Risk Management Introduction Effective date July 1997 ...• Reports and other forms of...

Risk ManagementIntroductionEffective date July 1997 Section 3000.1

Taking and managing risks are fundamental tothe business of banking. The U.S. bankingsupervisory agencies place significant emphasison the adequacy of an institution’s managementof risk, including the establishment of a man-agement structure that adequately identifies, mea-sures, monitors, and controls the risks involvedin its various products and lines of business. Ina branch, which is typically removed from itshead office by location and time zone, an effec-tive risk management system is critical not onlyto manage the scope of its activities but toachieve comprehensive, ongoing oversight bybranch and head office management. In theexamination process, examiners will thereforedetermine the extent to which risk managementtechniques are adequate (1) to control riskexposures that result from the branch’s activitiesand (2) to ensure adequate oversight by branchand head office management and thereby pro-mote a safe and sound banking environment.

Principles of sound management should applyto the entire spectrum of risks facing a branchincluding, but not limited to, the following:

• Credit riskwhich arises from the potential thata borrower or counterparty will fail to performon an obligation.

• Country/transfer riskwhich encompasses theentire spectrum of risks arising from theeconomic, social and political environmentsof a foreign country which may have potentialconsequences for foreigners’ debt and equityinvestments in that country. More specifically,transfer risk focuses on a borrower’s capacityto obtain the foreign exchange required toservice its cross-border debt.

• Market risk which is the risk to a financialinstitution resulting from adverse movementsin market rates or prices, such as interest rates,foreign exchange rates, or equity prices.

• Liquidity risk which is the potential that abranch will be unable to meet its obligationsas they come due because of an inability toliquidate assets or obtain adequate funding(referred to as ‘‘funding liquidity risk’’) or thatit cannot easily unwind or offset specificexposures without significantly lowering mar-ket prices because of inadequate market depthor market disruptions (‘‘market liquidity risk’’).

• Operational risk1 which arises from thepotential that inadequate information systems,operational problems, breaches in internal con-trols, fraud, or unforeseen catastrophes willresult in unexpected losses.

• Legal riskwhich arises from the potential thatunenforceable contracts, lawsuits, or adversejudgments can disrupt or otherwise negativelyaffect the operations or condition of the branch.

• Reputational riskwhich is the potential thatnegative publicity regarding a branch or itsparent bank will cause a decline in the cus-tomer base, costly litigation, or revenuereductions.

ELEMENTS OF RISKMANAGEMENT

When rating the quality of risk management atbranches, examiners should place primary con-sideration on findings relating to the followingelements of a sound risk management system:

• active senior management oversight at thehead office, regional management office (ifapplicable) and local branch levels;

• adequate policies, procedures, and limits; and• a strong management information system for

measuring, monitoring and reporting risks.

Each of these elements is described furtherbelow, along with a list of considerations rel-evant to assessing the adequacy of each element.

Examiners should recognize that the consid-erations specified in these guidelines are intendedonly to assist in the evaluation of risk manage-ment practices and not as a checklist of require-ments for each branch.

Adequate risk management programs can varyconsiderably in sophistication, depending on thesize and complexity of the FBO and its branchnetwork and the level of risk that it accepts.Examiners need to ensure that senior managers

1. While operational, legal and reputational risks are iden-tified as part of the branch’s overall risk assessment process,the effectiveness of the branch’s operational controls areincluded in the ‘‘O’’ component of the ROCA rating systemassessment. Further, when legal and reputational risks poten-tially result in violations of law or regulation, the ‘‘C’’component would also be impacted.

Branch and Agency Examination Manual September 1997

at the head office and/or at the regional manage-ment office are provided with the informationthey need to monitor and direct day-to-dayactivities of the branch.

The risk management processes of brancheswould typically contain detailed guidelines thatset specific prudential limits on the principaltypes of risks relevant to the FBO’s activitiesworldwide. Reporting systems should comprisean adequate array of reports that provide thelevels of detail about risk exposures that arerelevant to the duties and responsibilities ofsenior management at the head office and, whereapplicable, the regional management office.

The risk management systems will naturallyrequire independent monitoring and testing inaddition to review by internal or external audi-tors to ensure the integrity of the informationused by senior officials in overseeing compli-ance with policies and limits. The risk manage-ment systems or units of FBOs must also besufficiently independent of the business lines inorder to ensure an adequate separation of dutiesand the avoidance of conflicts of interest.

ACTIVE HEAD OFFICE SENIORMANAGEMENT OVERSIGHT

As part of its responsibility to provide a com-prehensive system of oversight for the branch,the head office has a role in developing andapproving a risk management system for thebranch. Senior management at the head office,regional management office and local branchlevels are responsible for implementing strate-gies in a manner that limits risks associated witheach strategy, and that ensures compliance withlaws and regulations on both a long-term andday-to-day basis. Accordingly, branch manage-ment should be fully involved in the activities ofthe branch and possess sufficient knowledge ofall major business lines to ensure that appropri-ate policies, controls, and risk monitoring sys-tems are in place and that accountability andlines of authority are clearly delineated. Man-agement is also responsible for establishing andcommunicating a strong awareness of and needfor effective internal controls and high ethicalstandards.

In assessing the quality of the oversight byhead office, regional and branch management,examiners should consider whether the branch

follows policies and practices such as thefollowing:

• Management has identified and clearlyunderstands the types of risks inherent in theactivities of the branch and makes appropriateefforts to remain informed about these risks asfinancial markets, risk management practices,and the branch’s activities evolve. Manage-ment periodically reviews risk exposure limitsto ensure they are appropriate consideringchanging circumstances.

• Management has reviewed and approvedappropriate policies to limit risks inherent inall significant activities of the branch, includ-ing lending, investing, trading, private bank-ing, and trust.

• Management is sufficiently familiar with andis using adequate recordkeeping and reportingsystems to measure and monitor the majorsources of risk to the branch.

• Management ensures that the branch’s areasof activities are managed and staffed by per-sonnel with knowledge and experience con-sistent with the nature and scope of theseactivities.

• Management ensures that the depth of staffresources is sufficient to operate and managethe activities of the branch and that branchemployees have the necessary integrity, ethi-cal values, and competence.

• Management at all levels provides adequatesupervision of the day-to-day activities of allemployees, including senior officers.

• Management is able to respond to risks thatmay arise from changes in the competitiveenvironment or from innovations in marketsin which the branch is active.

• Management identifies and reviews all risksassociated with new activities or products andensures that the branch infrastructure andinternal controls in place are adequate tomanage related risks prior to commencingnew activities or offering new products.

ADEQUATE POLICIES,PROCEDURES AND LIMITS

Head office management should tailor risk man-agement policies and procedures to the types ofrisks that arise from the activities the branchconducts. Once the risks are properly identified,the branch’s policies and procedures provide

3000.1 Risk Management Introduction

September 1997 Branch and Agency Examination Manual

detailed guidance for the day-to-day implemen-tation of broad business strategies, and generallyinclude limits designed to shield the branchfrom excessive or imprudent risks. While allbranches should have policies and proceduresthat address significant activities and risks, thecoverage and level of detail in these policies andprocedures will vary among branches. A smaller,less complex branch that has effective manage-ment that is actively involved in day-to-dayoperations generally would be expected to haveonly basic policies addressing the significantareas of operations and setting forth a limited setof requirements and procedures. In a largerbranch, where senior management must rely onwidely-dispersed staff to implement strategies inan extended range of potentially complex busi-nesses, far more detailed policies and relatedprocedures would generally be expected. Ineither case, management is expected to ensurethat policies and procedures address the materialareas of risk to the FBO and the branch and thatthey are modified when necessary to respond tosignificant changes in the branch’s activities orbusiness conditions.

In evaluating the adequacy of a branch’spolicies, procedures and limits, examiners shouldconsider whether:

• The branch’s policies, procedures and limitsprovide for adequate identification, measure-ment, monitoring and control of the risksposed by lending, investing, trading, privatebanking, trust and other significant activities.

• The branch’s policies, procedures and limitsare consistent with the experience level, statedgoals and objectives, and overall financialstrength of the organization.

• Policies clearly delineate accountability andlines of authority across the branch’s activities.

EFFECTIVE RISK MONITORINGAND MANAGEMENTINFORMATION SYSTEMS

Effective risk monitoring requires branches toidentify and measure all risk exposures. Conse-quently, risk monitoring activities must be sup-ported by information systems that provide seniormanagers at the head office, regional office, and

branch with timely reports on the financialcondition, operating performance, and riskexposure of the consolidated organization, aswell as with regular and sufficiently detailedreports for line managers to engage in theday-to-day management of the branch’s activities.

The sophistication of the risk monitoring andmanagement information systems should be con-sistent with the complexity and diversity of thebranch’s operations. Accordingly, smaller andless complicated branches may require only alimited set of management reports to supportrisk monitoring activities. These reports include,for example, daily or weekly balance sheets andincome statements, a watch list for potentiallytroubled loans, a report for past due loans, asimple interest rate risk report, and similaritems. Larger, more complex branches, however,would be expected to have much more compre-hensive reporting and monitoring systems thatallow, for example, for more frequent reporting,tighter monitoring of complex trading activities,and the aggregation of risks on a fully consoli-dated basis across all business lines and activi-ties. Branches of all sizes are expected to haverisk monitoring and management informationsystems in place that provide senior manage-ment with a clear understanding of the branch’spositions and risk exposures.

In assessing the adequacy of the measurementand monitoring of risk as well as managementreports and information systems at a branch,examiners should consider whether:

• The branch’s risk monitoring practices andreports address all risks.

• Key assumptions, data sources, and proce-dures used to measure and monitor risk areappropriate, adequately documented and peri-odically tested.

• Reports and other forms of communicationare consistent with the activities of the branch,are structured to monitor exposures and com-pliance with established limits, goals andobjectives, and, as appropriate, compareexpected to actual performance.

• Reports to head office are accurate and timelyand contain sufficient information for seniormanagement to identify any adverse trendsand to evaluate the level of risk assumed bythe branch.

Risk Management Introduction 3000.1

Branch and Agency Examination Manual September 1997

Credit Risk ManagementEffective date July 1997 Section 3010.1

CREDIT RISK

This section is devoted to credit risks associatedwith direct lending arrangements. The compre-hensiveness of a credit risk management systemwill depend upon the sophistication and typesof credit-related activities being conducted bythe branch. In some circumstances, a branchmay have no independent lending authority andmay simply serve as a booking office for loansapproved by the head office. A more activebranch may, however, have an independent creditreview department and established lendingauthorities. Therefore, credit policies, proce-dures, and documentation may vary significantly.

This section will assist the examiner inperforming two separate, but interrelated,procedures:

• The evaluation of the depth and scope offormalized policies and procedures used bythe branch to manage and control its creditrisks.

• An overview of the performance of thebranch’s entire lending operations by evaluat-ing the results of all lending departments.

Branch Credit Administration Policies

As part of the analysis of a branch’s loanportfolio, examiners review credit policies, creditadministration procedures, and credit risk con-trol procedures. The maintenance of prudentwritten lending policies, effective internal sys-tems and controls, and thorough loan documen-tation is essential to the institution’s manage-ment of the lending function.

The policies and procedures governing abranch’s lending activities must be clearly com-municated to management and lending staff.These policies and procedures must define pru-dent underwriting standards, credit risk controls,prudent internal limits, and an effective creditreview and risk identification process. The com-plexity and scope of these policies and proce-dures should be appropriate to the size andnature of the branch’s activities, and should beconsistent with prudent banking practices andapplicable federal and state laws and regulations.

The establishment of a written lending policyprovides the foundation for sound loan portfolio

management. Throughout this manual there isconsiderable emphasis on the establishment offormal written policies to guide and manage thescope of the branch’s activities within accept-able risk parameters, and to achieve comprehen-sive, ongoing oversight by branch and headoffice management. This is perhaps the mostimportant element in the branch lending func-tion. The banking organization, in dischargingits duty to both the depositors and shareholders,must ensure that loans in the branch portfolioare made in accordance with the following twoobjectives:

• To grant loans to creditworthy borrowers forconstructive purposes.

• To grant loans that generate income for thebenefit of shareholders and the protection ofdepositors, and in the case of branches, theprotection of third parties.

A loan policy will differ from loan proce-dures. Branches need both to adequately addressall areas of lending and loan administration. Thelending policy should contain a general outlineof the scope of the branch’s credit facilities andthe manner in which loans are made, serviced,and collected. The policy should be broad innature and not overly restrictive. The formula-tion and enforcement of inflexible rules not onlystifles initiative but also may hamper profitabil-ity and prevent the branch from serving custom-ers’ changing needs. A lending policy shouldprovide for the presentation to the head office ora committee thereof, of loans that credit officersbelieve are fundamentally sound and worthy ofconsideration, even though they may not con-form with certain aspects of the branch’s writtenlending policy. Any exceptions to the lendingpolicy should be approved, documented, moni-tored and reported to head office. Flexibilitymust exist to allow for fast reaction and earlyadaptation to changing conditions in the branch’searning assets mix and within its service area.

The written loan policy is the cornerstone forsound lending and loan administration. Anadequate loan policy serves to promote:

• Consistency in business and lending philoso-phy, despite changes in management.

• Stability as it provides a reference for lendingauthorities.

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• Clarity to minimize confusion concerning lend-ing guidelines.

• Objectivity as it provides sound guidelines forevaluating new business opportunities.

In developing the lending policy, consider-ation must be given to the branch’s businessplan, financial resources, and personnel. Typi-cally, a branch’s lending policy will be used todescribe the branch’s mission statement, e.g.,facilitating trade transactions with the homecountry and lending to U.S. subsidiaries of homecountry corporations.

A lending policy should prohibit discrimina-tory practices. However, a policy should identifyacceptable and unacceptable types of credit andestablish prudent underwriting standards, includ-ing pricing standards. Other internal factorsaddressed include granting credit authority,establishing lending limits, and defining organi-zational structure. As authority is spread through-out its offices, the organization must have aneffective method for monitoring adherence toestablished policy. The testing of credit qualitystandards can best be accomplished by an inter-nal loan review and reporting function to thehead office, which allows senior head officemanagement to monitor adherence to policiesand provides information sufficient to evaluatethe performance of branch officers and thecondition of the loan portfolio. The audit func-tion can also serve to enforce compliance withpolicies, guidelines, and approved credit admin-istration practices.

Components for a Sound LendingPolicy

The lending policy should require diversifica-tion within the portfolio and provide prudentunderwriting standards. There are certain com-ponents that form the basis for a sound loanpolicy and should be addressed by every lendinginstitution.

Aggregate Limits and Distributions byCategory—In order to limit the total amount ofloans outstanding, relationships with other bal-ance sheet accounts should be established.Branches usually express controls over the loanportfolio relative to their total claims on nonre-lated parties. In setting such limits, variousfactors, such as credit demand, legal lending

limit, borrower or industry concentration, thevolatility of funding and the credit risks involvedmust be considered. Additionally, limits onaggregate percentages of total loans in commer-cial, real estate, consumer, or other categoriesare common. Such policies are beneficial butshould allow for deviations with the approval bythe head office. This allows credit to be distrib-uted in relation to the changing needs of thetarget markets.

Geographic Limits—A branch’s trade areashould be clearly delineated and loan officersand senior management should be fully aware ofspecific geographic limitations for lending pur-poses. Although many branches will define theirtrade areas to include a number of states, fre-quently, the primary calling efforts are focusedon a narrower area. Certain types of lending,which require significant knowledge of localmarket conditions or intensive monitoring ofbranch personnel, should be carefully consid-ered. Examples include commercial loans tolarge regional companies, loans to finance com-mercial real estate projects, or asset based lend-ing that requires regular monitoring of accountsreceivables. In addition, the branch’s definedtrade area should not be so large that, given itsresources, proper and adequate monitoring andadministration of the branch’s credits cannot bereasonably determined.

Concentrations of Credit—The loan policyshould recognize the need for diversification ofrisk and establish some parameters on concen-trations of loans to industries, related groups ofborrowers, loans collateralized by a single secu-rity or securities with common characteristics,and loans to borrowers with common character-istics within an industry.

Examiners should recognize that as a part of alarger banking entity, individual branches mayhave concentrations that are well within properdiversification in the context of the overallorganization. Many branches specialize in termsof the kind of business transacted and the typesof credits extended. Many credits are trade-related and often reflect the economic makeupof the branch’s home country. In addition, cred-its at the branch are often booked at the directionof the head office and can reveal concentrationby industry, country, or borrower. Nonetheless,branches, as part of a sound risk managementsystem, must establish procedures for identify-

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ing and monitoring inherent risk resulting fromconcentrations of credit.

Institutions that have effective controls inplace to manage and reduce undue concentra-tions need not refuse credit to sound borrowerssimply because of the borrower’s industry orgeographic location. It is important to empha-size that this principle applies to loan renewals,rollovers, and new extensions of credit.

Types of Loans—The lending policy shouldstate the types of loans that the branch will makeand should set forth guidelines to follow inmaking specific loans. The decision about thetypes of loans to be granted should be based ona consideration of the business plan, expertise ofthe lending officers and support personnel, thefunding structure of the branch, and anticipatedcredit demands of the target markets. Creditsinvolving complex structures or repaymentarrangements or loans secured by collateral thatrequire more than normal policing should beavoided unless or until the branch obtains thenecessary personnel, policies, controls, and sys-tems to properly administer such loans. Types ofcredits that have resulted in an abnormal loss tothe branch should be identified, scrutinized, andcontrolled within the framework of stated policy.

Repayment Terms and Maximum Maturities—Loans should be granted with realistic repay-ment plans. Maturity scheduling should berelated to the anticipated source of repayment,the purpose of the loan, and the useful life of thecollateral. For term loans, a lending policyshould state the maximum number of monthsover which loans may be amortized. Specificprocedures should be developed for situationsrequiring balloon payments and modification ofthe original terms of a loan. If the branchrequires a cleanup (out-of-debt) period for linesof credit, the period should be explicitly stated.

Loan Pricing—Rates on various loan typesestablished by the loan policy must be sufficientto cover the costs of the funds loaned, ofservicing the loan, including general overheadand of probable losses while providing for areasonable margin of profit. Policy makers mustknow those costs before establishing rates thatarise out of an effective risk management pro-cess. Periodic review allows the rates to beadjusted to reflect changes in costs, competitivefactors, or the risks associated with the type ofextension of credit. Specific guidelines for other

relevant factors, such as commitment fees, arealso germane to pricing policy.

Documentation and Collateral—Trade financ-ing often represents a significant amount of thebranch’s lending activity. In such financing, thebranch deals only in documents while its cus-tomer is responsible for the merchandise underthe terms of the contract. The branch’s controlof documents, especially title documents, iscrucial. There are significant differences betweendomestic loan agreements and foreign ones.Nevertheless, the branch must ensure that it isadequately protected through loan agreementswith foreign borrowers. The loan agreementshould also protect against adverse changes inforeign tax rules, loan funding problems, andadditional withholding and other types of taxes.The branch should have policies for takingforeign collateral as security for a loan to assureadherence with the local required procedures.For example, liens on fixed assets in manycountries must be registered with the localgovernment.

Maximum Ratio of Loan Amount to CollateralValue or Acquisition Costs—The branch’s lend-ing policy should identify where the responsi-bility for appraisals or internal evaluations liesand should define formal, standard appraisal,and evaluation procedures, and procedures forpossible reappraisals or reevaluations in the caseof renewals or extensions. Acceptable types ofappraisals or evaluations should be listed. Thepolicy should also include the limits on thedollar amount and type of real or personalproperty that branch personnel are authorized toappraise. Circumstances regarding the use ofin-house appraisers versus a fee appraiser shouldbe identified. The ratio of loan amount to thevalue of the collateral, the method of valuation,and the differences for various types of propertyshould be detailed.

Financial Information—Extending credit ona safe and sound basis depends on complete andaccurate information regarding the borrower’scredit standing. One exception is when the loanis predicated on readily marketable collateral,the disposition of which was originally desig-nated as the source of repayment for the advance.Current and complete financial information isnecessary not only at the inception of the creditbut also throughout the term of the credit. Thelending policy should define the requirements of

Credit Risk Management 3010.1


financial statement information for various typesof credit extended by the branch. In addition, thelending policy should define the requirementsfor financial statements and operating data forbusinesses and individuals at various borrowinglevels and should include requirements foraudited, non-audited, annual, interim, income,cash flow and other financial statements, taxreturns, changes in owner’s equity and othersupporting notes, schedules, and managementanalyses. Financial statement requirements shouldinclude external credit checks required at thetime of periodic updates. The policy shoulddefine the financial requirements in such amanner that any credit data exception in anexamination report should be a clear contraven-tion of the branch’s lending policy.

Financial statements for foreign borrowers orguarantors may present additional risks or prob-lems not associated with domestic borrowers.Foreign customers’ financial statements may beprepared in either U.S. dollar equivalents or inthe borrower’s local currency. Most branchesanalyze the latter statements, particularly if thatcurrency is unstable, therefore figures stated inU.S. dollar equivalent amounts would be dis-torted by the conversion rates used at varioustimes. Sometimes, the branch may need toreconstruct a borrower’s financial statement inU.S. dollar equivalents to reflect the borrower’sfinancial strength and weaknesses more accu-rately. Since the financial information may notbe reliable, the branch’s policies should enable itto determine by other means the capacity, integ-rity, experience and reputation of the foreignborrower. While analyzing foreign borrowers’financial statements, examiners should take intoconsideration the differences in foreign account-ing practices from the generally acceptedaccounting principles (GAAP) in the UnitedStates.

Limits on Country Exposures—The loan pol-icy should define maximum exposures to coun-tries other than the United States. All sizeableexposures should be supported by country analy-ses and other supporting information. Countrylimits should be consistent with the creditwor-thiness of the respective countries.

Limits and Guidelines for Purchasing andSelling Loans Either Directly or Through Par-ticipations or Swaps—If sufficient loan demandexists, lending within the branch’s trade area issafer and less expensive than purchasing paper

from another bank. Direct lending promotescustomer relationships, serves the credit needsof customers, and develops additional business.In some instances, however, a branch may notbe able to make a loan to a customer for the fullamount requested because of prudential lendinglimitations or other reasons. In such situations,the branch may extend credit to its customer forthe full amount needed and sell or participateout that portion that exceeds the branch’s lend-ing limit or the amount it wishes to extend on itsown. Generally, such sales arrangements areestablished before the credit is ultimatelyapproved. These sales should be on a nonre-course basis to the branch and the originatingand purchasing institutions should share in therisks and contractual payments on a pro ratabasis. Selling or participating out portions ofloans to accommodate the credit needs of cus-tomers promotes goodwill and enables a branchto retain customers who might otherwise seekcredit elsewhere.

Conversely, many branches purchase loans orparticipations in loans originated by other orga-nizations. The policy should require that loanspurchased from another source be evaluated inthe same manner as loans originated by thebranch itself. Generally, the branch should avoidconcentrations in purchasing loans from any oneoutside source or concentrations in purchases ofloans to any one industry.

Purchasing and selling loans can have alegitimate role in a branch’s asset and liabilitymanagement and can contribute to the efficientfunctioning of the financial system. In addition,these activities can assist a branch in diversify-ing its risks and improving its liquidity.

The policy should state the limits for theaggregate amount of loans purchased from andsold to any one outside source and for all loanspurchased and sold. Limits should also beestablished for the aggregate amount of loans toparticular types of industries that may be pur-chased. Guidelines should be established for thetype and frequency of credit and other informa-tion that should be obtained from the leadinstitution in order to keep the branch continu-ally updated on the financial condition of theborrower and the status of the credit. Because ofthe inherent reliance on the lead institution toadminister and collect participated loans, thepurchasing branch should evaluate the leadinstitution’s ability to properly carry out theseresponsibilities. Conversely, guidelines shouldalso be established for supplying complete and



regularly updated credit information to the pur-chasers of loans originated and sold by thebranch.

Loan Authority—The lending policy shouldestablish limits for all lending officers. In manybranches of FBOs, most lending authorityremains with the head office. If lending policiesare clearly established and enforced, individualofficer limitations may be somewhat higher,based on the officer’s experience and tenurewith the branch. Frequently, group lending lim-its are set, allowing a combination of officers ora committee to approve larger loans than themembers would be permitted to approve indi-vidually. The reporting procedures and the fre-quency of committee meetings should be defined.

Collections, Charge-Offs, and SpecificReserves—The lending policy should definedelinquent obligations and contain guidelinesfor placing loans on nonaccrual status and initi-ating foreclosure proceedings. Delinquency sta-tus is determined by the contractual terms anddefined as when the principal or interest on anasset becomes due and unpaid for 30 days ormore. For regulatory reports, branches mustcomply with the reporting requirements for pastdue and nonaccrual loans. Additionally, thepolicy should dictate the appropriate reports tobe submitted to the head office concerning thoseobligations. The reports should include suffi-cient detail to allow for the determination of theloss potential and alternative courses of action.The policy should require a follow-up collectionnotice procedure that is systematic and progres-sively stronger. Guidelines should be estab-lished to ensure that all accounts are presentedto and reviewed by the head office for charge-offs or specific reserves in accordance withapplicable regulatory policy.

Legal Lending Limits—The lending policymay describe limitations on loans to one bor-rower, as are consistent with head office and/orfederal requirements. The Foreign Bank Super-vision Enhancement Act of 1991 supersededstate legal lending limits to the extent thatexposures to a single borrower by all state andfederal branches of the same FBO must beaggregated and applied against the capital of theFBO (12 USC 84.)

Other—The lending policy should be supple-mented with other written guidelines for specific

departments of the branch. Written policies andprocedures approved and enforced in variousdepartments should be referenced in the generallending policy of the branch.

Management should establish appropriate poli-cies, procedures, and information systems toensure that the impact of the branch’s lendingactivities on its interest rate exposure is care-fully analyzed, monitored, and managed. In thisregard, consideration should also be given to therisks associated with off-balance sheet instru-ments related to lending arrangements, such asloan commitments and swaps.

Approval Process

In addition to the components that form thebasis for a sound lending policy, there should bea documented approval process for exceptionsto that policy, including the need for approval ofexceptions by the head office. Managementinformation systems should report and highlightloan exceptions to branch management and thehead office.

Before a branch extends credit, its objectives,policies, and practices must be clearly estab-lished. Before examining a loan department,those objectives, policies, and practices shouldbe reviewed by the examiner to determine ifthey are reasonable and adequate to properlysupervise the portfolio. The absence of writtenguidelines is a major deficiency in the lendingarea and may indicate that the branch is notbeing properly supervised by its head office. Thevarious credit extending areas should be exam-ined to determine compliance with objectives,policies, and practices, which is a prime exami-nation objective.

Loan Information Systems

The loan information system should include theloan policy and loan administration procedures,loan documentation maintained for borrowers,reports prepared for the benefit of senior man-agement at the branch or at the head office, theloan grading and loan review system, and thesystem to manage problem loans.

Loan information and documentation shoulddemonstrate that the borrower has the abilityand willingness to repay the loan. These docu-ments should also indicate that the lending



officer has adhered to sound lending practices,acted prudently to safeguard the branch’s funds,and ensured repayment of the loan by all rea-sonable means. Loan information and otherdocumentation supporting an extension of creditshould be in English to enable the examiner toproperly evaluate the quality of the credit.

In general, loan documents should provideanswers to the following questions:

• Who is the borrower, including ownership andaffiliations?

• How did the borrower come to the branch?• What is the borrower’s business?• What is the purpose of the credit?• What are the primary and secondary sources

of repayment?• What is the borrower’s financial condition?• What are projections for the borrower’s future

financial performance?• How has the borrower performed on other

credit obligations?• What is the collateral for the loan, its location,

value, and condition?

If guarantees are involved, the branch musthave sufficient information on the guarantor’sfinancial condition. Income, liquidity, cash flows,contingent liabilities, and other relevant factorsshould be evaluated, including credit ratings,when available, to demonstrate the guarantor’sfinancial capacity to fulfill the obligation. Gen-erally, however, loan quality should be evalu-ated based on the primary source of payment notsecondary sources, such as guarantees. In thisrespect, guarantees from head office are notviewed as providing support to a loan.

An effective system to obtain and maintaincomplete and current loan information and docu-mentation is a necessary component of soundlending. Failure to establish and enforce thissystem will increase credit risk and cause thebranch to suffer losses that could have beenavoided.

Before the loan is funded, the branch mustensure that all the required documentation iscurrent. It is generally easier to ensure completeand current documentation before the loan isfunded, as the borrower will be cooperative andthe loan has the lending officer’s full attention.

To ensure on-going attention to documenta-tion, the loan policy should require the branch toobtain and maintain current documentation onborrowers and collateral. The loan policy shouldalso ensure that loan documentation is reviewed

periodically and any exceptions are addressedpromptly.

INTERNAL LOAN REVIEW

Key Loan Review Objectives

Depending on the branch’s size, its lendingactivities, and management philosophy, loanreview may be handled by a part-time person,one person, an independent contractor, or aseparate department staffed by a number ofemployees at the branch, at a regional U.S.office, or at the head office. An importantingredient of loan review is that it must beindependent from the approval process. Regard-less of how loan review is structured, a satisfac-tory loan review system should have the follow-ing objectives:

• Provide an objective grading system for loans.• Provide current information regarding port-

folio risk to branch management and the headoffice on a timely basis.

• Identify problem credits and place them underadditional scrutiny.

• Assist in the evaluation of the adequacy ofspecific and general reserves in accordancewith applicable regulatory policy.1

• Evaluate trends in the loan portfolio.• Cite loan policy exceptions and noncompli-

ance with procedures.• Cite documentation exceptions.• Cite violations of laws and regulations.• Assist in the development and revision of

policy and procedures.• Act as an information source concerning

emerging trends in the portfolio and thebranch’s lending areas.

Loan Review Reporting

Loan review reporting must be thorough, accu-rate, and timely to provide sufficient informationto allow management and the head office to both

1. Branches are not required to maintain an allowance forloan losses for Federal Reserve supervisory purposes. How-ever, it is recognized that the licensing and insuring authoritiesmay require U.S. branches to maintain such reserves undertheir respective jurisdictions to fulfill the requirements of theirindividual licensing or insurance statutes, or to satisfy otherspecific concerns of the authority.



identify and control risk. At a minimum, thereshould be three types of reporting required fromloan review: file memoranda, head office reports,and an annual schedule or loan review plan.

File memoranda are completed after eachloan is reviewed and are placed in the credit fileto document the reviewer’s conclusions. Loangrades and supporting facts should be included,along with any instances of noncompliance withthe branch’s policy, procedures and applicableregulations. Documentation exceptions shouldalso be indicated.

If the process is conducted by the lendingofficers themselves, then compliance with poli-cies and procedures is best determined by anotherbranch department, such as internal audit.

Head office/management reports are summa-ries of the loan reviewer’s conclusions regardingthe quality of the portfolio or segment of theportfolio. These reports should state the scope ofthe review; the distribution of loan grades forthe portfolio or segment of the portfolio; thepercentage of both collateral and financial docu-mentation exceptions; all instances of noncom-pliance with policies, procedures, or regulations;an assessment of the overall quality of theportfolio; and the resulting impact on the allow-ance for loan losses, where applicable, and anyother factors that might have an adverse effecton the portfolio.

These reports should go to head office man-agement. If applicable, a copy of these reportscan also be given to U.S. regional management,the manager of the loan department, and thebranch’s executive management; however, man-agement should not be allowed to influence thecontent of the report. The head office should begiven this report on a timely basis and requirelending officers to correct and respond to allsignificant problems and exceptions within aspecified time frame.

Although a good loan review system isimportant to ensure sound lending and strongloan administration, excessive reliance shouldnot be placed on this system. It is always thelending officers’ responsibility to maintain soundunderwriting standards and loan quality. It isalso their responsibility to monitor the portfolioon an ongoing basis and to initially identifyproblem credits. Loan review should not be thefirst line of defense to identify emerging prob-lems. Its primary responsibility is to identifyweaknesses in lending and loan administrationand their underlying causes.

Loan Problems

The failure of branch and head office manage-ment to establish a sound lending policy, toestablish adequate written procedures, and tomonitor and administer the lending functionwithin established guidelines may result in sub-stantial problems for the branch. Loan problemsmay be caused by a number of factors affectingthe branch or its borrowers, such as thefollowing:

Anxiety for Income—The loan portfolio isusually the branch’s most important revenueproducing asset. However, the pursuit of earn-ings must never be permitted to override soundunderwriting principles by extending credit thatcarries undue risks or unsatisfactory repaymentterms. Over the long term, unsound loans usu-ally cost far more than the revenue they produce.

Compromise of Credit Principles—Branchmanagement, for various reasons, may know-ingly grant loans carrying undue risks or unsat-isfactory terms in violation of its own underwrit-ing standards. These reasons may include headoffice relationships with associated companiesof the branch’s customer. Self-dealing, anxietyfor income, inappropriate salary incentives,bonuses based on loan portfolio growth, andcompetitive pressures may also lead to a com-promise of sound credit principles.

Incomplete Credit Information—Character andcapability may be determined by many meansbut complete credit information is the onlyacceptable and reasonably accurate method fordetermining a borrower’s financial condition.The lack of sufficient financial information is animportant cause of problem credits. Current andcomplete comparative financial statements,operating reports, and other pertinent statisticalsupport should be available. Other essentialinformation, such as the purpose of the borrow-ing, the intended plan and source of repayment,progress reports, inspections, and memorandaof outside information and loan conferences,should be contained in the branch’s credit files.Proper credit administration and accurate creditappraisals are not possible without suchinformation.

The Interagency Policy on Documentation ofLoans by U.S. Branches and Agencies of For-eign Banks, which was issued on May 14, 1993,



exempts these branches from certain docu-mentation requirements for credits to small andmedium-sized businesses and farm loans. (Referto the policy statement for specific limitations.)

Failure To Obtain or Enforce RepaymentAgreements—Loans granted without a clear writ-ten agreement governing repayment violate afundamental banking principle that frequently isa major cause of problem loans. Another com-mon cause of problem loans is when scheduledpayments or reductions are not collected inaccordance with the terms of the loan agreement.

Inadequate supervision of familiar borrowers.

Over-reliance on verbal information fur-nished by borrowers in lieu of reliable financialdata.

Downplaying of known credit weaknessesbecause of the borrower’s past history of over-coming recurrent hazards and distress.

Ignoring warning signs pertaining to theborrower, economy, region, industry, or otherrelated factors.

Lack of Supervision—Many loans that aresound at inception have developed into prob-lems and losses because of lack of effectiveon-going supervision.

Technical Incompetence—Able and experi-enced bankers should possess the technical abil-ity to analyze financial statements and to obtainand evaluate other credit information. Technicalincompetence often results in unexpected losses.

Overlending—Loans granted beyond the bor-rower’s reasonable capacity to repay are inher-ently unsound. Technical competence and soundcredit judgment are necessary in determining asound borrower’s safe, maximum loan level.

Competition—Competition among branchesfor size and market share may result in thecompromise of credit principles and the fundingof unsound loans.

Nonaccrual and Restructured Loans

Working in a prudent manner with borrowersthat are experiencing financial difficulties, branch

management may restructure loans or take othermeasures in recognition of borrowers’ conditionand repayment prospects. Such actions, if donein a way that is consistent with prudent lendingprinciples and supervisory practices, can improvea branch’s prospects for collection. Generallyaccepted accounting principles (GAAP) andregulatory reporting requirements provide aframework for working in a constructive fashionwith borrowers experiencing financial difficul-ties.

The Interagency Policy Statement on CreditAvailability, issued on March 1, 1991, presentedclarifications of a number of supervisory poli-cies regarding issues relating to nonaccrual assetsand restructured loans. These clarifications indi-cated that when certain criteria are met: (a) inter-est payments on nonaccrual assets can be rec-ognized as income on a cash basis, without firstrecovering any previous partial charge-offs;(b) nonaccrual assets can be restored to accrualstatus when subject to formal restructuring inaccordance with Financial Accounting Stan-dards Board (FASB) Statement No. 15; and(c) restructuring that yields a market rate ofinterest would not have to be included in restruc-tured loan amounts reported in the years subse-quent to the year of the restructuring.

Nonaccrual of Interest

Loans and lease financing receivables are to beplaced in nonaccrual status if:

• They are maintained on a cash basis becauseof deterioration in the financial condition ofthe borrower.

• Payment in full of principal or interest is notexpected; or

• Principal or interest has been in default for aperiod of 90 days or more, unless the loan isboth well secured and in the process ofcollection.

A debt is well secured if it is secured (a) bycollateral in the form of liens on or pledges ofreal or personal property, including securities,that have a realizable value sufficient to dis-charge the debt, including accrued interest, infull, or (b) by the guarantee of a financiallyresponsible party. A debt is in the process ofcollection if collection of the asset is proceedingin due course either through legal action, includ-



ing judgment enforcement procedures or, inappropriate circumstances, through collectionefforts not involving legal action, which arereasonably expected to result in repayment ofthe debt or in its restoration to a current status inthe near future.

Treatment of Cash Payments and Criteria forthe Cash Basis Recognition of Income—Whendoubt exists as to the collectibility of the remain-ing book balance of a loan in nonaccrual status,any payments received must be applied to reduceprincipal to the extent necessary to eliminatesuch doubt. Placing an asset in nonaccrual statusdoes not, in and of itself, require a charge-off, inwhole or in part, of the asset’s principal. How-ever, identified losses must be charged-off. Whena loan is in nonaccrual status, some or all of thecash interest payments received may be treatedas interest income on a cash basis if the remain-ing book balance of the asset, after a charge-off,if any, is deemed to be fully collectible. Abranch’s determination as to the ultimate col-lectibility of the asset’s remaining book balancemust be supported by a current, well-documentedcredit evaluation of the borrower’s financialcondition and prospects for repayment, includ-ing consideration of the borrower’s historicalrepayment performance and other relevantfactors.

When recognition of interest income on acash basis is appropriate, the amount of incomethat is recognized should be limited to thatwhich would have been accrued on the loan’sremaining book balance at the contractual rate.For a formally restructured loan, the effectiveinterest rate should be used. Any cash interestpayments received in excess of this limit, andnot applied to reduce the loan’s remaining bookbalance, should be recorded as recoveries ofprevious charge-offs, until these charge-offs havebeen fully recovered.

Restoration to Accrual Status—According tothe Revised Interagency Guidance on ReturningCertain Nonaccrual Loans to Accrual Statusissued June 10, 1993, nonaccrual loans may bereturned to accrual status, even though the loanshave not been brought fully current, providedtwo criteria are met: (1) all principal and interestamounts contractually due, including arrearages,are reasonably certain of repayment within areasonable period and (2) there is a sustainedperiod of repayment performance (generally aminimum of six months) by the borrower, in

accordance with the contractual terms, involv-ing payments of cash or cash equivalents. How-ever, loans that meet these criteria would con-tinue to be disclosed as past due and stillaccruing for purposes of the Report of Assetsand Liabilities (call report), until they have beenbrought fully current.

For purposes of meeting the first test, thebranch must have received repayment of thepast due principal and interest unless, as dis-cussed below, the loan has been formallyrestructured and qualifies for accrual status orthe asset has been acquired at a discount (becausethere is uncertainty as to the amounts or timingof future cash flows) from an unaffiliated thirdparty and meets the criteria for amortization,i.e., accretion of discount, specified in AICPAPractice Bulletin No. 6.

Until the loan is restored to accrual status,cash payments received must be treated inaccordance with the criteria stated above. Inaddition, after a formal restructuring, if a restruc-tured loan that has been returned to accrualstatus later meets the criteria for placement innonaccrual status as a result of past due statusbased on its modified terms or for any otherreasons, the asset must be placed in nonaccrualstatus. Under GAAP, when a charge-off wastaken before the date of the restructuring, thecharge-off does not have to be recovered beforethe restructured loan can be restored to accrualstatus. When a charge-off occurs after the dateof the restructuring, the considerations and treat-ments discussed in the previous paragraphs inthis section are applicable.

Treatment of Multiple Extensions of Credit toOne Borrower—As a general principle, nonac-crual status for an asset should be determinedbased on an assessment of the individual asset’scollectibility and payment ability and perfor-mance. Thus, when one loan to a borrower isplaced in nonaccrual status, a branch does nothave to place all other extensions of credit tothat borrower in nonaccrual status. When abranch has multiple loans or other extensions ofcredit outstanding to a single borrower, and oneloan meets the criteria for nonaccrual status, thebranch should evaluate its other extensions ofcredit to that borrower to determine whether oneor more of these other assets should also beplaced in nonaccrual status.

Examiner Review—Some states have promul-gated regulations or adopted policies for nonac-



crual of interest on delinquent loans, which maydiffer from the above procedures. In such cases,the branch should comply with the more restric-tive policy. The examiner should ensure that thebranch is complying with such guidelines. In allinstances, whether or not there is a formalpolicy, each branch should formulate its ownpolicies to ensure that income is not beingoverstated. The examiner should review thebranch’s specific policy to ensure that it isprudent.

When a branch places a loan in nonaccrualstatus, it must determine an appropriate treat-ment for previously accrued but uncollectedinterest and subsequent payments. One accept-able method is to reverse all previously accruedbut uncollected interest against appropriateincome and balance sheet accounts. For interestaccrued in the current accounting period, theentry is made directly against the interest incomeaccount. For prior accounting periods, all inter-est previously recognized, if accrued interestprovisions had not been provided, would bereversed (expensed) against current earnings.

Generally accepted accounting principles donot require the write-off of previously accruedinterest if principal and interest are ultimatelyprotected by sound collateral values. A branch isexpected to have a well-defined policy govern-ing the write-off of accrued interest receivable.

Treatment of Nonaccrual Loans withPartial Charge-offs

Questions have been raised regarding whetherpartial charge-offs associated with a nonaccrualloan (that has not been formally restructured)must first be fully recovered before a loan can berestored to accrual status. GAAP and regulatoryreporting requirements do not explicitly addressthis issue.

When a loan has been brought fully currentwith respect to contractual principal and interestand the borrower’s financial condition and pros-pects for repayment have improved so that thefull amount of contractual principal, includingany amounts charged-off, and interest is expectedto be repaid, the loan may be restored to accrualstatus without having to first recover the charge-off. On the other hand, this treatment would notbe appropriate when the charge-off is indicativeof continuing doubt regarding the collectibilityof principal or interest. Because the criteria for

nonaccrual status include the requirement thatloans or other assets be placed in nonaccrualstatus when repayment in full of principal orinterest is not expected, such nonaccrual loansshould not be restored to accrual status.

It is imperative that the reasons for the resto-ration of a partially charged-off loan to accrualstatus be documented. Such actions should besupported by a current, well-documented creditevaluation of the borrower’s financial conditionand prospects for full repayment of contractualprincipal, including any amounts charged-off,and interest. This documentation will be subjectto review by examiners.

Renegotiated Troubled Debt

Renegotiated troubled debt includes those loansand lease financing receivables that have beenrestructured or renegotiated to provide conces-sions to the borrower, e.g., a reduction of inter-est or principal payments because of a deterio-ration in the financial position of the borrower.A loan extended or renewed at a stated rateequal to the current interest rate for new debtwith similar risk is not considered renegotiateddebt. For further information, see FinancialAccounting Standards Board Statement No. 15,Accounting by Debtors and Creditors forTroubled Debt Restructuring, (FASB StatementNo. 15).

Branches should develop a policy relative torenegotiated troubled debt to ensure that suchitems are identified, monitored, and properlyhandled from an accounting and control stand-point. Such items should be relatively infrequentin occurrence. If not, the branch is probablyexperiencing significant problems. Before suchconcessions are made to a borrower, it is goodpractice to have the transactions receive priorapproval of the head office. All such transac-tions should be reported to the head office uponenactment.

Nonaccrual Assets Subject to FASBStatement No. 15 Restructuring

The Policy Statement on Credit AvailabilityIssues indicated that a loan or other debt instru-ment that has been formally restructured, so asto be reasonably certain of repayment and per-



formance according to its modified terms inaccordance with a reasonable repayment sched-ule, need not be maintained in nonaccrual status.Furthermore, the policy statement indicated that,in returning the asset to accrual status, sustainedhistorical payment performance for a reasonabletime before the restructuring may be taken intoaccount.

For example, a loan may have been restruc-tured, in part, to reduce the amount of theborrower’s contractual payments. In so doing,the borrower’s restructured terms may requirepayments that do not exceed the amount andfrequency that have been demonstrated by thesustained historical payment performance of theborrower for a reasonable time before the loanwas restructured. In this situation, assuming thatthe restructured loan is reasonably certain ofrepayment and performance according to itsmodified terms, the loan can be immediatelyrestored to accrual status.

Clearly, a period of sustained performance,whether before or after the date of the restruc-turing, is an important factor in determiningwhether there is reasonable assurance of repay-ment and performance according to the loan’smodified terms. In certain circumstances, evi-dence may exist regarding other characteristicsof the borrower that may be sufficient to dem-onstrate a relative improvement in the borrow-er’s condition and debt service capacity, therebyreducing the degree of reliance on the borrow-er’s performance to date in assessing prospectsfor future performance and collectibility underthe modified terms. For example, substantial andreliable sales, lease, or rental contracts obtainedby the borrower, or other important develop-ments that are expected to significantly increasethe borrower’s cash flow and debt servicecapacity and strengthen the borrower’s commit-ment to repay, may be sufficient to provide thisassurance. In certain circumstances, a prepon-derance of such evidence, in and of itself, maybe sufficient to warrant returning a restructuredloan to accrual status, provided the loan underits restructured terms is reasonably certain ofperformance and full collectibility.

It is imperative that the reasons for the resto-ration of restructured debt to accrual status befully documented. Such actions should be sup-ported by a current, well-documented creditevaluation of the borrower’s financial conditionand prospects for repayment under the modifiedterms. This documentation will be subject toreview by examiners.

The formal restructuring of a loan or otherdebt instrument should be undertaken in waysthat improve the likelihood that the credit willbe repaid in full under the modified terms inaccordance with a reasonable repayment sched-ule. When a restructured loan is not reasonablycertain of repayment and performance under itsmodified terms in accordance with a reasonablerepayment schedule, the loan may not be restoredto accrual status.

When restructuring loans, regulatory report-ing requirements and GAAP do not requirebanking organizations to grant excessive con-cessions, forgive principal, or take other stepsnot commensurate with the borrower’s ability torepay in order to use the reporting treatmentspecified in FASB Statement No.15. Further-more, regulatory reporting requirements andGAAP do not preclude institutions from includ-ing prudent contingent payment provisions inthe restructured terms that permit an institutionto obtain appropriate recovery of concessionsinvolved in the restructuring, should the borrow-er’s condition substantially improve.

A nonaccrual loan or debt instrument mayhave been formally restructured in accordancewith FASB Statement No. 15 so that it meets thecriteria for restoration to accrual status pre-sented in the previous section that addressesrestructured loans. Under GAAP, when a charge-off was taken before the date of the restructur-ing, the charge-off does not have to be recoveredbefore the restructured loan can be restored toaccrual status. When a charge-off occurs afterthe date of the restructuring, the considerationsand treatments discussed in the previous para-graphs in this section are applicable.

Reporting of Loan Fees and Interest

The accounting standards for nonrefundable feesand costs associated with lending, commitmentsto lend, and purchasing a loan or group of loans,are set forth in FASB Statement No. 91, Account-ing for Nonrefundable Fees and Costs Associ-ated with Originating or Acquiring Loans andInitial Direct Costs of Leases. The statementapplies to all types of loans and to debt securi-ties but not to loans or securities carried atmarket value and to all types of lenders. It mustbe applied to all lending and leasing transactionsin fiscal years beginning after December 15,1987, but retroactive application is permitted.



For further information, see FASB StatementNo. 91.

All other lending-related costs, whether or notincremental, should be charged to expense asincurred, including costs related to activitiesperformed by the lender or by independent thirdparties for the lender, for advertising, identifyingpotential borrowers, soliciting potential borrow-ers, servicing existing loans, and other ancillaryactivities related to establishing and monitoringcredit policies, supervision, and administration.Employees’ compensation and fringe benefitsrelated to these activities, unsuccessful loanorigination efforts, and idle time should becharged to expense as incurred. Administrativecosts, rent, depreciation, and all other occu-pancy and equipment costs are considered indi-rect costs and should be charged to expense asincurred.

Net unamortized loan fees represent an adjust-ment of the loan yield and shall be reported inthe same manner as unearned income on loans,i.e., deducted from the related loan balances, tothe extent possible, or deducted from total loansin any unearned income on loans in the callreport, which provides a breakdown of varioustypes of loans. Net unamortized direct loanorigination costs shall be added to the relatedloan balances. Amounts of loan origination,commitment, and other fees and costs recog-nized as an adjustment of yield should bereported under the appropriate Interest incomeitem in the income statement. Other fees, suchas fees that are recognized during the commit-ment period or included in income when thecommitment expires, i.e., fees, retrospectivelydetermined, and fees for commitments, whereexercise is remote, and (b) syndication fees thatare not deferred, should be reported as othernoninterest income.

Other Lending Concerns

The transfer of low quality loans from onedepository institution to another may be made toavoid detection and classification during regula-tory examinations. Transfer may be accom-plished through participations, purchases/sales,and asset swaps with other affiliated or nonaf-filiated financial institutions. Examiners shouldbe alert to situations where a branch’s intentionseems to be the concealment of low quality

assets for the purpose of avoiding examinationscrutiny and possible classification.

During branch examinations, examiners shouldidentify situations where low quality assets havebeen transferred between the branch beingexamined and another U.S. branch of a foreignbank or other depository institution. Low qualityloans, broadly defined, include loans that areclassified or specially mentioned or if subjectedto review would most likely be classified orspecially mentioned, past due loans, nonaccrualloans, loans on which the terms have beenrenegotiated because of a borrower’s poor finan-cial condition, and any other loans that theexaminer believes are of questionable quality.

Examining the Lending Function

The results of the loan examination shouldprovide the examiner with a method of arrivingat an overall evaluation for the entire branchloan portfolio. Historically, examination resultshave identified problems in the loan area througha detailed review of credits and credit documen-tation. The examiner should also correlate thefollowing items with the overall system ofpolicies, practices, procedures, and controlsinstituted by the branch to prevent such problems:

• Identified problem credits.• Unsafe or unsound lending procedures.• Past due loans.• Credit documentary exceptions.• Violations of laws and regulations.• Concentrations of credit.• Evidence of self-dealing loan transactions.• Collateral documentary exceptions.

The purpose of this correlation is to determinecauses of existing problems and weak situations,which represent a potential weakness in thebranch’s risk management process.

The examiner performing the procedures inthis section should make the final decision as tothe quality of the entire portfolio, the quality ofmanagement review and controls, and the scopeand adequacy of internal guidelines. A greatdeal of judgment is necessary in making thosedecisions because they significantly affect theoverall conclusions reached by the examiner-in-charge. The process of compiling informationgenerated, analyzing it, and formulating conclu-sions about the causes of existing deficiencies,



requires considerable thought and judgement onthe part of the examiner. The ultimate conclu-sions concern the risk management of the lend-ing function, as it now exists, and as it isprojected for the future. Furthermore, the exam-iner is expected to discern causes of existing andpotential problems, to capsulize the causes andeffects, and to present the problems to branchmanagement in such a manner as to obtainpositive corrective action.

Regulatory Compliance

Branches are expected to comply with laws,regulations, and applicable regulatory policy inall aspects of their lending programs. Moreover,branches should establish adequate internal con-trols to detect deficiencies or exceptions to theirlending policy that result in unsafe and unsoundlending practices. In regard to applicable lend-ing limits, the examiner should review thebranch’s lending practices in accordance withthe applicable state laws in the following areasthat prescribe limits on aggregate advances to asingle borrower and related borrowers.

Commissions or Gifts for Procuring Loans. Abranch officer, employee, agent, or attorneyshould not receive anything of value for procur-ing or endeavoring to procure a loan, which isprohibited under 18 USC 215.

Political Contributions. Loans made in con-nection with any election to any political officeshould comply with applicable state bankinglaws and regulations and with the Foreign Cor-rupt Practices Act of 1977 (Pub. L. 95-213,91 Stat. 1494 (1977), 15 USC 78dd-1 and 2,78m, 78o, and 78ff) and the Federal ElectionCampaign Act (2 USC 441b).

Loans to Executives, Officers, and PrincipalShareholders of Correspondent Banks. No pref-

erential treatment should be given to loans toinsiders of correspondent banks nor should therebe the appearance of a conflict of interest. Thebranch should comply with Title VIII of theFinancial Institutions Regulatory and InterestRate Control Act of 1978 (FIRA) (12 USC1972(2)).

Appraisals and Evaluations. Federally-insuredbranches should obtain an appraisal or evalua-tion for all real estate-related financial transac-tions prior to making the final credit decision inconformance with Title XI of the FinancialInstitutions Reform, Recovery and EnforcementAct of 1989 (FIRREA) (12 USC 3310, 3331-3351). Appraisal and evaluation requirementsare separately discussed in the Real EstateAppraisals and Evaluations part of this section.

Consumer Compliance. The residential lend-ing program at a federally-insured branch shouldensure that the loan applicant is adequatelyinformed of the annual interest rate, financecharges, amount financed, total payments, andrepayment schedule, as mandated in the FederalReserve’s Regulation Z, Truth in Lending(12 CFR 226). The federally insured branch’sprocess for taking, evaluating, and accepting orrejecting a credit application is subject to theFederal Reserve’s Regulation B, Equal CreditOpportunity (12 CFR 202).

Credit Life Insurance Income. The branch’ssale of mortgage life insurance in connectionwith its real estate lending activity should com-ply with the sales practices, sales commissionlimits, and disclosure requirements as defined inthe Federal Reserve’s policy statement on thedisposition of credit life insurance income(67 Federal Reserve Bulletin 431 (1981),FRRS 3–1556).



Credit Risk ManagementExamination ObjectivesEffective date July 1997 Section 3010.2

1. To determine if policies, practices, proce-dures, and internal controls regarding creditrisk management are adequate.

2. To determine if branch officers are operatingin conformance with the establishedguidelines.

3. To determine the scope and adequacy of theaudit and loan review functions.

4. To determine the overall quality of the loanportfolio and how that quality relates to therisk management function of the branch.

5. To prepare information regarding the branch’slending function in concise reportable format.

6. To determine compliance with applicablelaws and regulations.

7. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations ofapplicable law or regulations have been noted.


Credit Risk ManagementExamination ProceduresEffective date July 1997 Section 3010.3

The following procedures are intended to deter-mine that the branch under examination hasestablished satisfactory procedures to ensurethat controls regarding credit risk managementare adequate. Examiner discretion is required inapplying these procedures. Before beginning theassignment, the examiner should review thescope memorandum and consult with theexaminer-in-charge or other designated indi-vidual to determine the scope of the review.Some of the procedures may not be necessary,based on the quality of the branch’s internalcontrols or the nature and level of activity in thearea.

1. If selected for implementation, complete, orupdate the Internal Control Questionnairefor this section.

2. Determine if deficiencies noted at previousexaminations and internal/external auditshave been adequately addressed bymanagement.

3. Reconcile the customer central liability led-ger or subsidiary loan ledgers to the generalledger.

4. Obtain the branch’s internal listing of SharedNational Credits and verify ratings withregulatory records.

5. Review the branch’s lending policies todetermine:

a. If the policies are adequate for the size,nature, and business of the bank.

b. If the branch is in compliance with itspolicies.

c. If the policies are reviewed and updatedperiodically to ensure they are relevantwith changing market conditions andnew business lines of the bank.

d. If policies have been approved by thehead office.

6. If applicable, review minutes of the branch’sloan committee meetings to determine:

a. Current members and their attendancerecord.

b. Scope of work performed.

c. Any information deemed useful in theexamination of specific loan categoriesor other areas of the branch.

LOAN REVIEW

In general, a loan review program should pro-vide an independent means to identify credit andloan administration weaknesses, provide accu-rate and timely reports to management detailingweaknesses discovered, and provide a means forrecognizing potential problems.

7. Determine if the loan review programensures independence from the lending func-tion including whether:a. Policies specifically address the separa-

tion of loan review from the lending andcredit approval functions.

b. The loan review function reports directlyto the head office, a regional office, or asenior branch officer not involved in thelending function. If not, determine if thebranch has adequate controls to ensureindependence from the lending function.

8. Determine if the frequency of loan review isadequate, and if the program includes:a. A minimum frequency of reviews.b. A frequency which is sufficient to pro-

vide timely information concerningemerging trends in the portfolio andgeneral economic conditions.

c. Increased frequency for identified prob-lem credits.

9. Evaluate the adequacy of the scope of theloan review, including:a. Method of loan selection.b. Manner in which loans are reviewed,

including:• an analysis of the current financial

condition of the borrower whichaddresses repayment ability, and

• tests for documentation exceptions, pol-icy exceptions, noncompliance withinternal procedures, and violations oflaws and regulations.

10. Assess the qualifications of the personnelinvolved in the credit review function.

11. Evaluate the loan review reporting systemincluding credit file memoranda, head officereports, and an annual schedule or loanreview plan, to ensure it is thorough, accu-rate and timely and will provide sufficientinformation to allow management and thehead office to both identify and control risk.


Determine if the reports include:a. Identification of problem credits.b. Current information regarding portfolio

risk.c. Information concerning emerging trends

in the portfolio and the branch’s lendingareas.

CREDIT GRADING SYSTEM

12. Assess the adequacy of the credit gradingsystem and determine if it:a. Includes an objective grading system for

loans.b. Contains explicit definitions of the

branch’s internal grading system, andthat it is easily understood by all lendersand loan review staff.

c. Designates who has ultimate authority toassign and change credit grades.

13. Evaluate the accuracy of the branch’s creditgrading system by comparing the creditgrade assigned by the branch with thoseassigned by examiners. Determine the extentof management’s knowledge of its ownloan problems.

GENERAL CREDIT RISKADMINISTRATION

14. Assess the effectiveness of the branch’scredit administration and portfolio manage-ment by evaluating:a. Management’s general lending philoso-

phy in such a manner as to elicit man-agement responses.

b. The volume and magnitude of differ-ences in grades assigned by the branchand by the examiners.

c. The impact of credits not supported bycurrent and complete financial informa-tion and analysis of repayment ability.

d. The impact of credits for which loan andcollateral documentation are deficient.

e. The volume of loans improperly struc-tured, e.g., repayment schedule does notmatch loan purpose.

f. The volume and nature of concentrationsof credit, including concentrations ofclassified and criticized credits.

g. The appropriateness of transfers of lowquality credits to or from another affili-ated office.

h. The accuracy and completeness of reportssubmitted to the head office or regionaloffice.

i. Competency of senior management, loanofficers and credit administrationpersonnel.

15. Determine, through information previouslygenerated, the causes of existing problemsor weaknesses within the system, whichpresent potential for future problems.

PROBLEM LOANADMINISTRATION

16. Determine if the branch has adequate poli-cies and procedures for problem and work-out loans, including:a. A periodic review of individual problem

credits.b. Guidelines for collecting or strengthen-

ing the loan, including requirements forupdating collateral values and lien posi-tions, documentation review, officer callreports.

c. Volume and trend of past due or nonac-crual credits.

d. Qualified officers handling problem loans.e. Guidelines on proper accounting for prob-

lem loans, e.g., non-accrual policy; spe-cific reserve policy.

COMPLIANCE

17. Assess the branch’s compliance with lawsand regulations, by determining whether:a. The branch has loans to affiliates (Sec-

tion 23A of the Federal Reserve Act).b. A bank officer or employee received

anything of value for procuring orendeavoring to procure any extension ofcredit (18 USC 215 for Commission orGift for Procuring a Loan).

c. The branch has a stated purpose for eachloan over $10 thousand, except thosesecured by real estate (31 CFR 103.33(a)of the Bank Secrecy Act).

d. The branch is in compliance with stateand federal lending limits, as describedin Regulation K, or specific statutes.

e. The branch is in compliance with Regu-lation O regarding loans to insiders.(applicable to FDIC-insured branchesonly).

3010.3 Credit Risk Management Examination Procedures


18. Forward any violations of law to the exam-iner in charge of compliance, and include across reference here.

SPECIFIC RESERVES

19. Ensure that any specific reserves reportedby the branch are appropriate, i.e., based ona specific loss amount that has been identi-fied for an individual credit.

20. Determine if the branch accounts for spe-cific reserves appropriately when the under-lying asset has been transferred, sold, orpaid off.

21. Review the management reports submittedto the head office, to determine that reportsare sufficiently detailed to evaluate riskfactors.

22. Summarize your findings being sure toconsider the following:a. Check for noncompliance with internal

policies, practices, procedures, and con-trols. Determine if instances of noncom-pliance are system-wide or limited to aspecific area.

b. Organize exceptions in order of relativeimportance.

c. Organize and prepare a listing of viola-tions of laws and regulations.

d. Determine the aggregate amount of loanscriticized in each of the four levels ofcriticism.

e. Compile a listing of all loans notsupported by current and complete creditinformation and collateral documentation.

f. Compile a listing of low quality loanstransferred to or from another lendinginstitution through purchases/sales, par-ticipations, or swaps.

23. Discuss results of the examination of thelending function with senior management,structuring inquiries in such a manner as to:a. Elicit management responses for correc-

tion of deficiencies.24. Write, in appropriate report format, general

remarks including:a. The scope of the examination of the

lending function.b. The quality of internal policies, prac-

tices, procedures, and controls over thelending function.

c. The general level of adherence to inter-nal policies, practices, procedures, andcontrols.

d. The scope and adequacy of the internalloan review system.

e. The quality of the entire loan portfolio.f. The competency of management with

respect to the lending function.g. Causes of existing problems.h. Expectations for continued sound lend-

ing or correction of existing deficiencies.25. Prepare a complete set of workpapers to

support conclusions, and discuss all mate-rial findings with management.

Credit Risk Management Examination Procedures 3010.3


Credit Risk ManagementInternal Control QuestionnaireEffective date July 1997 Section 3010.4

Review the branch’s internal controls, policies,practices, and procedures for managing the loanportfolio. The system should be documented ina complete and concise manner and shouldinclude, where appropriate, narrative descrip-tions, flowcharts, copies of forms used, andother pertinent information.

1. Has a policy for credit risk managementbeen adopted that specifically:a. Establishes suggested guidelines for dis-

tribution of loans in the commercial, realestate, and other categories?

b. Establishes geographic limits, includingcountry limits,for loans?

c. Establishes suggested guidelines foraggregate outstanding loans in relation toother balance sheet categories?

d. Establishes loan authorities of commit-tees and individual lending officers?

e. Defines acceptable types of loans?f. Establishes maximum maturities for vari-

ous types of loans?g. Establishes loan pricing?h. Establishes appraisal policy?i. Establishes minimum financial informa-

tion required at the inception of thecredit?

j. Establishes limits and guidelines for pur-chasing loans?

k. Establishes collection procedures?l. Defines the duties and responsibilities of

loan officers and loan committees?m. Outlines loan portfolio management

objectives that acknowledge the need toemploy personnel with specialized knowl-edge and experience?

2. Are the following reported to the headoffice at least monthly:a. Past due loans?b. Loans on nonaccrual?c. Classified loans?d. Loans requiring special attention?e. New loans, loan renewals, and restruc-

tured loans?3. Are reports checked by a designated indi-

vidual for possible omissions before theyare submitted to the head office?

4. Are written applications required for allloans?

5. Do credit files contain the followinginformation:

GENERAL INFORMATION

• The borrower’s name, address, ownership,and affiliations?

• A description of the borrower’s business?• Amount, rate and maturity of the loan; type of

loan; appropriate approvals?• The purpose of the loan?• The primary and secondary sources of

repayment?• The planned repayment schedule?• The disposition of the loan proceeds?

FINANCIAL INFORMATION

• Current financial information on the borrowerand guarantor (if applicable)?

• Three years of previous financial statements?• An analysis of the borrower’s and guarantor’s

(if applicable) financial condition?• Projections for the borrower’s future financial

performance?• A description of the collateral, its location,

value, and condition?• Covenant compliance checksheet, if applicable.

6. Does the branch perform a credit investiga-tion on proposed and existing borrowers fornew loan applications?

7. Is it required that all loan commitments bein writing?

8. Are lines of credit reviewed and updated atleast annually?

9. Are borrowers’ outstanding liabilitieschecked to appropriate lines of credit beforeadditional advances are granted?

10. Does the branch employ a procedure fordisclosure of a loan or combination of loansthat are or will be secured by 25 percent ofanother insured financial institution’s stock?

11. Is there an internal review system that:a. Rechecks interest, discount, and maturity

date computations?b. Reexamines notes for proper execution,

receipt of all required supporting papers,and proper disclosure forms?


c. Determines that loan approvals are withinthe limits of the branch’s lending authori-ties?

d. Determines that notes bear the initial ofthe loan officer?

e. Ascertains that new loans are within thelimitations set for the borrower by cor-porate resolution?

f. Rechecks the liability ledger to deter-mine that new loans have been accu-rately posted?

Loan transfers, purchases and sales involvingother U.S. branches and affiliates of the FBO areevaluated to determine whether branch manage-ment retains responsibility for the loan. In sucha case, the management of the transferred loanswill be considered in assessing risk managementat the branch. Loan transfers are also evaluatedto determine whether they were transferred toavoid classification and to determine any effectof the transfer on the institution’s condition. Incases where the transfer is suspected of beingimproper, the appropriate regulatory authoritiesfor the other financial institution involved in thetransfer should be notified.

12. Review loan transfers for the following:a. Determine that the branch does not buy

back or pay interest on defaulted loans incontravention of the underlying loanagreement.

b. Compare the volume of loans purchasedand sold to the total portfolio.

c. Determine that the branch has sufficientexpertise to properly evaluate the vol-ume of loans purchased and sold.

d. Determine if loans are sold primarily toaccommodate overline needs of custom-ers or to generate fee income.

e. Investigate any situations where assetswere transferred before the date of theexamination to determine if any weretransferred to avoid possible criticismduring the examination.

f. Determine whether any of the loans trans-ferred were nonperforming at the time oftransfer, classified at the previous exami-

nation, or were considered to be ofquestionable quality for any other reason.

g. Review the branch’s policies and proce-dures to determine whether or not assetsor participations purchased by the branchare given an independent, complete, andadequate credit evaluation.

h. Determine that assets purchased by thebranch are properly reflected on its booksat fair market value.

While fair market value may be difficult todetermine, it should, at a minimum, reflect boththe rate of return being earned on such assetsand an appropriate risk premium. Determinethat appropriate write-offs are taken on anyassets sold by the branch at less than book value.

13. Is a systematic and progressively strongerfollow-up notice procedure utilized fordelinquent loans?

14. Has the branch conducted industry studiesfor those industries in which it is a substan-tial lender?

15. Are loan proceeds ever disbursed in cash? Ifso, notify BSA examiner.

16. Are loans ever paid off by liquidating cashcollateral? If so, notify BSA examiner.

17. Are adequate accounting and control proce-dures in effect with respect to recoveries?

18. Are adequate procedures in effect to moni-tor compliance with the lending limits?

19. Are original loan documents safeguardedproperly?

20. Are notes and collateral periodically veri-fied by an independent party?

CONCLUSION

21. Is the information covered by this ICQadequate for evaluating internal controls inthis area? If not, indicate any additionalexamination procedures deemed necessary.

22. Based on the information gathered, evaluatethe internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).

3010.4 Credit Risk Management Internal Control Questionnaire


Credit Risk ManagementAudit GuidelinesEffective date July 1997 Section 3010.5

1. Test the additions of the trial balances and thereconciliation of the trial balances to thegeneral ledger. Include loan commitmentsand other contingent liabilities.

2. Using an appropriate sampling technique,select loans from the trial balance and per-form the following:a. Prepare and mail confirmation forms to

borrowers. Loans serviced by other insti-tutions, either whole loans or participa-tions, should be confirmed only with theservicing institution. Confirmation formsshould include borrower’s name, loannumber, the original amount, interest rate,current loan balance, contingency andescrow account balance, and a briefdescription of the collateral.

b. After a reasonable time, mail secondrequests.

c. Follow up on any no-replies or excep-tions, and resolve differences.

d. Examine notes for completeness and verifydate, amount, and terms to trial balance.

e. In the event any notes are not held at thebranch, request confirmation by the holder.

f. Check to see that the note is signed,appears to be genuine, and is negotiable.

g. Check to see that the required initials ofthe approving officer are on the note.

h. Determine that the amount is within theofficer’s lending limit.

i. Compare collateral held in files with thedescription on the collateral register.

j. Determine that the proper assignments,stock powers, hypothecation agreements,statements of purpose, etc., are on file.

k. Test the pricing of the negotiable collateral.l. Determine that margins are reasonable

and are in line with branch policy andlegal requirements.

m. Determine if any collateral is held by anoutside custodian or has been temporarilyremoved for any reason.

n. Forward a confirmation request on anycollateral held outside the branch.

o. For accounts receivable financing, recon-cile accounts receivable invoices to col-lateral records.

p. For banker’s acceptances, compare collat-eral (e.g. trust receipts and warehousereceipts) with the description on the col-lateral records. Check to be sure thatprocedures are in effect to preclude acustomer from obtaining additional creditextensions on the same merchandise.

q. Review escrow account provisions todetermine if undisbursed amounts are atleast equal to the provisions in the escrowagreements. Determine if debit entries toescrow accounts are authorized accordingto the terms of the loan agreement and ifthey are supported by individual bills orother evidence.

r. List all discrepancies and investigate.

s. Determine that each file has documenta-tion supporting guarantees and subordina-tion agreements, where appropriate.

t. Determine that any necessary insurancecoverage is adequate and that the branchis named as loss payee.

u. Review participation agreements, makingexcerpts where necessary for such itemsas rate of service fee, interest rate, reten-tion of late charges, and remittancerequirements, and determine whether par-ticipant has complied.

v. Review disbursement ledgers and autho-rizations and determine if authorizationsare signed in accordance with the terms ofthe loan agreement.

3. Review the accrued interest accounts by:

a. Reviewing and testing procedures foraccounting for accrued interest and forhandling of adjustments.

b. Scanning accrued interest for any unusualentries and following up on any unusualitems by tracing to initial and supportingrecords.

c. For those loans selected in step 2, inde-pendently calculate the amount of accruedinterest and verify the amount to the detailof accrued interest receivable for thatloan.

4. Using a list of nonaccruing loans, check loanaccrual records to determine if interest incomeis not being recorded.


5. Obtain or prepare a schedule showing themonthly interest income amounts and theaccounts receivable loan balance at eachmonth-end since the last audit and:a. Calculate yield.

b. Investigate significant fluctuations and/ortrends.

6. Test accuracy and completeness of all man-agement reports.

3010.5 Credit Risk Management Audit Guidelines


Asset-Based LendingEffective date July 1997 Section 3020.1

Asset-based lending is a specialized area ofcommercial lending in which borrowers assigntheir interests in certain accounts receivable andinventory, and in selected cases, fixed assets, tothe lender as collateral. In asset-based lending,the primary repayment source is the conversionof the pledged assets into cash. Asset-basedlending differs from a commercial loan in whichthe bank takes a security interest in all accountsreceivable and inventory owned or acquired bythe borrower. This section will discuss asset-based lending in relation to the characteristics ofthe borrower, its advantages to the borrower andthe branch, credit and collateral analysis, docu-mentation, and safeguards to ensure the authen-ticity and collectibility of the assigned receivables.

The examiner must judge the quality of thecredit by evaluating the financial condition anddebt-servicing ability of the borrower and thequality of the collateral. In addition, the exam-iner must evaluate the branch’s internal con-trols, policies, practices, and procedures.

CHARACTERISTICS OF THEBORROWER

Many borrowers whose financial condition isnot strong enough to allow them to qualify forregular, secured commercial loans may use asset-based loans to meet their financial needs. Typi-cal characteristics of asset-based borrowers arethose which:

• Are growing rapidly and need year-roundfinancing in amounts too large to justifyunsecured credit or commercial lines of creditsecured by blanket liens on accounts receiv-able and inventory;

• Are nonseasonal and need year-round financ-ing because working capital and profits areinsufficient to permit periodic clean-ups;

• Have inadequate working capital for the vol-ume of sales and type of operation; and,

• Cannot obtain regular commercial loan termsbecause of deteriorating credit factors.

ADVANTAGES TO THEBORROWER AND THE BRANCH

From the borrower’s viewpoint, asset-basedlending:

• Provides an efficient way to finance an expand-ing operation because borrowing capacityexpands as sales increase;

• Permits the borrower to take advantage ofpurchase discounts because the companyreceives immediate cash on its sales and isable to pay trade creditors on a satisfactorybasis, thereby earning a good reputation andreducing the cost of goods sold;

• Ensures a revolving, expanding line of creditfor which the actual interest paid may be lessthan that for a fixed amount unsecured loan.

From the branch’s viewpoint, asset-basedlending:

• Generates a relatively high yield loan com-mensurate with the perceived credit risk of theborrower;

• Generates a depository relationship whichprovides income and enhances the branch’sability to monitor changes in the borrower’scash flow and overall financial condition;

• Permits a continuing branch relationship withlongstanding customers whose financial con-dition no longer warrant unsecured credit ortraditional commercial lines of credit; and,

• Minimizes potential loss when the loan iscollateralized by a percentage of the accountsreceivable and inventory.

However, as discussed further, this type oflending requires close and periodic supervisionof the borrower’s financial condition and regularmonitoring of the borrower’s accounts receiv-ables to ensure compliance with the financingagreement.

CREDIT AND COLLATERALANALYSIS

Although asset-based loans are collateralizedand closely monitored, it is important to analyzethe borrower’s financial statements. Even if thecollateral is of good quality and supports theloan, the borrower must demonstrate financialprogress. Full repayment through collateral liq-uidation is normally a solution of last resort. Theborrower’s financial statements should be ana-lyzed with particular emphasis on working capi-


tal and its trends. Trade reports should bereviewed, the agings of receivables and payablesshould be scrutinized, and inventory turnovershould be analyzed. Furthermore, the promptpayment of taxes, especially payroll taxes, shouldbe verified. A primary reason for a company toobtain asset-based financing is to maximizediscounts offered by suppliers; therefore, itshould pay creditors promptly upon receivingthe financing. If it is not doing so, it may bediverting the funds out of the business and/or thecompany’s financial condition may not warrantthis type of financing.

Branch management’s ability to recognize acustomer’s financial problems as they developand to initiate orderly liquidation, if necessary,is important in the supervision of asset-basedfinancing. The line theoretically could be fullyliquidated by discontinuing further advances,collecting the assigned receivables and liquidat-ing pledged inventory. However, such drasticaction could cause the borrower’s business toclose resulting in a probable deterioration of thereceivables from new disputes and in returnsand offsets. So that the branch’s loan may beliquidated in an orderly manner without lossesor other adverse effects, the branch usuallynotifies its borrower of a contemplated liquida-tion, allowing the borrower time to seek othermeans of continuing the business. Asset-basedlines where the financial position has declinedso that refinancing is prevented should be criti-cized, unless the branch has initiated an orderlyliquidation. When such a liquidation is occur-ring, the examiner may not see the need forclassification if the borrower’s business is con-tinuing, the existing collateral is of good quality,and no collateral deterioration is anticipated.

In asset-based lending, branch managementshould continually evaluate the realizable valueof assets pledged. To do so, management shouldreview the loan agreement and compliance there-with; the quality of the assets pledged, includingdocumentation; and the safeguards to ensure theauthenticity and collectibility of the pledgedassets. The information obtained is sometimesdifficult to interpret unless it is related to otherperiods, comparable businesses, or industry sta-tistics. The following factors should be consid-ered in evaluating the quality of assets pledged:

The turnover of the receivables pledged andthe borrower’s credit limit.If the turnover is

decreasing, the quality of receivables may bedeteriorating.

Aging of accounts receivable.The branchshould obtain a monthly aging of the accountsreceivable pledged. The examiner should notethe percentage of accounts delinquent in relationto the total accounts pledged, and those accountshaving past due balances, which also havecurrent amounts due.

Concentration of debtor accounts.A lendermay be vulnerable to loss if a large percentageof the dollar amount of receivables assigned isconcentrated in a few accounts. A list of con-centrations should be prepared periodicallyshowing the largest accounts.

Ineligible receivables.The examiner shouldbe aware of receivables that, by their nature,should be excluded from the lending formula.The following are examples of receivables thatmay be considered ineligible:

• Due from affiliated companies.Although suchreceivables might be valid, the temptation forthe borrower to create fraudulent invoiceswould be great.

• Receivables subject to a purchase money inter-est, such as floor plan arrangements.Themanufacturer will frequently file financingstatements when merchandise is delivered tothe borrower. That filing usually gives themanufacturer a superior lien on the receivable.An alternative would be to enter into anagreement with the manufacturer where rightsto the receivables are subordinated to thebranch.

Financial strength of debtor accounts.Thebranch should maintain credit information andtrade reports on large debtor accounts as part ofthe borrower’s credit file. The examiner shoulddetermine whether the debtor accounts are sig-nificant to the borrower’s business and are wellrated and financially strong.

Disputes, returns, and offsets.The borrowershould furnish promptly to the branch copies ofall significant credit memoranda issued. Ananalysis of those memoranda must be made. Alarge or increasing volume of such transactionscould adversely affect the branch’s collateralposition.

3020.1 Asset-Based Lending


DOCUMENTATION

Loan Agreement—An asset-based loan agree-ment is a contract between a borrower and thebranch that sets forth conditions governing thehandling of the account and the remedies avail-able in the event of default. Among the majorprovisions, might be:

• A percentage advance against acceptablereceivables. The advance may depend on thegross profit margin from the sale of merchan-dise and the credit quality of the borrower’scustomers. For example, if a borrower has agross profit margin of 30 percent, the maxi-mum advance might be 70 percent, with areduced percentage if the borrower’s custom-ers do not have top credit ratings.

• Use of only acceptable receivables. This termrefers to a branch’s outlining qualifications foracceptance. For example, acceptable receiv-ables may include only those accounts that arecurrent or not more than a given number ofdays past due. The entire amount of receiv-ables may be unacceptable if a certain per-centage, e.g., 10 percent, is 90 days or moredelinquent.

• A maximum dollar amount due from any oneaccount debtor. Because there is always thepossibility of unforeseen and undisclosedcredit failure or a return of merchandise, acommon benchmark is that no more than20 percent of the receivables assigned arefrom one customer.

Documentation of Advances—There are twodominant methods by which advances are made.Under theblanket assignmentmethod, the bor-rower periodically supplies the branch withdocumentation of the amount of receivablesoutstanding on its books. Based upon this infor-mation, the branch advances the agreed percent-age of the outstanding receivables. The receiv-ables are usually pledged on a non-notificationbasis and payments on receivables are madedirectly to the borrower, who then remits themto the branch. The branch applies all or a portionof such funds to the borrower’s loan and/or thecash collateral account, which is under thebranch’s control. Under theledgering of accountsmethod, the lender receives duplicate copies ofthe invoices together with the shipping docu-ments and/or delivery receipts. Upon receipt ofsatisfactory information, the branch advances

the agreed percentage of the outstanding receiv-ables. The receivables are usually pledged on anotification basis. Under this method, the branchmaintains complete control of all funds paid onall accounts pledged by requiring the borrower’scustomer(s) to remit directly to the branch. Thesame application of payments is then used asunder the blanket assignment method. Regard-less of the methods used, the branch shouldensure its collateral through a program of regu-lar audit and direct confirmation.

Security Agreement and FinancingStatement—Article 9 of the Uniform Commer-cial Code (UCC) applies to any transaction thatis intended to create a security interest inaccounts receivable. Under the UCC, the branchmust create a valid and enforceable securityinterest andperfect that interest. Once anenforceable security interest is created, thesecured party can always enforce it, on default,against the debtor, provided there is no superiorthird-party interest. If the holder of a valid andenforceable Article 9 interest takes the addi-tional steps required to perfect under Article 9, itwill defeat most such third parties.

Under the provisions of the UCC, a branchshould request from the Secretary of State, orother filing office, a listing of any open liens onthe customer’s receivables or inventory. Provid-ing no such liens are outstanding, the branchshould then obtain a Security Agreement,Accounts Receivable and a Financing Statementand file promptly. The security agreement andfinancing statement should cover current andfuture accounts and advances for all proceedsthereof (a ‘‘blanket assignment’’), or detail thespecific item(s) being taken as collateral (a‘‘specific assignment’’). To protect its rights tothe receivables, the lending branch should con-sider taking a lien on the borrower’s current andfuture inventory and all proceeds thereof.

Sections 9-203 and 9-204 of the UCC requirethat the parties take four steps to create a validand enforceable security interest. They must:

• Enter into a security agreement.• Reduce as much of that agreement to writing

as is necessary to satisfy Section 9-203, whichalso requires that the debtor sign this writingor give possession of the collateral to thecreditor.

• Have the debtor acquire rights in the collateral.• Have the secured party give value.

Asset-Based Lending 3020.1


Section 9-302(10) provides for automatic per-fection, without filing a financing statement,when any or all assignments to the branch do nottransfer a significant part of the outstandingaccounts of the borrower. However, in all otheraccounts receivable security interests, the branchmust file a financing statement to perfect itssecurity interest. The law of the jurisdiction inwhich the debtor is located provides where thefinancing statement must be filed. Filing loca-tion is determined by place of business, execu-tive office, or residence if the debtor has noplace of business in the state. Refer to theappropriate State jurisdiction for filinginstructions.

The financing statement, which is the docu-ment filed for public notice, must:

• Give the names and mailing addresses of thedebtor and secured party.

• Be signed by the debtor.• Give an address of the secured party from

which information concerning the securityinterest may be obtained.

• Give the mailing addresses of the debtor andthe secured party.

• Contain a statement indicating the types ofcollateral or describing the items or collateral.

• Be renewed every five years.

A copy of the security agreement is sufficientas a financing statement if it meets the precedingrequirements.

Although effective compliance with the UCCcreates, in most instances, a valid and enforce-able first lien, it does not insulate the branchfrom the need to police its collateral. By filing,the branch establishes the right to collect ononly those receivables assigned to it, provided:

• The sales are legitimate.• The merchandise has been delivered.• The merchandise is as ordered.• Sales were made without warranties (almost

all sales are covered by warranties).• The merchandise was not shipped on

consignment.• The merchandise is not subject to offset, i.e.,

contra accounts or liens.• The receivable has not already been paid to

the borrower.

ENSURING AUTHENTICITY ANDCOLLECTIBILITY

Regardless of the advance methods used, thefollowing safeguards, which branch manage-ment should consider and the examiner shouldevaluate, ensure the authenticity and collectibil-ity of the pledged assets:

Audits.To verify the information supplied bythe borrower to the branch, the branch sends itsstaff member(s) to the borrower’s place ofbusiness to audit its books. The audit shouldoccur several times a year, usually on a quarterlybasis. The scope of such audit should includepreparation of balance sheets, profit and lossstatements, working capital analysis, agings ofpayables and receivables, an inspection of inven-tory and related records, and a determinationthat the debtor accounts are properly marked onthe books as assigned to the branch. The auditalso should include procedures to determinewhether all significant credit memoranda havebeen properly issued and reported by the bor-rower to the branch.

Confirmations.To verify the authenticity ofthe pledged collateral, the branch should insti-tute a program of direct confirmation. Thisprocedure is particularly important if the accountsreceivable are pledged on a non-notificationbasis because the branch does not have the samecontrol of the debtor accounts as it does whenthe receivables are pledged on a notificationbasis. Direct confirmations should be madebefore the initial lending arrangement and, there-after, at least semiannually. Confirmations shouldbe on a positive basis. The branch should obtainwritten approval from the borrower before con-firming accounts receivable on a non-notificationbasis. Further, the branch should consider usingthe name of a phantom company as sender of theconfirmations and having the confirmationsreturned to a post office box to ensure thataccount debtors do not know that their receiv-ables are being pledged.

3020.1 Asset-Based Lending


Asset-Based LendingExamination ObjectivesEffective date July 1997 Section 3020.2

1. To determine if the policies, practices, pro-cedures, and internal controls regarding asset-based lending are adequate.


3. To evaluate the portfolio for collateral suffi-ciency, credit quality, and collectibility.

4. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawsor regulations have been noted.


Asset-Based LendingExamination ProceduresEffective date July 1997 Section 3020.3

Refer to the Credit Risk Management examina-tion procedures for general procedures to assessthe risk of asset-based lending activities. How-ever, if the branch engages in significant asset-based lending activities, and additional informa-tion is needed, the examiner should perform thefollowing examination procedures.

1. If selected for implementation, complete orupdate the Internal Control Questionnaire forthis area.

2. Determine if deficiencies noted at previousexaminations and internal/external auditshave been adequately addressed bymanagement.

3. Review the following information for selectedasset-based loans:a. Relationship between amount collected in

a month on the receivables pledged ascollateral and the borrower’s credit limit.

b. Aging of accounts receivable.c. Ineligible receivables.d. Concentration of debtor accounts.e. Financial strength of debtor accounts.f. Disputes, returns, and offsets.g. Management’s safeguards to ensure the

authenticity and collectibility of theassigned receivables.

4. Analyze secondary support offered by guar-antors and endorsers.

5. Ascertain compliance with established branchpolicy.

6. Discuss with appropriate officer(s) and pre-pare a summary of the branch’s asset-basedlending activities.

7. Evaluate the function with respect to:a. The adequacy of written policies relating

to asset-based lending.b. The manner in which branch officers are

conforming with established policy.c. Adverse trends within the asset-based lend-

ing department.d. Accuracy and completeness of the man-

agement reports relating to asset-basedlending obtained from the branch.

e. Internal control deficiencies or exceptions.f. Recommended corrective action when

policies, practices, or procedures aredeficient.

g. The competency of departmentalmanagement.

h. Other matters of significance.8. Update the workpapers with any information

that will facilitate future examinations.


Asset-Based LendingInternal Control QuestionnaireEffective date July 1997 Section 3020.4

Refer to the Credit Risk Management internalcontrol questionnaire for a general review of thebranch’s internal controls, policies, practices,and procedures. If the branch engages in signifi-cant asset-based lending activities, and addi-tional information is needed, the examiner shouldcomplete the following internal control question-naire. For audit procedures, refer to the CreditRisk Management section 3010.5.

1. Does the branch have policies specificallyrelating to asset-based lending that:a. Establish procedures for reviewing asset-

based lending applications?b. Establish standards for determining credit

lines?c. Establish standards for determining the

percentage advance to be made againstacceptable receivables?

d. Define acceptable receivables?e. Establish minimum requirements for veri-

fication of borrower’s pledged assets?f. Establish minimum standards for

documentation?2. Are policies reviewed at least annually to

determine if they are compatible with chang-ing market conditions?

3. Does the branch record on a timely basis afirst lien on the assigned receivables for eachborrower?

4. Do all loans granted on the security of thereceivables also have an assignment of theinventory?

5. Does the branch verify the borrower’saccounts receivable or require independentverification on a periodic basis?

6. Does the branch require the borrower toprovide aged accounts receivable scheduleson a periodic basis?

CONCLUSION

7. Is the information covered by this ICQ ad-equate for evaluating internal controls in thisarea? If not, indicate any additional exami-nation procedures deemed necessary.

8. Based on the information gathered, evaluateinternal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).


Asset SecuritizationEffective date July 1997 Section 3030.1

Banking organizations, including branches, havelong been involved with asset-backed securities(ABS), both as investors in such securities andas major participants in the securitization pro-cess. In recent years, they have stepped up theirinvolvement by increasing their participation inthe long-established market for securities backedby residential mortgage loans. Banking organi-zations have also expanded their securitizationactivities to include other types of assets, such ascredit card receivables, automobile loans, boatloans, commercial real estate loans, studentloans, nonperforming loans, and lease receivables.

AN OVERVIEW OF ASSETSECURITIZATION

In recent years, the number of banking organi-zations that have issued securities backed bytheir own assets and that have acquired ABS asinvestments has increased markedly. This increasehas resulted because securitization activities canyield significant financial and operational benefits.

In its simplest form, asset securitizationinvolves the selling of assets. The process firstsegregates generally illiquid assets into poolsand transforms them into capital market instru-ments. The payment of principal and interest onthese instruments depends on the cash flowsfrom the assets in the pool underlying the newsecurities. The new securities may have denomi-nations, cash flows, and other features that differfrom the pooled assets making the securities inthem more attractive to investors.

The federal government encourages the secu-ritization of residential mortgages. In 1970, theGovernment National Mortgage Association(GNMA) created the first publicly tradedmortgage-backed security. Soon, the FederalNational Mortgage Association (FNMA) andthe Federal Home Loan Mortgage Corporation(FHLMC), both government-sponsored agen-cies, also developed mortgage-backed securi-ties. The guarantees provided by these govern-ment or government-sponsored entities assureinvestors of the payment of principal and inter-est and have thus greatly facilitated the securi-tization of mortgage assets. As previously men-tioned, securities have also been issued that arebacked by other assets such as: credit cardreceivables, automobile loans, boat loans, com-

mercial real estate loans, home equity loans,student loans, nonperforming loans, and leasereceivables.

BENEFITS AND RISKS OF ASSETSECURITIZATION

While the objectives of securitization may varyfrom organization to organization, there areessentially five benefits that can be derived fromsecuritized transactions. First, the sale of assetsmay reduce regulatory costs. The removal of anasset from an FBO’s books generally reducescapital requirements and reserve requirementson the deposits funding the asset. Second, assetsecuritization provides originators with an addi-tional source of funding or liquidity or both. Theprocess of securitization basically converts anilliquid asset into a security with greater mar-ketability. Securitized issues often require acredit enhancement, which results in a highercredit rating than what would normally beobtainable by the institution itself. Conse-quently, these issues may provide a cheaperform of funding to the banking organization.Third, securitization may be used to reduceinterest-rate risk by improving the organiza-tion’s asset-liability mix. Such a benefit is morelikely if the organization has a large investmentin fixed-rate, low-yield assets. Fourth, byremoving assets, the organization enhances itsreturn on equity and assets. Finally, the ability tosell these securities worldwide diversifies theorganization’s funding base which reduces thedependence of the branch on local economies.

It may be appropriate for a banking organiza-tion, including a branch, to engage in securiti-zation activities and to invest in ABS, if it doesso in a prudent manner. Nonetheless, theseactivities can significantly affect a branch’soverall risk exposure. It is of great importance,particularly given the growth and expansion ofsuch activities, that examiners be fully informedof the fundamentals of the securitization pro-cess, including knowledge of the various risksthat securitization and investing in ABS createfor branches. Additionally, examiners need to beaware of the pertinent examination proceduresin order to effectively assess the branch’s expo-sure to risk and its ability to manage thatexposure.


The following instructions were developedfor Federal Reserve System use in order toprovide examiners with the information andguidance they need on asset securitization. Theseinstructions discuss the mechanics of securitiza-tion and related accounting issues while alsoproviding a set of examination guidelines,objectives, and procedures.1 The various stateand federal agencies may differ in terms ofspecific practices and methodologies used toimplement these guidelines. For further guid-ance in this area, examiners should consult withtheir respective agencies.

THE SECURITIZATION PROCESS

The asset securitization process begins with thesegregation of loans or leases into pools that arerelatively homogeneous with respect to credit,maturity, and interest-rate risks. These pools ofassets are then transferred to a trust or otherentity known as an issuer, because it issues thesecurities or ownership interests that are acquiredby investors. These asset-backed securities maytake the form of debt, certificates of beneficialownership, or other instruments. The issuer istypically protected from bankruptcy by variousstructural and legal arrangements. A sponsorthat provides the assets to be securitized owns orotherwise establishes the issuer.

Each issue of ABS has a servicer that isresponsible for collecting interest and principalpayments on the loans or leases in the under-lying pool of assets and for transmitting thesefunds to investors (or a trustee representingthem). A trustee is responsible for monitoringthe activities of the servicer to ensure that itproperly fulfills its role.

A guarantor may also be involved to ensurethat principal and interest payments will bereceived by investors on a timely basis, even ifthe servicer does not collect these paymentsfrom the obligors. Many issues of mortgage-backed securities are guaranteed directly byGNMA, a government agency backed by thefull faith and credit of the U.S. government, orby FNMA or FHLMC, both government-

sponsored agencies that are perceived by thecredit markets to have the implicit support of thefederal government. Privately issued, mortgage-backed securities and other types of asset-backed securities generally depend on someform of credit enhancement provided by theoriginator or third party to insulate the investorfrom a portion of or all credit losses. Usually,the amount of the credit enhancement is basedupon several multiples of the historical lossesexperienced on the particular asset backing thesecurity.

Credit Enhancement

One form of credit enhancement is the recourseprovision, or guarantee, that requires the origi-nator to cover any losses up to an amountcontractually agreed upon. Some asset-backedsecurities, such as those backed by credit cardreceivables, typically use a spread account. Thisaccount is actually an escrow account. Thefunds in this account are derived from a portionof the spread between the interest earned on theassets in the underlying pool and the lowerinterest paid on securities issued by the trust.The amounts that accumulate in the account areused to cover credit losses in the underlyingasset pool up to several multiples of historicallosses on the particular asset collateralizing thesecurities.

Overcollateralization, another form of creditenhancement covering a predetermined amountof potential credit losses, occurs when the valueof the underlying assets exceeds the face valueof the securities. A third form of credit enhance-ment involves the use of the senior-subordinatedsecurity structure. Under such a structure, atleast two classes of asset-backed securities areissued, with the senior class having a priorityclaim on the cash flows from the underlyingpool of assets. Therefore, the subordinated classmust absorb credit losses before they can becharged to the senior portion. Because the seniorclass has this priority claim, cash flows from theunderlying pool of assets must first satisfy therequirements of the senior class. Only after theserequirements have been met will the cash flowsbe directed to service the subordinated class.

A more recent form of credit enhancement isthe cash collateral account, which is establishedwhen a third party deposits cash into a pledgedaccount. The use of cash collateral accounts

1. The Federal Reserve System has developed a three-volume set that contains educational material concerning theprocess of asset securitization and examination guidelines.The volumes are as follows: (a) An Introduction to AssetSecuritization, (b) Accounting Issues Relating to Asset Secu-ritization, and (c) Examination Guidelines for AssetSecuritization.

3030.1 Asset Securitization


grew as the number of highly rated banks andother credit enhancers declined in the early1990s. Other forms of credit enhancementinclude standby letters of credit, pool insurance,or surety bonds from third parties.

An investment banking firm or other organi-zation generally serves as an underwriter forABS. In addition, for asset-backed issues thatare publicly offered, a credit rating agency willanalyze the policies and operations of the origi-nator and servicer as well as the structure,underlying pool of assets, expected cash flows,and other attributes of such securities. Beforeassigning a rating to the issue, the rating agencywill also assess the extent of loss protectionprovided to investors by the credit enhance-ments associated with the issue.

Traditional lending activities are generallyfunded by deposits or other liabilities with boththe assets and related liabilities reflected on thebalance sheet. Liabilities must generally increasein order to fund additional loans. In contrast, thesecuritization process generally does not increaseon-balance-sheet liabilities in proportion to thevolume of loans or other assets securitized. Asdiscussed more fully below, when bankingorganizations securitize their assets and thesetransactions are treated as sales, both the assetsand the related ABS (i.e., liabilities) are removedfrom the balance sheet. The cash proceeds fromthe securitization transactions are generally usedto originate or acquire additional loans or otherassets for securitization and the process isrepeated. Thus, for the same volume of loanoriginations, securitization results in lower assetsand liabilities in comparison to traditional lend-ing activities.

The Structure Of Different TypesOf ABS

Asset securitization involves different types ofcapital market instruments. These instrumentsmay be structured aspass-throughs or pay-throughs. Under a pass-through structure, thecash flows from the underlying pool of assetsare passed through to investors on a pro ratabasis. This type of security may be a single-classinstrument such as a GNMA pass-through or amulti-class instrument such as a real estatemortgage investment conduit (REMIC).2

The pay-through structure with multipleclasses combines the cash flows from the under-lying pool of assets and reallocates them to twoor more issues of securities that have differentcash flow characteristics and maturities. Anexample is the collateralized mortgage obliga-tion (CMO), which has a series of bond classes,each with its own specified coupon and statedmaturity. In most cases, the assets that make upthe CMO collateral pools are pass-throughsecurities. Scheduled principal payments, andany prepayments, from the underlying collateralgo first to the earliest maturing class of bonds.This first class of bonds must be retired beforethe principal cash flows are used to retire thelater bond classes. The development of thepay-through structure resulted from the desire tobroaden the marketability of these securities toinvestors who were interested in maturities otherthan those generally associated with pass-through securities.

Multiple-class, ABS may also be issued asderivative instruments, such as stripped securi-ties. Investors in each class of a stripped securitywill receive a different portion of the principaland interest cash flows from the underlying poolof assets. In their purest form, stripped securitiesmay be issued as interest-only (IO) strips, forwhich the investor receives 100 percent of theinterest from the underlying pool of assets andas principal-only (PO) strips, for which theinvestor receives all of the principal.

In addition to these securities, other types offinancial instruments may arise as a result ofasset securitization, as follows:

• Loan servicing rights—these instruments arecreated when organizations purchase or origi-nate loans, sell or securitize the loans, andretain the right to act as servicers for pools ofloans. The cost of these purchased servicingrights may be recorded as an intangible assetwhen certain criteria are met. In addition,servicing rights are created when organiza-

2. In the early 1980s, collateralized mortgage obligations

(CMOs), or multiple class securities, were introduced to helpminimize the reinvestment and interest rate risks inherent inthe traditional fixed rate mortgage-backed security. As a resultof the Tax Reform Act of 1986, REMIC was created. TheREMIC is a more flexible mortgage security, which expandedthe appeal of the CMO structure to a wider investor base andoffered preferred tax status to both investors and issuers.Today, almost all CMOs are issued in REMIC form. (FromThe ABCs of CMOs, REMICs and IO/POs: Rocket ScienceComes to Mortgage Finance, Journal of Accountancy, April1991, p. 41.)

Asset Securitization 3030.1


tions purchase the right to act as servicers forloan pools.

• Excess servicing fee receivables—Theseinstruments generally arise when the presentvalue of any additional cash flows from theunderlying assets that a servicer expects toreceive exceeds standard servicing fees.

• ABS residuals (sometimes referred to asresiduals or residual interests)—They repre-sent claims on any cash flows that remain afterall obligations to investors and any relatedexpenses have been met. Such excess cashflows may arise as a result of overcollateral-ization or from reinvestment income. Residu-als can be retained by sponsors or purchasedby investors in the form of securities.

SUPERVISORY CONSIDERATIONS

Clear benefits can accrue to banking organiza-tions that engage in securitization activities andinvest in ABS. Nonetheless, securitizationactivities can increase the overall risk profile ofthe banking organization if the activities are notcarried out in a prudent manner. For the mostpart, the types of risks that financial institutionsencounter in the securitization process are iden-tical to those that they face in traditional lendingtransactions. These involve credit risk, concen-tration risk, interest-rate risk, including prepay-ment risk, operational risk, liquidity risk, moralrecourse risk, and funding risk. However,because the securitization process separates thetraditional lending function into several limitedroles such as originator, servicer, credit enhancer,trustee, and investor, the types of risks that abranch will encounter will differ depending onthe role it assumes.

As with direct investments in the underlyingassets, investors in ABS will be exposed tocredit risk, that is, the risk that obligors willdefault on principal and interest payments.Investors are also subject to the risk that thevarious parties, for example, the servicer ortrustee, in the securitization structure will beunable to fulfill their contractual obligations.Moreover, investors may be susceptible to con-centrations of risks across various ABS issuesthrough over-exposure to an organization per-forming various roles in the securitization pro-cess, or as a result of geographic concentrationswithin the pool of assets providing the cashflows for an individual issue. Also, because the

secondary markets for certain ABS are thin,investors may encounter greater than anticipateddifficulties when seeking to sell their securities.Furthermore, certain derivative instruments, suchas stripped ABS and residuals, may be extremelysensitive to interest rates and exhibit a highdegree of price volatility, and, therefore, maydramatically affect the risk exposure of inves-tors, unless used in a properly structured hedg-ing strategy.

Issuer

Banking organizations that issue ABS may besubject to pressures to sell only their best assets,thus reducing the quality of their own loanportfolios. On the other hand, some organiza-tions may feel pressures to relax their creditstandards because they can sell assets withhigher risk than they would normally want toretain for their own portfolios.

To protect their names in the market, issuersmay feel pressures to provide moral recourse byrepurchasing securities backed by loans or leasesthat they originated and which have since dete-riorated and become nonperforming. Fundingrisk may also be a problem for issuers whenmarket aberrations do not permit the issuance ofABS that are in the securitization pipeline.

Servicer

Banking organizations that service securitiza-tion issues must ensure that their policies,operations, and systems will not permit break-downs that may lead to defaults. Substantial feeincome can be realized by acting as servicer. Aninstitution already has a fixed investment in itsservicing systems, and achieving economies ofscale relating to that investment is in its bestinterest. The danger, though, lies in overloadingthe systems’ capacity, thereby creating enor-mous out-of-balance positions and cost over-runs. Servicing problems may potentially pre-cipitate a technical default, which, in turn, couldlead to the premature redemption of the security.In addition, expected collection costs couldexceed fee income. (For further guidance, referto the Federal Reserve’sCommercial BankExamination Manual, Loan Portfolio Manage-ment section.)

3030.1 Asset Securitization


Accounting Issues

Asset securitization transactions are frequentlystructured to obtain certain accounting treat-ments, which, in turn, affect reported measuresof profitability and capital adequacy. In transfer-ring assets into a pool to serve as collateral forABS, a key question is whether the transfershould be treated as a sale of the assets or as acollateralized borrowing, that is, a financingtransaction secured by assets. Sales treatmentresults in the assets being removed from thebranch’s balance sheet, thus reducing total assetsrelative to earnings and capital and, thereby,producing higher performance and capital ratios.Treatment of these transactions as financings,however, means that the assets in the poolremain on the balance sheet and the relatedliabilities are subject to reserve requirements.3

Securitization Of Commercial Paper

Over time, banking institutions have increas-ingly been involved in the securitization ofcommercial paper. It is important to note, how-ever, that asset-backed commercial paper pro-grams differ from other methods of securitiza-tion. One difference is that more than one typeof asset may be included in the receivables pool.Moreover, in certain cases, the cash flow fromthe receivables pool may not necessarily matchthe payments to investors because the maturityof the underlying asset pool does not alwaysparallel the maturity of the structure of thecommercial paper. Consequently, when the papermatures, it is usually rolled over or funded byanother issue. In certain circumstances, a matur-ing issue of commercial paper cannot be rolledover. To address this problem, many bankinginstitutions have established back-up liquidityfacilities. Certain banking institutions have clas-sified these back-up facilities as pure liquidityfacilities despite the credit-enhancement ele-ment present in such facilities and, as a result,have incorrectly assessed the risks associatedwith such back-up liquidity facilities. In thesecases, the back-up liquidity facilities have beenmore similar to direct credit substitutes than toloan commitments.

3. Note, however, that it is the Federal Reserve’s Regula-tion D that defines what constitutes a reservable liability of adepository institution. Thus, although a given transaction mayqualify as an asset sale for regulatory reporting purposes, itnevertheless could result in a reservable liability underRegulation D.

Asset Securitization 3030.1


Asset SecuritizationExamination ObjectivesEffective date July 1997 Section 3030.2

1. To determine if the branch is in compliancewith laws, regulations and policy statements.

2. To determine if the branch is involved inoriginating, servicing, providing creditenhancements, serving as a trustee for, orinvesting in securitized assets.

3. To determine that securitization activitiesare properly managed within the context ofthe branch’s overall risk managementtechniques.

4. To determine that management has anappropriate level of experience in securiti-zation activities.

5. To ensure that the branch does not hold anyasset-backed securities that are inappropri-ate, given the size of the branch and thesophistication of its operations, e.g., IOsand POs.

6. To ensure that all asset-backed securitiesowned and any assets sold with recourse areproperly accounted for on the branch’sbooks and in the branch’s regulatory reports.

7. To determine that sources of credit risk areunderstood and properly analyzed and man-aged without excessive reliance on creditratings by outside agencies.

8. To determine that credit, operational, andother risks are recognized and are addressedthrough appropriate policies, procedures,management reports, and other controls.

9. To determine if officers are operating inconformance with established branch poli-cies and procedures.

10. To determine that liquidity and market risksare recognized and the branch is not exces-sively dependent on securitization as a sub-stitute for funding or as a source of income.

11. To determine that steps have been taken tominimize the potential for conflicts of inter-est due to securitization.

12. To determine that possible sources of struc-tural failure in securitization transactionsare recognized, and that branch and headoffice management has adopted measures tominimize the impact of such failures shouldthey occur.

13. To determine that branch and head officemanagement is aware of the legal risks anduncertainty regarding various aspects ofsecuritization.

14. To determine that concentrations of expo-sure in the underlying asset pools, in theasset-backed securities portfolio, or in thestructural elements of securitization trans-actions are avoided.

15. To determine that all sources of risk areevaluated at the inception of each securiti-zation activity and are monitored on anongoing basis.

16. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations oflaws, regulations or policy statements havebeen noted.


Asset SecuritizationExamination ProceduresEffective date July 1997 Section 3030.3

These procedures represent a comprehensive listof processes and activities to be reviewed duringa full scope examination. The examiner-in-charge will establish the general scope of theexamination and work with the examinationstaff to tailor specific areas for review as cir-cumstances warrant. The procedures selectedwill be based on internal audit comments, pre-vious examination workpapers, a general reviewof the activity to be examined, and the judge-ment of the examiner and examiner-in-charge.

1. Request a schedule of all asset-backedsecurities owned by the branch. Reconcileto subsidiary ledgers of the balance sheetand review credit ratings assigned to thesesecurities by independent rating agencies.Determine that the accounting methods andprocedures used for these assets, at incep-tion and throughout the carrying life, areappropriate.

2. Request and review information on thetypes and amount of assets that have beensecuritized by the branch. In addition,request information concerning potentialcontractual or contingent liability from guar-antees, underwriting, and servicing of secu-ritized assets, whether originally securitizedby the branch or not.

3. Review the branch’s policies and proce-dures to ensure that it follows prudentstandards of credit assessment and approvalfor all securitization exposure. Proceduresshould include thorough and independentcredit assessment of each loan or pool forwhich it has assumed credit risk followedby periodic credit reviews to monitor per-formance throughout the life of the expo-sure. If a branch invests in asset-backedsecurities, determine whether there is solereliance upon the conclusions of externalrating services when evaluating the securities.

4. Determine that rigorous credit standards areapplied regardless of the role the branchplays in the securitization process, for exam-ple, servicer, credit enhancer, or investor.

5. Determine that major policies and proce-dures, including internal credit review andapproval procedures and in-house exposurelimits, are reviewed periodically andapproved by head office management.

6. Determine whether adequate procedures forevaluating the branch’s internal control pro-cedures and financial strength of the otherinstitutions involved in the securitizationprocess are in place.

7. Obtain the documentation outlining anycredit enhancements and the remedies avail-able in the event of a default. In addition,both originators and purchasers of securi-tized assets should have a prospectus on theissue. Obtaining a copy of the prospectuscan be an invaluable source of information;a prospectus generally should contain infor-mation on credit enhancement, default pro-visions, subordination agreements, etc. Inaddition to the prospectus, obtain the docu-mentation confirming the purchase or saleof a security.

8. Ensure that, regardless of the role a branchplays in the securitization process, the docu-mentation for an asset-backed securityclearly specifies the limitations of thebranch’s legal responsibility to assumelosses.

9. Verify whether the branch, acting as origi-nator, packager, or underwriter, has writtenpolicies addressing the repurchase of assetsand other reimbursement to investors in theevent that a defaulted package results inlosses exceeding any contractual creditenhancement. The repurchase of defaultedassets or pools, although not required by theunderlying agreement, in effect sets a stan-dard by which a branch could potentially befound legally liable for all sold assets.Review and report any situations in whichthe branch has repurchased or otherwisereimbursed investors for poor quality assets.

10. Evaluate credit risk of asset-backed securi-ties and classify any adverse credit risk. Listclassified assets and evaluate the impact ofthe classifications on the overall evaluationof the branch.

11. Aggregate securitization exposures with allloans, extensions of credit, debt and equitysecurities, legally binding financial guaran-tees and commitments, and any other invest-ments involving the same obligor whendetermining compliance with internal creditexposure limits.


12. Review the branch’s valuation methodol-ogy for asset-backed securities to determineif it is appropriate.

13. Review securitized assets for industrial orgeographic concentrations. Excessive expo-sures to an industry or region among theunderlying assets should be noted in thereview of the loan portfolio and evaluated inthe context of the risk managementassessment.

14. Ensure that, in addition to policies limitingdirect credit exposure, a branch has devel-oped exposure limits with respect to par-ticular originators, credit enhancers, trust-ees, and servicers.

15. Review the policies of a branch engaged inunderwriting with regard to situations inwhich it cannot sell underwritten asset-backed securities. Credit review, fundingcapabilities, and approval limits shouldallow the branch to purchase and holdunsold securities. All potential credit expo-sure should be within prudential lendinglimits.

16. Ensure that internal systems and controlsadequately track the performance and con-dition of internal exposures and monitor thebranch’s compliance with internal proce-dures and limits. In addition, verify thatadequate audit trails and internal audit cov-erage are in place. Ensure that the internalreports are adequate in scope and frequency.

17. Determine that management informationsystems provide:a. A listing of all securitizations in which

the branch is involved.b. A listing of industry and geographic

concentrations.c. Information on total exposure to specific

originators, servicers, credit enhancers,trustees, or underwriters.

d. Information regarding portfolio aging andperformance relative to expectations.

e. Periodic and timely information to headoffice management on the branch’sinvolvement in, and credit exposure aris-ing from, securitization.

18. Check whether internal auditors review allfacets of securitization on a regularly basis.

19. Review policies and procedures for compli-ance with applicable state and federal lend-ing limits. These requirements must beanalyzed to determine whether a particularasset-backed security issue is considered asingle investment or a loan to each of thecreditors underlying the pool. Collateralizedmortgage obligations may be exempt fromthis limitation, if they are issued or guaran-teed by an agency or instrumentality of theU.S. government.

20. Determine whether the underwriting ofasset-backed securities of affiliates are:

a. Rated by an unaffiliated, nationally rec-ognized statistical rating organization.

b. Issued or guaranteed by FNMA, FHLMC,or GNMA, or represent interests in suchobligations.

21. Determine if purchases of high-riskmortgage-backed securities were made toreduce the overall interest rate risk of thebranch. Determine if the branch evaluatesand documents at least quarterly whetherthese securities have reduced its interest raterisk.

22. Review and discuss any documentationexceptions, violations, internal controlexceptions, and classifications with manage-ment and obtain and document manage-ment’s response.

23. Review the branch’s liquidity agreementswith any asset-backed commercial paperprograms and determine whether the agree-ments have any credit related components.Is the branch required to purchase the assets?Are these assets repurchased from thebranch? If the facility is determined to be acommitment, determine whether its matu-rity is short-term or long-term. Do any ofthe liquidity agreements contain a materialadverse clause or any other credit contin-gency provision?

3030.3 Asset Securitization Examination Procedures


Asset SecuritizationInternal Controls QuestionnaireEffective date July 1997 Section 3030.4

Review the branch’s internal controls, policies,practices, and procedures for all aspects of assetsecuritization. The branch’s system should bedocumented in a complete and concise mannerand should include,where appropriate, narra-tive descriptions, flowcharts, copies of formsused, and other pertinent information.

POLICIES

1. Does the branch employ the services of asecurities dealer? If so, does the branch relysolely on the advice of such a dealer whenpurchasing asset-backed securities for thebranch’s investment portfolio? Does thebranch have staff responsible for reviewingand approving the investment manager’sacquisitions? Have minimum criteria beenestablished for selecting a securities dealer?

2. To ensure a proper level of supervision overbranch activities, has head office manage-ment reviewed and ratified asset securitiza-tion policies, practices, and procedures that:a. Require an initial thorough and indepen-

dent credit assessment of each asset poolfor which the branch has assumed creditrisk as either a participant in the securiti-zation process or as an investor?

b. Address the repurchase of assets and otherforms of reimbursement to investors bythe branch when it is serving as theoriginator, packager, or underwriter inthe event that a default results in lossesexceeding any contractual creditenhancement?

c. Ensure that the credit, pricing, and servic-ing standards for securitized assets areequivalent to standards for assets thatremain on the branch’s books?

d. Ensure that the credit, pricing, and servic-ing standards and compliance with anyprovisions relating to government guaran-tees are reviewed periodically by headoffice management?

e. Establish in-house diversification require-ments, within proper risk managementtechniques, regarding aggregate outstand-ing exposures to a particular institution,industry, or geographic area?

f. Hedge the branch’s exposure to adverseprice movements when engaged in under-writing or market-making activities?

3. Are securitization policies reviewed andreaffirmed at least annually to determine ifthey are compatible with changing marketconditions?

INTERNALCONTROL/MANAGEMENTINFORMATION SYSTEMS

4. Do the branch’s internal systems and con-trols adequately track the performance andcondition of internal exposures, and do thesystems monitor the branch’s compliancewith internal procedures and limits? Areadequate audit trails and internal and externalaudit coverage provided?

5. Do the branch’s cost accounting systemsprovide a reliable determination of the prof-itability and volatility of asset securitizationactivities?

6. Are management information systems andreporting procedures adequate, in that they:a. Provide a listing of all securitizations for

which the branch is originator, servicer,credit enhancer, underwriter, or trustee?

b. Provide a listing of industry and geo-graphic concentrations?

c. Provide information on total exposure tospecific originators, servicers, creditenhancers, trustees, or underwriters?

d. Provide information regarding portfolioaging and performance relative to expec-tations?

e. Provide periodic and timely informationto head office management on the branch’sinvolvement in, and credit exposure aris-ing from, securitization?

f. Provide credit ratings assigned by inde-pendent rating agencies to all asset-backed securities held by the branch?

CONCLUSION

7. Is the information covered by this ICQadequate for evaluating internal controls inthis area? If not, indicate any additionalexamination procedures deemed necessary.


8. Based on the information gathered, evaluatethe internal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).

3030.4 Asset Securitization Internal Controls Questionnaire


Banker’s AcceptancesEffective date July 1997 Section 3040.1

One method of financing international trade isby the use of a banker’s acceptance. Such aninstrument may be used to finance all of thesuccessive stages of the movement of goodsthrough the channels of trade from the point oforigin to the final destination.

A banker’s acceptance is an order in the formof a time draft (also referred to as a bill ofexchange or a usance draft) drawn by one party(the drawer) in favor of itself or another party(the payee), addressed to (drawn on) a bank (thedrawee) and accepted by that bank to pay theholder a certain sum on or before a specifieddate. The bank’s acceptance of this order fromthe drawer, by stamping across the face of thedraft ACCEPTED and dating and signing thestamp, is a formal acknowledgement of theobligation and constitutes an unconditionalpromise by that bank to honor the time draft atmaturity. The drawee bank creating the accep-tance is primarily liable for the instrument,while the payee, as first endorser, is secondarilyliable for paying the holder in due course. If thedrawee (acceptor) is other than a bank, theinstrument is a trade acceptance, not a banker’sacceptance.

Most banker’s acceptances are used to financetrade transactions. Accordingly, acceptances areoften created in connection with a letter ofcredit, although they may arise in connectionwith collection or open account transactions.Refer to the manual section entitled Letters ofCredit. In general, acceptance credit is consid-ered self-liquidating in that it provides the meansfor its own payment at maturity. Self-liquidationis accomplished because the acceptance must bebased on a specific trade transaction in whichgoods are being shipped prior to entering thechannels of trade. Therefore, satisfactory evi-dence should be available indicating that thedraft, when created, is based on an actualshipment or storage. Furthermore, at maturity ofthe draft, the proceeds from the sale of the goodswill be used to settle the draft. To a lesser extent,acceptances also finance the domestic shipmentof goods and domestic or foreign storage ofreadily marketable staples.

The payee of the acceptance may hold anacceptance until maturity, discount it with his orher bank, or sell it in the acceptance market.When a bank discounts (purchases) its ownacceptance for the payee, its Customers’ Liabil-ity on Acceptances (asset) and Bank’s Liability

on Acceptances (liability) accounts are reducedand the discounted acceptance is recorded withother loans and discounts. If the accepting banksubsequently rediscounts (sells) the acceptancein the market, that acceptance is rebooked asCustomers’ Liability on Acceptances and Bank’sLiability on Acceptances outstanding and theloan and discount account is reduced. Redis-counted acceptances are not considered borrow-ings. The customer’s liability on acceptances isreduced by a customer’s prepayment or antici-pation, of an acceptance outstanding. However,the bank’s liability is not similarly reduced byan anticipation.

The established market for banker’s accep-tances in the United States is regulated by theFederal Reserve System. Federal Reserve Banksare authorized to discount or purchase eligiblebanker’s acceptances subject to qualitative andquantitative limits, thus providing a source ofliquidity to the selling banks. The creation ofbanker’s acceptances is governed by Section 13of the Federal Reserve Act (12 USC 372), whichestablishes criteria that must be met in order forthe instrument to be eligible for either discountor purchase by the Federal Reserve Banks. Inaddition, for federally-licensed branches, theeligible banker’s acceptance limit is in additionto the loan and investment securities limits. Therules governing whether an acceptance meetsthe eligibility requirements for discount or pur-chase are important for two major reasons. First,acceptances meeting the conditions of eligibilityare more readily salable in the market than areacceptances that do not satisfy these conditionsand, as such, provide a greater degree of liquid-ity for the accepting bank. Second, unlike eli-gible acceptances, ineligible acceptances aresubject to reserve maintenance requirements,thus raising the cost to the borrower over that ofan eligible acceptance. For federally-licensedbranches, ineligible banker’s acceptances aresubject to the limits specified in 12 USC 84 andare combined with loans. The examiner must befamiliar with the criteria used for determiningeligibility for discount or purchase by the Fed-eral Reserve Banks.

Branches that are subject to reserve require-ments (i.e. controlled by an entity with $1 bil-lion in total worldwide consolidated assets)under Section 7 of the International Banking Actof 1978 (12 USC 3105(a)) are subject to thelimitations described in Section 13 of the Fed-


eral Reserve Act (12 USC 372). These regula-tions limit the amount of eligible banker’s accep-tances that may be created to 150 percent (or200 percent with the permission of the Board) ofthe paid up and unimpaired capital stock andsurplus of the foreign banking organization(FBO). In addition, all U.S. branches of an FBOare prohibited from creating eligible banker’sacceptances for any one person in the aggregatein excess of 10 percent of the FBO’s capital.Eligible banker’s acceptances growing out ofdomestic transactions are not to exceed 50 per-

cent of the aggregate of all eligible acceptancesauthorized for a branch.

Banker’s acceptances, as a source of financeand investment, offer significant advantages toborrowers, accepting banks, and investors alike.Over the years, a banker’s acceptance has oftenbeen a cheaper financing vehicle than a loan,because it is readily marketable, is considered animportant secondary reserve for the acceptingbank, and is a relatively secure investment to theinvestor because of its two-name backing.

3040.1 Banker’s Acceptances


Banker’s AcceptancesExamination ObjectivesEffective date July 1997 Section 3040.2

1. To determine if objectives, policies, prac-tices, procedures, and internal controlsregarding banker’s acceptances are adequate.


3. To determine the scope and adequacy of theaudit function as it applies to banker’sacceptances.

4. To evaluate the portfolio for documentationand collateral sufficiency, credit quality, andcollectibility.

5. To determine compliance with applicablefederal and state laws and regulations.

6. To recommend corrective action when poli-cies, practices, procedures, or internal con-trols are deficient or when violations of lawor regulations have been noted.


Banker’s AcceptancesExamination ProceduresEffective date July 1997 Section 3040.3

1. If selected for implementation, complete orupdate the Internal Control Questionnairefor this section.

2. Determine if deficiencies noted at previousexaminations and internal/external auditshave been adequately addressed by manage-ment.

3. Review the bankers acceptance section ofthe lending policy for adequacy.

4. Check scope of internal audit to ensure thatit covers a review of bankers acceptances.

5. Reconcile balances to departmental controlsand the general ledger.

6. Verify that appropriate accounting methodsare used and that regulatory reports areaccurately prepared.

7. Determine that there is appropriate segrega-tion of duties in that:a. Individuals who prepare and post BA

records also do not issue official checksor handle cash,

b. Individuals who perform reconciliationsand certifications also do not processacceptances, and

c. Persons who investigate exceptions andrespond to inquiries do not normallyprocess acceptances.

8. Ensure the branch has an adequate systemto track outstanding exceptions anddelinquencies.

9. Ensure that acceptances are registered insome manner (manual log book or com-puter system), consecutively numbered, andidentified by type of transaction so as toleave an audit trail.

10. Review procedures for safeguarding blank,accepted, and pre-signed documents anddrafts.

11. Review procedures for determining BA eli-gibility. Ensure that ineligible acceptancesare appropriately segregated from the elibibleacceptances. Ineligible acceptances cannotbe discounted at the Federal Reserve andare treated as reservable liabilities.

Eligibility can be determined by reviewingdocumentary evidence detailing the nature ofthe transaction underlying the credit extended.This evidence may be in the form of correspon-dence, title documents, or document transmittalletters that provide sufficient detail to judge

eligibility according to established criteria.Details provided should cover:

• Value of merchandise.• Description of merchandise.• Origin and destination of shipment.• Date of shipment.• Certification that the merchandise is not being

financed elsewhere.

12. Review procedures for financing cleanacceptances(i.e. when the title and shippingdocumentation is not processed by the office)to ensure they include:a. Details of the shipment such as invoice

amount, type of commodity or merchan-dise, ports of embarkation and debarka-tion, and the bill of lading date.

b. Certification that duplicate financing doesnot exist.

c. An agreement by the customer to pro-vide copies of invoices and bills oflading to the branch upon request.

13. Review procedures for monitoring the stipu-lated aggregate liability limitations on out-standing acceptances. Systems should be inplace to monitor the global customer expo-sure on the aggregate outstanding amounton a consolidated basis which cannot exceed150% of parent bank capital.

14. Select a sample of bankers acceptancescreated for specific borrowers and reviewcredit files for credit risk. Forward findingsto examiner in charge of loan review.

15. Ensure the branch has procedures in placeto comply with OFAC and Anti-Boycottprovisions.

16. Prepare, in appropriate format, the findingsand conclusions regarding:a. The adequacy of policies relating to

banker’s acceptances.b. Whether branch officers are operating in

conformance with established policy.c. Adverse trends within the banker’s accep-

tance department.d. The accuracy and completeness of the

schedules obtained.e. Internal control deficiencies or exceptions.f. Recommended corrective action when

policies, practices, or procedures aredeficient.


g. Other matters of significance.17. Update the workpapers with any informa-

tion that will facilitate future examinations.

3040.3 Banker’s Acceptances Examination Procedures


Banker’s AcceptancesInternal Control QuestionnaireEffective date July 1997 Section 3040.4

POLICIES

1. Have policies been adopted that:a. Establish procedures for reviewing bank-

er’s acceptance applications?b. Define qualified customers?c. Establish minimum standards for docu-

mentation in accordance with the Uni-form Commercial Code?

2. Are policies reviewed at least annually todetermine if they are compatible with chang-ing market conditions?

RECORDS

3. Is the preparation and posting of subsidiarybanker’s acceptance records performed orreviewed by persons who do not also handlecash or issue official checks or drafts?

4. Are the subsidiary banker’s acceptancerecords balanced daily with the appropriategeneral ledger accounts and are reconcilingitems adequately investigated by personswho do not normally handle acceptancesand post records?

5. Are acceptance delinquencies prepared forand reviewed by management on a timelybasis?

6. Are inquiries about acceptance balancesreceived and investigated by persons whodo not normally handle settlements or postrecords?

7. Are bookkeeping adjustments checked andapproved by an appropriate officer?

8. Is a daily record maintained, summarizingacceptance transactions details, i.e., bank-er’s acceptances created, payments received,and fees collected, to support applicablegeneral ledger account entries?

9. Are acceptances of other banks that havebeen purchased in the open market segre-gated on the branch’s records from thebranch’s own acceptances purchased?

10. Are prepayments on banker’s acceptancesnetted against the appropriate asset accountCustomer Liability for Acceptances Out-standing (or loans and discounts, dependingupon whether the branch has discounted itsown acceptance), and do they continue to

be shown as a liability under Bank’s Liabil-ity on Acceptances Outstanding?

11. Are banker’s acceptance record copies andliability ledger trial balances prepared andreconciled monthly with control accountsby employees who do not process or recordacceptance transactions?

FEES

12. Is the preparation and posting of fees anddiscounts performed or reviewed by per-sons who do not also handle cash or issueofficial checks or drafts?

13. Are any independent fee and discount com-putations made and compared or adequatelytested to initial fee and discount records bypersons who do not also handle cash orissue official checks or drafts?

OTHER

14. Are acceptance record copies, own accep-tances discounted (purchased) and accep-tances of other banks purchased safe-guarded during banking hours, locked inthe vault overnight, and periodicallyinventoried?

15. Are blank (pre-signed) customer drafts main-tained under dual control in the vault, num-bered, inventoried monthly, and verifiedwith the customer on a monthly basis?

16. Are any acceptance fee rebates approved byan officer?

17. Does the branch have an internal reviewsystem that:a. Reviews collateral and supporting docu-

mentation held for negotiability andproper assignment?

b. Test checks the values assigned to col-lateral at frequent intervals?

c. Determines that lending officers are peri-odically advised of maturing banker’sacceptances or acceptance lines.

d. Determines that the individuals to whomfunds are being disbursed are authorizedby the beneficiary to receive the funds?

e. Addresses funding procedures for redis-counted acceptances?


f. Tests for compliance with IBFrestrictions?

18. Does the branch’s acceptance filing systemprovide for the identification of each accep-tance, e.g., by consecutive numbering andapplicable letter of credit, to provide aproper audit trail?

CONCLUSION

19. Is the information covered by this internalcontrol questionnaire adequate for evaluat-

ing internal controls in this area? If not,indicate any additional examination proce-dures deemed necessary.

20. Based on the information gathered, evaluateinternal controls in this area (i.e. strong,satisfactory, fair, marginal, unsatisfactory).

3040.4 Banker’s Acceptances Internal Control Questionnaire


Risk Management Introduction Effective date July 1997 ...• Reports and other forms of...

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