like all risk-bearing activities, the risk exposuresa banking organization assumes in its trading,derivative, and capital-markets activities shouldbe fully supported by an adequate capital posi-tion. Accordingly, banking organizations shouldensure that their capital positions are sufficientlystrong to support all trading and capital-marketsrisks on a fully consolidated basis and thatadequate capital is maintained in all affiliatedentities engaged in these activities. Institutionswith significant trading activities should havereasonable methods to measure the risks of theiractivities and allocate capital against the eco-nomic substance of those risks. To that extent,regulatory capital requirements should be viewedas minimum requirements, and those institutionsexposed to a high or inordinate degree of risk orforms of risk that may not be fully addressed inregulatory requirements are expected to operateabove minimum regulatory standards consistentwith the economic substance of the risks entailed.

For bank supervisors, the baseline for capitaladequacy assessment is an organization’s risk-based capital ratio (the ratio of qualifying capitalto assets and off-balance-sheet items that havebeen ‘‘risk weighted’’ according to their per-ceived credit risk). Supervisors also focus on thetier 1 leverage ratio to help assess capitaladequacy. For banking organizations that havesignificant trading activities, the risk-based capi-tal ratio also takes into account an institution’sexposure to market risk.1

RISK-BASED CAPITAL MEASURE

The principal objectives of the risk-based capitalmeasure 2 are to (1) make regulatory capital

requirements generally sensitive to differencesin risk profiles among banking organizations;(2) factor off-balance-sheet exposures into theassessment of capital adequacy; (3) minimizedisincentives to holding liquid, low-risk assets;and (4) achieve greater consistency in the evalu-ation of the capital adequacy of major banksthroughout the world. The risk-based capitalmeasure focuses primarily on the credit riskassociated with the nature of banking organiza-tions’ on- and off-balance-sheet exposures andon the type and quality of their capital. Itprovides a definition of capital and a frameworkfor calculating risk-weighted assets by assigningassets and off-balance-sheet items to broad cate-gories of credit risk. A banking organization’srisk-based capital ratio is calculated by dividingits qualifying capital by its risk-weighted assets.The risk-based capital measure sets forth mini-mum supervisory capital standards that apply toall banking organizations on a consolidatedbasis.

The risk-based capital ratio focuses princi-pally on broad categories of credit risk. For mostbanking organizations, the ratio does not incor-porate other risk factors that may affect theorganization’s financial condition. These factorsmay include overall interest-rate exposure;liquidity, funding, and market risks; the qualityand level of earnings; investment or loan port-folio concentrations; the effectiveness of loanand investment policies; the quality of assets;and management’s ability to monitor and con-trol financial and operating risks. An overallassessment of capital adequacy must take intoaccount these other factors and may differ sig-nificantly from conclusions that might be drawnsolely from the level of an organization’s risk-based capital ratio.

Definition of Capital

For risk-based capital purposes, a banking orga-nization’s capital consists of two major compo-nents: core capital elements (tier 1 capital) andsupplementary capital elements (tier 2 capital).Core capital elements include common equityincluding capital stock, surplus, and undividedprofits; qualifying noncumulative perpetual pre-ferred stock (or, for bank holding companies,cumulative perpetual preferred stock, the aggre-

1. The market-risk capital rules are mandatory for certainbanking organizations that have significant exposure to mar-ket risk. See ‘‘Market-Risk Measure’’ later in this section.

2. The risk-based capital measure is based on a frameworkdeveloped jointly by supervisory authorities from the G-10countries. The Federal Reserve implemented the risk-basedmeasure in January 1989. This section provides a briefoverview of the current risk-based capital measure. Moredetailed discussions can be found in the Federal Reserve’sCommercial Bank Examination Manual. Specific guidelinesfor calculating the risk-based capital ratio are found inRegulation H (12 CFR 208, appendixes A and E) for statemember banks and in Regulation Y (12 CFR 225, appendixesA and E) for bank holding companies.


gate of which may not exceed 25 percent oftier 1 capital); and minority interest in the equityaccounts of consolidated subsidiaries. Tier 1capital is generally defined as the sum of corecapital elements less any amounts of goodwill,certain other intangible assets, disalloweddeferred tax assets, interest-only strips, nonfi-nancial equity investments, investments in finan-cial subsidiaries that do not qualify within capi-tal, and any other investments in subsidiariesthat the Federal Reserve determines should bededucted from tier 1 capital. Tier 1 capitalrepresents the highest form of capital, namelypermanent equity. Tier 2 capital consists of alimited amount of the allowance for loan andlease losses, perpetual preferred stock that doesnot qualify as tier 1 capital, mandatory convert-ible securities and other hybrid capital instru-ments, long-term preferred stock with an origi-nal term of 20 years or more, and limitedamounts of term subordinated debt, intermediate-term preferred stock, unrealized holding gainson qualifying equity securities, and unrealizedgains (losses) on other assets. See section 3020.1,‘‘Assessment of Capital Adequacy,’’ in the Com-mercial Bank Examination Manual for a com-plete definition of capital elements.

Capital investments in unconsolidated bank-ing and finance subsidiaries and reciprocal hold-ings of other banking organizations’ capitalinstruments are deducted from an organization’scapital. The sum of tier 1 and tier 2 capital lessany deductions makes up total capital, which isthe numerator of the risk-based capital ratio.

In assessing an institution’s capital adequacy,supervisors and examiners should consider thecapacity of the institution’s paid-in equity andother capital instruments to absorb economiclosses. In this regard, the Federal Reserve’slong-standing view is that common equity (thatis, common stock and surplus and retainedearnings) should be the dominant component ofa banking organization’s capital structure andthat organizations should avoid undue relianceon non–common equity capital elements.3 Com-mon equity allows an organization to absorblosses on an ongoing basis and is permanentlyavailable for this purpose. Further, this elementof capital best allows organizations to conserveresources when they are under stress because itprovides full discretion in the amount and tim-

ing of dividends and other distributions. Conse-quently, common equity is the basis on whichmost market judgments of capital adequacy aremade.

Consideration of the capacity of an institu-tion’s capital structure to absorb losses shouldalso take into account how that structure couldbe affected by changes in the institution’s per-formance. For example, an institution experienc-ing a net operating loss—perhaps because of therealization of unexpected losses—will face notonly a reduction in its retained earnings but alsopossible constraints on its access to capitalmarkets. These constraints could be exacerbatedif conversion options are exercised to the detri-ment of the institution. A decrease in commonequity, the key element of tier 1 capital, mayhave further unfavorable implications for anorganization’s regulatory capital position. Theeligible amounts of most types of tier 1 pre-ferred stock and tier 2 or tier 3 capital ele-ments may be reduced because current capitalregulations limit the amount of these elementsthat can be included in regulatory capital toa maximum percentage of tier 1 capital. Suchadverse magnification effects could be furtheraccentuated if adverse events take place atcritical junctures for raising or maintaining capi-tal, for example, as limited-life capital instru-ments are approaching maturity or as new capi-tal instruments are being issued.

Risk-Weighted Assets

Each asset and off-balance-sheet item is assignedto one of four broad risk categories based on theobligor or, if relevant, the guarantor or type ofcollateral. The risk categories are 0, 20, 50, and100 percent. The standard risk category, whichincludes the majority of items, is 100 percent.The appropriate dollar value of the amount ineach category is multiplied by the risk weightassociated with that category. The weightedvalues are added together and the resulting sumis the organization’s risk-weighted assets, thedenominator of the risk-based capital ratio.4

Off-balance-sheet items are incorporated intothe risk-based capital ratio by first being con-verted into a ‘‘credit-equivalent’’ amount. Toaccomplish this, the face amount of the item is

3. The Basel Committee on Banking Supervision affirmedthis view in a release issued in October 1998, which stated thatcommon shareholders’ funds are the key element of capital.

4. See the Commercial Bank Examination Manual for acomplete discussion of risk-weighted assets.

2110.1 Capital Adequacy


multiplied by a credit-conversion factor (0, 20,50, or 100 percent). The credit-equivalent amountis then assigned to a risk category in the samemanner as on-balance-sheet items. For over-the-counter (OTC) derivative transactions, the credit-equivalent amount is determined by multiplyingthe notional principal amount of the underlyingcontract by a credit-conversion factor and add-ing the resulting product (which is an estimateof potential future exposure) to the positivemark-to-market value of the contract (which isthe current exposure). A contract with a negativemark-to-market value is treated as having acurrent exposure of zero. (See ‘‘Credit-Equivalent Computations for Derivative Con-tracts’’ later in this section.)

The primary determinant of the appropriaterisk category for a particular off-balance-sheetitem is the obligor. Collateral or guaranteesmay be used to a limited extent to assign anitem to a lower risk category than would beavailable to the obligor. The forms of collateralgenerally recognized for risk-based capitalpurposes are cash on deposit in the lendinginstitution; securities issued or guaranteedby central governments of the Organizationfor Economic Cooperation and Development(OECD) countries,5 U.S. government agencies,or U.S. government–sponsored agencies; andsecurities issued by multilateral lending institu-tions or regional development banks in whichthe U.S. government is a shareholder or contrib-uting member. The only guarantees recognizedare those provided by central or state and localgovernments of the OECD countries, U.S. gov-ernment agencies, U.S. government–sponsoredagencies, multilateral lending institutions orregional development banks in which the UnitedStates is a shareholder or contributing member,U.S. depository institutions, and foreign banks.

Banking organizations are expected to meeta minimum ratio of capital to risk-weightedassets of 8 percent, with at least 4 percent takingthe form of tier 1 capital. Organizations thatdo not meet the minimum ratios, or that areconsidered to lack sufficient capital to supporttheir activities, are expected to develop andimplement capital plans for achieving adequatelevels of capital. These plans must be acceptableto the Federal Reserve.

TIER 1 LEVERAGE RATIO

The principal objective of the tier 1 leveragemeasure is to place a constraint on the maximumdegree to which a banking organization canleverage its equity capital base.6 A bankingorganization’s tier 1 leverage ratio is calculatedby dividing its tier 1 capital by its average totalconsolidated assets. Generally, average total con-solidated assets are defined as the quarterlyaverage total assets reported on the organiza-tion’s most recent regulatory reports of financialcondition, less goodwill, certain other intangibleassets, disallowed deferred tax assets, interest-only strips, nonfinancial equity investments, andinvestments in financial subsidiaries that do notqualify within capital.

The Federal Reserve has adopted a minimumtier 1 leverage ratio of 3 percent for the mosthighly rated banks. A state member bank oper-ating at or near this level is expected to havewell-diversified risk, including no undue interest-rate-risk exposure; have excellent asset quality;have high liquidity; have good earnings; and ingeneral be considered a strong banking organi-zation rated a composite 1 under the CAMELSrating system for banks. Other state memberbanks are expected to have a minimum tier 1leverage ratio of 4 percent. Bank holding com-panies rated a composite 1 under the BOPECrating system and those that have implementedthe Board’s risk-based capital measure for mar-ket risk must maintain a minimum tier 1 lever-age ratio of 3 percent. Other bank holdingcompanies are expected to have a minimum tier1 leverage ratio of 4 percent. In all cases,

5. OECD countries are defined to include all full membersof the Organization for Economic Cooperation and Develop-ment regardless of entry date, as well as countries that haveconcluded special lending arrangements with the InternationalMonetary Fund (IMF) associated with the IMF’s GeneralArrangements to Borrow, but excludes any country that hasrescheduled its external sovereign debt within the previousfive years. As of May 1999, the OECD countries wereAustralia, Austria, Belgium, Canada, the Czech Republic,Denmark, Finland, France, Germany, Greece, Hungary, Ice-land, Ireland, Italy, Japan, Korea, Luxembourg, Mexico, theNetherlands, New Zealand, Norway, Poland, Portugal, Spain,Sweden, Switzerland, Turkey, the United Kingdom, and theUnited States. Saudi Arabia has concluded special lendingarrangements with the IMF associated with the IMF’s GeneralArrangements to Borrow.

6. The tier 1 leverage measure, intended to be a supplementto the risk-based capital measure, was adopted by the FederalReserve in 1990. Guidelines for calculating the tier 1 leverageratio are found in Regulation H (12 CFR 208, appendix B) forstate member banks and in Regulation Y (12 CFR 225,appendix D) for bank holding companies.

Capital Adequacy 2110.1


banking organizations should hold capital com-mensurate with the level and nature of all risksto which they are exposed.

CREDIT-EQUIVALENTCOMPUTATIONS FORDERIVATIVE CONTRACTS

Applicable Derivative Contracts

Credit-equivalent amounts are computed foreach of the following off-balance-sheet contracts:

• interest-rate contracts— single-currency interest-rate swaps— basis swaps— forward rate agreements— interest-rate options purchased (including

caps, collars, and floors purchased)— any other instrument linked to interest rates

that gives rise to similar credit risks (includ-ing when-issued securities and forwardforward deposits accepted)

• exchange-rate contracts— cross-currency interest-rate swaps— forward foreign-exchange-rate contracts— currency options purchased— any other instrument linked to exchange

rates that gives rise to similar credit risks• equity derivative contracts

— equity-linked swaps— equity-linked options purchased— forward equity-linked contracts— any other instrument linked to equities that

gives rise to similar credit risks• commodity (including precious metal) deriva-

tive contracts— commodity-linked swaps— commodity-linked options purchased— forward commodity-linked contracts— any other instrument linked to commodi-

ties that gives rise to similar credit risks• credit derivatives

— credit-default swaps— total-rate-of-return swaps— other types of credit derivatives

Exceptions

Exchange-rate contracts that have an originalmaturity of 14 or fewer calendar days andderivative contracts traded on exchanges that

require daily receipt and payment of cash-variation margin may be excluded from therisk-based ratio calculation. Gold contracts areaccorded the same treatment as exchange-ratecontracts except that gold contracts with anoriginal maturity of 14 or fewer calendar daysare included in the risk-based ratio calculation.OTC options purchased are included and treatedin the same way as other derivative contracts.

Calculation of Credit-EquivalentAmounts

The credit-equivalent amount of a derivativecontract (excluding credit derivatives) that is notsubject to a qualifying bilateral netting contractis equal to the sum of—

• the current exposure (sometimes referred to asthe replacement cost) of the contract and

• an estimate of the potential future creditexposure of the contract.

The current exposure is determined by themark-to-market value of the contract. If themark-to-market value is positive, then the cur-rent exposure is equal to that mark-to-marketvalue. If the mark-to-market value is zero ornegative, then the current exposure is zero.Mark-to-market values are measured in dollars,regardless of the currency or currencies speci-fied in the contract, and should reflect changes inthe relevant rates as well as in counterpartycredit quality.

The potential future credit exposure of acontract, including a contract that has a negativemark-to-market value, is estimated by multiply-ing the notional principal amount of the contractby a credit-conversion factor. Banking organi-zations should use, subject to examiner review,the effective rather than the apparent or statednotional amount in this calculation. The conver-sion factors (in percent) are listed in table 1. TheBoard has noted that these conversion factors,which are based on observed volatilities of theparticular types of instruments, are subject toreview and modification in light of changingvolatilities or market conditions.



Table 1—Conversion-Factor Matrix

Remaining maturity Interest rate

Foreign-exchangerate and

gold EquityPreciousmetals

Othercommodity

One year or less 0.0 1.0 6.0 7.0 10.0Over one to five years 0.5 5.0 8.0 7.0 12.0Over five years 1.5 7.5 10.0 8.0 15.0

For a contract that is structured such that onspecified dates any outstanding exposure issettled and the terms are reset so that the marketvalue of the contract is zero, the remainingmaturity is equal to the time until the next resetdate. For an interest-rate contract with a remain-ing maturity of more than one year that meetsthese criteria, the minimum conversion factor is0.5 percent.

For a contract with multiple exchanges ofprincipal, the conversion factor is multiplied bythe number of remaining payments in the con-tract. A derivative contract not included in thedefinitions of interest-rate, exchange-rate, equity,

or commodity contracts is subject to the sameconversion factors as a commodity, excludingprecious metals.

No potential future credit exposure is calcu-lated for a single-currency interest-rate swap inwhich payments are made based on two floating-rate indexes, so-called floating/floating or basisswaps. The credit exposure on these contracts isevaluated solely on the basis of their mark-to-market values.

Examples of the calculation of credit-equivalent amounts for selected instruments arein table 2.

Table 2—Calculating Credit-Equivalent Amounts for Derivative Contracts

Type of Contract

Notionalprincipalamount

Conversionfactor

Potentialexposure(dollars)

Mark-to-

market

Currentexposure(dollars)

Credit-equivalent

amount

(1) 120-day forwardforeign exchange 5,000,000 .01 50,000 100,000 100,000 150,000

(2) 4-year forwardforeign exchange 6,000,000 .05 300,000−120,000 0 300,000

(3) 3-year single-currency fixed- andfloating-interest-rateswap 10,000,000 .005 50,000 200,000 200,000 250,000

(4) 6-month oil swap 10,000,000 .10 1,000,000−250,000 0 1,000,000(5) 7-year cross-

currency floatingand floating-interest-rate swap 20,000,000 .075 1,500,000−1,500,000 0 1,500,000

TOTAL 2,900,000 + 300,000 3,200,000



Avoidance of Double Counting

In certain cases, credit exposures arising fromderivative contracts may be reflected, in part, onthe balance sheet. To avoid double countingthese exposures in the assessment of capitaladequacy and, perhaps, assigning inappropriaterisk weights, examiners may need to excludecounterparty credit exposures arising from thederivative instruments covered by the guidelinesfrom balance-sheet assets when calculating abanking organization’s risk-based capital ratios.This exclusion will eliminate the possibility thatan organization could be required to hold capitalagainst both an off-balance-sheet and on-balance-sheet amount for the same item. This treatmentis not accorded to margin accounts and accruedreceivables related to interest-rate and exchange-rate contracts.

The aggregate on-balance-sheet amountexcluded from the risk-based capital calculationis equal to the lower of—

• each contract’s positive on-balance-sheetamount or

• its positive market value included in the off-balance-sheet risk-based capital calculation.

For example, a forward contract that is markedto market will have the same market value onthe balance sheet as is used in calculating thecredit-equivalent amount for off-balance-sheetexposures under the guidelines. Therefore, theon-balance-sheet amount is not included in therisk-based capital calculation. When either thecontract’s on-balance-sheet amount or its mar-ket value is negative or zero, no deduction fromon-balance-sheet items is necessary for thatcontract.

If the positive on-balance-sheet asset amountexceeds the contract’s market value, the excess(up to the amount of the on-balance-sheet asset)should be included in the appropriate risk-weight category. For example, a purchasedoption will often have an on-balance-sheetamount equal to the fee paid until the optionexpires. If that amount exceeds market value,the excess of carrying value over market valuewould be included in the appropriate risk-weightcategory for purposes of the on-balance-sheetportion of the calculation.

Netting of Swaps and SimilarContracts

Netting refers to the offsetting of positive andnegative mark-to-market values in the determi-nation of a current exposure to be used in thecalculation of a credit-equivalent amount. Anylegally enforceable form of bilateral netting(that is, netting with a single counterparty) ofderivative contracts is recognized for purposesof calculating the credit-equivalent amount pro-vided that—

• the netting is accomplished under a writtennetting contract that creates a single legalobligation, covering all included individualcontracts, with the effect that the organizationwould have a claim to receive, or an obliga-tion to receive or pay, only the net amount ofthe sum of the positive and negative mark-to-market values on included individual con-tracts if a counterparty, or a counterparty towhom the contract has been validly assigned,fails to perform due to default, insolvency,liquidation, or similar circumstances;

• the banking organization obtains written andreasoned legal opinions that in the event of alegal challenge—including one resulting fromdefault, insolvency, liquidation, or similarcircumstances—the relevant court and admin-istrative authorities would find the bankingorganization’s exposure to be such a netamount under—— the law of the jurisdiction in which the

counterparty is chartered or the equivalentlocation in the case of noncorporateentities, and if a branch of the counterpartyis involved, then also under the law ofthe jurisdiction in which the branch islocated;

— the law that governs the individual con-tracts covered by the netting contract; and

— the law that governs the netting contract;• the banking organization establishes and main-

tains procedures to ensure that the legal char-acteristics of netting contracts are kept underreview in light of possible changes in relevantlaw; and

• the banking organization maintains documen-tation in its files that is adequate to support thenetting of rate contracts, including a copy ofthe bilateral netting contract and necessarylegal opinions.



A contract containing a walkaway clause is noteligible for netting for purposes of calculatingthe credit-equivalent amount.

By netting individual contracts for the pur-pose of calculating credit-equivalent amounts ofderivative contracts, a banking organization rep-resents that it has met the requirements of therisk-based measure of the capital adequacyguidelines for bank holding companies and thatall the appropriate documents are in the organi-zation’s files and available for inspection bythe Federal Reserve. The Federal Reserve maydetermine that a banking organization’s files areinadequate or that a netting contract, or any ofits underlying individual contracts, may not belegally enforceable. If such a determination ismade, the netting contract may be disqualifiedfrom recognition for risk-based capital pur-poses, or underlying individual contracts may betreated as though they are not subject to thenetting contract.

The credit-equivalent amount of contractsthat are subject to a qualifying bilateral nettingcontract is calculated by adding—

• the current exposure of the netting contract(net current exposure) and

• the sum of the estimates of the potential futurecredit exposures on all individual contractssubject to the netting contract (gross potentialfuture exposure) adjusted to reflect the effectsof the netting contract.

The net current exposure of the netting contractis determined by summing all positive andnegative mark-to-market values of the indi-vidual contracts included in the netting contract.If the net sum of the mark-to-market values ispositive, then the current exposure of the nettingcontract is equal to that sum. If the net sum ofthe mark-to-market values is zero or negative,then the current exposure of the netting contractis zero. The Federal Reserve may determine thata netting contract qualifies for risk-based capitalnetting treatment even though certain individualcontracts may not qualify. In these instances, thenonqualifying contracts should be treated asindividual contracts that are not subject to thenetting contract.

Gross potential future exposure orAgross iscalculated by summing the estimates of poten-tial future exposure for each individual contractsubject to the qualifying bilateral netting con-tract. The effects of the bilateral netting contracton the gross potential future exposure are rec-

ognized through the application of a formulathat results in an adjusted add-on amount (Anet).The formula, which employs the ratio of netcurrent exposure to gross current exposure(NGR), is expressed as:

Anet = (0.4 × Agross) + 0.6(NGR ×Agross)

The NGR may be calculated in accordancewith either the counterparty-by-counterpartyapproach or the aggregate approach. Under thecounterparty-by-counterparty approach, the NGRis the ratio of the net current exposure for anetting contract to the gross current exposure ofthe netting contract. The gross current exposureis the sum of the current exposures of allindividual contracts subject to the netting con-tract. Net negative mark-to-market values forindividual netting contracts with the same coun-terparty may not be used to offset net positivemark-to-market values for other netting con-tracts with the same counterparty.

Under the aggregate approach, the NGR isthe ratio of the sum of all the net currentexposures for qualifying bilateral netting con-tracts to the sum of all the gross current expo-sures for those netting contracts (each grosscurrent exposure is calculated in the samemanner as in the counterparty-by-counterpartyapproach). Net negative mark-to-market valuesfor individual counterparties may not be used tooffset net positive current exposures for othercounterparties.

A banking organization must consistently useeither the counterparty-by-counterparty approachor the aggregate approach to calculate the NGR.Regardless of the approach used, the NGRshould be applied individually to each qualify-ing bilateral netting contract to determine theadjusted add-on for that netting contract.

In the event a netting contract covers con-tracts that are normally excluded from the risk-based ratio calculation—for example, exchange-rate contracts with an original maturity of 14 orfewer calendar days or instruments traded onexchanges that require daily payment of cashvariation margin—an institution may elect toeither include or exclude all mark-to-marketvalues of such contracts when determining netcurrent exposure, provided the method chosen isapplied consistently.

Examiners are to review the netting of off-balance-sheet derivative contractual arrange-ments used by banking organizations whencalculating or verifying risk-based capital ratios



to ensure that the positions of such contracts arereported gross unless the net positions of thosecontracts reflect netting arrangements that complywith the netting requirements listed previously.

CAPITAL TREATMENT OFCREDIT DERIVATIVES

Credit derivatives are off-balance-sheet arrange-ments that allow one party (the beneficiary) totransfer credit risk of a reference asset—whichthe beneficiary may or may not own—to anotherparty (the guarantor). Many banks increasinglyuse these instruments to manage their overallcredit-risk exposure. In general, credit deriva-tives have three distinguishing features:

1. the transfer of the credit risk associated witha reference asset through contingent pay-ments based on events of default and, usu-ally, the prices of instruments before, at, andshortly after default (reference assets aremost often traded sovereign and corporatedebt instruments or syndicated bank loans)

2. the periodic exchange of payments or thepayment of a premium rather than the pay-ment of fees customary with other off-balance-sheet credit products, such as lettersof credit

3. the use of an International Swap DerivativesAssociation (ISDA) master agreement andthe legal format of a derivatives contract

For risk-based capital purposes, total-rate-of-return swaps and credit-default swaps generallyshould be treated as off-balance-sheet directcredit substitutes.7 The notional amount of acontract should be converted at 100 percent todetermine the credit-equivalent amount to beincluded in the risk-weighted assets of a guar-antor.8 A bank that provides a guarantee througha credit derivative transaction should assign itscredit exposure to the risk category appropriate

to the obligor of the reference asset or anycollateral. On the other hand, a bank that ownsthe underlying asset upon which effective creditprotection has been acquired through a creditderivative may, under certain circumstances,assign the unamortized portion of the underlyingasset to the risk category appropriate to theguarantor (for example, the 20 percent riskcategory if the guarantor is an OECD bank).9

Whether the credit derivative is considered aneligible guarantee for purposes of risk-basedcapital depends on the degree of credit protec-tion actually provided, which may be limiteddepending on the terms of the arrangement. Forexample, a relatively restrictive definition of adefault event or a materiality threshold thatrequires a comparably high percentage of loss tooccur before the guarantor is obliged to paycould effectively limit the amount of credit riskactually transferred in the transaction. If theterms of the credit derivative arrangement sig-nificantly limit the degree of risk transference,then the beneficiary bank cannot reduce the riskweight of the ‘‘protected’’ asset to that of theguarantor. On the other hand, even if the transferof credit risk is limited, a banking organizationproviding limited credit protection through acredit derivative should hold appropriate capitalagainst the underlying exposure while the orga-nization is exposed to the credit risk of thereference asset.

Banking organizations providing a guaranteethrough a credit derivative may mitigate thecredit risk associated with the transaction byentering into an offsetting credit derivative withanother counterparty, a so-called ‘‘back-to-back’’ position. Organizations that have enteredinto such a position may treat the first creditderivative as guaranteed by the offsetting trans-action for risk-based capital purposes. Accord-ingly, the notional amount of the first creditderivative may be assigned to the risk categoryappropriate to the counterparty providing creditprotection through the offsetting credit deriva-tive arrangement (for example, to the 20 percentrisk category if the counterparty is an OECDbank).

In some instances, the reference asset in thecredit derivative transaction may not be iden-tical to the underlying asset for which the

7. Unlike total-rate-of-return swaps and credit-defaultswaps, credit-linked notes are on-balance-sheet assets orliabilities. A guarantor bank should assign the on-balance-sheet amount of the credit-linked note to the risk categoryappropriate to either the issuer or the reference asset, which-ever is higher. For a beneficiary bank, cash considerationreceived in the sale of the note may be considered as collateralfor risk-based capital purposes.

8. A guarantor bank that has made cash payments repre-senting depreciation on reference assets may deduct suchpayments from the notional amount when computing credit-equivalent amounts for capital purposes.

9. In addition to holding capital against credit risk, a bankthat is subject to the market-risk rule (see ‘‘Market-RiskMeasure,’’ below) must hold capital against market risk forcredit derivatives held in its trading account.



beneficiary has acquired credit protection. Forexample, a credit derivative used to offset thecredit exposure of a loan to a corporate cus-tomer may use a publicly traded corporate bondof the customer as the reference asset, whosecredit quality serves as a proxy for the on-balance-sheet loan. In such a case, the under-lying asset will still generally be consideredguaranteed for capital purposes as long asboth the underlying asset and the reference assetare obligations of the same legal entity andhave the same level of seniority in bankruptcy.In addition, banking organizations offsettingcredit exposure in this manner would be obli-gated to demonstrate to examiners that thereis a high degree of correlation between thetwo instruments; the reference instrument isa reasonable and sufficiently liquid proxy forthe underlying asset so that the instrumentscan be reasonably expected to behave similarlyin the event of default; and, at a minimum, thereference asset and underlying asset are subjectto cross-default or cross-acceleration provisions.A banking organization that uses a credit deriva-tive that is based on a reference asset that differsfrom the protected underlying asset must docu-ment the credit derivative being used to offsetcredit risk and must link it directly to the asset orassets whose credit risk the transaction isdesigned to offset. The documentation and theeffectiveness of the credit derivative transactionare subject to examiner review. Banking orga-nizations providing credit protection throughsuch arrangements must hold capital against therisk exposures that are assumed.

Some credit derivative transactions providecredit protection for a group or basket of refer-ence assets and call for the guarantor to absorblosses on only the first asset that defaults. Oncethe first asset in the group defaults, the creditprotection for the remaining assets covered bythe credit derivative ceases. If examiners deter-mine that (1) the credit risk for the basket ofassets has effectively been transferred to theguarantor and (2) the beneficiary banking orga-nization owns all of the reference assets includedin the basket, then the beneficiary may assignthe asset with the smallest dollar amount in thegroup—if less than or equal to the notionalamount of the credit derivative—to the riskcategory appropriate to the guarantor. Con-versely, a banking organization extending creditprotection through a credit derivative on a bas-ket of assets must assign the contract’s notionalamount of credit exposure to the highest risk

category appropriate to the assets in the basket.In addition to holding capital against credit risk,a bank that is subject to the market-risk rule (seebelow) must hold capital against market risk forcredit derivatives held in its trading account.(For a description of market-risk capital require-ments, see SR-97-18).

CAPITAL TREATMENT OFSYNTHETIC COLLATERALIZEDLOAN OBLIGATIONS

Credit derivatives can be used to syntheticallyreplicate collateralized loan obligations (CLOs).Banking organizations can use CLOs and theirsynthetic variants to manage their balance sheetsand, in some instances, transfer credit risk to thecapital markets. These transactions allow eco-nomic capital to be allocated more efficiently,resulting in, among other things, improved share-holders’ returns. A CLO is an asset-backedsecurity that is usually supported by a variety ofassets, including whole commercial loans,revolving credit facilities, letters of credit, bank-er’s acceptances, or other asset-backed securi-ties. In a typical CLO transaction, the sponsor-ing banking organization transfers the loans andother assets to a bankruptcy-remote special-purpose vehicle (SPV), which then issues asset-backed securities consisting of one or moreclasses of debt. The CLO enables the sponsoringinstitution to reduce its leverage and risk-basedcapital requirements, improve its liquidity, andmanage credit concentrations.

The first synthetic CLO issued in 1997 usedcredit-linked notes (CLNs).10 Rather than trans-fer assets to the SPV, the sponsoring bank issuedCLNs to the SPV, individually referencing thepayment obligation of a particular company or‘‘reference obligor.’’ In that particular transac-tion, the notional amount of the CLNs issuedequaled the dollar amount of the reference assetsthe sponsor was hedging on its balance sheet.Since that time, other structures have evolvedthat also use credit-default swaps to transfercredit risk and create different levels of riskexposure, but that hedge only a portion of thenotional amount of the overall reference port-

10. CLNs are obligations whose principal repayment isconditioned upon the performance of a referenced asset orportfolio. The assets’ performance may be based on a varietyof measures, such as movements in price or credit spread orthe occurrence of default.



folio. In most traditional CLO structures, assetsare actually transferred into the SPV. In syn-thetic securitizations, the underlying exposuresthat make up the reference portfolio remain inthe institution’s banking book. The credit risk istransferred into the SPV through credit-defaultswaps or CLNs. In this way, the institution isable to avoid sensitive client-relationship issuesarising from loan-transfer notification require-ments, loan-assignment provisions, and loan-participation restrictions. Client confidentialityalso can be maintained.

Under the risk-based capital guidelines, cor-porate credits are typically assigned to the100 percent risk category and are assessed8 percent capital. In the case of high-qualityinvestment-grade corporate exposures, the 8 per-cent capital requirement may exceed the eco-nomic capital that a bank sets aside to cover thecredit risk of the transaction. Clearly, one of themotivations behind CLOs and other securitiza-tions is to more closely align the sponsoringinstitution’s regulatory capital requirements withthe economic capital required by the market.The introduction of synthetic CLOs has raisedquestions about their treatment for purposes ofcalculating the leverage and risk-based capitalratios of the Federal Reserve and other bankingagencies.11 In this regard, supervisors andexaminers should consider the capital treatmentof synthetic CLOs from the perspective of bothinvestors and sponsoring banking organizationsfor three types of transactions: (1) the sponsor-ing banking organization, through a syntheticCLO, hedges the entire notional amount of areference asset portfolio; (2) the sponsoringbanking organization hedges a portion of thereference portfolio and retains a high-quality,senior risk position that absorbs only thosecredit losses in excess of the junior-loss posi-tions; and (3) the sponsoring banking organiza-tion retains a subordinated position that absorbsfirst losses in a reference portfolio. Each of thesetransactions is explained more fully below.

Entire Notional Amount of theReference Portfolio Is Hedged

In a synthetic securitization that hedges theentire notional amount of the reference port-

folio, an SPV acquires the credit risk on areference portfolio by purchasing CLNs issuedby the sponsoring banking organization. TheSPV funds the purchase of the CLNs by issuinga series of notes in several tranches to third-party investors. The investor notes are in effectcollateralized by the CLNs. Each CLN repre-sents one obligor and the bank’s credit-riskexposure to that obligor, which may take theform of, for example, bonds, commitments,loans, and counterparty exposures. Since thenoteholders are exposed to the full amount ofcredit risk associated with the individual refer-ence obligors, all of the credit risk of thereference portfolio is shifted from the sponsor-ing bank to the capital markets. The dollaramount of notes issued to investors equals thenotional amount of the reference portfolio. Ifthere is a default of any obligor linked to a CLNin the SPV, the institution will call the individualnote and redeem it based on the repaymentterms specified in the note agreement. The termof each CLN is set such that the credit exposureto which it is linked matures before the maturityof the CLN. This ensures that the CLN will be inplace for the full term of the exposure to whichit is linked.

An investor in the notes issued by the SPV isexposed to the risk of default of the underlyingreference assets, as well as to the risk that thesponsoring institution will not repay principal atthe maturity of the notes. Because of the linkagebetween the credit quality of the sponsoringinstitution and the issued notes, a downgrade ofthe sponsor’s credit rating most likely will resultin the notes also being downgraded. Thus, abanking organization investing in this type ofsynthetic CLO should assign the notes to thehigher of the risk categories appropriate to theunderlying reference assets or the issuing entity.

For purposes of risk-based capital, the spon-soring banking organizations may treat the cashproceeds from the sale of CLNs that provideprotection against underlying reference assets ascash collateralizing these assets.12 This treat-ment would permit the reference assets, if car-ried on the sponsoring institution’s books, to be

11. For more information, see SR-99-32, ‘‘Capital Treat-ment for Synthetic Collateralized Obligations.’’

12. The CLNs should not contain terms that would signifi-cantly limit the credit protection provided against the under-lying reference assets, for example, a materiality thresholdthat requires a relatively high percentage of loss to occurbefore CLN payments are adversely affected or a structuringof CLN post-default payments that does not adequately passthrough credit-related losses on the reference assets to inves-tors in the CLNs.



assigned to the zero percent risk category to theextent that their notional amount is fully collat-eralized by cash. This treatment may be appliedeven if the cash collateral is transferred directlyinto the general operating funds of the institu-tion and is not deposited in a segregated account.The synthetic CLO would not confer any bene-fits to the sponsoring banking organization forpurposes of calculating its tier 1 leverage ratiobecause the reference assets remain on theorganization’s balance sheet.

High-Quality, Senior Risk Position inthe Reference Portfolio Is Retained

In some synthetic CLOs, the sponsoring bank-ing organization uses a combination of credit-default swaps and CLNs to essentially transferthe credit risk of a designated portfolio of itscredit exposures to the capital markets. Thistype of transaction allows the sponsoring insti-tution to allocate economic capital more effi-ciently and to significantly reduce its regulatorycapital requirements. In this structure, the spon-soring banking organization purchases defaultprotection from an SPV for a specifically iden-tified portfolio of banking-book credit expo-sures, which may include letters of credit andloan commitments. The credit risk on the iden-tified reference portfolio (which continues toremain in the sponsor’s banking book) is trans-ferred to the SPV through the use of credit-default swaps. In exchange for the credit pro-tection, the sponsoring institution pays the SPVan annual fee. The default swaps on each of theobligors in the reference portfolio are structuredto pay the average default losses on all seniorunsecured obligations of defaulted borrowers.To support its guarantee, the SPV sells CLNs toinvestors and uses the cash proceeds to purchaseTreasury notes from the U.S. government. TheSPV then pledges the Treasuries to the sponsor-ing banking organization to cover any defaultlosses.13 The CLNs are often issued in multipletranches of differing seniority and in an aggre-gate amount that is significantly less than thenotional amount of the reference portfolio. Theamount of notes issued typically is set at a levelsufficient to cover some multiple of expectedlosses but well below the notional amount of thereference portfolio being hedged.

There may be several levels of loss in thistype of synthetic securitization. The first-lossposition may be a small cash reserve, sufficientto cover expected losses, that accumulates overa period of years and is funded from the excessof the SPV’s income (that is, the yield on theTreasury securities plus the credit-default-swapfee) over the interest paid to investors on thenotes. The investors in the SPV assume asecond-loss position through their investment inthe SPV’s senior and junior notes, which tend tobe rated AAA and BB, respectively. Finally, thesponsoring banking organization retains a high-quality, senior risk position that would absorbany credit losses in the reference portfolio thatexceed the first- and second-loss positions. Typi-cally, no default payments are made until thematurity of the overall transaction, regardless ofwhen a reference obligor defaults. While opera-tionally important to the sponsoring bankingorganization, this feature has the effect of ignor-ing the time value of money. Thus, when thereference obligor defaults under the terms of thecredit derivative and the reference asset fallssignificantly in value, the sponsoring bankingorganization should, in accordance with gener-ally accepted accounting principles, makeappropriate adjustments in its regulatory reportsto reflect the estimated loss relating to the timevalue of money.

For risk-based capital purposes, bankingorganizations investing in the notes must assignthem to the risk weight appropriate to theunderlying reference assets.14 A banking orga-nization sponsoring such a transaction mustinclude in its risk-weighted assets its retainedsenior exposures in the reference portfolio, tothe extent these are held in its banking book.The portion of the reference portfolio that iscollateralized by the pledged Treasury securitiesmay be assigned a zero percent risk weight. Theremainder of the portfolio should be riskweighted according to the obligor of the expo-sures, unless certain stringent minimum condi-tions are met. (See the following paragraph.)When the sponsoring institution has virtuallyeliminated its credit-risk exposure to the refer-ence portfolio through the issuance of CLNs,and when the other stringent minimum

13. The names of corporate obligors included in the refer-ence portfolio may be disclosed to investors in the CLNs.

14. Under this type of transaction, if a structure exposesinvesting banking organizations to the creditworthiness of asubstantive issuer (for example, the sponsoring institution),then the investing institutions should assign the notes to thehigher of the risk categories appropriate to the underlyingreference assets or the sponsoring institution.



requirements are met, the institution may assignthe uncollateralized portion of its retained seniorposition in the reference portfolio to the 20 per-cent risk weight. To the extent that the referenceportfolio includes loans and other balance-sheetassets in the banking book, a banking organiza-tion that sponsors this type of synthetic securi-tization would not realize any benefits whendetermining its leverage ratio.

The stringent minimum requirements, whichare discussed more fully in the attachment toSR-99-32, are that (1) the probability of loss onthe retained senior position be extremely lowdue to the high credit quality of the referenceportfolio and the amount of prior credit protec-tion; (2) market discipline be injected into theprocess through the sale of CLNs into themarket, the most senior of which must be ratedAAA by a nationally recognized credit ratingagency; and (3) the sponsoring institution per-forms rigorous and robust stress testing anddemonstrates that the level of credit enhance-ment is sufficient to protect itself from lossesunder scenarios appropriate to the specific trans-action. The Federal Reserve may impose otherrequirements as deemed necessary to ensure thatthe sponsoring institution has virtually elimi-nated all of its credit exposure. Furthermore,supervisors and examiners retain the discretionto increase the risk-based capital requirementassessed against the retained senior exposure inthese structures, if the underlying asset pooldeteriorates significantly.

Based on a qualitative review, Federal Reservestaff will determine on a case-by-case basiswhether the senior retained portion of a spon-soring banking organization’s synthetic securi-tization qualifies for the 20 percent risk weight.The sponsoring institution must be able to dem-onstrate that virtually all of the credit risk of thereference portfolio has been transferred from thebanking book to the capital markets. As is thecase with organizations engaging in more tradi-tional securitization activities, examiners mustcarefully evaluate whether the institution is fullycapable of assessing the credit risk it retains inits banking book and whether the institution isadequately capitalized given its residual riskexposure. Supervisors will require the sponsor-ing organization to maintain higher levels ofcapital if it is not deemed to be adequatelycapitalized given the retained residual risks. Inaddition, an institution sponsoring syntheticsecuritizations must adequately disclose to themarketplace the effect of the transaction on its

risk profile and capital adequacy. A failure onthe part of the sponsoring banking organizationto require the investors in the CLNs to absorbthe credit losses that they contractually agreedto assume may be considered an unsafeand unsound banking practice. In addition, thisfailure generally would constitute ‘‘implicitrecourse’’ or support to the transaction thatwould result in the sponsoring banking organi-zation losing the preferential capital treatmenton its retained senior position.

If an organization sponsoring a syntheticsecuritization does not meet the stringent mini-mum criteria outlined in SR-99-32, it still mayreduce the risk-based capital requirement on thesenior risk position retained in the banking bookby using a credit derivative to transfer theremaining credit risk to a third-party OECDbank. Provided the credit derivative transactionqualifies as a guarantee under the risk-basedcapital guidelines, the risk weight on the seniorposition may be reduced from 100 percent to20 percent. Institutions may not enter into non-substantive transactions that transfer banking-book items into the trading account in order toobtain lower regulatory capital requirements.15

Retention of a First-Loss Position

In certain synthetic transactions, the sponsoringbanking organization may retain the credit riskassociated with a first-loss position and, throughthe use of credit-default swaps, pass the second-and senior-loss positions to a third-party entity,most often an OECD bank. The third-partyentity, acting as an intermediary, enters intooffsetting credit-default swaps with an SPV. Theswaps transfer the credit risk associated with thesecond-loss position to the SPV but the creditrisk of the senior position is retained.16 Asdescribed in the second transaction type above,the SPV then issues CLNs to the capital marketsfor a portion of the reference portfolio andpurchases Treasury collateral to cover some

15. For instance, a lower risk weight would not be appliedto a nonsubstantive transaction in which the sponsoringinstitution enters into a credit derivative to pass the credit riskof the senior retained portion held in its banking book to anOECD bank and then enters into a second credit derivativetransaction with the same OECD bank in order to reassumeinto its trading account the credit risk initially transferred.

16. Because the credit risk of the senior position is nottransferred to the capital markets but instead remains with theintermediary bank, the sponsoring banking organization shouldensure that its counterparty is of high credit quality, forexample, at least investment grade.



multiple of expected losses on the underlyingexposures.

Two alternative approaches could be used todetermine how the sponsoring banking organi-zation should treat the overall transaction forrisk-based capital purposes. The first approachemploys an analogy to the low-level capital rulefor assets sold with recourse. Under this rule, atransfer of assets with recourse that is contrac-tually limited to an amount less than the effec-tive risk-based capital requirements for the trans-ferred assets is assessed a total capital chargeequal to the maximum amount of loss possibleunder the recourse obligation. If this rule wasapplied to a sponsoring banking organizationretaining a one percent first-loss position on asynthetically securitized portfolio that wouldotherwise be assessed 8 percent capital, theorganization would be required to hold dollar-for-dollar capital against the one percent first-loss risk position. The sponsoring institutionwould not be assessed a capital charge againstthe second and senior risk positions.17

The second approach employs a literal read-ing of the capital guidelines to determine thesponsoring banking organization’s risk-basedcapital charge. In this instance, the one percentfirst-loss position retained by the sponsoringinstitution would be treated as a guarantee, thatis, a direct credit substitute, which would beassessed an 8 percent capital charge against itsface value of one percent. The second-lossposition, which is collateralized by Treasurysecurities, would be viewed as fully collateral-ized and subject to a zero percent capital charge.The senior-loss position guaranteed by theintermediary bank would be assigned to the20 percent risk category appropriate to claimsguaranteed by OECD banks.18 It is possible thatthis approach may result in a higher risk-basedcapital requirement than the dollar-for-dollarcapital charge imposed by the first approach—

depending on whether the reference portfolioconsists primarily of loans to private obligors, orundrawn long-term commitments. These com-mitments generally have an effective risk-basedcapital requirement that is one-half the require-ment for loans, since they are converted to anon-balance-sheet credit-equivalent amount usingthe 50 percent conversion factor. If the referencepool consists primarily of drawn loans to com-mercial obligors, then the capital requirement onthe senior-loss position would be significantlyhigher than if the reference portfolio containedonly undrawn long-term commitments. As aresult, the capital charge for the overall transac-tion could be greater than the dollar-for-dollarcapital requirement set forth in the first approach.

Sponsoring institutions are required to holdcapital against a retained first-loss position in asynthetic securitization. The capital should equalthe higher of the two capital charges resultingfrom the sponsoring institution’s application ofthe first and second approaches outlined above.Further, although the sponsoring banking orga-nization retains only the credit-risk associatedwith the first-loss position, it still should con-tinue to monitor all the underlying credit expo-sures of the reference portfolio to detect anychanges in the credit-risk profile of the counter-parties. This is important to ensure that theinstitution has adequate capital to protect againstunexpected losses. Examiners should determinewhether the sponsoring bank has the capabilityto assess and manage the retained risk in itscredit portfolio after the synthetic securitizationis completed. For risk-based capital purposes,banking organizations investing in the notesmust assign them to the risk weight appropriateto the underlying reference assets.19

ASSESSING CAPITALADEQUACY AT LARGE,COMPLEX BANKINGORGANIZATIONS

Supervisors should place increasing emphasison banking organizations’ internal processes for

17. A banking organization that sponsors this type ofsynthetic securitization would not realize any benefits in thedetermination of its leverage ratio since the reference assetsthemselves remain on the sponsoring institution’s balancesheet.

18. If the intermediary is a banking organization, then itcould place both sets of credit-default swaps in its tradingaccount and, if subject to the Federal Reserve’s market-riskcapital rules, use its general market-risk model and, ifapproved, specific-risk model to calculate the appropriaterisk-based capital requirement. If the specific-risk model hasnot been approved, then the sponsoring banking organizationwould be subject to the standardized specific-risk capitalcharge.

19. Under this type of transaction, if a structure exposesinvesting banking organizations to the creditworthiness of asubstantive issuer (for example, the sponsoring institution),then the investing institutions should assign the notes to thehigher of the risk categories appropriate to the underlyingreference assets or the sponsoring institution.



assessing risks and for ensuring that capital,liquidity, and other financial resources are ade-quate in relation to the organization’s overallrisk profiles. This emphasis is necessary in partbecause of the greater scope and complexity ofbusiness activities, particularly those related toongoing financial innovation, at many bankingorganizations. In this setting, one of the mostchallenging issues bankers and supervisors faceis how to integrate the assessment of an institu-tion’s capital adequacy with a comprehensiveview of the risks it faces. Simple ratios—including risk-based capital ratios—and tradi-tional ‘‘rules of thumb’’ no longer suffice inassessing the overall capital adequacy of manybanking organizations, especially large institu-tions and others with complex risk profiles, suchas those that are significantly engaged in secu-ritizations or other complex transfers of risk.

Consequently, supervisors and examinersshould evaluate internal capital-management pro-cesses to judge whether they meaningfully tiethe identification, monitoring, and evaluationof risk to the determination of an institution’scapital needs. The fundamental elements of asound internal analysis of capital adequacyinclude measuring all material risks, relatingcapital to the level of risk, stating explicit capitaladequacy goals with respect to risk, and assess-ing conformity to an institution’s stated objec-tives. It is particularly important that largeinstitutions and others with complex risk pro-files be able to assess their current capitaladequacy and future capital needs systemati-cally and comprehensively, in light of their riskprofiles and business plans. For more informa-tion, see SR-99-18, ‘‘Assessing Capital Ade-quacy in Relation to Risk at Large BankingOrganizations and Others with Complex RiskProfiles.’’

The practices described in this subsectionextend beyond those currently followed by mostlarge banking organizations to evaluate theircapital adequacy. Therefore, supervisors andexaminers should not expect these institutionsto immediately have in place a comprehensiveinternal process for assessing capital adequacy.Rather, examiners should look for efforts toinitiate such a process and thereafter makesteady and meaningful progress toward a com-prehensive assessment of capital adequacy.Examiners should evaluate an institution’sprogress at each examination or inspection,considering progress relative to both the institu-tion’s former practice and its peers, and record

the results of this evaluation in the examinationor inspection report.

For those banking organizations activelyinvolved in complex securitizations, othersecondary-market credit activities, or other com-plex transfers of risk, examiners should expecta sound internal process for capital adequacyanalysis to be in place immediately as a matterof safe and sound banking. Secondary-marketcredit activities generally include loan syndica-tions, loan sales and participations, credit deriva-tives, and asset securitizations, as well as theprovision of credit enhancements and liquidityfacilities to such transactions. These activi-ties are described further in SR-97-21, ‘‘RiskManagement and Capital Adequacy of Expo-sures Arising from Secondary-Market CreditActivities.’’

Examiners should evaluate whether an orga-nization is making adequate progress in assess-ing its capital needs on the basis of the risksarising from its business activities, rather thanfocusing its internal processes primarily oncompliance with regulatory standards or com-parisons with the capital ratios of peer institu-tions. In addition to evaluating an organization’scurrent practices, supervisors and examinersshould take account of plans and schedules toenhance existing capital-assessment processesand related risk-measurement systems, withappropriate sensitivity to transition timetablesand implementation costs. Evaluation of adher-ence to schedules should be part of the exam-ination and inspection process. Regardless ofplanned enhancements, supervisors should expectcurrent internal processes for capital adequacyassessment to be appropriate to the nature, size,and complexity of an organization’s activities,and to its process for determining the allowancefor credit losses.

The results of the evaluation of internal pro-cesses for assessing capital adequacy shouldcurrently be reflected in the institution’s ratingsfor management. Examination and inspectionreports should contain a brief description of theinternal processes involved in internal analysisof the adequacy of capital in relation to risk, anassessment of whether these processes are ade-quate for the complexity of the institution and itsrisk profile, and an evaluation of the institution’sefforts to develop and enhance these processes.Significant deficiencies and inadequate progressin developing and maintaining capital-assessmentprocedures should be noted in examination andinspection reports. As noted above, examiners



should expect those institutions already engagedin complex activities involving the transfer ofrisk, such as securitization and related activi-ties, to have sound internal processes for ana-lyzing capital adequacy in place immediately asa fundamental component of safe and soundoperation. As these processes develop andbecome fully implemented, supervisors andexaminers should also increasingly rely oninternal assessments of capital adequacy as anintegral part of an institution’s capital adequacyrating. If these internal assessments suggest thatcapital levels appear to be insufficient to supportthe risks taken by the institution, examinersshould note this finding in examination andinspection reports, discuss plans for correctingthis insufficiency with the institution’s directorsand management, and initiate supervisory actions,as appropriate.

Fundamental Elements of a SoundInternal Analysis of Capital Adequacy

Because risk-measurement and -managementissues are evolving rapidly, it is currently neitherpossible nor desirable for supervisors to pre-scribe in detail the precise contents and structureof a sound and effective internal capital-assessment process for large and complex insti-tutions. Indeed, the attributes of sound practicewill evolve over time as methodologies andcapabilities change, and will depend signifi-cantly on the individual circumstances of eachinstitution. Nevertheless, a sound process forassessing capital adequacy should include fourfundamental elements:

1. Identifying and measuring all material risks.A disciplined risk-measurement programpromotes consistency and thoroughness inassessing current and prospective risk pro-files, while recognizing that risks often can-not be precisely measured. The detail andsophistication of risk measurement should beappropriate to the characteristics of an insti-tution’s activities and to the size and natureof the risks that each activity presents. At aminimum, risk-measurement systems shouldbe sufficiently comprehensive and rigorousto capture the nature and magnitude of risksfaced by the institution, while differentiatingrisk exposures consistently among risk cate-gories and levels. Controls should be in place

to ensure objectivity and consistency and thatall material risks, both on- and off-balance-sheet, are adequately addressed.

Banking organizations should conductdetailed analyses to support the accuracy orappropriateness of the risk-measurement tech-niques used. Similarly, inputs used in riskmeasurement should be of good quality.Those risks not easily quantified should beevaluated through more subjective, qualita-tive techniques or through stress testing.Changes in an institution’s risk profile shouldbe incorporated into risk measures on atimely basis, whether the changes are due tonew products, increased volumes or changesin concentrations, the quality of the bank’sportfolio, or the overall economic environ-ment. Thus, measurement should not be ori-ented to the current treatment of these trans-actions under risk-based capital regulations.When measuring risks, institutions shouldperform comprehensive and rigorous stresstests to identify possible events or changes inmarkets that could have serious adverseeffects in the future. Institutions should alsogive adequate consideration to contingentexposures arising from loan commitments,securitization programs, and other transac-tions or activities that may create theseexposures for the bank.

2. Relating capital to the level of risk.Theamount of capital held should reflect not onlythe measured amount of risk, but also anadequate ‘‘cushion’’ above that amount totake account of potential uncertainties in riskmeasurement. A banking organization’s capi-tal should reflect the perceived level of pre-cision in the risk measures used, the poten-tial volatility of exposures, and the relativeimportance to the institution of the activitiesproducing the risk. Capital levels should alsoreflect that historical correlations amongexposures can rapidly change. Institutionsshould be able to demonstrate that theirapproach to relating capital to risk is concep-tually sound and that outputs and results arereasonable. An institution could use sensitiv-ity analysis of key inputs and peer analysis inassessing its approach. One credible methodfor assessing capital adequacy is for an insti-tution to consider itself adequately capital-ized if it meets a reasonable and objectivelydetermined standard of financial health, tem-pered by sound judgment—for example, atarget public-agency debt rating or even a



statistically measured maximum probabilityof becoming insolvent over a given timehorizon. In effect, this latter method is thefoundation of the Basel Accord’s treatmentof capital requirements for market foreign-exchange risk.

3. Stating explicit capital adequacy goals withrespect to risk.Institutions need to establishexplicit goals for capitalization as a standardfor evaluating their capital adequacy withrespect to risk. These target capital levelsmight reflect the desired level of risk cover-age or, alternatively, a desired credit ratingfor the institution that reflects a desireddegree of creditworthiness and, thus, accessto funding sources. These goals should bereviewed and approved by the board ofdirectors. Because risk profiles and goalsmay differ across institutions, the chosentarget levels of capital may differ signifi-cantly as well. Moreover, institutions shouldevaluate whether their long-run capital tar-gets might differ from short-run goals, basedon current and planned changes in risk pro-files and the recognition that accommodatingnew capital needs can require significant leadtime.

In addition, capital goals and the monitor-ing of performance against those goals shouldbe integrated with the methodology used toidentify the adequacy of the allowance forcredit losses (the allowance). Although boththe allowance and capital represent the abil-ity to absorb losses, insufficiently clear dis-tinction of their respective roles in absorbinglosses can distort analysis of their adequacy.For example, an institution’s internal stan-dard of capital adequacy for credit risk couldreflect the desire that capital absorb ‘‘unex-pected losses,’’ that is, some level of poten-tial losses in excess of that level alreadyestimated as being inherent in the currentportfolio and reflected in the allowance.20 Inthis setting, an institution that does not main-tain its allowance at the high end of the rangeof estimated credit losses would require morecapital than would otherwise be necessary

to maintain its overall desired capacity toabsorb potential losses. Failure to recognizethis relationship could lead an institutionto overestimate the strength of its capitalposition.

4. Assessing conformity to the institution’sstated objectives.Both the target level andcomposition of capital, along with the pro-cess for setting and monitoring such targets,should be reviewed and approved periodi-cally by the institution’s board of directors.

Risks Addressed in a Sound InternalAnalysis of Capital Adequacy

Sound internal risk-measurement and capital-assessment processes should address the fullrange of risks faced by an institution. The fourrisks listed below do not represent an exhaustivelist of potential issues that should be addressed.The capital regulations of the Federal Reserveand other U.S. banking agencies refer to manyspecific factors and other risks that institutionsshould consider in assessing capital adequacy.

• Credit risk. Internal credit-risk-rating systemsare vital to measuring and managing creditrisk at large banking organizations. Accord-ingly, a large institution’s internal ratingssystem should be adequate to support theidentification and measurement of risk for itslending activities and adequately integratedinto the institution’s overall analysis of capitaladequacy. Well-structured credit-risk-ratingsystems should reflect implicit, if not explicit,judgments of loss probabilities or expectedloss, and should be supported where possibleby quantitative analyses. Definitions of riskratings should be sufficiently detailed anddescriptive, applied consistently, and regularlyreviewed for consistency throughout the insti-tution. SR-98-25, ‘‘Sound Credit-Risk Man-agement and the Use of Internal Credit-RiskRatings at Large Banking Organizations,’’discusses the need for banks to have suffi-ciently detailed, consistent, and accurate riskratings for all loans, not only for criticized orproblem credits. It describes an emergingsound practice of incorporating such ratingsinformation into internal capital frameworks,recognizing that riskier assets require highercapital levels.

Banking organizations should also take fullaccount of credit risk arising from securitiza-

20. In March 1999, the banking agencies and the Securitiesand Exchange Commission issued a joint interagency letter tofinancial institutions stressing that depository institutionsshould have prudent and conservative allowances that fallwithin an acceptable range of estimated losses. The FederalReserve has issued additional guidance on credit-loss allow-ances to supervisors and bankers in SR-99-13, ‘‘RecentDevelopments Regarding Loan-Loss Allowances.’’



tion and other secondary-market credit activi-ties, including credit derivatives. Maintainingdetailed and comprehensive credit-risk mea-sures is most necessary at institutions thatconduct asset securitization programs, dueto the potential of these activities to greatlychange—and reduce the transparency of—therisk profile of credit portfolios. SR-97-21,‘‘Risk Management and Capital Adequacy ofExposures Arising from Secondary-MarketCredit Activities,’’ states that such changeshave the effect of distorting portfolios thatwere previously ‘‘balanced’’ in terms of creditrisk. As used here, the term ‘‘balanced’’ refersto the overall weighted mix of risks assumedin a loan portfolio by the current regulatoryrisk-based capital standard. This standard, forexample, effectively treats the commercialloan portfolios of all banks as having ‘‘typi-cal’’ levels of risk. The current capital stan-dard treats most loans alike; consequently,banks have an incentive to reduce their regu-latory capital requirements by securitizingor otherwise selling lower-risk assets, whileincreasing the average level of remainingcredit risk through devices like first-loss posi-tions and contingent exposures. It is impor-tant, therefore, that these institutions have theability to assess their remaining risks and holdlevels of capital and allowances for creditlosses. These institutions are at the frontier offinancial innovation, and they should also beat the frontier of risk measurement and inter-nal capital allocation.

• Market risk. The current regulatory capitalstandard for market risk (see ‘‘Market-RiskMeasure,’’ below) is based largely on a bank’sown measure of value-at-risk (VAR). Thisapproach was intended to produce a moreaccurate measure of risk and one that is alsocompatible with the management practices ofbanks. The market-risk standard also empha-sizes the importance of stress testing as acritical complement to a mechanical VAR-based calculation in evaluating the adequacyof capital to support the trading function.

• Interest-rate risk.Interest-rate risk within thebanking book (that is, in nontrading activities)should also be closely monitored. The bank-ing agencies have emphasized that banksshould carefully assess the risk to the eco-nomic value of their capital from adversechanges in interest rates. The ‘‘Joint PolicyStatement on Interest-Rate Risk,’’ SR-96-13,provides guidance in this matter that includes

the importance of assessing interest-rate riskto the economic value of a banking organiza-tion’s capital and, in particular, sound practicein selecting appropriate interest-rate scenariosto be applied for capital adequacy purposes.

• Operational and other risks.Many bankingorganizations see operational risk—oftenviewed as any risk not categorized as credit ormarket risk—as second in significance only tocredit risk. This view has become more widelyheld in the wake of recent, highly visiblebreakdowns in internal controls and corporategovernance by internationally active institu-tions. Although operational risk does not eas-ily lend itself to quantitative measurement, itcan have substantial costs to banking organi-zations through error, fraud, or other perfor-mance problems. The great dependence ofbanking organizations on information tech-nology systems highlights only one aspect ofthe growing need to identify and control thisoperational risk.

Examiner Review of Internal Analysisof Capital Adequacy

Supervisors and examiners should review inter-nal processes for capital assessment at large andcomplex banking organizations, as well as theadequacy of their capital and their compliancewith regulatory standards, as part of the regularsupervisory process. In general, this reviewshould assess the degree to which an institutionhas in place, or is making progress towardimplementing, a sound internal process to assesscapital adequacy as described above. Examinersshould briefly describe in the examination orinspection report the approach and internal pro-cesses used by an institution to assess its capi-tal adequacy with respect to the risks it takes.Examiners should then document their evalua-tion of the adequacy and appropriateness ofthese processes for the size and complexity ofthe institution, along with their assessmentof the quality and timing of the institution’splans to develop and enhance its processes forevaluating capital adequacy with respect to risk.In all cases, the findings of this review should beconsidered in determining the institution’ssupervisory rating for management. Over time,this review should also become an integralelement of assessing and assigning a supervi-sory rating for capital adequacy as the institution



develops appropriate processes for establishingcapital targets and analyzing its capital ade-quacy as described above. If an institution’sinternal assessments suggest that capital levelsappear to be insufficient to support its riskpositions, examiners should note this finding inexamination and inspection reports, discuss plansfor correcting this insufficiency with the institu-tion’s directors and management, and, as appro-priate, initiate follow-up supervisory actions.

Supervisors and examiners should assess thedegree to which internal targets and processesincorporate the full range of material risks facedby a banking organization. Examiners shouldalso assess the adequacy of risk measures usedin assessing internal capital adequacy for thispurpose, and the extent to which these riskmeasures are also used operationally in settinglimits, evaluating business-line performance, andevaluating and controlling risk more generally.Measurement systems that are in place but arenot integral to an institution’s risk managementshould be viewed with some skepticism. Super-visors and examiners should review whether aninstitution treats similar risks across productsand/or business lines consistently, and whetherchanges in the institution’s risk profile are fullyreflected in a timely manner. Finally, supervisorsand examiners should consider the results ofsensitivity analyses and stress tests conductedby the institution, and how these results relate tocapital plans.

In addition to being in compliance with reg-ulatory capital ratios, banking organizationsshould be able to demonstrate through internalanalysis that their capital levels and compositionare adequate to support the risks they face, andthat these levels are properly monitored andreviewed by directors. Supervisors and examin-ers should review this analysis, including thetarget levels of capital chosen, to determinewhether it is sufficiently comprehensive andrelevant to the current operating environment.Supervisors and examiners should also considerthe extent to which an institution has providedfor unexpected events in setting its capital lev-els. In this connection, the analysis should covera sufficiently wide range of external conditionsand scenarios, and the sophistication of tech-niques and stress tests used should be commen-surate with the institution’s activities. Consider-ation of such conditions and scenarios shouldtake appropriate account of the possibility thatadverse events may have disproportionate effectson overall capital levels, such as the effect

of tier 1 limitations, adverse capital-marketresponses, and other such magnification effects.Finally, supervisors should consider the qualityof the institution’s management informationreporting and systems, the manner in whichbusiness risks and activities are aggregated, andmanagement’s record in responding to emergingor changing risks.

In performing this review, supervisors andexaminers should be careful to distinguishbetween (1) a comprehensive process that seeksto identify an institution’s capital requirementson the basis of measured economic risk, and(2) one that focuses only narrowly on thecalculation and use of allocated capital (alsoknown as ‘‘economic value added’’ or EVA) forindividual products or business lines for internalprofitability analysis. The latter approach, whichmeasures the amount by which operations orprojects return more or less than their cost ofcapital, can be important to an organization intargeting activities for future growth or cut-backs. However, it requires that the organizationfirst determine by some method the amount ofcapital necessary for each activity or businessline. Moreover, an EVA approach often is unableto meaningfully aggregate the allocated capitalacross business lines and risk types as a tool forevaluating the institution’s overall capital ade-quacy. Supervisors and examiners should there-fore focus on the first process above and shouldnot be confused with related efforts of manage-ment to measure relative returns of the firm or ofindividual business lines, given an amount ofcapital already invested or allocated.

MARKET-RISK MEASURE

In August 1996, the Federal Reserve amendedits risk-based capital framework to incorporate ameasure for market risk. (See 12 CFR 208,appendix E, for state member banks and 12 CFR225, appendix E, for bank holding companies.)As described more fully below, certain institu-tions with significant exposure to market riskmust measure that risk using their internalvalue-at-risk (VAR) measurement model and,subject to parameters contained in the market-risk rules, hold sufficient levels of capital tocover the exposure. The market-risk amendmentis a supplement to the credit risk-based capitalrules: An institution applying the market-riskrules remains subject to the requirements of the



credit-risk rules, but must adjust its risk-basedcapital ratio to reflect market risk.21

Covered Banking Organizations

The market-risk rules apply to any insured statemember bank or bank holding company whosetrading activity (on a worldwide consolidatedbasis) equals (1) 10 percent or more of its totalassets or (2) $1 billion or more. For purposes ofthese criteria, a banking organization’s tradingactivity is defined as the sum of its trading assetsand trading liabilities as reported in its mostrecent Consolidated Report of Condition andIncome (call report) for a bank or in its mostrecent Y-9C report for a bank holding company.Total assets means quarter-end total assets asmost recently reported by the institution. Whenaddressing this capital requirement, bank hold-ing companies should include any securitiessubsidiary that underwrites and deals in corpo-rate securities, as well as any other subsidiariesconsolidated in their FR Y-9 reports.

On a case-by-case basis, the Federal Reservemay require an institution that does not meet theapplicability criteria to comply with the market-risk rules if deemed necessary for safety-and-soundness reasons. The Federal Reserve mayalso exclude an institution that meets the appli-cability criteria if its recent or current exposureis not reflected by the level of its ongoingtrading activity. Institutions most likely to beexempted from the market-risk capital require-ment are small banks whose reported tradingactivities exceed the 10 percent criterion butwhose management of trading risks does notraise supervisory concerns. Such banks may befocused on maintaining a market in localmunicipal securities but are not otherwiseactively engaged in trading or position-takingactivities. However, before making any excep-tions to the criteria, Reserve Banks shouldconsult with Board staff. An institution that doesnot meet the applicability criteria may, subjectto supervisory approval, comply voluntarily withthe market-risk rules. An institution applyingthe market-risk rules must have its internal-model and risk-management procedures evalu-

ated by the Federal Reserve to ensure compli-ance with the rules.

Covered Positions

For supervisory purposes, a covered bankingorganization must hold capital to support itsexposure to general market risk arising fromfluctuations in interest rates, equity prices,foreign-exchange rates, and commodity prices(general market risk includes the risk associatedwith all derivative positions). In addition, theinstitution’s capital must support its exposure tospecific risk arising from changes in the marketvalue of debt and equity positions in the tradingaccount caused by factors other than broadmarket movements (specific risk includes thecredit risk of an instrument’s issuer). An insti-tution’s covered positions include all of itstrading-account positions as well as all foreign-exchange and commodity positions, whether ornot they are in the trading account.

For market-risk capital purposes, an institu-tion’s trading account is defined in the instruc-tions to the banking agencies’ call report. Ingeneral, the trading account includes on- andoff-balance-sheet positions in financial instru-ments acquired with the intent to resell in orderto profit from short-term price or rate move-ments (or other price or rate variations). Allpositions in the trading account must be markedto market and reflected in an institution’s earn-ings statement. Debt positions in the tradingaccount include instruments such as fixed orfloating-rate debt securities, nonconvertible pre-ferred stock, certain convertible bonds, orderivative contracts of debt instruments. Equitypositions in the trading account include instru-ments such as common stock, certain convert-ible bonds, commitments to buy or sell equities,or derivative contracts of equity instruments. Aninstitution may include in its measure for gen-eral market risk certain non–trading accountinstruments that it deliberately uses to hedgetrading activities. Those instruments are notsubject to a specific-risk capital charge butinstead continue to be included in risk-weightedassets under the credit-risk framework.

The market-risk capital charge applies to allof an institution’s foreign-exchange and com-modities positions. An institution’s foreign-exchange positions include, for each currency,items such as its net spot position (including

21. An institution adjusts its risk-based capital ratio byremoving certain assets from its credit-risk weight categoriesand instead including those assets (and others) in the measurefor market risk.



ordinary assets and liabilities denominated in aforeign currency), forward positions, guaranteesthat are certain to be called and likely to beunrecoverable, and any other items that reactprimarily to changes in exchange rates. Aninstitution may, subject to examiner approval,exclude from the market-risk measure any struc-tural positions in foreign currencies. For thispurpose, structural positions include transac-tions designed to hedge an institution’s capitalratios against the effect of adverse exchange-ratemovements on (1) subordinated debt, equity, orminority interests in consolidated subsidiariesand capital assigned to foreign branches that aredenominated in foreign currencies and (2) anypositions related to unconsolidated subsidiariesand other items that are deducted from aninstitution’s capital when calculating its capitalbase. An institution’s commodity positionsinclude all positions, including derivatives, thatreact primarily to changes in commodity prices.

Adjustment to the Risk-Based CapitalCalculation

An institution applying the market-risk rulesmust measure its market risk and, on a dailybasis, hold capital to maintain an overall mini-mum 8 percent ratio of total qualifying capital torisk-weighted assets adjusted for market risk.

The denominator of an institution’s risk-based capital ratio is its adjusted credit-riskweighted assets plus its market-risk-equivalentassets. Adjusted risk-weighted assets are risk-weighted assets, as determined under the credit-risk-based capital standards, less the risk-weighted amounts of all covered positions otherthan foreign-exchange positions outside the trad-ing account and OTC derivatives. (In otherwords, an institution should not risk weight (orcould risk weight at zero percent) any nonderiva-tive debt, equity, or foreign-exchange positionsin its trading account and any nonderivativecommodity positions whether in or out of thetrading account. These positions are no longersubject to a credit-risk capital charge.) An insti-tution’s market-risk-equivalent assets is its mea-sure for market risk (determined as discussed inthe following sections) multiplied by 12.5 (thereciprocal of the minimum 8 percent capitalratio).

An institution’s measure for market risk is aVAR-based capital charge plus an add-on capital

charge for specific risk. The VAR-based capitalcharge is the larger of either (1) the averageVAR measure for the last 60 business days,calculated under the regulatory criteria andincreased by a multiplication factor rangingfrom three to four, or (2) the previous day’sVAR calculated under the regulatory criteria butwithout the multiplication factor. An institu-tion’s multiplication factor is three unless itsbacktesting results or supervisory judgment indi-cate that a higher factor or other action isappropriate.22

The numerator of an institution’s risk-basedcapital ratio consists of a combination of core(tier 1) capital, supplemental (tier 2) capital, anda third tier of capital (tier 3), which may onlybe used to meet market-risk capital require-ments. To qualify as capital, instruments mustbe unsecured and may not contain or be coveredby any covenants, terms, or restrictions that areinconsistent with safe and sound banking prac-tices. Tier 3 capital is subordinated debt with anoriginal maturity of at least two years. It must befully paid up and subject to a lock-in clause thatprevents the issuer from repaying the debt evenat maturity if the issuer’s capital ratio is, or withrepayment would become, less than the mini-mum 8 percent risk-based capital ratio.

For purposes of overall capital, at least 50 per-cent of an institution’s total qualifying capitalmust be tier 1 capital (that is, tier 2 capital plustier 3 capital may not exceed 100 percent of tier1 capital). In addition, term subordinated debt(excluding mandatory convertible debt) andintermediate-term preferred stock (and relatedsurplus) included in tier 2 capital may notexceed 50 percent of tier 1 capital. For thepurposes of the market-risk capital calculation,an institution must meet a further restriction:The sum of tier 2 capital and tier 3 capitalallocated for market risk may not exceed250 percent of tier 1 capital allocated for marketrisk.23

22. One year after an institution begins to apply themarket-risk rules, it must begin ‘‘backtesting’’ its VAR mea-sures generated for internal risk-management purposes againstactual trading results to assist in evaluating the accuracy of itsinternal model.

23. The market-risk rules (12 CFR 208, appendix E,section 3(b)(2)) discuss ‘‘allocating’’ capital to cover creditrisk and market risk. The allocation terminology is onlyrelevant for the limit on tier 3 capital. Otherwise, as long asthe condition that tier 1 capital constitutes at least 50 percentof total qualifying capital is satisfied, there is no requirementthat an institution must allocate or identify its capital for creditor market risk.



Internal Models

An institution applying the market-risk rulesmust use its internal model to measure its dailyVAR in accordance with the rule’s requirements.However, institutions can and will use differentassumptions and modeling techniques whendetermining their VAR measures for internal


Trading and Capital-Markets Activities Manual April 2003Page 20.1

risk-management purposes. These differencesoften reflect distinct business strategies andapproaches to risk management. For example,an institution may calculate VAR using aninternal model based on variance-covariancematrices, historical simulations, Monte Carlosimulations, or other statistical approaches. Inall cases, however, the model must cover theinstitution’s material risks.24 Where shortcom-ings exist, the use of the model for the calcula-tion of general market risk may be allowed,subject to certain conditions designed to cor-rect deficiencies in the model within a giventimeframe.

The market-risk rules do not specify model-ing parameters for an institution’s internal risk-management purposes. However, the rules doinclude minimum qualitative requirements forinternal risk-management processes, as well ascertain quantitative requirements for the param-eters and assumptions for internal models usedto measure market-risk exposure for regulatorycapital purposes. Examiners should verify thatan institution’s risk-measurement model andrisk-management system conform to the mini-mum qualitative and quantitative requirementsdiscussed below.

Qualitative Requirements

The qualitative requirements reiterate severalbasic components of sound risk managementdiscussed in earlier sections of this manual. Forexample, an institution must have a risk-controlunit that reports directly to senior managementand is independent from business-trading func-tions. The risk-control unit is expected to con-duct regular backtests to evaluate the model’saccuracy and conduct stress tests to identify theimpact of adverse market events on the institu-tion’s portfolio. An in-depth understanding ofthe risk-control unit’s role and responsibilities iscompleted through discussions with the institu-tion’s market-risk and senior management teamsand through the review of documented policiesand procedures. In addition, examiners shouldreview the institution’s organizational structure

and risk-management committees and minutes.The review of committee minutes providesinsights into the level of discussion of market-risk issues by senior management and, in somecases, by outside directors of the institution.

An institution must have an internal modelthat is fully integrated into its daily manage-ment, must have policies and procedures forconducting appropriate stress tests and backtestsand for responding to the results of those tests,and must conduct independent reviews of itsrisk-management and -measurement systems atleast annually. An institution should developand use those stress tests appropriate to itsparticular situation. Thus, the market-risk rulesdo not include specific stress-test methodologies.

An institution’s stress tests should be rigorousand comprehensive enough to cover a range offactors that could create extraordinary losses ina trading portfolio, or that could make thecontrol of risk in a portfolio difficult. The reviewof stress testing is important, given that VAR-based models are designed to measure marketrisk in relatively stable markets (for example, ata 99 percent confidence interval, as prescribed inthe market-risk amendment to the capital rules).However, sound risk-management practicesrequire analyses of wider market conditions.Examiners should review the institution’s poli-cies and procedures for conducting stress testsand assess the timeliness and frequency of stresstests, the comprehensive capture of traded posi-tions and parameters (for example, changes inrisk factors), and the dissemination and use oftesting results. Examiners should pay particularattention to whether stress tests result in aneffective management tool for controlling expo-sure and their ‘‘plausibility’’ in relation to theinstitution’s risk profile. Stress testing continuesto be more of an art than a science, and the roleof the examiner is to ensure that institutionshave the appropriate capabilities, processes, andmanagement oversight to conduct meaningfulstress testing.

Stress tests should be both qualitative andquantitative, incorporate both market risk andliquidity aspects of market disturbances, andreflect the impact of an event on positions witheither linear or nonlinear price characteristics.Examiners should assess whether banks are in aposition to conduct three types of broad stresstests—those incorporating (1) historical events,using market data from the respective timeperiods; (2) hypothetical events, using ‘‘marketdata’’ constructed by the institution to model

24. For institutions using an externally developed or out-sourced risk-measurement model, the model may be used forrisk-based capital purposes provided it complies with therequirements of the market-risk rules, management fullyunderstands the model, the model is integrated into theinstitution’s daily risk management, and the institution’soverall risk-management process is sound.



extreme market events that would pose a sig-nificant financial risk to the institution; and(3) institution-specific analysis, based on theinstitution’s portfolios, that identifies key vul-nerabilities. When stress tests reveal a particularvulnerability, the institution should take effec-tive steps to appropriately manage those risks.

An institution’s independent review of itsrisk-management process should include theactivities of business-trading units and the risk-control unit. Examiners should verify that aninstitution’s review includes assessing whetherits risk-management system is fully integratedinto the daily management process and whetherthe system is adequately documented. Examinerassessments of the integration of risk modelsinto the daily market-risk-management processis a fundamental component of the review forcompliance with the market-risk capital rule. Asa starting point, examiners should review therisk reports that are generated by the institu-tion’s internal model to assess the ‘‘stratifica-tion,’’ or level of detail of information providedto different levels of management, from headtraders to senior managers and directors. Thereview should evaluate the organizational struc-ture of the risk-control unit and analyze theapproval process for risk-pricing models andvaluation systems. The institution’s reviewshould consider the scope of market risks cap-tured by the risk-measurement model; accuracyand completeness of position data; verificationof the consistency, timeliness, and reliability ofdata sources used to run the internal model;accuracy and appropriateness of volatility andcorrelation assumptions; and validity of valua-tion and risk-transformation calculations. Exam-iners should assess the degree to which theinstitution’s methodology serves as the basis fortrading limits allocated to the various trading-business units. Examiners should review thislimit structure to assess its coverage of risksensitivities within the trading portfolio. In addi-tion, examiners should assess the limit-development and -monitoring mechanisms toensure that positions versus limits and exces-sions are appropriately documented andapproved.

In addition to formal reviews, examiners andspecialist teams may hold regular discussionswith institutions regarding their market-riskexposures and the methodologies they employto measure and control these risks. These dis-cussions enable supervisors to remain abreast ofthe institution’s changes in methodology (for

example, its treatment of nonlinear risks or itsapproach to stress testing) and its ongoing com-pliance with the market-risk capital rule. Thesediscussions are particularly important duringturbulent markets where exposures and capitalmay be affected by dramatic swings in marketvolatility.

In order to monitor compliance with themarket-risk amendment and to further theirunderstanding of market-risk exposures, super-visors should make quarterly requests to insti-tutions subject to the market-risk amendment forthe following information:

• total trading gain or loss for the quarter (netinterest income from trading activities plusrealized and unrealized trading gain or loss)

• average risk-based capital charge for marketrisk during the quarter

• market-risk capital charge for specific riskduring the quarter

• market-risk capital charge for general riskduring the quarter

• average one-day VAR for the quarter• maximum one-day VAR for the quarter• largest one-day loss during the quarter and the

VAR for the preceding day• the number of times the loss exceeded the

one-day VAR during the quarter, and for eachoccurrence, the amount of the loss and theprior day’s VAR

• the cause of backtesting exceptions, either byportfolio or major risk factor (for example,volatility in the S&P 500)

• the market-risk multiplier currently in use

If significant deficiencies are uncovered, exam-iners may require the institution’s audit group toenhance the scope and independence of itsmarket-risk review processes. If the audit orindependent review function lacks expertise inthis area, examiners may require that the insti-tution outsource this review to a qualified inde-pendent consultant. Follow-up discussions areheld with the institution once appropriate reviewscopes are developed and upon the completionof such reviews.

Quantitative Requirements

To ensure that an institution with significantmarket risk holds prudential levels of capital and



that regulatory capital charges for market riskare consistent across institutions with similarexposures, an institution’s VAR measures mustmeet the following quantitative requirements:

• The VAR methodology must be commensu-rate with the nature and size of the insti-tution’s trading activities and risk profile.Because the capital rules do not prescribe aparticular VAR methodology, the institutioncan use generally accepted techniques, such asvariance-covariance, historical simulation, andMonte Carlo simulations.

• VAR measures must be computed each busi-ness day based on a 99 percent (one-tailed)confidence level of estimated maximum loss.

• VAR measures must be based on a price shockequivalent to a 10-day movement in rates andprices. The Federal Reserve believes thatshorter periods do not adequately reflect theprice movements that are likely during periodsof market volatility and that they would sig-nificantly understate the risks embedded inoptions positions, which display nonlinearprice characteristics. The Board recognizes,however, that it may be overly burdensomefor institutions to apply precise 10-day priceor rate movements to options positions at thistime and, accordingly, will permit institutionsto estimate one-day price movements usingthe ‘‘square root of time’’ approach.25 Asbanks enhance their modeling techniques,examiners should consider whether they aremaking substantive progress in developingadequate and more robust methods for identi-fying nonlinear price risks. Such progress isparticularly important at institutions with siz-able options positions.

• VAR measures must be based on a minimumhistorical observation period of one yearfor estimating future price and rate changes.If historical market movements are notweighted evenly over the observation period,the weighted average for the observationperiod must be at least six months, which isequivalent to the average for the minimumone-year observation period.

• An institution must update its model data atleast once every three months and more fre-quently if market conditions warrant.

• VAR measures may incorporate empirical cor-relations (calculated from historical data onrates and prices) both within and across broadrisk categories, subject to examiner confirma-tion that the model’s system for measuringsuch correlation is sound. If an institution’smodel does not incorporate empirical correla-tions across risk categories, then the institu-tion must calculate the VAR measures bysumming the separate VAR measures for thebroad risk categories (that is, interest rates,equity prices, foreign-exchange rates, and com-modity prices).

During the examination process, examinersshould review an institution’s risk-managementprocess and internal model to ensure that itprocesses all relevant data and that modelingand risk-management practices conform to theparameters and requirements of the market-risk rule. When reviewing an internal modelfor risk-based capital purposes, examiners mayconsider reports and opinions about the accu-racy of an institution’s model that have beengenerated by external auditors or qualifiedconsultants.

If a banking institution does not fully complywith a particular standard, examiners shouldreview the banking institution’s plan for meet-ing the requirement of the market-risk amend-ment. These reviews should be tailored to theinstitution’s risk profile (for example, its level ofoptions activity) and methodologies.

In reviewing the model’s ability to captureoptionality, examiners’ reviews should identifythe subportfolios in which optionality risk ispresent and review the flow of deal data to therisk model and the capture of higher-order risks(for example, gamma and vega) within VAR.Where options risks are not fully captured, theinstitutions should identify and quantify theserisks and identify corrective-action plans toincorporate the risks. Examiners should reviewthe calculation of volatilities (implied or histori-cal), sources of this data (liquid or illiquidmarkets), and measurement of implied pricevolatility along varying strike prices. The under-standing of the institution’s determination ofvolatility smiles and skewness is a basic tenetin assessing a VAR model’s reasonableness ifoptionality risk is material. Volatility smilesreflect the phenomenon that out-of-the-marketand in-the-market options both have highervolatilities than at-the-market options. Volatilityskew refers to the differential patterns of implied

25. For example, under certain statistical assumptions, aninstitution can estimate the 10-day price volatility of aninstrument by multiplying the volatility calculated on one-daychanges by the square root of 10 (approximately 3.16).



volatilities between out-of-the-market calls andout-of-the-market puts.

The examiners should review the institution’smethodology for aggregating VAR estimatesacross the entire portfolio. The institution shouldhave well-documented policies and proceduresgoverning its aggregation process, including theuse of correlation assumptions. The inspectionof correlation assumptions is accomplishedthrough a review of the institution’s documentedtesting of correlation assumptions and select-transaction testing when individual portfoliosare analyzed to gauge the effects of correlationassumptions. Although the summation of port-folio VARs is permitted under the capital rules,the aggregation of VAR measures generallyoverstates risk and may represent an ineffectiverisk-management tool. Examiners should encour-age institutions to develop more rigorous andappropriate correlation estimates to arrive at amore meaningful portfolio VAR.

The aggregation processes utilized by bank-ing institutions may also be subject to certain‘‘missing risks,’’ resulting in an understatementof risk in the daily VAR. Examiners shouldunderstand the aggregation process through dis-cussions with risk-management personnel andreviews of models-related documents. Examin-ers should identify key control points, such astimely updating and determination of correlationstatistics, that may result in the misstatement ofportfolio VAR.

Examiners should evaluate the institution’ssystems infrastructure and its ability to supportthe effective aggregation of risk across tradingportfolios. They should also review the systemsarchitecture to identify products that are cap-tured through automated processes and thosethat are captured in spreadsheets or maintainedin disparate systems. This review is important inorder to understand the aggregation processes,including the application of correlations, and itsimpact on the timeliness and accuracy of risk-management reports.

Market-Risk Factors

For risk-based capital purposes, an institution’sinternal model must use risk factors that addressmarket risk associated with interest rates, equityprices, exchange rates, and commodity prices,including the market risk associated with optionsin each of these risk categories. An institution

may use the market-risk factors it has deter-mined affect the value of its positions and therisks to which it is exposed. However, examin-ers should confirm that an institution is usingsufficient risk factors to cover the risks inherentin its portfolio. For example, examiners shouldverify that interest-rate-risk factors correspondto interest rates in each currency in which theinstitution has interest-rate-sensitive positions.The risk-measurement system should model theyield curve using one of a number of generallyaccepted approaches, such as by estimatingforward rates or zero-coupon yields, and shouldincorporate risk factors to capture spread risk.The yield curve should be divided into variousmaturity segments to capture variation in thevolatility of rates along the yield curve. Formaterial exposure to interest-rate movements inthe major currencies and markets, modelingtechniques should capture at least six segmentsof the yield curve.

The internal model should incorporate riskfactors corresponding to individual foreign cur-rencies in which the institution’s positions aredenominated, each of the equity markets inwhich the institution has significant positions (ata minimum, a risk factor should capture market-wide movements in equity prices), and each ofthe commodity markets in which the institutionhas significant positions. Risk factors shouldmeasure the volatilities of rates and prices under-lying options positions. An institution with alarge or complex options portfolio should mea-sure the volatilities of options positions bydifferent maturities. The sophistication andnature of the modeling techniques should corre-spond to the level of the institution’s exposure.

Backtesting

One year after beginning to apply the market-risk rules, an institution will be required tobacktest VAR measures that have been calcu-lated for its internal risk-management purposes.The results of the backtests will be used toevaluate the accuracy of the institution’s internalmodel, and may result in an adjustment to theinstitution’s VAR multiplication factor used forcalculating regulatory capital requirements. Spe-cifically, the backtests must compare the insti-tution’s daily VAR measures calculated forinternal purposes, calibrated to a one-day move-ment in rates and prices and a 99 percent



(one-tailed) confidence level, against the insti-tution’s actual daily net trading profit or loss forthe past year (that is, the preceding 250 businessdays). In addition to recording daily gains andlosses arising from changes in market valuationsof the trading portfolio, net trading profits (orlosses) may include items such as fees andcommissions and earnings from bid/ask spreads.These backtests must be performed each quarter.Examiners should review the institution’s back-testing results at both the portfolio and subport-folio (for example, business-line) levels. Althoughnot required under the capital rules, subportfoliobacktesting provides management and exam-iners with deeper insight into the causes ofexceptions. It also gives examiners a frameworkfor discussing with risk managers the adequacyof the institution’s modeling assumptions andissues of position valuation and profit attributionat the business-line level. Examiners shouldreview the profit-and-loss basis of the backtest-ing process, including actual trading profits andlosses (that is, realized and unrealized profits orlosses on end-of-day portfolio positions) and feeincome and commissions associated with trad-ing activities.

If the backtest reveals that an institution’sdaily net trading loss exceeded the correspond-ing VAR measure five or more times, the insti-tution’s multiplication factor should begin toincrease—from three to as high as four if 10 ormore exceptions are found. However, the deci-sion on the specific size of any increase to theinstitution’s multiplier may be tempered byexaminer judgment and the circumstances sur-rounding the exceptions. In particular, specialconsideration may be granted for exceptions thatare produced by abnormal changes in interestrates or changes in exchange rates as a result ofmajor political events or other highly unusualmarket events. Examiners may also considerfactors such as the magnitude of an exception(that is, the difference between the VAR mea-sure and the actual trading loss) and the institu-tion’s response to the exception. Examiners maydetermine that an institution does not need toincrease its multiplication factor if it has takenadequate steps to address any modeling deficien-cies or has taken other actions that are sufficientto improve its risk-management process. TheFederal Reserve will monitor industry progressin developing backtesting methodologies andmay adjust the backtesting requirements in thefuture. When the backtest reveals exceptions,examiners should review the institution’s docu-

mentation of the size and cause of the exceptionand any corrective action taken to improve theassumptions or risk factor inputs underlying theVAR model.

Specific Risk

An institution may use its internal model tocalculate specific risk if it can demonstrate thatthe model sufficiently captures the changes inmarket values for covered debt and equityinstruments and related derivatives (for exam-ple, credit derivatives) that are caused by factorsother than broad market movements. Thesefactors include idiosyncratic price variation andevent/default risk. The capital rules also stipu-late that the model should explain the historicalprice variation in the portfolio and capturepotential concentrations, including magnitudeand changes in composition. Finally, the modelshould be sufficiently robust to capture thegreater volatility caused by adverse market con-ditions. If the bank’s internal model cannot meetthese requirements, the bank must use the stan-dardized approach to measuring specific riskunder the capital rules. The capital charge forspecific risk may be determined either by apply-ing standardized measurement techniques (thestandardized approach) or using an institution’sinternal model.

Standardized Approach

Under the standardized approach, trading-account debt instruments are categorized as‘‘government,’’ ‘‘qualifying,’’ or ‘‘other,’’ basedon the type of obligor and, in the case ofinstruments such as corporate debt, on the creditrating and remaining maturity of the instrument.Each category has a specific-risk weightingfactor. The specific-risk capital charge for debtpositions is calculated by multiplying the cur-rent market value of each net long or shortposition in a category by the appropriate risk-weight factor. An institution must risk weightderivatives (for example, swaps, futures, for-wards, or options on certain debt instruments)according to the relevant underlying instrument.For example, in a forward contract, an institu-tion must risk weight the market value of theeffective notional amount of the underlyinginstrument (or index portfolio). Swaps must be



included as the notional position in the under-lying debt instrument or index portfolio; thereceiving side is treated as a long position andthe paying side treated as a short position.Options, whether long or short, are included byrisk weighting the market value of the effectivenotional amount of the underlying instrument orindex multiplied by the option’s delta. An insti-tution may net long and short positions inidentical debt instruments that have the sameissuer, coupon, currency, and maturity. An insti-tution may also net a matched position in aderivative instrument and the derivative’s cor-responding underlying instrument.

The government category includes generalobligation debt instruments of central govern-ments of OECD countries, as well as localcurrency obligations of non-OECD central gov-ernments to the extent the institution has liabili-ties booked in that currency. The risk-weightfactor for the government category is zeropercent.

The qualifying category includes debt instru-ments of U.S. government–sponsored agencies,general obligation debt instruments issued bystates and other political subdivisions of OECDcountries, multilateral development banks, anddebt instruments issued by U.S. depositoryinstitutions or OECD banks that do not qualifyas capital of the issuing institution. Qualifyinginstruments also may be corporate debt andrevenue instruments issued by states and politi-cal subdivisions of OECD countries that are(1) rated as investment grade by at least twonationally recognized credit rating firms; (2) ratedas investment grade by one nationally recog-nized credit rating firm and not less than invest-ment grade by any other credit rating agency; or(3) if unrated and the issuer has securities listedon a recognized stock exchange, deemed to beof comparable investment quality by the report-ing institution, subject to review by the FederalReserve. The risk-weighting factors for qualify-ing instruments vary according to the remainingmaturity of the instrument as set in table 3.

Other debt instruments not included in thegovernment or qualifying categories receive arisk weight of 8 percent.

Table 3—Specific-Risk WeightingFactors

Remaining maturityRisk-weight

factor

6 months or less 0.25%Over 6 months to 24 months 1.00%Over 24 months 1.60%

The specific-risk charge for equity positionsis based on an institution’s gross equity positionfor each national market. Gross equity positionis defined as the sum of all long and short equitypositions, including positions arising fromderivatives such as equity swaps, forwards,futures, and options. The current market valueof each gross equity position is weighted by adesignated factor, and the relevant underlyinginstrument is used to determine risk weights ofequity derivatives. For example, swaps areincluded as the notional position in the under-lying equity instrument or index portfolio; thereceiving side is treated as a long position andthe paying side as a short position.

The specific-risk charge is 8 percent of thegross equity position, unless the institution’sportfolio is both liquid and well diversified, inwhich case the capital charge is 4 percent. Aportfolio is liquid and well diversified if (1) it ischaracterized by a limited sensitivity to pricechanges of any single equity or closely relatedgroup of equity issues; (2) the volatility of theportfolio’s value is not dominated by the vola-tility of equity issues from any single industry oreconomic sector; (3) it contains a large numberof equity positions, and no single position rep-resents a substantial portion of the portfolio’stotal market value;26 and (4) it consists mainlyof issues traded on organized exchanges or inwell-established OTC markets.

For positions in an index comprising a broad-based, diversified portfolio of equities, thespecific-risk charge is 2 percent of the net longor short position in the index. In addition, a2 percent specific-risk charge applies to onlyone side (long or short) in the case of certainfutures-related arbitrage strategies (for instance,long and short positions in the same index atdifferent dates or in different market centers andlong and short positions at the same date in

26. For practical purposes, examiners may interpret ‘‘sub-stantial’’ as meaning more than 5 percent.



different, but similar indexes). Finally, undercertain conditions, futures positions on a broad-based index that are matched against positionsin the equities composing the index are subjectto a specific-risk charge of 2 percent againsteach side of the transaction.

Internal-Models Approach

Institutions using models will be permitted tobase their specific-risk capital charge on mod-eled estimates if they meet all of the qualitativeand quantitative requirements for general riskmodels as well as the additional criteria set outbelow. Institutions that are unable to meet theseadditional criteria will be required to base theirspecific-risk capital charge on the full amount ofthe standardized specific-risk charge. Condi-tional permission for the use of specific-riskmodels is discouraged. Institutions should usethe standardized approach for a particular port-folio until they have fully developed a model toaccurately measure the specific risk inherent inthat portfolio.

The criteria for applying modeled estimatesof specific risk require that an institution’smodel—

• explain the historical price variation in theportfolio,27

• demonstrably capture concentration (magni-tude and changes in composition),28

• be robust to an adverse environment,29 and

• be validated through backtesting aimed atassessing whether specific risk is being accu-rately captured.

In addition, the institution must be able todemonstrate that it has methodologies in placethat allow it to adequately capture event anddefault risk for its trading positions. In assessingthe model’s robustness, examiners review thebanking institution’s testing of the model, includ-ing regression analysis testing (that is, ‘‘goodness-of-fit’’), stress-test simulations of ‘‘shocked’’market conditions, and changing credit-cycleconditions. Examiners evaluate the scope oftesting (for example, what factors are shockedand to what degree, as well as what the resultantchanges in risk exposures are), the number oftests completed, and the results of these tests. Iftesting is deemed insufficient or the results areunclear, the banking institution is expected toaddress these concerns before supervisory rec-ognition of the model.

As previously noted, the review of models isconducted after supervisory recognition of thebanking institution’s general market-risk meth-odology. The examiner reviews are generallyconducted on a subportfolio basis (for example,investment-grade corporate debt, credit deriva-tives, etc.), focusing on the modeling methodol-ogy, validation, and backtesting process. Theportfolio-level approach addresses the case inwhich a banking institution’s model adequatelycaptures specific risk within its investment-grade corporate debt portfolio but not within itshigh-yield corporate debt portfolio. In this case,the banking institution would generally begranted internal-models treatment for theinvestment-grade debt portfolio and continue toapply the standardized approach to its high-yielddebt portfolio.

Examiner assessments of the adequacy of abanking institution’s specific-risk modelingaddress the following major points:

• the type, size, and composition of the modeledportfolio and other relevant information (forexample, market data)

• the VAR-based methodology and relevantassumptions applicable to the modeled port-folio and a description of how the methodol-ogy captures the key specific-risk areas—

27. The key ex ante measures of model quality are‘‘goodness-of-fit’’ measures that address the question of howmuch of the historical variation in price value is explained bythe model. One measure of this type that can often be used isan R-squared measure from regression methodology. If thismeasure is to be used, the institution’s model would beexpected to be able to explain a high percentage, such as 90percent, of the historical price variation or to explicitly includeestimates of the residual variability not captured in the factorsincluded in this regression. For some types of models, it maynot be feasible to calculate a goodness-of-fit measure. In suchan instance, a bank is expected to work with its nationalsupervisor to define an acceptable alternative measure thatwould meet this regulatory objective.

28. The institution would be expected to demonstrate thatthe model is sensitive to changes in portfolio construction andthat higher capital charges are attracted for portfolios that haveincreasing concentrations.

29. The institution should be able to demonstrate that themodel will signal rising risk in an adverse environment. Thiscould be achieved by incorporating in the historical estimationperiod of the model at least one full credit cycle and byensuring that the model would not have been inaccurate in thedownward portion of the cycle. Another approach for dem-

onstrating rising risk is through the simulation of historical orplausible worst-case environments.



idiosyncratic variation and event and defaultrisk

• the backtesting analysis performed by thebanking institution that demonstrates the mod-el’s ability to capture specific risk within theidentified portfolio (This backtesting is spe-cific to the modeled portfolio, not the entiretrading portfolio.)

• additional testing (for example, stress testing)performed by the banking institution to dem-onstrate the model’s performance under market-stress events

Institutions that meet the criteria set out abovefor models but that do not have methodologiesin place to adequately capture event and defaultrisk will be required to calculate their specific-risk capital charge based on the internal-modelmeasurements plus an additional prudential sur-charge as defined in the following paragraph.The surcharge is designed to treat the modelingof specific risk on the same basis as a generalmarket-risk model that has proven deficientduring backtesting. That is, the equivalent of ascaling factor of four would apply to the esti-mate of specific risk until such time as aninstitution can demonstrate that the methodolo-gies it uses adequately capture event and defaultrisk. Once an institution is able to demonstratethat, the minimum multiplication factor of threecan be applied. However, a higher multiplicationfactor of four on the modeling of specific riskwould remain possible if future backtestingresults were to indicate a serious deficiency withthe model.

For institutions applying the surcharge, thetotal of the market-risk capital requirement willequal a minimum of three times the internalmodel’s general- and specific-risk measure plusa surcharge in the amount of either—

• the specific-risk portion of the VAR measure,which should be isolated according to super-visory guidelines30 or

• the VAR measures of subportfolios of debtand equity positions that contain specific risk.31

Institutions using the second option are requiredto identify their subportfolio structure ahead oftime and should not change it without supervi-sory consent.

Institutions that apply modeled estimates ofspecific risk are required to conduct backtestingaimed at assessing whether specific risk is beingaccurately captured. The methodology an insti-tution should use for validating its specific-riskestimates is to perform separate backtests onsubportfolios using daily data on subportfoliossubject to specific risk. The key subportfoliosfor this purpose are traded debt and equitypositions. However, if an institution itselfdecomposes its trading portfolio into finer cate-gories (for example, emerging markets or tradedcorporate debt), it is appropriate to keep thesedistinctions for subportfolio backtesting pur-poses. Institutions are required to commit to asubportfolio structure and stick to it unless theinstitution can demonstrate to the supervisor thatchanging the structure would make sense.

Institutions are required to have in place aprocess to analyze exceptions identified throughthe backtesting of specific risk. This process isintended to serve as the fundamental way inwhich institutions correct their models of spe-cific risk if they become inaccurate. Models thatincorporate specific risk are presumed unaccept-able if the results at the subportfolio levelproduce 10 or more exceptions. Institutions that

30. Techniques for separating general market risk andspecific risk would include the following:

Equities

• The market should be identified with a single factor that isrepresentative of the market as a whole, for example, awidely accepted, broadly based stock index for the countryconcerned.

• Institutions that use factor models may assign one factor oftheir model, or a single linear combination of factors, astheir general market-risk factor.

Bonds

The market should be identified with a reference curve for thecurrency concerned. For example, the curve might be agovernment bond yield curve or a swap curve; in any case, thecurve should be based on a well-established and liquidunderlying market and should be accepted by the market as areference curve for the currency concerned.

Institutions may select their own technique for identifyingthe specific-risk component of the VAR measure for purposesof applying the multiplier of four. Techniques would include—

• using the incremental increase in VAR arising from themodeling of specific-risk factors,

• using the difference between the VAR measure and ameasure calculated by substituting each individual equityposition by a representative index, or

• using an analytic separation between general market riskand specific risk implied by a particular model.

31. This surcharge would apply to subportfolios containingpositions that would be subject to specific risk under thestandardized-based approach.



have unacceptable specific-risk models areexpected to take immediate action to correct theproblem in the model and ensure that there is asufficient capital buffer to absorb the risk thatthe backtest showed had not been adequatelycaptured.

Examiners must confirm with the institutionthat its model incorporates specific risk for both

debt and equity positions. For instance, if themodel addressed the specific risk of debt posi-tions but not equity positions, then the institu-tion could use the model-based specific-riskcharge (subject to the limitation described ear-lier) for debt positions, but must use the fullstandard specific-risk charge for equity positions.



AccountingSection 2120.1

The securities and financial contracts that makeup an institution’s trading portfolio are generallymarked to market, and gains or losses on thepositions are recognized in the current period’sincome. A single class of financial instrumentthat can meet trading, investment, or hedgingobjectives may have a different accounting treat-ment applied to it depending on management’spurpose for holding it. Therefore, an examinerreviewing trading activities should be familiarwith the different accounting methods to ensurethat the particular accounting treatment beingused is appropriate for the purpose of holding afinancial instrument and the economic substanceof the related transaction.

The accounting principles that apply to secu-rities portfolios, including trading accounts andderivative instruments are complex; theirauthoritative standards and related banking prac-tices have evolved over time. This section sum-marizes the major aspects of the accountingprinciples for trading and derivative activitiesfor both financial and regulatory reporting pur-poses. Accordingly, this section does not setforth new accounting policies or list or explainthe detailed line items of financial reports thatmust be reported for securities portfolios orderivative instruments. Examiners should con-sult the sources of generally accepted account-ing principles (GAAP) and regulatory reportingrequirements that are referred to in this sectionfor more detailed guidance.

Examiners should be aware that accountingpractices in foreign countries may differ fromthose followed in the United States. Neverthe-less, foreign institutions are required to submitregulatory reports prepared in accordance withregulatory reporting instructions for U.S. bank-ing agencies, which are generally consistentwith GAAP. This section will focus on reportingrequirements of the United States.

The major topics covered in this section arelisted below. The discussion of specific types ofbalance-sheet instruments (such as securities)and derivative instruments (for example, swaps,futures, forwards, and options) is interwovenwith these discussions.

• sources of GAAP accounting standards andregulatory reporting requirements

• the broad framework for accounting for secu-rities portfolios, including the general frame-

work for trading activities• general framework for derivative instruments,

including hedges• specific accounting principles for derivative

instruments, including domestic futures;foreign-currency instruments; forward con-tracts (domestic), including forward rate agree-ments; interest-rate swaps; and options

ACCOUNTING STANDARDS

The Federal Reserve has long viewed account-ing standards as a necessary step to efficientmarket discipline and bank supervision. Account-ing standards provide the foundation for cred-ible and comparable financial statements andother financial reports. Accurate information,reported in a timely manner, provides a basis forthe decisions of market participants. The effec-tiveness of market discipline, to a very consid-erable degree, rests on the quality and timelinessof reported financial information.

Financial statements and regulatory financialreports perform a critical role for depositoryinstitution supervisors. Supervisory agencieshave monitoring systems in place which enablethem to follow, off-site, the financial develop-ments at depository institutions. When reportedfinancial information indicates that an institu-tion’s financial condition has deteriorated, thesesystems can signal the need for on-site exami-nations and any other appropriate actions. Inshort, the better the quality of reported financialinformation from institutions, the greater theability of agencies to monitor and superviseeffectively.

Accounting Principles for FinancialReporting

Financial statements provide information neededto evaluate an institution’s financial conditionand performance. GAAP must be followed forfinancial-reporting purposes—that is, for annualand quarterly published financial statements.The standards in GAAP for trading activitiesand derivative instruments are based on pro-nouncements issued by the Financial Account-ing Standards Board (FASB); the AmericanInstitute of Certified Public Accountants


(AICPA); and, for publicly traded companies,the Securities and Exchange Commission (SEC).GAAP pronouncements usually take the formsdescribed in table 1.

Table 1—GAAP Pronouncements andAbbreviations

Source Major Pronouncements

FASB Statements of FinancialAccounting Standards(FAS)

FASB Interpretations (FIN)Technical Bulletins (TB)

AICPA Audit and Accounting GuidesIndustry Audit GuidesStatements of Position (SOP)Accounting InterpretationsIssues Papers*

SEC Financial Reporting Releases(FRR)

Regulation S-XGuide 3 to Regulation S-X,

Article 9Staff Accounting Bulletins

(SAB)

EmergingIssues TaskForce (EITF)

Consensus positions by a groupof leading accountants fromindustry and the accountingprofession

* These are generally nonauthoritative.

The SEC requires publicly traded bankingorganizations and other public companies tofollow GAAP in preparing their form 10-Ks,annual reports, and other SEC financial reports.These public companies must also follow spe-cial reporting requirements mandated by theSEC, such as the guidance listed above, whenpreparing their financial reports.

Accounting Principles for RegulatoryReporting

Currently, state member banks are subject totwo main regulatory requirements to file finan-cial statements with the Federal Reserve. Onerequirement involves financial statements and

other reports that are filed with the Boardby state member banks that are subject to thereporting requirements of the SEC.1 The otherrequirement involves the regulatory financialstatements for state member banks, other feder-ally insured commercial banks, and federallyinsured savings banks—the Reports of Condi-tion and Income, commonly referred to as callreports. The call reports, the form and content ofwhich are developed by the Federal FinancialInstitutions Examination Council (FFIEC), arecurrently required to be filed in a manner gen-erally consistent with GAAP.2 For purposes ofpreparing the call reports, the guidance in theinstructions (including related glossary items) tothe Reports of Condition and Income should befollowed. U.S. banking agencies require foreignbanking organizations operating in the UnitedStates to file regulatory financial reports pre-pared in accordance with relevant regulatoryreporting instructions.

Various Y-series reports submitted to theFederal Reserve by bank holding companieshave long been prepared in accordance withGAAP. Section 112 of the Federal DepositInsurance Corporation Improvement Act of 1991(FDICIA) mandates that state member bankswith total consolidated assets of $500 million ormore have to submit to the Federal Reserveannual reports containing audited financial state-ments prepared in accordance with GAAP.Alternatively, the financial-statement requirementcan be satisfied by filing consolidated financialstatements of the bank holding company. Thus,the summary of GAAP that follows will berelevant for purposes of (1) financial statementsof state member banks and bank holding com-panies, (2) call reports of banks, (3) Y-seriesreports of bank holding companies, and (4) the

1. Generally, pursuant to section 12(b) or 12(g) of theSecurities Exchange Act of 1934, state member banks whosesecurities are subject to registration are required to file withthe Federal Reserve Board annual reports, quarterly financialstatements, and other financial reports that conform with SECreporting requirements.

2. The importance of accounting standards for regulatoryreports is recognized by section 121 of the Federal DepositInsurance Corporation Act of 1991. Section 121 requiresthat accounting principles applicable to regulatory financialreports filed by federally insured banks and thrifts with theirfederal banking agency must be consistent with GAAP.However, under section 121, a federal banking agency mayrequire institutions to use accounting principles ‘‘no lessstringent than GAAP’’ when the agency determines thatGAAP does not meet supervisory objectives.

2120.1 Accounting


section 112 annual reports of state memberbanks and bank holding companies.

ACCOUNTING FOR SECURITIESPORTFOLIOS

Treatment Under FASB StatementNo. 115

Statement of Financial Accounting StandardsNo. 115 (FAS 115), ‘‘Accounting for CertainInvestments in Debt and Equity Securities,’’ asamended by Statement of Financial AccountingStandards No. 140 (FAS 140), ‘‘Accounting forTransfers and Servicing of Financial Assets andExtinguishments of Liabilities,’’ is the authori-tative guidance for accounting for equity secu-rities that have readily determinable fair valuesand for all debt securities.3 (FAS 140 replacesFAS 125, which had the same title.) Investmentssubject to FAS 115 are to be classified in threecategories and accounted for as follows:

• Held-to-maturity account. Debt securities thatthe institution has the positive intent andability to hold to maturity are classified asheld-to-maturity securities and reported atamortized cost. FAS 140 amended FAS 115 torequire that securities that can contractually beprepaid or otherwise settled in such a way thatthe holder of the security would not

recover substantially all of its recorded invest-ment must be recorded as either available-for-sale or trading. Reclassifications of held-to-maturity securities as a result of the initialapplication of FAS 140 would not call intoquestion an entity’s intent to hold other secu-rities to maturity in the future.

• Trading account. Debt and equity securitiesthat are bought and held principally for thepurpose of selling them in the near term areclassified as trading securities and reported atfair value, with unrealized gains and lossesincluded in earnings. Trading generally reflectsactive and frequent buying and selling, andtrading securities are generally used with theobjective of generating profits on short-termdifferences in price.

• Available-for-sale account. Debt and equitysecurities not classified as either held-to-maturity securities or trading securities areclassified as available-for-sale securities andreported at fair value, with unrealized gainsand losses excluded from earnings and reportedas a net amount in a separate component ofshareholders’ equity.

Under FAS 115, mortgage-backed securitiesthat are held for sale in conjunction with mort-gage banking activities should be reported at fairvalue in the trading account. FAS 115 does notapply to loans, including mortgage loans, thathave not been securitized.

Upon the acquisition of a debt or equitysecurity, an institution must place the securityinto one of the above three categories. At eachreporting date, the institution must reassesswhether the balance-sheet classification 4 contin-ues to be appropriate.

Proper classification of securities is a keyexamination issue. As stated above, instrumentsthat are intended to be held principally for thepurpose of selling them in the near term shouldbe classified as trading assets. Reporting secu-rities held for trading purposes as available-for-sale or held-to-maturity would result in theimproper deferral of unrealized gains and lossesfrom earnings and regulatory capital. Accord-ingly, examiners should scrutinize institutionsthat exhibit a pattern or practice of sellingsecurities from the available-for-sale or held-to-maturity accounts after a short-term holding

3. FAS 115 does not apply to investments in equitysecurities accounted for under the equity method nor toinvestments in consolidated subsidiaries. This statement doesnot apply to institutions whose specialized accounting prac-tices include accounting for substantially all investments indebt and equity securities at market value or fair value, withchanges in value recognized in earnings (income) or in thechange in net assets. Examples of those institutions arebrokers and dealers in securities, defined benefit pensionplans, and investment companies.

FAS 115 states that the fair value of an equity security isreadily determinable if sales prices or bid-and-asked quota-tions are currently available on a securities exchange regis-tered with the SEC or in the over-the-counter market, pro-vided that those prices or quotations for the over-the-countermarket are publicly reported by the National Association ofSecurities Dealers’ automated quotation systems or by theNational Quotation Bureau. Restricted stock does not meetthat definition.

The fair value of an equity security traded only in a foreignmarket is readily determinable if that foreign market is of abreadth and scope comparable to one of the U.S. marketsreferred to above. The fair value of an investment in a mutualfund is readily determinable if the fair value per share (unit)is determined and published and is the basis for currenttransactions.

4. In this context, ‘‘classification’’ refers to the security’sbalance-sheet category, not the credit quality of the asset.

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period, particularly if significant amounts oflosses on securities in these accounts have notbeen recognized.

FAS 115 recognizes that certain changes incircumstances may cause the institution tochange its intent to hold a certain security tomaturity without calling into question its intentto hold other debt securities to maturity in thefuture. Thus, the sale or transfer of a held-to-maturity security due to one of the followingchanges in circumstances will not be viewedas inconsistent with its original balance-sheetclassification:

• evidence of a significant deterioration in theissuer’s creditworthiness

• a change in tax law that eliminates or reducesthe tax-exempt status of interest on the debtsecurity (but not a change in tax law thatrevises the marginal tax rates applicable tointerest income)

• a major business combination or major dispo-sition (such as the sale of a segment) thatnecessitates the sale or transfer of held-to-maturity securities to maintain the institu-tion’s existing interest-rate risk position orcredit-risk policy

• a change in statutory or regulatory require-ments significantly modifying either what con-stitutes a permissible investment or the maxi-mum level of investments in certain kinds ofsecurities, thereby causing an institution todispose of a held-to-maturity security

• a significant increase by the regulator in theindustry’s capital requirements that causes theinstitution to downsize by selling held-to-maturity securities

• a significant increase in the risk weights ofdebt securities used for regulatory risk-basedcapital purposes.

Furthermore, FAS 115 recognizes other eventsthat are isolated, nonrecurring, and unusual forthe reporting institution and that could not havebeen reasonably anticipated may cause the in-stitution to sell or transfer a held-to-maturitysecurity without necessarily calling into ques-tion its intent to hold other debt securities tomaturity. EITF 96-10, as amended by FAS 140,provides that transactions that are not accountedfor as sales under FAS 140 would not contradictthe entity’s intent to hold that security, or anyother securities, to maturity. (See paragraph nineof FAS 140 for additional guidance on criteriawhich would require such transactions to be

accounted for as sales.) However, all sales andtransfers of held-to-maturity securities mustbe disclosed in the footnotes to the financialstatements.

An institution must not classify a debt secu-rity as held-to-maturity if the institution intendsto hold the security for only an indefinite period.5Consequently, a debt security should not, forexample, be classified as held-to-maturity if thebanking organization or other company antici-pates that the security would be available to besold in response to—

• changes in market interest rates and relatedchanges in the security’s prepayment risk,

• needs for liquidity (for example, due to thewithdrawal of deposits, increased demand forloans, surrender of insurance policies, or pay-ment of insurance claims),

• changes in the availability of and the yield onalternative investments,

• changes in funding sources and terms, and

• changes in foreign-currency risk.

According to FAS 115, an institution’s asset-liability management may consider the maturityand repricing characteristics of all investmentsin debt securities, including those held to matu-rity or available for sale, without tainting orcasting doubt on the standard’s criterion thatthere be a ‘‘positive intent to hold until matu-rity.’’ However, to demonstrate its ongoingintent and ability to hold the securities to matu-rity, management should designate the held-to-maturity securities as not available for sale forpurposes of the ongoing adjustments that are anecessary part of its asset-liability management.Further, liquidity can be derived from the held-to-maturity category by the use of repurchaseagreements that are classified as financings, butnot sales.

5. In summary, under FAS 115, sales of debt securities thatmeet either of the following two conditions may be consideredas ‘‘maturities’’ for purposes of the balance-sheet classifica-tion of securities: (1) The sale of a security occurs near enoughto its maturity date (or call date if exercise of the call isprobable)—for example, within three months—that interest-rate risk has been substantially eliminated as a pricing factor.(2) The sale of a security occurs after the institution hasalready collected at least 85 percent of the principal outstand-ing at acquisition from either prepayments or scheduledpayments on a debt security payable in equal installments overits term (variable-rate securities do not need to have equalpayments).

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Transfers of a security between investmentcategories should be accounted for at fair value.FAS 115 requires that, at the date of transfer, thesecurity’s unrealized holding gain or loss mustbe accounted for as follows:

• For a security transferred from the tradingcategory, the unrealized holding gain or loss atthe date of transfer will already have beenrecognized in earnings and should not bereversed.

• For a security transferred into the tradingcategory, the unrealized holding gain or loss atthe date of transfer should be recognized inearnings immediately.

• For a debt security transferred into theavailable-for-sale category from the held-to-maturity category, the unrealized holding gainor loss at the date of transfer should berecognized in a separate component of share-holders’ equity.

• For a debt security transferred into the held-to-maturity category from the available-for-sale category, the unrealized holding gain orloss at the date of transfer should continue tobe reported in a separate component of share-holders’ equity but also should be amortizedover the remaining life of the security as anadjustment of its yield in a manner consistentwith the amortization of any premium ordiscount.

Transfers from the held-to-maturity categoryshould be rare, except for transfers that arecaused by the changes in circumstances dis-cussed above. According to the standard, trans-fers into or from the trading category shouldalso be rare.

FAS 115 requires that institutions determinewhether a decline in fair value below the amor-tized cost for individual securities in theavailable-for-sale or held-to-maturity accountsis ‘‘other than temporary’’ (that is, whether thisdecline results from permanent impairment).For example, if it is probable that the investorwill be unable to collect all amounts due accord-ing to the contractual terms of a debt securitythat was not impaired at acquisition, an other-than-temporary impairment should be consid-ered to have occurred. If the decline in fair valueis judged to be other than temporary, the costbasis of the individual security should be writtendown to its fair value, and the write-downshould be accounted in earnings as a realizedloss. This new cost basis should not be written

up if there are any subsequent recoveries in fairvalue.

Other Sources of RegulatoryReporting Guidance

As mentioned above, FAS 115 has been adoptedfor regulatory reporting purposes. Call reportinstructions are another source of guidance,particularly, the glossary entries on—

• coupon stripping, Treasury receipts, andSTRIPS;

• fails;• foreign debt exchange transactions;• market value of securities;• nonaccrual status;• premiums and discounts;• short positions;• transfers of financial assets;• trading accounts;• trade-date and settlement-date accounting;6

and• when-issued securities transactions.

Traditional Model Under GAAP

The traditional model was used to account forinvestment and equity securities before FAS115. However, the traditional model still appliesto assets that are not within the scope of FAS115 (for example, equity securities that do nothave readily determinable fair values).

Under the traditional accounting model forsecurities portfolios and certain other assets,debt securities are placed into the followingthree categories on the basis of the institution’sintent and ability to hold them:

• Investment account. Investment assets are car-ried at amortized cost. A bank must have theintent and ability to hold these securities forlong-term investment purposes. The marketvalue of the investment account is fullydisclosed in the footnotes to the financialstatements.

• Trading account. Trading assets are markedto market. Unrealized gains and losses are

6. As described in this glossary entry, for call reportpurposes, the preferred method for reporting securities trans-actions is recognition on the trade date.

Accounting 2120.1


recognized in income. Trading is character-ized by a high volume of purchase and saleactivity.

• Held-for-sale account. Assets so classified arecarried at the lower of cost or market value(LOCOM). Unrealized losses on these securi-ties are recognized in income. This accountis characterized by intermittent sales ofsecurities.

Under GAAP, the traditional model has beengenerally followed for other assets as well.Thus, loans that are held for trading purposeswould be marked to market, and loans that areheld for sale would be carried at LOCOM.

SECURITIZATIONS

FAS 140 covers the accounting treatment for thesecuritization of receivables. The statementaddresses (1) when a transaction qualifies as asale for accounting purposes and (2) the treat-ment of the various financial components (iden-tifiable assets and liabilities) that are created inthe securitization process.

To identify whether a transfer of assets quali-fies as a sale for accounting purposes, FAS 140focuses on control of the assets while taking a‘‘fi nancial components approach.’’ The standardrequires that an entity surrender control to‘‘ derecognize’’ the assets or take the assets offits balance sheet. Under FAS 140, control isconsidered to be surrendered and, therefore, atransfer is considered a sale if all of the follow-ing conditions are met:

• The transferred assets have been put beyondthe reach of the transferor, even in bankruptcy.

• Either (1) the transferee has the right to pledgeor exchange the transferred assets or (2) thetransferee is a qualifying special-purposeentity, and the holder of beneficial interests inthat entity has the right to pledge or exchangethe transferred assets.

• The transferor does not maintain control overthe transferred assets through (1) an agree-ment that entitles and obligates the transferorto repurchase or redeem them before theirmaturity or (2) an agreement that entitles thetransferor to repurchase or redeem transferredassets that are not readily obtainable.

The financial components approach recognizesthat complex transactions, such as securitiza-

tions, often involve the use of valuation tech-niques and estimates to determine the value ofeach component and any gain or loss on thetransaction. FAS 140 requires that entities rec-ognize newly created (acquired) assets andliabilities, including derivatives, at fair value. Italso requires all assets sold and the portion ofany assets retained to be valued by allocating theprevious carrying value of the assets based ontheir relative fair value.

Financial assets that can be prepaid contrac-tually or that can otherwise be settled in such away that the holder would not recover substan-tially all of its recorded investments should bemeasured in the same way as investments indebt securities—as either available-for-sale ortrading under FAS 115. Examples include someinterest-only strips, retained interests in securi-tizations, loans, other receivables, or other finan-cial assets. However, financial instruments cov-ered under the scope of Statement of FinancialAccounting Standards No. 133 (FAS 133),‘‘Accounting for Derivative Instruments andHedging Activities,’’ as amended by Statementof Financial Accounting Standards Nos. 137 and138 (FAS 137 and FAS 138), should follow thatguidance.

ACCOUNTING FOR REPURCHASEAGREEMENTS

In addition to securitizations, FAS 140 deter-mines the accounting for repurchase agree-ments. A repurchase agreement is accounted foras either a secured borrowing or as a sale andsubsequent repurchase. The treatment dependson whether the seller has surrendered control ofthe securities as described in the above ‘‘ Secu-ritizations’’ subsection. If control is maintained,the transaction should be accounted for as asecured borrowing. If control is surrendered, thetransaction should be accounted for as a sale andsubsequent repurchase. Control is generally con-sidered to be maintained if the security beingrepurchased is identical to the security beingsold.

In a dollar-roll transaction, an institutionagrees to sell a security and repurchase a similar,but not identical, security. If the security beingrepurchased is considered to be ‘‘ substantiallythe same’’ as the security sold, the transactionshould be reported as a borrowing. Otherwise,the transaction should be reported as a sale and

2120.1 Accounting


subsequent repurchase. The AICPA Audit andAccounting Guide for Banks and Savings Insti-tutions establishes criteria that must be met for asecurity to be considered ‘‘ substantially thesame’’ ; these criteria include having the sameobligor, maturity, form, and interest rate.

Generally, a bank surrenders control if therepurchase agreement does not require the repur-chase of the same or substantially the samesecurity. In such cases, the bank accounts for thetransaction as a sale (with gain or loss) and aforward contract to repurchase the securities.When a repurchase agreement is not a sale (forexample, it requires the repurchase of the sameor substantially the same security), the transac-tion is accounted for as a borrowing. However,repurchase agreements that extend to the secu-rity’s maturity date, and repurchase agreementsin which the seller has not obtained sufficientcollateral to cover the replacement cost of thesecurity, should be accounted for as sales.

ACCOUNTING FOR DERIVATIVEINSTRUMENTS

As discussed in the previous subsection, thegeneral accounting framework for securities port-folios divides them into three categories: held-to-maturity (accounted for at amortized cost),available-for-sale (accounted for at fair value,with unrealized changes in fair value recorded inequity), and trading securities (accounted for atfair value, with changes in fair value recorded inearnings).

In contrast, derivative instruments can beclassified in one of the following categories:(1) no hedge designation, (2) fair-value hedge,(3) cash-flow hedge, and (4) foreign-currencyhedge. The general accounting framework forderivative instruments under GAAP is set forthbelow:

• If the derivative does not have a hedge desig-nation, the gains or losses based on changes inthe fair value of the derivative instrument areincluded in current income.

• If the derivative is determined to be a hedge ofexposure to changes in the fair value of arecognized asset or liability or an unrecog-nized firm commitment (fair-value hedge), thegains or losses based on changes in fair valueare included in current net income with theoffsetting gain or loss on the hedged item

attributable to the risk being hedged.• If the derivative is determined to be a hedge of

exposure to variable cash flows of a forecastedtransaction (cash-flow hedge), the gains orlosses based on changes in fair value areincluded in other comprehensive income out-side of net income.

• If the derivative represents a hedge of theforeign-currency exposure of a net investmentin foreign operation, an unrecognized firmcommitment, an available-for-sale security, ora foreign currency–denominated forecastedtransaction (foreign-currency hedge), the gainsor losses based on changes in fair value areincluded in comprehensive income, outside ofnet income, as part of the cumulative transla-tion adjustment.

This general framework is set forth in FAS 133.This statement, issued in June 1998 and amendedby FAS 137 and FAS 138, became effective forfiscal years beginning after June 15, 2000. Thus,banks operating on a calendar year adopted theguidance on January 1, 2001.

FAS 133 as amended comprehensively changesaccounting and disclosure standards for deriva-tives. It amends Statement of Financial Account-ing Standards No. 52 (FAS 52), ‘‘ Foreign Cur-rency Translation,’’ to permit special accountingfor foreign-currency hedges and makes the fol-lowing standards obsolete:

• FAS 80 Accounting for Futures Contracts• FAS 105 Disclosure of Information About

Financial Instruments with Off Bal-ance Sheet Risk and Financial In-struments with Concentrations ofCredit Risk

• FAS 107 Disclosures About Fair Value ofFinancial Instruments

• FAS 119 Disclosure About DerivativeFinancial Instruments and FairValue of Financial Instruments

FAS 133 as amended requires entities to recog-nize all derivatives on the balance sheet as eitherassets or liabilities and to report them at theirfair value. The accounting recognition of changesin the fair value of a derivative (gains or losses)depends on the intended use of the derivativeand the resulting designation. For qualifyinghedges, an entity is required to establish at theinception of the hedge the method it will use forassessing the effectiveness of the hedgingderivative and the measurement approach for

Accounting 2120.1


determining the ineffective aspect of the hedge.The methods applied should be consistent withthe entity’s approach to managing risk. FAS 133as amended also precludes designating a non-derivative financial instrument as a hedge of anasset, a liability, an unrecognized firm commit-ment, or a forecasted transaction, except if anyof these are denominated in a foreign currency.

Proper classification of derivative instrumentsis a key examination issue. Inappropriately clas-sifying a derivative instrument as a hedge wouldresult in the improper treatment of gains andlosses in earnings and regulatory capital. Insti-tutions should retain adequate documentation tosupport their hedge activity. Examiners shouldscrutinize any institutions that do not complywith these GAAP requirements.

Definitions

A derivative instrument is a financial instrumentor other contract with all three of the followingcharacteristics:

• It has one or more underlyings and one ormore notional amounts or payment provisionsor both.

• It requires no initial net investment or aninitial net investment that is smaller than whatwould be required for other types of contractsexpected to have a similar response to changesin market factors.

• Its terms require or permit net settlement, itcan be readily settled net by means outside thecontract, or it provides for delivery of an assetthat puts the recipient in a position not sub-stantially different from net settlement.

An underlying is a specified interest rate, secu-rity price, commodity price, foreign-exchangerate, index of prices or rates, or other variable.An underlying may be a price or rate of an assetor liability but it is not the asset or liability itself.

A notional amount is a number of currencyunits, shares, bushels, pounds, or other unitsspecified in the contract.

A payment provision specifies a fixed ordeterminable settlement to be made if the under-lying behaves in a specified manner.

A hedge is an identifiable asset, liability, firmcommitment, or anticipated transaction.

Offset is the liquidating of a purchase offutures through the sale of an equal number of

contracts of the same delivery month on thesame underlying instrument on the sameexchange, or the covering of a short sale offutures through the purchase of an equal numberof contracts of the same delivery month on thesame underlying instrument on the sameexchange.

Special Types of Derivatives

Credit derivatives are financial instruments thatpermit one party (the beneficiary) to transfer thecredit risk of a reference asset, which it typicallyowns, to another party (the guarantor) withoutactually selling the assets. Credit derivativesthat provide for payments to be made only toreimburse the guaranteed party for a loss incurredbecause the debtor fails to pay when payment isdue (financial guarantees), which is an identifi-able event, are not considered derivatives foraccounting purposes under FAS 133 as amended.Those credit derivatives not accounted for underFAS 133 would not be recorded in the financialstatements as assets or liabilities at fair valuebut, if material, would typically be disclosed inthe financial statements. Credit derivatives notconsidered financial guarantees, as definedabove, are reported as derivatives as determinedby FAS 133 as amended.

Equity derivatives are derivatives that arelinked to various indexes and individual securi-ties in the equity markets. FAS 133 as amendedcovers the accounting treatment for equityderivatives that are not indexed to an institu-tion’s own stock. Equity derivatives indexed tothe institution’s own stock are determined inaccordance with APB No. 18, ‘‘ The EquityMethod of Accounting for Investments in Com-mon Stock,’’ and Statement of Financial Account-ing Standards No. 123 (FAS 123), ‘‘Accountingfor Stock-Based Compensation.’’

Hedging Activities

Accounting for Fair-Value Hedges

A fair-value hedge is a derivative instrumentthat hedges exposure to changes in the fair valueof an asset or a liability, or an identified portionthereof, that is attributable to a particular risk.To qualify for fair-value-hedge accounting, thehedge must meet both of the following criteria:

2120.1 Accounting


• At the inception of the hedging relationship,formal documentation must be made of theinstitution’s risk-management objective andstrategy for undertaking the hedge. This docu-mentation should include the hedged instru-ment, the hedged item, the nature of the risk,and how the hedge’s effectiveness in offset-ting the exposure to changes in the fair valuewill be assessed.

• Assessment is required whenever financialstatements or earnings are reported, and atleast every three months, to ensure the hedgerelationship is highly effective in achievingoffsetting changes in fair value to the hedgedrisk.

An asset or liability is eligible for designation asa hedged item in a fair-value hedge if all of thefollowing criteria are met:

• The hedged item is specifically identified asan asset, a liability, or a firm commitment. Thehedged item can be a single asset, liability, orfirm commitment or a portfolio of similarassets, liabilities, or firm commitments.

• The hedged item is not one of the following:— an asset or liability that is already reported

at fair value— an investment accounted for by the equity

method— a minority interest in one or more consoli-

dated subsidiaries— an equity investment in a consolidated

subsidiary— a firm commitment either to enter into a

business combination or to acquire ordispose of a subsidiary, a minority interest,or an equity-method investee

— an equity instrument issued by the institu-tion and classified as stockholders’ equityin the statement of financial position

• If the hedged item is all or a portion of a debtsecurity classified as held-to-maturity, the des-ignated risk being hedged is the risk of changesin its fair value attributable to changes in theobligor’s creditworthiness. If the hedged itemis an option component of a held-to-maturitysecurity that permits its repayment, the desig-nated risk being hedged is the risk of changesin the entire fair value of that optioncomponent.

• If the hedged item is a nonfinancial asset orliability or is not a recognized loan-servicingright or a nonfinancial firm commitment withfinancial components, the designated risk being

hedged is the risk of changes in the fair valueof the entire hedged asset or liability.

• If the hedged item is a financial asset orliability, a recognized loan-servicing right, ora nonfinancial firm commitment with financialcomponents, the designated risk being hedgedis—— the risk of changes in the overall fair value

of the entire hedged item,— the risk of changes in its fair value attrib-

utable to changes in market interest rates,— the risk of changes in its fair value attrib-

utable to changes in the related foreign-currency exchange rates, or

— the risk of changes in its fair value attrib-utable to changes in the obligor’s credit-worthiness.

An institution is subject to applicable GAAPrequirements for assessment of impairment forassets or for recognition of an increased obliga-tion for liabilities. An institution shall alsodiscontinue the accounting treatment for a finan-cial instrument as a fair-value hedge if any ofthe following conditions occurs:

• Any criterion of the fair-value hedge or hedgeditem is no longer met.

• The derivative expires or is sold, terminated,or exercised.

• The institution removes the designation of thefair-value hedge.

Accounting for Cash-Flow Hedges

A cash-flow hedge is a derivative hedging theexposure to variability in expected cash flowsattributed to a particular risk. That exposure maybe associated with an existing asset or liability(that is, variable-rate debt) or a forecasted trans-action (that is, a forecasted purchase or sale).Designated hedging instruments and hedgeditems or transactions qualify for cash-flow-hedge accounting if all of the following criteriaare met:

• Formal documentation is required at theinception of the hedging relationship, and theinstitution’s risk-management objective andstrategy for undertaking the hedge must bedocumented as noted above in ‘‘Accountingfor Fair-Value Hedges.’’

• The hedge’s effectiveness must be assessed as

Accounting 2120.1


described in ‘‘Accounting for Fair-ValueHedges.’’

• If an instrument is used to hedge the variableinterest rates associated with a financial assetor liability, the hedging instrument must beclearly linked to the financial asset or liabilityand highly effective in achieving offset.

A forecasted transaction is eligible for designa-tion as a hedged item in a cash-flow hedge if allof the following additional criteria are met:

• The forecasted transaction is specifically iden-tified as a single transaction or a group ofindividual transactions.

• The occurrence of the forecasted transaction isprobable.

• The forecasted transaction is with a party thatis external to the reporting institution.

• The forecasted transaction is not the acquisi-tion of an asset or incurrence of a liability thatwill subsequently be remeasured and whosechanges in fair value will be attributed to thehedged risk currently reported in earnings.

• If the variable cash flows of the forecastedtransaction relate to a debt security that isclassified as held-to-maturity, the risk beinghedged is the risk of changes in the cash flowsattributable to default or the risk of changes inthe obligor’s creditworthiness.

• The forecasted transaction does not involvea business combination subject to the provi-sions of Statement of Financial AccountingStandards No. 141 (FAS 141), ‘‘ BusinessCombinations,’’ and is not a transactioninvolving—— a parent company’s interest in consoli-

dated subsidiaries,— a minority interest in a consolidated

subsidiary,— an equity-method investment, or— an institution’s own equity instruments.

• If the hedged transaction is the forecastedpurchase or sale of a financial asset or liabilityor the variable cash inflow or outflow of anexisting financial asset or liability, the desig-nated risk being hedged is—— the risk of changes in the cash flows of the

entire asset or liability,— the risk of changes in its cash flows

attributable to changes in market interestrates,

— the risk of changes in the cash flows of theequivalent functional currency attributableto changes in the related foreign-currency

exchange rates, or— the risk of changes in cash flows attribut-

able to default or the risk of change in theobligor’s creditworthiness.

As required for fair-value-hedge accounting, aninstitution shall discontinue the accounting forcash-flow hedges if—

— any criterion for a cash-flow hedge or thehedged forecasted transaction is no longermet;

— the derivative expires or is sold, termi-nated, or exercised; or

— the institution removes the designation ofthe cash-flow hedge.

If cash-flow-hedge accounting is discontin-

2120.1 Accounting


ued, the accumulated amount in other compre-hensive income remains and is reclassified intoearnings when the hedged forecasted transactionaffects earnings. Existing GAAP for impairmentof an asset or recognition of an increased liabil-ity applies.

Accounting for Foreign-Currency Hedges

Consistent with the functional-currency conceptof FAS 52 (discussed below), FAS 133 indicatesthat an institution may designate the followingtypes of hedges as hedges of foreign-currencyexposure:

• a fair value of an unrecognized firm commit-ment or an available-for-sale security

• a cash-flow hedge of a forecasted foreign-currency-denominated transaction or a fore-casted intercompany foreign-currency-denominated transaction

• a hedge of a net investment in a foreignoperation

Foreign-currency fair-value hedges and cash-flow hedges are generally subject to the fair-value-hedge and cash-flow-hedge accountingrequirements discussed in those respectivesubsections.

ACCOUNTING FORFOREIGN-CURRENCYINSTRUMENTS

The primary source of authoritative guidance foraccounting for foreign-currency translations andforeign-currency transactions is FAS 52. Thestandard encompasses futures contracts, forwardagreements, and currency swaps as they relate toforeign-currency hedging. FAS 52 draws a dis-tinction between foreign-exchange ‘‘transla-tion’’ and ‘‘transactions.’’ Translation, generally,focuses on the combining of foreign and domes-tic entities so they can be presented and reportedin the consolidated financial statements in onecurrency. Foreign-currency transactions, in con-trast, are transactions (such as purchases orsales) by an operation in currencies other thanits ‘‘functional currency.’’ For U.S. depositoryinstitutions, the functional currency will gener-ally be the dollar for its U.S. operations and thelocal currency of wherever its foreign operationstransact business.

Foreign-Currency Translations

Translation is the conversion of the financialstatements of a foreign operation (a branch,division, or subsidiary) denominated in theoperation’s functional currency to U.S. dollars,generally for inclusion in consolidated financialstatements. The balance sheets of foreign opera-tions are translated at the exchange rate in effecton the statement date, while income-statementamounts are generally translated at an appropri-ate weighted amount. Meeting this criterion willbe particularly difficult when an anticipatedtransaction is not expected to take place in thenear future.

Detailed guidance for determining the func-tional currency is set forth in appendix 1 of FAS52: ‘‘An entity’s functional currency is thecurrency of the primary economic environmentin which the entity operates; normally, that is thecurrency of the environment in which an entityprimarily generates and expends cash. The func-tional currency of an entity is, in principle, amatter of fact. In some cases, the facts willclearly identify the functional currency; in othercases, they will not.’’

FAS 52 indicates the salient economic indi-cators and other possible factors that should beconsidered both individually and collectivelywhen determining the functional currency: cashflow, price and market sales indicators, expenseindicators, financing indicators, intercompanytransactions and arrangements, and other factors.

Foreign-Currency Transactions

Gains or losses on foreign-currency transac-tions, in contrast to translation, are recognized inincome as they occur, unless they arise from aqualifying hedge. FAS 52 provides guidanceabout the types of foreign-currency transactionsfor which gain or loss is not currently recog-nized in earnings. Gains and losses on thefollowing foreign-currency transactions shouldnot be included in determining net income butshould be reported in the same manner astranslation adjustments:• foreign-currency transactions that are desig-

nated and effective as economic hedges of anet investment in a foreign entity, commenc-ing as of the designation date

• intercompany foreign-currency transactionsthat are long-term investments (that is, settle-

Accounting 2120.1


ment is not planned or anticipated in theforeseeable future), when the entities to thetransaction are consolidated, combined, oraccounted for by the equity method in thereporting institution’s financial statements.

NETTING OR OFFSETTINGASSETS AND LIABILITIES

FASB Interpretation 39 (FIN 39), ‘‘Offsetting ofAmounts Related to Certain Contracts,’’ pro-vides guidance on the netting of assets andliabilities arising from (1) traditional activities,such as loans and deposits, and (2) derivativeinstruments. The assets and liabilities fromderivatives are primarily the fair values, orestimated market values, for swaps and othercontracts, and the receivables and payables onthese instruments. FIN 39 clarifies the definitionof a ‘‘right of setoff’’ that GAAP has longindicated must exist before netting of assets andliabilities can occur in the balance sheet. One ofthe main purposes of FIN 39 was to clarify thatFASB’s earlier guidance on the netting of assetsand liabilities (Technical Bulletin 88-2) appliesto amounts recognized for OBS derivativeinstruments as well.

Balance-sheet items arise from off-balance-sheet interest-rate and foreign-currency instru-ments in primarily two ways. First, those bank-ing organizations and other companies thatengage in various trading activities involvingOBS derivative instruments (for example,interest-rate and currency swaps, forwards, andoptions) are required by GAAP to mark tomarket these positions by recording their fairvalues (estimated market values) on the balancesheet and recording any changes in these fairvalues (unrealized gains and losses) in earnings.Second, interest-rate and currency swaps havereceivables and payables that accrue over time,reflecting expected cash inflows and outflowsthat must periodically be exchanged under thesecontracts, and these receivables and payablesmust be recorded on the balance sheet as assetsand liabilities, respectively.7

Under FIN 39, offsetting, or the netting ofassets and liabilities, is not permitted unless allof the following four criteria are met:

• Two parties must owe each other determin-able amounts.

• The reporting entity must have a right to setoff its obligation with the amount due to it.

• The reporting entity must actually intend toset off these amounts.

• The right of setoff must be enforceable at law.

When all four criteria are met, a bank or othercompany may offset the related asset and liabil-ity and report the net amount in its GAAPfinancial statements. On the other hand, if anyone of these criteria is not met, the fair value ofcontracts in a loss position with a given coun-terparty will not be offset against the fair valueof contracts in a gain position with that coun-terparty, and organizations will be required torecord gross unrealized gains on such contractsas assets and to report gross unrealized losses asliabilities. However, FIN 39 relaxes the thirdcriterion (the parties’ intent requirement) topermit the netting of fair values of OBS deriva-tive contracts executed with the same counter-party under a legally enforceable master nettingagreement.8 A master netting arrangement existsif the reporting institution has multiple con-tracts, whether for the same type of conditionalor exchange contract or for different types ofcontracts, with a single counterparty that aresubject to a contractual agreement that providesfor the net settlement of all contracts through asingle payment in a single currency in the eventof default or termination of any one contract.

FIN 39 defines ‘‘right of setoff’’ and specifiesconditions that must be met to permit offsettingfor accounting purposes. FASB’s Interpretation

7. In contrast, the notional amounts of off-balance-sheetderivative instruments, or the principal amounts of the under-lying asset or assets to which the values of the contracts areindexed, are not recorded on the balance sheet. Note, however,that if the OBS instrument is carried at market value, thatvalue will include any receivable or payable components.Thus, for those OBS instruments that are subject to a master

netting agreement, the accrual components in fair value arealso netted.

8. The risk-based capital guidelines provide generally thata credit-equivalent amount is calculated for each individualinterest-rate and exchange-rate contract. The credit-equivalentamount is determined by summing the positive mark-to-market values of each contract with an estimate of thepotential future credit exposure. The credit-equivalent amountis then assigned to the appropriate risk-weight category.

Netting of swaps and similar contracts is recognized forrisk-based capital purposes only when accomplished through‘‘netting by novation.’’ This is defined as a written bilateralcontract between two counterparties under which any obliga-tion to each other is automatically amalgamated with all otherobligations for the same currency and value date, legallysubstituting one single net amount for the previous grossobligations.

2120.1 Accounting


41 (FIN 41), ‘‘Offsetting of Amounts Relating toCertain Repurchase and Reverse RepurchaseAgreements,’’ was issued in December 1994.This interpretation modifies FIN 39 to permitoffsetting in the balance sheet of payables and

receivables that represent repurchase agree-ments and reverse repurchase agreements undercertain circumstances in which net settlement isnot feasible. (See FIN 41 for further information.)

Accounting 2120.1


AccountingExamination Objectives Section 2120.2

1. To determine whether the organization’s writ-ten accounting policies relating to tradingand hedging with derivatives instrumentshave been approved by senior managementfor conformance with generally acceptedaccounting practices. To determine that suchpolicies conform with regulatory reportingprinciples.

2. To determine whether capital-markets andtrading activities appear in regulatory reports,as reported by accounting personnel, andconform with written accounting policies.

3. To determine whether securities held inavailable-for-sale or held-to-maturity accountsmeet the criteria of Statement of FinancialAccounting Standards No. 115 (FAS 115)and are, therefore, properly excluded fromthe trading account.

4. To determine whether market values of tradedassets are accurately reflected in regulatoryreports.

5. To determine whether, for financial and regu-latory reporting purposes, financial instru-

ments are netted for only those counterpar-ties whose contracts conform with specificcriteria permitting such setoff.

6. To determine whether management’s asser-tions that financial instruments are hedgesmeet the necessary criteria for exclusionfrom classification as trading instruments.

7. To ascertain whether the organization hasadequate support that a purported hedgereduces risk in conformance with Statementof Financial Accounting Standards No. 133(FAS 133), as amended by Statement ofFinancial Accounting Standards Nos. 137and 138 (FAS 137 and FAS 138).

8. To determine whether the amount and recog-nition of deferred losses arising from hedg-ing activities are properly recorded and beingamortized appropriately.

9. To recommend corrective action when poli-cies, procedures, practices, internal controls,or management information systems arefound to be deficient or when violations oflaw, rulings, or regulations have been noted.


AccountingExamination Procedures Section 2120.3

These procedures list a number of processes andactivities to be reviewed during a full-scopeexamination. The examiner-in-charge will estab-lish the general scope of examination and willwork with the examination staff to tailor specificareas for review as circumstances warrant. Aspart of this process, the examiner reviewing afunction or product will analyze and evaluateinternal-audit comments and previous examina-tion workpapers to assist in designing the scopeof examination. In addition, after a generalreview of a particular area to be examined, theexaminer should use these procedures, to theextent they are applicable, for further guidance.Ultimately, it is the seasoned judgment of theexaminer and the examiner-in-charge as to whichprocedures are warranted in examining anyparticular activity.

1. Obtain a copy of the organization’s account-ing policies and review them for conform-ance with the relevant sections of authorita-tive pronouncements by the FinancialAccounting Standards Board (FASB) andAmerican Institute of Certified PublicAccountants (AICPA) (for Y-series reports)and for conformance with the call reportinstructions.

2. Using a sample of securities purchase andsales transactions, check the following:a. Securities subledgers accurately state the

cost, and the market values of the securi-ties agree to outside quotations.

b. Securities are properly classified amongtrading, available-for-sale, and held-to-maturity classifications.

c. Transactions that transfer securities fromthe trading account to either held-to-maturity or available-for-sale are autho-rized and conform with authoritativeaccounting guidance (such transfers shouldbe rare, according to Statement of Finan-cial Accounting Standards No. 115 (FAS115)).

3. Obtain a sample of financial instruments held

in the trading account and compare thereported market value against outside quota-tions or compare valuation assumptionsagainst market data.

4. Review the organization’s controls overreporting of certain financial instruments ona net basis. Using a sample of transactions,review the contractual terms to determinethat the transactions qualify for netting forfinancial reporting and regulatory reportingpurposes, according to the criteria specifiedby FASB Interpretations 39 and 41 (FIN 39and FIN 41) or regulatory reportingrequirements.

5. Review the organization’s methods for iden-tifying and quantifying risk for purposesof hedging. Review the adequacy of docu-mented risk reduction (pursuant to Statementof Financial Accounting Standards Nos. 52and 133 (FAS 52 and FAS 133)—FAS 133was amended by Statement of FinancialAccounting Standards Nos. 137 and 138) andthe enterprise or business-unit risk reduction(FAS 133) that are necessary conditions toapplying hedge accounting treatment.

6. Obtain schedules of the gains or losses result-ing from hedging activities and reviewwhether the determination was appropriateand reasonable.

7. Determine if accounting reversals are welldocumented.

8. Determine if accounting profits and lossesprepared by control staff are reviewed by theappropriate level of management and that thesenior staff in the front office (head trader,treasurer) has agreed with accounting num-bers. Determine if the frequency of review bysenior managers is adequate for the institu-tion’s volume and level of earnings.

9. Recommend corrective action when policies,procedures, practices, internal controls, ormanagement information systems are foundto be deficient or when violations of law,rulings, or regulations have been noted.


AccountingInternal Control Questionnaire Section 2120.4

1. Does the organization have a well-staffedaccounting unit that is responsible for follow-ing procedures and instructions for recordingtransactions; marking to market when appro-priate; filing regulatory and stockholderreports; and dealing with regulatory, tax, andaccounting issues?

2. Do the organization’s accounting policiesconform to the relevant sections (that is,those sections regarding trading and hedgingtransactions) of authoritative pronounce-ments by the Financial Accounting StandardsBoard (FASB) and American Institute ofCertified Public Accountants (AICPA), anddo the organization’s policies conform to thecall report instructions? If the organization isa foreign institution, does the organizationhave appropriate policies and procedures toconvert foreign accounting principles to U.S.reporting guidance? Is there an adequateaudit trail to reconcile the financial state-ments to regulatory reports?

3. For revaluation—a. do securities subledgers accurately state

the cost, and do market values of thesecurities agree to outside quotations, and

b. are securities properly classified amongtrading, available-for-sale, and held-to-maturity classifications?

Evaluate the transfer of securities from thetrading account to either held-to-maturity oravailable-for-sale for authorization in con-formance with authoritative accounting guid-ance. Are such transfers rare? (According toStatement of Financial Accounting StandardsNo. 115 (FAS 115), such transfers should berare.)

4. Do the revaluation rates used for a sample offinancial instruments held in the tradingaccount appear within range when comparedwith supporting documentation of marketrates?

5. Do the contractual terms of a sample oftransactions qualify for netting for financialreporting and regulatory reporting purposes,according to the criteria specified by FASBInterpretations 39 and 41 (FIN 39 and 41) orregulatory reporting requirements?

6. Does the financial institution have proce-dures to document risk reduction (pursuant toStatement of Financial Accounting StandardsNos. 52 and 133 (FAS 52 and FAS 133—FAS 133 was amended by Statement ofFinancial Accounting Standards Nos. 137and 138), and does it have enterprise orbusiness-unit risk-reduction (FAS 133) con-ditions to apply hedge accounting treatment?Do the procedures apply to the full range ofapplicable products used for investment? Isrecord retention adequate for this process?

7. Are the methods for assessing gains or lossesresulting from hedging activities appropriateand reasonable?

8. Are accounting reversals justified by super-visory personnel, and are reversals welldocumented?

9. Are profits and losses prepared by controlstaff reviewed by the appropriate level ofmanagement and senior staff (head trader,treasurer) for agreement? Is the frequency ofreview by senior managers adequate for theinstitution’s volume and level of earnings?


AccountingAppendix—Related Financial-Statement DisclosuresSection 2120.5

SECURITIES PORTFOLIODISCLOSURES UNDER FAS 115

For securities classified as available-for-sale andseparately for securities classified as held-to-maturity, all reporting institutions should dis-close the aggregate fair value, gross unrealizedholding gains, gross unrealized holding losses,and amortized cost basis by major security typeas of each date for which a statement of financialposition is presented. Financial institutionsshould include the following major securitytypes in their disclosure, though additional typesmay be included as appropriate:

• equity securities• debt securities issued by the U.S. Treasury and

other U.S. government corporations andagencies

• debt securities issued by states of the UnitedStates and political subdivisions of the states

• debt securities issued by foreign governments• corporate debt securities• mortgage-backed securities• other debt securities

For investments in debt securities classified asavailable-for-sale and separately for securitiesclassified as held-to-maturity, all reporting insti-tutions should disclose information about thecontractual maturities of those securities as ofthe date of the most recent statement of financialposition presented. Maturity information may becombined in appropriate groupings. In comply-ing with this requirement, financial institutionsshould disclose the fair value and the amortizedcost of debt securities based on at least fourmaturity groupings: (1) within one year, (2) afterone year through five years, (3) after five yearsthrough ten years, and (4) after ten years.Securities not due at a single maturity date, suchas mortgage-backed securities, may be disclosedseparately rather than allocated over severalmaturity groupings; if allocated, the basis forallocation also should be disclosed. For eachperiod for which the results of operations arepresented, an institution should disclose—

• the proceeds from sales of available-for-salesecurities and the gross realized gains andgross realized losses on those sales,

• the basis on which cost was determined incomputing realized gain or loss (that is,specific identification, average cost, or othermethod used),

• the gross gains and gross losses included inearnings from transfers of securities from theavailable-for-sale category into the tradingcategory,

• the change in net unrealized holding gain orloss on available-for-sale securities that hasbeen included in the separate component ofshareholders’ equity during the period, and

• the change in net unrealized holding gain orloss on trading securities that has been includedin earnings during the period.

For any sales of or transfers from securitiesclassified as held-to-maturity, the amortized costamount of the sold or transferred security, therelated realized or unrealized gain or loss, andthe circumstances leading to the decision to sellor transfer the security should be disclosed inthe notes to the financial statements for eachperiod for which the results of operations arepresented. Such sales or transfers should be rare,except for sales and transfers caused by thechanges in circumstances as previously dis-cussed in section 2120.1.

ACCOUNTING DISCLOSURESFOR DERIVATIVES ANDHEDGING ACTIVITIES

Under Statement of Financial Accounting Stan-dards No. 133 (FAS 133), as amended byStatement of Financial Accounting StandardsNos. 137 and 138 (FAS 137 and FAS 138),institutions that hold or issue derivative instru-ments or nonderivative instruments qualifyingas hedge instruments should disclose theirobjectives for holding or issuing the instrumentsand their strategies for achieving the objectives.Institutions should distinguish whether thederivative instrument is to be used as a fair-value, cash-flow, or foreign-currency hedge.The description should include the risk-management policy for each of the types ofhedges. Institutions not using derivative instru-ments as hedging instruments should indicatethe purpose of the derivative activity.


Fair-Value Hedges

For foreign-currency-transaction gains or lossesthat qualify as fair-value hedges, report—

• the net gain or loss recognized in earningsduring the reporting period, which representsthe amount of hedge ineffectiveness and thecomponent of gain or loss, if any, excludedfrom the assessment of hedge effectiveness,and a description of where the net gain or lossis reported in the income statement and

• the amount of net gain or loss recognized inearnings when a hedged firm commitment nolonger qualifies as a fair-value hedge.

Cash-Flow Hedges

For cash-flow gains or losses that qualify ascash-flow hedges, report—

• the net gain or loss recognized in earningsduring the reporting period, which representsthe amount of ineffectiveness and the compo-nent of the derivative’s gain or loss, if any,excluded from the assessment of hedge effec-tiveness, and a description of where the netgain or loss is reported in the incomestatement;

• a description of the transactions or otherevents that will result in the reclassificationinto earnings of gains and losses that arereported in accumulated other comprehensiveincome (OCI), and the estimated net amountof the existing gains or losses at the reportingdate that is expected to be reclassified intoearnings within the next 12 months;

• the maximum length of time over which theentity is hedging its exposure to the variabilityin further cash flows for forecasted transac-tions, excluding those forecasted transactionsrelated to the payment of variable interest onexisting financial instruments; and

• the amount of gains and losses reclassifiedinto earnings as a result of the discontinuanceof cash-flow hedges because it is probable thatthe original forecasted transactions will notoccur by the end of the originally specifiedtime period or within an additional time periodas outlined in FAS 133 as amended.

Foreign-Currency Hedges

For derivatives, as well as nonderivatives, that

may give rise to foreign-currency-transactiongains or losses under Statement of FinancialAccounting Standards No. 52 (FAS 52), and thathave been designated as and qualify for foreign-currency hedges, the net amount of gains orlosses included in the cumulative translationadjustment during the reporting period shouldbe disclosed.

Reporting Changes in OtherComprehensive Income

Institutions should show as a separate classifi-cation within OCI the net gain or loss onderivative instruments designated and qualify-ing as cash-flow hedges. Additionally, pursuantto Statement of Financial Accounting StandardsNo. 130, ‘‘ Reporting Comprehensive Income’’(FAS 130), institutions should disclose thebeginning and ending accumulated derivativegain or loss, the related net change associatedwith current-period hedging transactions, andthe net amount of any reclassification intoearnings.

SEC Disclosure Requirements forDerivatives

In the first quarter of 1997, the Securities andExchange Commission (SEC) issued rulesrequiring the following expanded disclosures forderivative and other financial instruments forpublic companies:

• in the footnotes of the financial statements,improved descriptions of accounting policiesfor derivatives

• outside of the footnotes to the financial state-ments, disclosure of quantitative and qualita-tive information about derivatives and otherfinancial instruments— For the quantitative disclosures about

market-risk-sensitive instruments, regis-trants must follow one of three methodolo-gies and distinguish between instrumentsused for trading purposes and instrumentsused for purposes other than trading. Thethree disclosure methodology alternativesare (1) tabular presentation of fair valuesand contract terms, (2) sensitivity analysis,or (3) value-at-risk disclosures. Registrantsmust disclose separate quantitative infor-mation for each type of market risk to

2120.5 Accounting: Appendix—Related Financial-Statement Disclosures


which the entity is exposed (for example,interest-rate or foreign-exchange rate).

— The qualitative disclosures about marketrisk must include the registrant’s primarymarket-risk exposures at the end of thereporting period, how those exposures aremanaged, and changes in primary riskexposures or how those risks are managed

as compared with the previous reportingperiod.

• disclosures about derivative financial instru-ments with any financial instruments, firmcommitments, commodity positions, andanticipated transactions that are being hedgedby such items (these are included to avoidmisleading disclosures).

Accounting: Appendix—Related Financial-Statement Disclosures 2120.5


Regulatory ReportingSection 2130.1

The internal-control function is critical in theassessment of an institution’s regulatory report-ing. The examiner must gain a thorough under-standing of (1) the information flows from theexecution of a transaction to its inclusion in theappropriate regulatory report, (2) the design andperformance of critical internal-control pro-cedures, and (3) the adherence to regulatoryreporting standards.

Examiners, report processors, and economistswho analyze regulatory reports or otherwise usethe data contained in them depend on the data’saccuracy. False reporting is punishable by civilmonetary penalties as prescribed in the Finan-cial Institutions Recovery, Reform, andEnhancement Act of 1989 (FIRREA).

OVERVIEW OF REPORTS

Several types of regulatory reports contain trad-ing data: the Report of Condition (FFIEC 031–034), the Report of Assets and Liabilities of U.S.Branches and Agencies of Foreign Banks (FFIEC002), and financial statements of the securitiessubsidiaries.

The Federal Reserve Board (FRB) and Fed-eral Financial Institutions Examination Council(FFIEC) require financial institutions to summa-rize their gross positions outstanding in tradedproducts on the Report of Condition and Incomeas well as on the Report of Assets and Liabilities(collectively, the call reports). These regulatoryreports vary according to the size and type ofinstitution. For example, the reports required bythe FFIEC include the 002 for U.S. branches andagencies of foreign banks and a series of reportsfor domestic banks, while the FRB requires theY-series to cover bank holding companies.

Section 20 subsidiaries show their securitiesrevenue and capitalization in detail on the Finan-cial and Operational Combined Uniform Single(FOCUS) report as required by the Securitiesand Exchange Commission (SEC). This report

is filed with the appropriate self-regulatoryorganization (SRO), and the SEC furnishesmicrodata to the Board for bank-affiliated secu-rities dealers. The Y-20, another FRB report,summarizes the FOCUS data and segregatesrevenues from eligible and ineligible securities.The Y-20 report is only filed by securitiessubsidiaries that are still operating pursuant tosection 4(c)(8) of the Bank Holding CompanyAct, and are therefore subject to the Board’srevenue test designed to prevent violation of theformer Glass-Steagall Act. Other bank holdingcompany subsidiaries that trade eligible securi-ties also file the FOCUS report with the SECand the appropriate SRO. The appendix to thissection describes frequently used regulatoryreports.

SOUND PRACTICES

• Every organization should have procedures toprepare regulatory reports. When conversionfrom foreign accounting principles to gener-ally accepted accounting principles (GAAP) isrequired, a mapping should document an audittrail. This documentation is particularlyimportant as the degree to which reconcilia-tion is automated declines.

• Every institution should maintain clear andconcise records with special emphasis ondocumenting adjustments.

• Every organization should have a procedure toensure that current reporting instructions aremaintained and understood by control staff.

• To ensure correct classification of new prod-ucts, every organization should have a proce-dure whereby staff who are preparing regula-tory reports are consulted if new products areintroduced.

• Every organization should have a procedure,such as contacting the appropriate statisticsunits within the Federal Reserve System, toresolve questions when they arise.


Regulatory ReportingExamination Objectives Section 2130.2

The examiner’s principal objective when review-ing the regulatory reporting function is to verifythe accuracy and consistency of reportingrequirements. The examiner’s review of regula-tory reporting, as it applies to trading activitiesof the institution, should be coordinated withoverall trading-examination objectives. To assessthe accuracy of regulatory reports, examinersshould review appropriate supporting docu-ments, such as workpapers, general ledgers,subsidiary ledgers, and other information usedto prepare the regulatory reports.

The reports must meet the following objectives:

1. To confirm that the trading data are as of thereport date and that they match the records ofthe traders and include all material post-closing adjustments to the general ledger.

2. To check that the data conform to the require-ments of the report instructions. (‘‘Account-ing requirements’’ refers to how a transactionshould be valued. It also prescribes whentransactions should be reported (for example,the rules regarding trade-date accounting).The reports required by the Board are gener-ally consistent with generally acceptedaccounting principles (GAAP).

3. To assess the effectiveness of the system ofinternal controls over the regulatory report-ing function. To identify, document, and testinternal-control procedures that are critical tothe accurate, reliable, and complete reportingof trading transactions in regulatory reports.

4. To determine the effectiveness of the internalcontrols over financial reporting, which canhave an impact on the extent of examinationprocedures that need to be applied to verifythe accuracy of regulatory reports. (For exam-ple, if an examiner has determined that anorganization has very effective internal con-trols over financial reporting, then the extentof detailed testing procedures applied toverifying the accuracy of regulatory reportswill be less extensive than the proceduresapplied to an institution that has ineffectivecontrols or a system of controls with poten-tial weaknesses.)

5. To review the Financial and OperationalCombined Uniform Single (FOCUS) reportto evaluate capital adequacy. (For section 20subsidiaries, the examiner reviews the FRY-20 report to ensure that revenue fromineligible securities does not exceed 10 per-cent of total revenue.)


Regulatory ReportingExamination Procedures Section 2130.3

These procedures list processes and activitiesthat may be reviewed during a full-scope exami-nation. The examiner-in-charge will establishthe general scope of examination and work withthe examination staff to tailor specific areas forreview as circumstances warrant. As part of thisprocess, the examiner reviewing a function orproduct will analyze and evaluate internal-auditcomments and previous examination workpa-pers to assist in designing the scope of exami-nation. In addition, after a general review of aparticular area to be examined, the examinershould use these procedures, to the extent theyare applicable, for further guidance. Ultimately,it is the seasoned judgment of the examiner andthe examiner-in-charge as to which proceduresare warranted in examining any particularactivity.

1. Early in the examination, the examiner shouldreview trading data for arithmetic mistakes,general accounting errors, and any misunder-standing of the regulatory reporting instruc-tions. Common conceptual errors includeincorrect recognition of income on tradedproducts, incorrect valuation of trading-account securities, omission of securities notyet settled, and reporting of currency swapsas interest-rate swaps.

2. The examiner should ensure that previouslynoted exceptions (either in the prior Reportof Examination or by auditors) have beenproperly addressed.

3. The examiner should review the workpapersof the person responsible for preparing regu-

latory reports in order to check the descrip-tions of each transaction included in the lineitems. These details must match the instruc-tions for the corresponding lines.

4. The examiner should reconcile the regulatoryreports to the institution’s official records,especially the general ledger, and to reportsof the area in charge of trading. The recon-ciliation process begins with a review of theregulatory report through a spot check of theregulatory report against the preparer’ssources. The examiner may be able to avoidline-by-line reconciliation if accuracy runshigh in the spot check or if the examinerverifies that the institution has an approved,independently verified reconciliation process.

5. The examiner should ensure that post-closingadjustments and all accounting and timingdifferences, if any, between the regulatoryreporting requirements and generally acceptedaccounting principles (GAAP) have beeneffected.

Call report data are the basis for the balancesheet, off-balance-sheet items or activities,income statement, and risk-based capital sched-ules of the Report of Examination. Correctionsto the data made during the reconcilement of theregulatory reports must be reflected in Report ofExamination schedules. In the rare instancewhen the dates of the regulatory reports and theexamination do not coincide, data as of theexamination date must be compiled in accor-dance with call report instructions.


Regulatory ReportingInternal Control Questionnaire Section 2130.4

1. Before reports are submitted to the regula-tory authorities, are all regulatory reportsreviewed for accuracy by a person who isindependent of the preparation process?

2. Does internal audit at the institution reviewthe process of regulatory reporting, includ-ing the accuracy of the trading data onregulatory reports?

3. Are internal controls in place that providereasonable assurances of the accuracy, relia-bility, and completeness of reported tradinginformation?

4. Are the internal controls documented andtested by internal audit? If not, examinationpersonnel should document and test criticalinternal controls in this area to the extentappropriate to satisfy examination objectives.

5. Does supporting documentation includesources of information and reconciliation tothe general or subsidiary ledgers, and arereconciling items handled appropriately?

6. Are procedures in place to capture exoticinstruments or other transactions that requirespecial handling? Off-balance-sheet items

that are handled outside of normal pro-cesses or automated systems may be omittedif procedures and adequate communicationexist between the reporting and tradingfunctions.

7. Do reporting personnel have an adequateunderstanding of trading instruments, trad-ing transactions, and reporting requirementsto ensure accurate and reliable regulatoryreporting?

8. Does the preparer or reviewer maintain themost current instructions for the reports heor she is responsible for?

9. Does the accounting department have pro-cedures to ensure that the preparer orreviewer investigates questions from theFRB report analysts? (Report analysts askthe accounting department over the tele-phone to explain arithmetic discrepanciesand large variances from prior periods.)

10. What knowledge does the signatory haveregarding the report he or she is signing andthe controls in place to ensure accuracy?


Regulatory ReportingAppendix—Reports for Trading Instruments Section 2130.5

REPORTS LISTED BY TYPE OFINSTITUTION

Listed below, according to the type of respon-dent, are the regulatory reports that include dataon traded products. Some of the reports show

detail by product type, while others only havedata aggregated for selected products. Beforeundertaking a review of any trading instruments,examiners should become familiar with the dataavailable to them in the reports filed by theentity under examination.

Bank Holding Company Reports

1. FR Y-9C Consolidated financial statements for top-tier bank holding companies with totalconsolidated assets of $150 million or more and lower-tier bank holdingcompanies that have total consolidated assets of $1 billion or more. In addition,FR Y-9C reports are filed by all multibank bank holding companies with debtoutstanding to the general public or that are engaged in certain nonbankactivities, regardless of size.

Frequency: quarterly

Each of the instruments listed below is captured on this report. See the reportinstructions/glossary for the treatment of each instrument. See schedule HC-Rfor risk-based capital components.

Schedule HC-B

SecuritiesU.S. TreasuriesMunicipalMortgage-backedAsset-backedForeign governmentsCorporationsLDC debtEquities

Schedule HC-L

Futures and forwardsForward rate agreementsInterest-rate swapsForeign exchangeCurrency swapsOptions (interest-rate, currency)CommoditiesIndex-linked activitiesHybrids


2. FR Y-9SP Parent-company-only financial statements for one-bank holding companies withtotal consolidated assets of less than $150 million.

Frequency: semiannually

Typically, examiners will encounter only securities (for example, U.S. Treasur-ies, obligations of states and municipalities, and mortgage-backed securities)when reviewing this report. No off-balance-sheet items are captured on thisreport.

3. FR Y-9LP Parent-company-only financial statements for each bank holding company thatfiles the FR Y-9C. In addition, for tiered bank holding companies, parent-company-only financial statements for each lower-tier bank holding company ifthe top-tier bank holding company files the FR Y-9C.


Typically, examiners will encounter only securities transactions (for example,U.S. Treasuries, municipal, and mortgage-backed) when reviewing this report.No off-balance-sheet items are captured on this report.

4. FR Y-8 Bank Holding Company Report of Insured Depository Institutions’ Section 23ATransactions with Affiliates.


This report collects information on transactions between an insured depositoryinstitution and its affiliates that are subject to section 23A of the Federal ReserveAct (FRA). The information is used to enhance the Federal Reserve’s ability tomonitor bank exposures to affiliates and to ensure compliance with section 23Aof the FRA. Section 23A is one of the most important statutes on limitingexposures to individual institutions and protecting the federal safety net.Reporters include all top-tier bank holding companies (BHCs), includingfinancial holding companies (FHCs). In addition, all foreign banking organiza-tions that directly own a U.S. subsidiary bank must file this report. Participationis mandatory.

5. FR Y-20 Financial statements for a bank holding company subsidiary engaged inineligible securities underwriting and dealing.

Frequency: quarterly only by firms that continue to function as ‘‘ section 20subsidiaries’’

Schedules SUD and SUD-A capture securities transactions (for example, U.S.Treasuries, municipal, foreign, and asset-backed securities) as well as transac-tions involving equities, futures and forwards, and options.

2130.5 Regulatory Reporting: Appendix—Reports for Trading Instruments


6. FR Y-11Q Financial statements for each individual nonbank subsidiary of a bank holdingcompany with total consolidated assets of $150 million or more in which thenonbank subsidiary has total assets of 5 percent or more of the top-tier bankholding company’s consolidated tier 1 capital, or in which the nonbanksubsidiary’s total operating revenue equals 5 percent or more of the top-tierbank holding company’s consolidated total operating revenue.


Each of the instruments listed below is captured on this report.

Balance-Sheet ItemsSecurities

Off-Balance-Sheet ItemsFutures and forwardsForward rate contractsInterest-rate swapsForeign exchangeCurrency swapsOption contracts

7. FR Y-11I Financial statements for each individual nonbank subsidiary that is owned orcontrolled by a bank holding company with total consolidated assets of less than$150 million or with total consolidated assets of $150 million or more if (1) thetotal assets of the nonbank subsidiary are less than 5 percent of the top-tier bankholding company’s consolidated tier 1 capital and (2) the total operating revenueis less than 5 percent of the top-tier bank holding company’s consolidated totaloperating revenue.

Frequency: annually


Balance-Sheet ItemsSecurities

Off-Balance-Sheet ItemsFutures and forwardsForward rate contractsInterest-rate swapsForeign exchangeCurrency swapsOption contracts

Regulatory Reporting: Appendix—Reports for Trading Instruments 2130.5


8. FR Y-12 Report filed by top-tier domestic bank holding companies that file the FR Y-9Cor FR Y-9SP and that meet the reporting thresholds. The FR Y-12 collectsinformation on these companies’ equity investments in nonfinancial companieson three schedules: Type of Investments, Type of Securities, and Type of Entitywithin the Banking Organization.

Frequency: quarterly for FR Y-9C filers, semiannually for FR Y-9SP filers


Balance-Sheet ItemsDirect and indirect equity investments

Off-Balance-Sheet ItemsUnused equity commitments

9. FFIEC 009 Country Exposure Report filed by U.S. commercial banks and/or bank holdingcompanies that meet the reporting criteria specified in the instructions to thisreport.


9a. FFIEC 009a Country Exposure Information Report supplements the FFIEC 009 and isintended to detail significant exposures as defined in the instructions to thisreport.


These reports show country distribution of foreign claims held by U.S. banksand bank holding companies. They also include foreign securities in theaggregate assets of the countries shown.

These reports may also be filed by U.S.-chartered insured commercial banks,Edge Act and agreement corporations, and other banking organizations.

10. X-17A-5 FOCUS Report.


This report collects data on securities and spot commodities owned bybroker-dealers. In addition, it reflects the haircuts the broker-dealers are requiredto take, when applicable, pursuant to SEC rule 15c3-1(f).



Bank Reports

1. FFIEC 031 Consolidated reports of condition and income for a bank with domestic andforeign offices.


Each of the instruments listed below is captured on this report. See the reportinstructions for the treatment of each instrument. See schedule RC-R forrisk-based capital computation.

Schedules RC-B and RC-DSecurities

U.S. TreasuryMunicipalMortgage-backedAsset-backedForeign governmentEquityAll others


Trading and Capital-Markets Activities Manual April 2003Page 4.1

Schedule RC-LFutures and forwardsForward rate agreementsInterest-rate swapsForeign exchangeCurrency swapsOptions (interest-rate, currency)CommoditiesIndex-linked activitiesHybridsCredit derivatives

The FFIEC 032, 033, and 034 reports of condition and income captureinformation on the same instruments as the FFIEC 031.

2. FFIEC 030 Report of condition for foreign branch of U.S. bank.

Frequency: annually for all overseas branch offices of insured U.S. commercialbanks

quarterly for significant branches with either total assets of at least$2 billion or commitments to purchase foreign currencies and U.S.dollar exchange of at least $5 billion

This is a two-page report that captures information on balance-sheet data as wellas selected off-balance-sheet data (options, foreign exchange, interest-rateswaps, and futures and forward contracts).

Reports for U.S. Branches and Agencies of Foreign Banks

1. FFIEC 002 Report of assets and liabilities of U.S. branches and agencies of foreign banks.


This report captures information pertaining to balance-sheet and off-balance-sheet transactions reported by all branches and agencies.

Schedule RALSecurities

U.S. TreasuriesGovernment agenciesAll others

Schedules L and M—part 5Futures and forwardsForward rate agreementsInterest-rate swapsForeign exchangeCurrency swapsOptions (interest-rate, currency)



2. FR 2069 Weekly report of assets and liabilities for large U.S. branches and agencies offoreign banks.

Frequency: as of the close of business every Wednesday

Securities are included in this abbreviated report of assets and liabilities, whichresembles schedule RAL on FFIEC 002.

3. FFIEC 019 Country exposure for U.S. branches and agencies of foreign banks.


This report shows country distribution of foreign claims held by branches andagencies. It includes foreign securities in the aggregate assets of the countriesshown.

The FFIEC 009 (filed by banks, bank holding companies, and Edge Act andagreement corporations) is similar to this form.

Other Reports

1. FR 2314a Report of condition for foreign subsidiaries of U.S. banking organizations (to befiled by companies with total assets exceeding U.S. $100 million as of the reportdate).

Frequency: annually

quarterly for significant subsidiaries with either total assets greaterthan $2 billion or $5 billion in commitments to purchase and sellforeign currencies

1a. FR 2314b Report of condition for foreign subsidiaries of U.S. banking organizations (to befiled by companies with total assets between U.S. $50–100 million as of thereport date).

Frequency: annually

1b. FR 2314c Report of Condition for Foreign Subsidiaries of U.S. Banking Organizations (tobe filed by companies with total assets less than U.S. $50 million as of the reportdate).

Frequency: annually

These three schedules are intended to capture financial information on theoverseas subsidiaries of U.S. banking organizations (that is, bank holdingcompanies, banks, and Edge Act corporations). The level of detail reported willdepend on the asset size of the reporting entity. The FR 2314a and FR 2314bcapture information on balance-sheet and off-balance-sheet transactions. The FR2314c report cannot be used to track individual categories as the other tworeports can.



2. FR 2886b Report of condition for Edge Act and agreement corporations.


This report reflects the consolidation of all Edge and agreement operations,except for those majority-owned Edge or agreement subsidiaries. The latter areaccounted for within a single line item, claims on affiliates. Asset instruments(securities and LDC debt) are reflected in the securities and loan lines,respectively, of this report. Off-balance-sheet items are grouped except forforeign-exchange and options contracts.



Regulatory ComplianceSection 2140.1

The trading activities and related instrumentsdiscussed in this manual are covered by varioussecurities, commodities, or banking laws andregulations. Trading and other activities relatingto securities are regulated under a variety ofstatutes, including the Securities Act of 1933,Securities Exchange Act of 1934, and Govern-ment Securities Act of 1986. In addition toregulation by the Securities and Exchange Com-mission (SEC) and U.S. Treasury Department,various self-regulatory organizations (SROs) areresponsible for oversight of securities broker-dealers. The SROs include the Municipal Secu-rities Rulemaking Board (MSRB), the NationalAssociation of Securities Dealers (NASD), andexchanges such as the New York Stock Exchange(NYSE).

Bank activities in the trading of securities aresubject to further regulation from the variousbanking regulators. One of the more importantstatutory provisions governing securities activi-ties of banks was the Banking Act of 1933 (theGlass-Steagall Act), which provided that mem-ber banks could purchase only certain limitedtypes of securities (referred to as ‘‘eligiblesecurities’’) and prohibited member banks fromaffiliating with entities that were engaged prin-cipally in the business of underwriting or issuingineligible securities. Securities underwriting anddealing activities were authorized for separatelyincorporated nonbank entities owned, directly orindirectly, by bank holding companies. Theseso-called section 20 subsidiaries (after section20 of the Glass-Steagall Act) operated pursuantto a number of restrictions, including limitationson the annual revenue derived from dealing inbank-ineligible securities.

Under the provisions of the Gramm-Leach-Bliley Act (GLB Act) enacted in 1999, financialholding companies are permitted to establishbroker-dealer subsidiaries engaged in underwrit-ing, dealing, and market making in securities,without the restrictions that were applicable tosection 20 subsidiaries. The GLB Act provisionsalso permit financial subsidiaries of banks toengage in comparable activities, subject tocertain bank capital limitations and deduc-tions. Permissible equity trading activities offoreign and Edge corporation subsidiaries ofU.S. banks are governed under the Board’sRegulation K.

The GLB Act requires banking regulators torely to the greatest extent possible on the func-

tional regulator of securities firms. Only undercertain specified circumstances may a bankingregulator conduct an examination of a broker-dealer. Thus, bank examiners need to becomefamiliar with the regulatory environment inwhich securities broker-dealers have tradition-ally operated. This section will focus on thatgoal, deferring to existing material in the fol-lowing manuals:Commercial Bank Examina-tion Manual, Merchant and Investment BankExamination Manual, andBank Holding Com-pany Supervision Manual.

Activities involving instruments other thansecurities also may be subject to a variety ofregulatory provisions. Commodities futures andoptions are regulated primarily by the Commod-ity Futures Trading Commission (CFTC), withthe activities of futures commission merchants(FCMs) subject to regulation by the CFTC aswell as the rules of the National Futures Asso-ciation (an SRO) and various exchanges onwhich trading is conducted. Most over-the-counter derivative instruments (for example,foreign-exchange contracts, forward rate agree-ments, and interest-rate swaps) are exempt fromgeneral CFTC regulation, either by statute in thecase of foreign exchange or under CFTC regu-latory exemptions in the case of other types ofswaps and related transactions. While theseinstruments are not themselves subject to regu-lation, the activities of regulated entities in theseinstruments are subject to oversight by thebanking or other regulators.

In addition to laws and regulations issued bythe regulatory authorities, industry trade groupssuch as the International Swaps and DerivativesAssociation (ISDA) or the Public SecuritiesAssociation (PSA) have developed industryguidelines or standards in some areas. Addition-ally, organizations such as the Financial Account-ing Standards Board (FASB) and the AmericanInstitute of Certified Public Accountants (AICPA)issue opinions and standards that relate to afinancial institution’s trading activities and finan-cial disclosure.1

1. For example, FASB’s Statement of Financial Account-ing Standards No. 80 outlines accounting requirements relat-ing to futures contracts, while Practice Bulletin 4 of theAICPA addresses accounting issues concerning debt-for-equity swaps involving less developed country (LDC)obligations.


PRINCIPLES OF SUPERVISION

The SEC’s main principles of securities regula-tion are the protection of investors (especiallythe small and unsophisticated) and maintenanceof the integrity and liquidity of the capitalmarkets. These principles are not unlike thegoals of banking regulators, who seek to pro-mote a stable banking system. However, securi-ties and banking regulators differ in how theyapply these goals to an institution that is encoun-tering problems. Capital adequacy rules forsecurities are liquidity based and designed toensure that a troubled broker-dealer can promptlypay off all customers in the event of liquidation.Banking regulators face a different set of con-straints when dealing with troubled banks andare less inclined to rely as quickly on theliquidation process.

REGISTRATION

Securities broker-dealers generally must registerwith the SEC before conducting business. Whilebroker-dealer activities undertaken by a bankitself generally are exempt from registrationrequirements, bank subsidiaries and bank hold-ing companies or subsidiaries that are broker-dealers must register with the SEC. Registeredsecurities broker-dealers also are registered withthe NASD or another SRO, such as an exchange,and are required to have their sales and super-visory personnel pass written examinations.

Broker-dealers that engage in transactionsinvolving municipal or government securitiesgenerally are registered with the SEC, but aresubject to somewhat different requirements thanthe general registration requirements. When thebank itself acts as a government securitiesbroker-dealer, the bank is required to notify itsappropriate bank regulatory authority that it isacting in that capacity.

CAPITAL REQUIREMENTS

Registered securities broker-dealers are subjectto minimum net capital requirements pursuant toSEC Rule 15c3-1 or the U.S. Treasury’s rulesfor government securities dealers (17 CFR 402).Requirements in excess of the minimum are alsoestablished by NYSE, NASD, and other SROs.If any of these minimums are breached, the firm

is subject to harsh restrictions on its operations.Net capital is generally defined as the broker-dealer’s net worth plus subordinated borrow-ings, minus nonliquid (nonallowable) assets,certain operational deductions, and requireddeductions (‘‘ haircuts’’ ) from the market valueof securities inventory and commitments. Thelevel of the haircut depends on the type andduration of the security; the greater the durationand risk (or volatility), the greater the haircut.

CREDIT RESTRICTIONS

Various credit and concentration restrictions areimposed on a securities broker-dealer if thedealer is unduly concentrated in a given issue.Additionally, the Federal Reserve’s Regula-tion T imposes limits on the amount of creditthat may be extended by broker-dealers to cus-tomers purchasing securities. This restrictionvaries with the type of security.

REGULATORY REQUIREMENTS

Regulatory Examinations

All securities broker-dealers are required topublish annual financial statements auditedby independent accountants. The SEC has theauthority to conduct examinations, includingexaminations for compliance with sales-practiceand customer securities custody-protection rules,recordkeeping and internal controls, and regula-tory reporting. In most cases, the SEC delegatesthis examination responsibility to the NYSE orthe appropriate SRO. The NASD also conductsall examinations of firms, except banks, thatengage strictly in municipal or governmentsecurities trading. In the case of banks, bankregulators are responsible for the examination.

Regulatory Reporting

Securities broker-dealers are required to file amonthly Financial and Operational CombinedUniform Single (FOCUS) report with theirexamining authority. This report contains finan-cial statements and computations for the netcapital rule, segregated funds held on behalf

2140.1 Regulatory Compliance


of commodity futures customers, and a reserveaccount designed to protect customer balances.2Government securities dealers file a somewhatsimilar report, the G-405 or ‘‘ FOG’’ report,unless they are banks. Bank dealers file theirnormal call reports. Although FOCUS and FOGreports are generally confidential, securitiesbroker-dealers will often make them available tolarge customers for credit reasons.

U.S. commercial banks and branches andagencies of foreign banks are required to file callreports with the appropriate federal bank regu-latory agency. The call report includes schedulesthat detail various off-balance-sheet instruments

and information on the institutions’ trading-account securities.

FOREIGN SECURITIESACTIVITIES

Foreign-owned securities firms in the UnitedStates are subject to the same rules as domesti-cally owned firms. In general, offshore activitiesconducted by U.S. broker-dealers that are locatedentirely outside of U.S. jurisdiction and do notinvolve U.S. persons are not subject to U.S.securities regulation. Moreover, for FOCUS andFOG reporting purposes, the securities broker-dealer is not required to consolidate foreign(or domestic) subsidiaries unless the assets andliabilities have been guaranteed by the parent.

2. SEC Rule 15c3-3 restricts the use of customers’ fundsand fully paid securities for proprietary transactions.

Regulatory Compliance 2140.1


Regulatory ComplianceExamination Objectives Section 2140.2

The overall objective is to determine if theinstitution’s trading activities are in compliancewith applicable laws, regulations, and super-visory guidelines. Specified senior management,as well as the regulatory reporting area of thebank, must be thoroughly familiar with regula-tory requirements. Whenever possible, the bankexaminer uses the examination results of thesecurities regulators and FOCUS/FOG reportsto help assess the firm’s overall compliancerecord.

1. To determine if the institution’s internal con-trols and audit program address the regula-

tory compliance aspect of its various tradingactivities.

2. To determine if the bank has in place risk-management procedures and controls thatprovide management with accurate and timelyinformation on all trading positions and theirpotential impact on the institution’s financialand regulatory position.

3. To ascertain whether the institution’s person-nel involved in trading activities are aware ofand knowledgeable about laws, regulations,and supervisory and other standards applica-ble to these activities.


EthicsSection 2150.1

The board of directors and senior managementof a financial institution should establish ethicalstandards and codes of conduct governing itsemployees’ activities. These standards areintended to protect the institution’s integrity andstanding in the market as well as protect theinstitution from legal and reputational risks. Theorderly operation of financial markets dependsgreatly on an overall level of trust among allmarket participants. At all times, traders andmarketing and support staff must conduct them-selves with unquestionable integrity to protectthe institution’s reputation with customers andmarket participants.

CODES OF CONDUCT ANDETHICAL STANDARDS

To ensure that employees understand all ethicaland legal implications of trading activities,institutions should have comprehensive codes ofconduct and ethical standards for capital-marketsand trading activities—especially in areas wherethe complexity, speed, competitive environ-ment, and volume of activity could create thepotential for abuse and misunderstandings. At aminimum, policies and standards should addresspotential conflicts of interest, confidentiality andthe use of insider information, and customersales practices. Ethical standards and codes ofconduct in these areas should conform withapplicable laws, industry conventions, and otherbank policies. They should also provide properoversight mechanisms for monitoring staff com-pliance and dealing with violations and cus-tomer complaints. Internal controls, includingthe role of internal and external audits, shouldbe appropriate to ensure adherence to corporateethical standards of conduct. An institution’spolicies and procedures should provide for on-going staff training. Policies and proceduresshould also provide for at least an annual review,revision, and approval of the ethical standardsand code of conduct to ensure that they incor-porate new products, business initiatives, andmarket developments. To ensure that all employ-ees understand the ethical, legal, and reputa-tional risk implications of bank activities, ethi-cal standards and codes of conduct should becommunicated throughout the organization andreinforced by periodic training.

Conflicts of Interest

Institutions should ensure that capital-marketspersonnel do not allow self-interest to influenceor give the appearance of influencing any activ-ity conducted on behalf of the institution. Properoversight mechanisms, internal controls, andinternal-audit procedures for monitoring compli-ance and addressing conflicts of interest shouldbe in place. Safeguards should include specificrestrictions on trading for the employee’s per-sonal account and on the acceptance of gratu-ities and entertainment. When developing com-pensation programs, institutions should recognizeand guard against any potential conflicts thatmay arise between compensation structures andthe institution’s ethical standards and code ofconduct.

Fee-based activities, securitization, underwrit-ing, and secondary-market trading activities in anumber of traditional bank assets may create thepotential for conflicts of interests if there is noclear segregation of duties and responsibilities.Conflicts of interest may arise when access toinside information gives an institution an unfairadvantage over other market participants.Accordingly, policies should ensure that employ-ees conduct themselves consistent with legaland regulatory restrictions on the use of insideinformation.

Confidentiality and InsiderInformation

The maintenance of confidentiality and cus-tomer anonymity is critical for the operation ofan efficient trading environment. No clientinformation should be divulged outside theinstitution without the client’s authorizationunless the information is required by law orregulatory authorities acting in their officialcapacities. Managers are responsible for ensur-ing that their staffs are aware of what constitutesconfidential information and that they knowhow to deal appropriately with situations thatrequire customer anonymity.

Many institutions have established appropri-ate policies (so-called Chinese walls or fire-walls) that separate those areas of the institutionthat routinely have access to confidential orinsider information from those areas that are


legally restricted from having access to theinformation. Any conflicts between an institu-tion’s risk-management or marketing structuresand its Chinese walls should be formally recog-nized and managed.

Sales Practices

It is a sound business practice for managers toestablish policies and procedures governing stan-dards for dealing with counterparties. Theseguidelines and policies preserve the institution’sreputation in the marketplace by avoiding situ-ations that create unjustified expectations on thepart of a counterparty or client or that expose theinstitution to legal or reputational risk arisingfrom a customer’s use of bank products andservices.

Customer Suitability

When determining the responsibilities of salesand marketing staff, management should takeinto account the sophistication of a counterparty,the nature of the relationship, and the type oftransaction being contemplated or executed. Inaddition, certain regulated entities and marketsmay have specific legal or regulatory require-ments governing sales and marketing practices,which marketers and sales personnel must beaware of.

Financial institutions should take steps toascertain the character and financial sophistica-tion of their counterparties. An appropriate levelof due diligence should be performed on allcounterparties that the institution deals with.Financial institutions should also determine thattheir counterparties have the legal authority toenter into, and will be legally bound by theterms of, the transaction.

When an advisory relationship does not existbetween a financial institution and its counter-party, the transaction is assumed to be con-ducted at ‘‘arm’s length,’’ and the counterpartyis generally considered to be wholly responsiblefor the transactions it chooses to enter. At times,clients may not wish to make independent invest-ment or hedging decisions and instead may wishto rely on a financial institution’s recommenda-tions and investment advice. Similarly, clientsmay give a financial institution the discretionaryauthority to trade on their behalf. Financial

institutions that provide investment advice toclients or use discretionary authority to trade ona client’s behalf should formalize and set forththe boundaries of these relationships. Formaladvisory relationships may entail significantlydifferent legal and business obligations betweenan institution and its customers than less formalagency relationships. The authority, rights, andresponsibilities of both parties should be docu-mented in a written agreement.

Marketing personnel should receive properguidance and training on how to delineate andmaintain appropriate client relationships. Salesand trading personnel should receive guidanceabout avoiding the implication of an advisoryrelationship when none is intended.

For its own protection, a financial institutionshould take steps to ensure that its counterpar-ties understand the nature and risks inherent inagreed-upon transactions. These procedures mayvary with the type and sophistication of acounterparty. When a counterparty is unsophis-ticated, either generally or with respect to aparticular type of transaction, the financial insti-tution should take additional steps to adequatelydisclose the attendant risks of specific types oftransactions. Furthermore, a financial institutionthat recommends specific transactions to anunsophisticated counterparty should haveadequate information on which to base itsrecommendation—and the recommendationshould be consistent with the needs of thecounterparty as known to the financial institu-tion. The institution also should ensure that itsrecommendations are consistent with any restric-tions imposed by a counterparty’s managementor board of directors on the types or amounts oftransactions it may enter into.

Institutions should establish policies govern-ing the content of sales materials provided totheir customers. Typically, these policies call forsales materials that accurately describe the termsof the proposed transaction and fairly representthe risks involved. To help a customer adequatelyassess the risk of a transaction, an institution’spolicies may identify the types of analysis to beprovided to the customer. Often these analysesinclude stress tests of the proposed instrument ortransaction over a sufficiently broad range ofpossible outcomes. Some institutions use stan-dardized disclosure statements and analyses toinform customers of the risks involved andsuggest that the customer independently obtainadvice about the tax, accounting, legal, andother aspects of a proposed transaction.

2150.1 Ethics


Institutions should also ensure that proce-dures and mechanisms to document analyses oftransactions and disclosures to clients are ade-quate and that internal controls ensure ongoingadherence to disclosure and customer-appropriateness policies and procedures. Man-agement should clearly communicate to capital-markets and all other relevant personnel anyspecific standards that the institution has estab-lished for sales materials.

Many customers request periodic valuationsof their positions. Institutions that provide peri-odic valuations of customers’ holdings shouldhave internal policies and procedures governingthe manner in which such quotations are derivedand transmitted to the customer, including thenature and form of disclosure and any disclaim-ers. Price quotes can be either indicative, meantto give a general level of market prices for atransaction, or they can be firm, which representprices at which the institution is willing toexecute a transaction. When providing a quoteto a counterparty, institutions should be carefulthat the counterparty does not confuse indicativequotes with firm prices. Firms receiving dealerquotes should be aware that these values maynot be the same as those used by the dealer forits internal purposes and may not represent other‘‘market’’ or model-based valuations.

When securities trading activities are con-ducted in a registered broker-dealer that is amember of the National Association of Securi-ties Dealers (NASD), the broker-dealer willhave obligations to its customers under theNASD’s business-conduct and suitability rules.The banking agencies have adopted identicalrules governing the sales of government securi-ties in financial institutions. The business-conduct rule requires an NASD member to‘‘observe high standards of commercial honor,and just and equitable principles of trade’’ in theconduct of its business. The suitability rulerequires that, in recommending a transaction toa customer, an NASD member must have ‘‘rea-sonable grounds for believing that the recom-mendation is suitable for the customer upon thebasis of facts, if any, disclosed by the customersas to the customer’s other securities holdingsand as to the customer’s financial situation andneeds.’’

The suitability rule further provides that, forcustomers who are not institutional customers,an NASD member must make reasonable effortsto obtain information concerning the customer’sfinancial and tax status and investment objec-

tives before executing a transaction recom-mended to the customer. For institutional cus-tomers, an NASD interpretation of its suitabilityrule requires that a member determine (1) theinstitutional customer’s capability for evaluatinginvestment risk generally and evaluating the riskof the particular instruments offered and(2) whether the customer is exercising indepen-dent judgment in making investment decisions.The NASD interpretation cites factors relevantto determining these two requirements.

LEGAL AND REPUTATIONALRISKS

The increasingly complex relationships betweenbanking organizations and their customers cansubject a bank to legal and reputational risks.Although banking organizations are not directlyaccountable for the actions of their customers,these organizations should recognize that—tothe extent their name or product is associatedwith a customer’s misconduct—additional legaland reputational risks may arise. Such risks maylead to significant costs that may place down-ward pressure on earnings and the price of theinstitution’s stock and upward pressure on theinstitution’s cost of funds. In an extreme case,these costs may have a negative impact on theoverall safety and soundness of the institution.

Legal and reputational risks are often associ-ated with new products. Generally, bankingorganizations have established new-product pro-cesses that are designed to independently vet allrisks. However, modifications to an existingproduct or new uses of a product after its initialapproval may also constitute a ‘‘new’’ product.An institution’s product-approval process shouldincorporate re-reviews of these new products toverify that all risks associated with the productare understood and incorporated in the risk-management framework.

Ultimately, the corporate culture of a bankingorganization determines the effectiveness of itsrisk-management procedures and its susceptibil-ity to legal and reputational risk. The board ofdirectors and executive management of a bank-ing organization are responsible for establishingand maintaining an appropriate corporate cul-ture and the corresponding business practices.The culture of a banking organization shouldencourage the escalation of legal- andreputational-risk issues through policies and pro-

Ethics 2150.1


cedures that ensure these issues are vetted andresolved at an appropriate level of seniority. Theboard of directors should be advised of anymaterial issues involving legal and reputationalrisk.

MANAGEMENT OVERSIGHT

Management should monitor any pattern ofcomplaints concerning trading, capital-markets,and sales personnel that originates from outsidethe institution, such as from customers, othertrading institutions, or intermediaries. Patternsof broker usage should be monitored to alertmanagement to unusual concentrations. Bro-kers’ entertainment of traders should be fullydocumented, reviewed, and approved by man-agement. In addition, excessive entertainment ofbrokers by traders should be prohibited.

Management should also be well acquaintedwith the institution’s trading activities and cor-responding reports so that, upon regular review,they can determine unusual patterns or concen-trations of trading activity or transactions with acustomer that are not consistent with the cus-tomer’s usual activities. Management shouldclearly and regularly communicate all prohib-ited practices to capital-markets and all otherrelevant personnel.

COMPLIANCE MEASURES

Personnel affirmations and disclosures are valu-able tools for ensuring compliance with aninstitution’s code of conduct and ethical stan-dards. Procedures for obtaining appropriateaffirmations and disclosures where and whenthey are required, as well as the development ofthe forms on which these statements are made,are particularly important. At a minimum,employees should be asked to acknowledgeannually that they have read and understand theinstitution’s ethical standards and code of con-duct. Some companies also require that thisannual affirmation contain a covenant thatemployees will report any noted violations.Several major financial institutions have adoptedadditional disclosure procedures to enforce thepersonal financial responsibilities set out in theircodes. They require officers to file with thecompliance manager an annual statement ontheir families’ financial matters or, in somecases, a statement of indebtedness. Finally, manyinstitutions require traders to conduct their per-sonal trading through a designated account atthe institution. Adequate internal controls,including review by internal audit and, whenappropriate, external audit, are critical forensuring compliance with an institution’s ethicalstandards.

2150.1 Ethics


EthicsExamination Objectives Section 2150.2

1. To determine if the institution has adequatecodes of conduct and ethical standards spe-cific to its capital-markets and trading activi-ties, that their scope is comprehensive, andthat they are periodically updated.

2. To review and ensure the adequacy of theinstitution’s policies, procedures, and internal-control mechanisms used to avoid potentialconflicts of interest, prevent breaches in cus-tomer confidentiality, and ensure ethical salespractices across the institution’s tradingactivities. To determine if the institution hasestablished appropriate and effective firewallpolicies where needed.

3. To determine that management has adequatepolicing mechanisms and internal controls tomonitor compliance with the code of conductand ethical standards and that procedures for

reporting and dealing with violations areadequate. To determine if the supervision ofstaff is adequate for the level of businessconducted.

4. To determine that management has adequatenew-product processes that are designed toevaluate independently the risks of productsthat have been modified or products forwhich new uses have been developed.

5. To determine that the board of directors andsenior management recognize the potentiallegal and reputational risks that arise from acustomer’s misuse of bank products.

6. To recommend corrective actions when poli-cies, procedures, practices, or internal con-trols are found to be deficient or whenviolations of law, rulings, or regulations havebeen noted.


EthicsExamination Procedures Section 2150.3

These procedures list processes and activitiesthat may be reviewed during a full-scope exami-nation. The examiner-in-charge will establishthe general scope of the examination and workwith the examination staff to tailor specific areasfor review as circumstances warrant. As part ofthis process, the examiner reviewing a functionor product will analyze and evaluate internal-audit comments and previous examination work-papers to assist in designing the scope of theexamination. In addition, after a general reviewof a particular area to be examined, the examinershould use these procedures, to the extent theyare applicable, for further guidance. Ultimately,it is the seasoned judgment of the examiner andthe examiner-in-charge as to which proceduresare warranted in examining any particularactivity.

1. Obtain copies of the institution’s writtencode of conduct, ethical standards, andrelated policies and guidance. Determine ifthere are codes specific to all relevant trad-ing and marketing activities. Determine ifthere is a general policy concerning viola-tions of the code. Is there a specific proce-dure for reporting violations to senior man-agement and the general auditor? Does thisprocedure detail the grounds for disciplin-ary action?

2. Obtain any procedures that are used to helpstaff develop new accounts or prepare salespresentations and documents.

3. Evaluate the adequacy and scope of thevarious codes and policies. Are prohibitedpractices clearly identified? Prohibited prac-tices may include but are not limited to thefollowing:a. altering clients’ orders without their

permissionb. using the names of others when submit-

ting bidsc. compensating clients for losses on tradesd. submitting false price information to pub-

lic information servicese. churning managed client accountsf. altering official books and records with-

out legitimate business purposesg. trading in instruments that are prohibited

by regulatory authorities4. Determine if standards for the content of

sales presentations and the offering of trans-

action documents are clearly identified. Dothese standards address an appropriate rangeof transactions, customers, and customerrelationships?

5. Evaluate the adequacy of oversight mecha-nisms, internal controls, and internal-auditprocedures for monitoring compliance andaddressing conflicts of interests. Review theinstitutions’s firewall policies that segregateits trading and advisory activities from thoseareas that have access to material nonpublicor ‘‘insider information.’’ Are employeesaware of the requirements of the lawrestricting the use of such information, spe-cifically section 10(b) of the SecuritiesExchange Act of 1934 and SEC Rule10(b)5?

6. Identify the officer within the institutionwho is designated as the compliance man-ager. Are trading personnel required to con-firm in writing their acknowledgment of theinstitution’s various codes and to reportviolations? Are they required to file annualstatements of indebtedness and outsideaffiliations? Check to see that adherence tothese reporting requirements is being moni-tored by the compliance manager.

7. Determine how compliance with sales-practice policies is monitored by the insti-tution. Are personnel outside the tradingarea reviewing sales documents and disclo-sures for their compliance with policies?Review and evaluate the findings of internaland external audits conducted in this area.

8. Conduct limited transaction testing of salesdocumentation to review compliance withfinancial institution policies and soundpractices.

9. Determine the adequacy of the new-product-approval process, including the policies andprocedures for the review of modified prod-ucts for which new uses have been developed.

10. Determine whether there are adequate poli-cies, procedures, and internal controls toprotect the institution from legal and repu-tational risks that arise from a customer’smisuse of bank products.

11. Recommend corrective action when poli-cies, procedures, practices, or internal con-trols are found to be deficient or whenviolations of law, rulings, or regulationshave been noted.


EthicsInternal Control Questionnaire Section 2150.4

1. Does the institution have a written code ofconduct and written ethical standards? Arethere specific codes for capital-markets staff?a. Is there a statement on the intention of the

code and standards to conform with U.S.laws or the laws of other countries wherethe institution has operations?

b. Do the code and standards cover thewhole institution, including subsidiaries?If not, are there codes and standards thatapply to those particular areas?

c. Do the code and standards address spe-cific activities that are unique to thisparticular institution? Do other areas ofthe institution with a higher potential forconflicts of interest have more explicitpolicies?

d. Do the code and standards address thefollowing issues:• Employee relationships with present or

prospective customers and suppliers?Has the institution conducted an appro-priate inquiry of customer integrity?Does the institution’s code properlyaddress the following employee-customer or -supplier issues?— safeguarding confidential information— borrowings— favors— acceptance of gifts— outside activities— kickbacks, bribes, and other

remunerations— integrity of accounting records— candor in dealings with auditors,

examiners, and legal counsel— appropriate background check and

assessment of the credit quality andfinancial sophistication of newcustomers

— appropriate sales practices— an understanding of the customer’s

business purposes for entering intocomplex or structured transactions

• Internal employee relationships betweenspecific areas of the bank?— Do policies exist to cover the sharing

of information between trading andother areas of the bank?

— Is the confidentiality of accountrelationships addressed?

• Personal employee activities outside thecorporation? Does the institution—

— periodically check whether employ-ees maintain sound personal finan-cial conduct and avoid excessivedebts or risks?

— monitor employee business interac-tion with other staff members, fam-ily, or organizations in which anemployee has a financial interest?

— prohibit employee use of confiden-tial information for personal gain?

— provide adequate control overemployee trading in personalaccounts?

— require periodic disclosure andapproval of outside directorships andbusiness associations?

• For personal and corporate politicalactivities, the illegality of corporatepolitical activities (for example, contri-butions of goods, services, or othersupport)?

• The necessity to avoid what might onlyappear to be a possible conflict ofinterest?

2. Does management have the necessary mecha-nism in place to monitor compliance with thecode of conduct and the ethical standards?a. Are officers and staff members required to

sign an acknowledgment form that veri-fies they have indeed seen and read thecode of conduct and the ethical standards?• Is there a periodic program to make staff

aware of and acknowledge the impor-tance of adhering to the code andstandards?

• To identify a potential conflict of inter-est, are officers required to disclose theirborrowing arrangements with otherfinancial institutions?

b. What departments and which officers areresponsible for monitoring compliancewith the code of conduct, ethical stan-dards, and related policies? What mecha-nisms do these officers employ, and arethe mechanisms adequate?

c. How is information in the code and stan-dards relayed to staff?• Have there been any breaches of the

code and standards? If so, what was thesituation and how was it resolved?

• Do bank personnel avail themselves ofthe resources outlined in the code and


standards when there is a questionregarding a potential conflict of inter-est? If not, why?

• Are all employees aware of the exist-ence of the code and standards? If not,why?

• Does the bank’s management generallybelieve that all potential conflicts ofinterest have been anticipated and areadequately covered in the code andstandards?

• Are internal auditors involved in moni-toring the code and standards?

• Does the organization’s culture encour-age officers and employees to follow thestandards established by the code and toescalate legal- and reputational-riskissues? Are these issues vetted andresolved at an appropriate level ofseniority? Is the board of directorsadvised of material issues involvinglegal and reputational risk?

3. Are there resources for an employee to obtainan opinion on the legitimacy of a particularcircumstance outlined in the code of conductor in the ethical standards?a. Does the code emphasize the need for

employees to report questionable activi-ties even when the issues are not theirparticular responsibility? Are the properchannels of action outlined for these typesof cases?

b. Does the code outline penalties or reper-cussions, such as the following, forbreaches of the code of conduct and theethical standards?• potential to lose one’s job• potential for civil or legal action• eventual damage to the corporation’s

reputation4. Are the code of conduct and ethical standards

updated frequently to encompass newactivities?

2150.4 Ethics: Internal Control Questionnaire


Legal Risk Section 2070 - Federal ReserveSection 2070.1 An institution’s trading and...

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