deposit accounts section 3000.1

Deposit AccountsEffective date April 2011 Section 3000.1

Deposits are funds that customers place with abank and that the bank is obligated to repay ondemand, after a specific period of time or afterexpiration of some required notice period.Deposits are the primary funding source formost banks and, as a result, have a significanteffect on a bank’s liquidity. Banks use depositsin a variety of ways, primarily to fund loans andinvestments. Management should establish aprocedure for determining the volatility andcomposition of the deposit structure to ensurethat funds are employed profitably, while allow-ing for their potential withdrawal. Therefore, abank’s management should implement pro-grams to retain and prudently expand the bank’sdeposit base.

Bankers place great significance on the depositstructure because favorable operating resultsdepend, in part, on a core deposit base. Becauseof competition for funds, the need for mostindividuals and corporations to minimize idlefunds, and the effect of disintermediation (themovement of deposits to other higher-yieldingmarkets) on a bank’s deposit base, bank man-agement should adopt and implement a devel-opment and retention program for all types ofdeposits.

DEPOSIT DEVELOPMENT ANDRETENTION PROGRAM

Important elements of the examination processare the review of a bank’s deposit developmentand retention program and the methods used todetermine the volatility and composition of thedeposit structure. A bank’s deposit developmentand retention program should include—

• a marketing strategy,

• projections of deposit structure and associatedcosts, and

• a formula for comparing results againstprojections.

To structure a deposit program properly, bankmanagement must consider many factors, someof which include—

• the composition of the market-area economicbase,

• the ability to employ deposits profitably,

• the adequacy of current operations (staffingand systems) and the location and size ofbanking quarters relative to the bank’s volumeof business,

• the degree of competition from banks andnonbank financial institutions and their pro-grams to attract deposit customers, and

• the effects of the national economy and themonetary and fiscal policies of the federalgovernment on the bank’s service area.

The bank’s size and the composition of itsmarket determine how formal its deposit pro-gram should be. After a bank develops itsdeposit program, management must continue tomonitor the above factors and correlate anyfindings to determine if adjustments are needed.The long-term success of any deposit programrelates directly to the ability of management tomake adjustments at the earliest possible time.

DEPOSIT STRUCTURE

Management should look not only at depositgrowth but also at the nature of the depositstructure. To invest deposited funds properly inview of anticipated or potential withdrawals,management must be able to determine whatpercentage of the overall deposit structure iscentered in core deposits, in fluctuating or sea-sonal deposits, and in volatile deposits. It isimportant that internal reports with informationconcerning the composition of the deposit struc-ture be provided to management periodically.Management’s lack of such knowledge couldlead to an asset-liability mismatch, causing prob-lems at a later date.

In analyzing the deposit structure, informa-tion gathered by the various examination proce-dures should be sufficient to allow the examinerto evaluate the composition of both volatile andcore deposits. Ultimately, the examiner shouldbe satisfied with management’s efforts to planfor the bank’s future.

Examiners must analyze the present andpotential effect deposit accounts have on thefinancial condition of the bank, particularly withregard to the quality and scope of management’splanning. The examiner’s efforts should bedirected to the various types of deposit accountsthat the bank uses for its funding base. The

Commercial Bank Examination Manual April 2016

examiners assigned to the areas of funds man-agement and to the analytical review of thebank’s income and expenses should be informedof any significant change in interest-bearingdeposit-account activity.

COST OF FUNDS

Interest paid on deposits is generally the largestexpense to a bank. As a result, interest-bearingdeposit accounts employed in a marginally prof-itable manner could have significant and lastingeffects on bank earnings. The examiner shouldconsider the following in evaluating the effect ofinterest-bearing deposit accounts on a bank’searnings:

• an estimated change in interest expense result-ing from a change in interest rates on depositaccounts or a shift in funds from one type ofaccount to another

• service-charge income• projected operating costs• changes in required reserves• promotional and advertising costs• the quality of management’s planning

SPECIAL DEPOSIT-RELATEDISSUES

The examiner should keep the following issuesin mind during an examination to ensure thebank is in compliance, where applicable.

Abandoned-Property Law

State abandoned-property laws generally arecalled escheat laws. Although escheat laws varyfrom state to state, they normally require a bankto remit the proceeds of any deposit account tothe state treasurer when—

• the deposit account has been dormant for acertain number of years and

• the owner of the account cannot be located.

Service charges on dormant accounts shouldbear a direct relationship to the cost of servicingthe accounts, which ensures that the charges arenot excessive. A bank’s board of directors (or acommittee appointed by the board) should review

the basis on which service charges on dormantaccounts are assessed and should document thereview. There have been occasions when exces-sive servicing charges have resulted in no pro-ceeds being remitted at the time the accountbecame subject to escheat requirements. In thesecases, courts have required banks to reimbursethe state. (See also the ‘‘Dormant Accounts’’discussion later in this section.)

Bank Secrecy Act

Examiners should be aware of the Bank SecrecyAct when examining the deposit area and shouldfollow up on any unusual activities or arrange-ments noted. The act was implemented by theTreasury Department’s Financial Recordkeep-ing and Reporting of Currency and ForeignTransactions Regulation. For further informa-tion, see the FFIEC Bank Secrecy Act Examina-tion Manual, section 208.63 of the FederalReserve’s Regulation H, and the FinancialCrimes Enforcement Network (FinCEN)’s BankSecrecy Act regulations at 31 CFR Chapter X.Prior to March 1, 2011, FINCEN’s regulationwas at 31 CFR 103.

Banking Hours and Processing ofDemand Deposits

The Board’s Regulation CC (12 CFR 229),‘‘Availability of Funds and Collection of Checks,’’and the Uniform Commercial Code (UCC) gov-ern banking-day cutoff hours and the processingof deposits. A ‘‘banking day’’ is that part of aday on which an office of the bank is open to thepublic for carrying out substantially all of itsbanking functions. Saturdays, Sundays, and cer-tain specified holidays are not banking daysunder Regulation CC, although such days mightbe banking days under the UCC if a bank isopen for substantially all of its functions onthose days.

Regulation CC requires a bank to makedeposited funds available for withdrawal withina certain period after the banking day on whichthey are received. Cash deposits, wire transfers,and certain check deposits that pose little risk tothe depositary bank (such as Treasury checksand cashier’s checks) generally are to be madeavailable for withdrawal by the business day

3000.1 Deposit Accounts

April 2016 Commercial Bank Examination Manual

after the day of deposit. The time when thedepositary bank must make other check depositsavailable for withdrawal depends on whether thecheck is local or nonlocal to the depositary bank.As of September 1, 1990, proceeds of local andnonlocal checks must be available for with-drawal by the second and fifth business dayfollowing deposit, respectively. However, Regu-lation CC allows a bank to set, within certainlimits, cutoff hours, after which the bank willdeem funds to be received on the next bankingday for purposes of calculating the availabilitydate (12 CFR 229.19). Different cutoff-hourlimits apply to different types of deposits.

For the purpose of allowing banks to processchecks, the UCC provides that a bank may set acutoff hour of 2 p.m. or later and that itemsreceived after that time will be consideredreceived as of the next banking day (UCCsection 4-108). Under both the UCC and Regu-lation CC, both the banking day on which a bankis deemed to have received a check and thecutoff hour affect the time frames within whicha bank must send the check through the forward-collection and return processes.

A bank that fails to set its cutoff hour appro-priately, does not make funds available withinthe appropriate time frames, or processes checksin an untimely manner may be subject to civilliability for not performing its duties in accor-dance with various provisions of Regulation CCand the UCC.

Banking Accounts for ForeignGovernments, Embassies, Missions,and Political Figures

On June 15, 2004, an interagency advisoryconcerning the embassy banking business andrelated banking matters was issued by the fed-eral banking and thrift agencies (the Board ofGovernors of the Federal Reserve System, theFederal Deposit Insurance Corporation, theOffice of the Comptroller of the Currency, theOffice of Thrift Supervision, and the NationalCredit Union Administration (the agencies)).The advisory was issued in coordination withthe U.S. Department of the Treasury’s FinancialCrimes Enforcement Network. The purpose ofthe advisory is to provide general guidance tobanking organizations regarding the treatmentof accounts for foreign governments, foreignembassies, and foreign political figures.

The joint interagency statement advises bank-ing organizations that the decision to accept orreject an embassy or foreign government accountis theirs alone to make. The statement advisesthat financial institutions should be aware thatthere are varying degrees of risk associated withsuch accounts, depending on the customer andthe nature of the services provided. Institutionsshould take appropriate steps to manage suchrisks consistent with sound practices and appli-cable anti-money-laundering laws and regula-tions. The advisory also encourages bankingorganizations to direct questions about embassybanking to their primary federal bank regulators.(See SR-04-10.)

On March 24, 2011, an interagency advisorywas issued to supplement SR-04-10, ‘‘BankingAccounts for Foreign Governments, Embassies,and Political Figures.’’ The supplemental advi-sory provides information to financial institu-tions regarding the provision of account servicesto foreign embassies, consulates and to foreignmissions in a manner that fulfills the needs ofthose foreign governments while complyingwith the provisions of the Bank Secrecy Act(BSA). It advises that financial institutions areexpected to demonstrate the capacity to conductappropriate risk assessments and implement therequisite controls and oversight systems to effec-tively manage the risk identified in these rela-tionships with foreign missions. The advisoryalso confirms that it is the financial institution’sdecision to accept or reject a foreign missionaccount. (See SR-11-6 and the attached supple-mental interagency advisory.)

Interagency Advisory on AccessingAccounts from Foreign Governments,Embassies, and Foreign Political Figures

The 2004 interagency advisory answers ques-tions on whether financial institutions shouldconduct business with foreign embassies andwhether institutions should establish accountservices for foreign governments, foreign embas-sies, and foreign political figures. As it wouldwith any new account, an institution shouldevaluate whether or not to accept a new accountfor a foreign government, embassy, or politicalfigure. That decision should be made by theinstitution’s management, under standards andguidelines established by the board of directors,and should be based on the institution’s ownbusiness objectives, its assessment of the risks

Deposit Accounts 3000.1


associated with particular accounts or lines ofbusiness, and its capacity to manage those risks.The agencies will not, in the absence of extraor-dinary circumstances, direct or encourage anyinstitution to open, close, or refuse a particularaccount or relationship.

Providing financial services to foreign gov-ernments and embassies and to foreign politicalfigures can, depending on the nature of thecustomer and the services provided, involvevarying degrees of risk. Such services can rangefrom account relationships that enable anembassy to handle the payment of operationalexpenses, for example, payroll, rent, and utili-ties, to ancillary services or accounts provided toembassy staff or foreign government officials.Each of these relationships potentially posesdifferent levels of risk. Institutions are expectedto assess the risks involved in any such relation-ships and to take steps to ensure both that suchrisks are appropriately managed and that theinstitution can do so in full compliance with itsobligations under the BSA, as amended by theUSA Patriot Act, and the regulations promul-gated thereunder.

When an institution elects to establish finan-cial relationships with foreign governments,embassies, or foreign political figures, the agen-cies, consistent with their usual practice ofrisk-based supervision, will make their ownassessment of the risks involved in such busi-ness. As is the case with all accounts, theinstitution should expect appropriate scrutiny byexaminers that is commensurate with the levelof risk presented by the account relationship. Asin any case where higher risks are presented, theinstitution should expect an increased level ofreview by examiners to ensure that the institu-tion has in place controls and compliance over-sight systems that are adequate to monitor andmanage such risks, as well as personnel trainedin the management of such risks and in therequirements of applicable laws and regulations.

Institutions that have or are considering tak-ing on relationships with foreign governments,embassies, or political figures should ensure thatsuch customers are aware of the requirements ofU.S. laws and regulations to which the institu-tion is subject. Institutions should, to the maxi-mum extent feasible, seek to structure suchrelationships in order to conform them to con-ventional U.S. domestic banking relationships soas to reduce the risks that might be presented bysuch relationships.

Foreign-Currency Deposits

Domestic depository institutions are permittedto accept deposits denominated in foreign cur-rency. Institutions should notify customers thatsuch deposits are subject to foreign-exchangerisk. The bank should convert such accounts tothe U.S. dollar equivalent for purposes of report-ing to the Federal Reserve. Examination staffshould ascertain that all reports are in order andshould evaluate the bank’s use of such funds andits management of the accompanying foreign-exchange risk. Accounts denominated in foreigncurrency are not subject to the requirements ofRegulation CC. (See SR-90-03 (IB), ‘‘Foreign(Non–U.S.) Currency Denominated DepositsOffered at Domestic Depository Institutions.’’)

International Banking Facilities

An international banking facility (IBF) is a setof asset and liability accounts segregated on thebooks of a depository institution. IBF activitiesare essentially limited to accepting depositsfrom and extending credit to foreign residents(including banks), other IBFs, and the institu-tions establishing the IBF. IBFs are not requiredto maintain reserves against their time depositsor loans. The examiner should follow the specialexamination procedures in the international sec-tion of this manual when examining an IBF.

Deposits Insured by the FederalDeposit Insurance Corporation

The Federal Deposit Insurance Corporation(FDIC) is an independent agency of the U.S.government. The FDIC protects depositorsagainst the loss of their insured deposits due tothe failure of an insured bank, savings bank,savings association, insured branch of a foreignbank, or other depository institution whosedeposits are insured pursuant to the FederalDeposit Insurance Corporation Act. If a deposi-tor’s accounts at one FDIC-insured depositoryinstitution total up to $250,000 (or the standardmaximum deposit insurance amount [SMDIA]),the funds are fully insured and protected. Adepositor can have more than the SMDIA at oneinsured depository institution and still be fullyinsured provided the accounts meet certainrequirements. In addition, federal law currently



provides for insurance coverage of up to$250,000 or the SMDIA.

The FDIC insurance covers all types of depos-its received at an insured depository institution,including deposits in checking, negotiable orderof withdrawal (NOW), and savings accounts;money market deposit accounts; and time depos-its such as certificates of deposit (CDs). FDICdeposit insurance covers the balance of eachdepositor’s account, dollar-for-dollar, up to theSMDIA, including the principal and any accruedinterest through the date of an insured deposi-tory institution’s closing.

Deposits in separate branches of an insureddepository institution are not separately insured.Deposits in one insured institution are insuredseparately from deposits in another insured insti-tution. Deposits maintained in different catego-ries of legal ownership at the same depositoryinstitution can be separately insured. Therefore,it is possible to have deposits of more than theSMDIA at one insured institution and still befully insured.

Deposit Insurance Reform Acts

On March 14, 2006, the FDIC amended itsdeposit insurance regulations (effective April 1,2006) by issuing an interim rule with a requestfor public comment on or before May 22, 2006.(See 71 Fed. Reg. 14631, 71 Fed. Reg. 53550(Sept. 12, 2006) and 12 CFR Part 330.) Theinterim rule implemented applicable revisions tothe Federal Deposit Insurance Act made by theFederal Deposit Insurance Reform Act of 2005(Reform Act) and the Federal Deposit InsuranceReform Conforming Amendments Act of 2005(the Conforming Amendments Act). The ReformAct provided for consideration of inflation adjust-ments (cost-of-living adjustment) to increase thecurrent SMDIA on a five-year cycle beginningon April 1, 2010.

Second, the Reform Act increased the depositinsurance limit for accounts up to $250,000, alsosubject to inflation adjustments. The types ofaccounts included are individual retirementaccounts (IRAs),1 eligible deferred compensa-tion plan accounts,2 and individual account plan

accounts,3 and any plan described in section401(d) of the IRC, to the extent that participantsand beneficiaries under such plans have a rightto direct the investment of assets held in indi-vidual accounts maintained on their behalf bythe plans.

Third, the Reform Act provided per-participantinsurance coverage to employee benefit planaccounts, even if the depository institution atwhich the deposits are placed is not authorizedto accept employee benefit plan deposits. Thecost-of-living adjustment is to be calculatedaccording to the Personal Consumption Expen-ditures Chain-type Price Index published by theU.S. Department of Commerce and roundeddown to the nearest $10,000.

The Conforming Amendments Act createdthe term government depositor in connectionwith public funds described in and insuredpursuant to section 11(a)(2) of the FederalDeposit Insurance Act (FDIA). (See 12 USC1821(a)(2).) The Conforming Amendments Actprovides that the deposits of a governmentdepositor are insured in an amount up to theSMDIA, subject to the inflation adjustmentdescribed previously.

Deposit Insurance Rule AmendmentsRetirement and Employee Benefit PlanAccounts

When deposits from a retirement or employeebenefit plan (EBP)—such as a 401(k) retirementaccount, Keogh plan account, corporate pensionplan, or profit-sharing program—are entitled topass-through insurance, the SMDIA on FDICinsurance does not apply to the entire EBPaccount balance. Rather, the FDIC insurancecoverage ‘‘passes through’’ to each owner orbeneficiary, and the deposited funds of eachindividual EBP participant are insured up to theSMDIA.

The Reform Act and the Conforming Amend-ments Act, and the FDIC’s March 23, 2006,interim rule eliminated the previous requirementthat pass-through coverage for employee benefitplan accounts be dependent on the capital levelof a depository institution where such depositsare placed. Pass-through coverage for employeebenefit plan deposits was not available if the

1. IRAs described in section 408(a) of the Internal RevenueCode (IRC). (See 26 USC 408(a).)

2. Eligible deferred compensation plan accounts describedin section 457 of the IRC. (See 26 USC 457.)

3. Individual account plan accounts such as those definedin section 3(34) of the Employee Retirement Income SecurityAct.



deposits were placed with an institution that wasnot permitted to accept brokered deposits becauseof the capital requirements. Insured institutionsthat are not ‘‘well capitalized’’ or ‘‘adequatelycapitalized’’ are now prohibited by the ReformAct from accepting employee benefit plan depos-its. Under the Reform Act, employee benefitplan deposits accepted by an insured depositoryinstitution, even those prohibited from acceptingsuch deposits, are nonetheless eligible for pass-through deposit insurance coverage. The rule’samendment (see 12 CFR 330.14) applies to allemployee benefit plan deposits, including em-ployee benefit plan deposits placed before April1, 2006. The rule’s other requirements in section330.14 continue to apply. In particular, only the‘‘noncontingent’’ interests of plan participants inan applicable plan are eligible for pass-throughcoverage. A ‘‘noncontingent interest’’ is aninterest that can be determined without theevaluation of contingencies other than life expec-tancy. The maximum coverage for accounts isup to $250,000 or the SMDIA. These accountscontinue to be made up of individual retirementaccounts (the traditional IRAs and the RothIRAs); section 457 deferred compensation planaccounts, ‘‘self-directed’’ Keogh plan accounts(or HR 10 accounts); and ‘‘self-directed’’ definedcontribution plan accounts, which are primarily40l(k) plan accounts. The term self-directedmeans that the plan participants have the right todirect how their funds are invested, includingthe ability to direct that the funds be invested atan FDIC-insured institution.

Reserve Requirements

The Monetary Control Act of 1980 and theFederal Reserve’s Regulation D, ‘‘ReserveRequirements of Depository Institutions,’’ estab-lish two categories of deposits for reserve-requirement purposes. The first category is thetransaction account, which represents a depositor account from which the depositor or accountholder is permitted to make orders of withdraw-als by negotiable instrument, payment orders ofwithdrawal, telephone transfer, or similar devicesfor making payments to a third party or others.Transaction accounts include demand deposits,NOW accounts, automatic transfer (ATS)accounts, and telephone or preauthorized trans-fer accounts. The second category is the non-transaction deposit account, which includes

all deposits that are not transaction accounts,such as (1) savings deposits, that is, moneymarket deposit accounts and other savings depos-its, and (2) time deposits, that is, time certifi-cates of deposit and time deposits, open account.See Regulation D for specific definitions of thevarious deposit accounts.

Treasury Tax and Loan Accounts

Member banks may select either the ‘‘remittance-option’’ or the ‘‘note-option’’ method to forwarddeposited funds to the U.S. Treasury. With theremittance option, the bank remits the TreasuryTax and Loan (TT&L) account deposits to theFederal Reserve Bank the next business dayafter deposit. The remittance portion is notinterest-bearing.

The note option permits the bank to retain theTT&L deposits. With the note option, the bankdebits the TT&L remittance account for theamount of the previous day’s deposit and simul-taneously credits the note-option account. Thus,TT&L funds are now purchased funds evi-denced by an interest-bearing, variable-rate,open-ended, secured note callable on demand byTreasury. Rates paid are 1⁄4 of 1 percent less thanthe average weekly rate on federal funds. Inter-est is calculated on the weekly average dailyclosing balance in the TT&L note-option account.Although there is no required maximum note-option ceiling, banks may establish a maximumbalance by providing written notice to the Fed-eral Reserve Bank. As per 31 CFR 203.24, theTT&L balance requires the bank to pledgecollateral to secure these accounts, usually fromits investment portfolio. The note option is notincluded in reserve-requirement computationsand is not subject to deposit insurance because itis classified as a demand note issued to the U.S.Treasury, a type of borrowing.

POTENTIAL PROBLEM AREAS

The following types of deposit accounts andrelated activities have above-average risk and,therefore, require the examiner’s specialattention.



Bank-Controlled Deposit Accounts

Bank-controlled deposit accounts, such as sus-pense, official checks, cash-collateral, dealerreserves, and undisbursed loan proceeds, areused to perform many necessary banking func-tions. However, the absence of sound adminis-trative policies and adequate internal controlscan cause significant loss to the bank. To ensurethat such accounts are properly administeredand controlled, the directorate must ensure thatoperating policies and procedures are in effectthat establish acceptable purpose and use;appropriate entries; controls over postingentries; and the length of time an item mayremain unrecorded, unposted, or outstanding.Internal controls that limit employee access tobank-controlled accounts, determine the respon-sibility for frequency of reconcilement, discour-age improper posting of items, and provide forperiodic internal supervisory review of accountactivity are essential to efficient depositadministration.

The deposit suspense account is used toprocess unidentified, unposted, or rejected items.Characteristically, items posted to such accountsclear in one business day. The length of time anitem remains in control accounts often reflectson the bank’s operational efficiency. This deposittype has a higher risk potential because thetransactions are incomplete and require manualprocessing to be completed. As a result of theneed for human interaction and the exceptionnature of these transactions, the possibility ofmisappropriation exists.

Official checks, a type of demand deposit,include bank checks, cashier’s checks, expensechecks, interest checks, dividend-paymentchecks, certified checks, money orders, andtraveler’s checks. Official checks reflect thebank’s promise to pay a specified sum uponpresentation of the bank’s check. Becauseaccounts are controlled and reconciled by bankpersonnel, it is important that appropriate inter-nal controls are in place to ensure that accountreconcilement is segregated from check origina-tion. Operational inefficiencies, such as unre-corded checks that have been issued, can resultin a significant understatement of the bank’sliabilities. Misuse of official checks may resultin substantial losses through theft.

Cash-collateral, dealer differential or reserve,undisbursed loan proceeds, and various loanescrow accounts are also sources of potential

loss. The risk lies in inefficiency or misuse if theaccounts become overdrawn or if funds arediverted for other purposes, such as the paymentof principal or interest on bank loans. Fundsdeposited to these accounts should be used onlyfor their stated purposes.

Brokered Deposits

As defined in Federal Deposit Insurance Corpo-ration (FDIC) regulations, brokered deposits arefunds a depository institution obtains, directly orindirectly, from or through the mediation orassistance of a deposit broker, for deposit intoone or more deposit accounts (12 CFR 337.6).Thus, brokered deposits include both those inwhich the entire beneficial interest in a givenbank deposit account or instrument is held by asingle depositor and those in which the depositbroker pools funds from more than one investorfor deposit in a given bank deposit account.

Section 29 of the Federal Deposit InsuranceAct (the FDI Act) (12 USC 1831f(g)(1)) and theFDIC’s regulations (12 CFR 337.6 (a)(5)) definedeposit broker to mean—

• any person engaged in the business of placingdeposits, or facilitating the placement of depos-its, of third parties with insured depositoryinstitutions or the business of placing depositswith insured depository institutions for thepurpose of selling interests in those deposits tothird parties; and

• an agent or a trustee who establishes a depositaccount to facilitate a business arrangementwith an insured depository institution to usethe proceeds of the account to fund a prear-ranged loan.

The term deposit broker does not include —

• an insured depository institution, with respectto funds placed with that depository institution;

• an employee of an insured depository institu-tion, with respect to funds placed with theemploying depository institution;

• a trust department of an insured depositoryinstitution, if the trust or other fiduciary rela-tionship in question has not been establishedfor the primary purpose of placing funds withinsured depository institutions;

• the trustee of a pension or other employeebenefit plan, with respect to funds of the plan;



• a person acting as a plan administrator or aninvestment adviser in connection with a pen-sion plan or other employee benefit planprovided that person is performing managerialfunctions with respect to the plan;

• the trustee of a testamentary account;• the trustee of an irrevocable trust,4 as long as

the trust in question has not been establishedfor the primary purpose of placing funds withinsured depository institutions;

• a trustee or custodian of a pension or profit-sharing plan qualified under section 401(d) or403(a) of the Internal Revenue Code of 1986(26 USC 401(d), 503(a)); or

• an agent or a nominee whose primary purposeis not the placement of funds with depositoryinstitutions; or

• an insured depository institution acting as anintermediary or agent of a U.S. governmentdepartment or agency for a government-sponsored minority or women-owned deposi-tory institution deposit program.

A small- or medium-sized bank’s dependenceon the deposits of customers who reside orconduct their business outside of the bank’snormal service area should be closely monitoredby the bank and analyzed by the examiner. Suchdeposits may be the product of personal rela-tionships or good customer service; however,large out-of-area deposits are sometimes attractedby liberal credit accommodations or signifi-cantly higher interest rates than competitorsoffer. Deposit growth that is due to liberal creditaccommodations generally proves costly in termsof the credit risks taken relative to the benefitsreceived from corresponding deposits, whichmay be less stable. Banks outside dynamicmetropolitan areas are limited in growth becausethey usually can maintain stable deposit growthonly as a result of prudent reinvestment in thebank’s service area. Deposit development andretention policies should recognize the limitsimposed by prudent competition and the bank’sservice area.

Historically, most banking organizations havenot relied on funds obtained through depositbrokers to supplement their traditional fundingsources. A concern regarding the activities ofdeposit brokers is that the ready availability of

large amounts of funds through the issuance ofinsured obligations undercuts market discipline.

The use of brokered deposits by sound,well-managed banks can play a legitimate role inthe asset-liability management of a bank andenhance the efficiency of financial markets.However, the use of brokered deposits also cancontribute to the weakening of a bank byallowing it to grow at an unmanageable orimprudent pace and can exacerbate the conditionof a troubled bank. Consequently, without propermonitoring and management, brokered and otherhighly rate-sensitive deposits, such as thoseobtained through the Internet, certificate ofdeposit (CD) listing services, and similar adver-tising programs, may be unstable sources offunding for an institution.

Deposits attracted over the Internet, throughCD listing services, or through special advertis-ing programs offering premium rates to custom-ers without another banking relationship, requirespecial monitoring. Although these deposits maynot fall within the technical definition of ‘‘bro-kered’’ in 12 USC 1831f and 12 CFR 337.6,their inherent risk characteristics are similar tobrokered deposits. That is, such deposits aretypically attractive to rate-sensitive customerswho may not have significant loyalty to thebank. Extensive reliance on funding products ofthis type, especially those obtained from outsidea bank’s geographic market area, has the poten-tial to weaken a bank’s funding position.

Some banks have used brokered and Internet-based funding to support rapid growth in loansand other assets. In accordance with the safety-and-soundness standards, a bank’s asset growthshould be prudent and its management mustconsider the source, volatility, and use of thefunds generated to support asset growth. (See 12CFR 208 appendix D-1.)

To compensate for the high rates typicallyoffered for brokered deposits, institutions hold-ing them tend to seek assets that carry commen-surately high yields. These assets can ofteninvolve excessive credit risk or cause the bankto take on undue interest-rate risk through amismatch in the maturity of assets and liabili-ties. The FDI Act (12 USC 1831f) includescertain restrictions on the use of brokered depos-its to prohibit undercapitalized insured deposi-tory institutions from accepting funds obtained,directly or indirectly, by or through any depositbroker for deposit into one or more depositaccounts.

4. This exception does not apply to an agent or a trusteewho establishes a deposit account to facilitate a businessarrangement with an insured depository institution to use theproceeds of the account to fund a prearranged loan.



Capital Categories

For the purposes of section 29 of the FDI Act,the regulations of the FDIC and the FederalReserve (for the FDIC, 12 CFR 325.103 and forthe Federal Reserve, 12 CFR 208.43) providethe definitions of well-capitalized, adequatelycapitalized, and undercapitalized financial insti-tutions (banks). These definitions are tied topercentages of leverage and risk-based capital.Section 29 of the FDI Act limits the rates ofinterest on brokered deposits that may be offeredby insured depository institutions that areadequately capitalized or undercapitalized.

Well-capitalized bank. A bank is deemed to bewell capitalized if it—

• has a total risk-based capital ratio of 10.0percent or greater;

• has a tier 1 risk-based capital ratio of 6.0percent or greater;

• has a leverage ratio of 5.0 percent or greater;and

• is not subject to any written agreement, order,capital directive, or prompt-corrective-actiondirective issued by the Board pursuant tosection 8 of the FDI Act (12 USC 1818), theInternational Lending Supervision Act of 1983(12 USC 3907), or section 38 of the FDI Act(12 USC 1831o), or any regulation thereunder,to meet and maintain a specific capital levelfor any capital measure.

A well-capitalized insured depository institutionmay solicit and accept, renew, or roll over anybrokered deposit without restriction.

Adequately capitalized bank. A bank isdeemed to be adequately capitalized if it—

• has a total risk-based capital ratio of 8.0 per-cent or greater;

• has a tier 1 risk-based capital ratio of 4.0 per-cent or greater;

• has—— a leverage ratio of 4.0 percent or greater or— a leverage ratio of 3.0 percent or greater if

the bank is rated composite 1 under theCAMELS rating system in the most recentexamination of the bank and is not expe-riencing or anticipating significant growth;and

• does not meet the definition of a well capital-ized bank.

An adequately capitalized insured depositoryinstitution may not accept, renew, or roll overany brokered deposit unless it has applied forand been granted a waiver of this prohibition bythe FDIC. If the insured depository institutionhas been granted a waiver by the FDIC, theinstitution may accept, renew, or roll over abrokered deposit. The institution may not pay aneffective yield on the deposit that exceeds, bymore than 75 basis points: (1) the effective yieldpaid on deposits of comparable size and matu-rity, and for deposits accepted, within the insti-tution’s normal market area5 or (2) the ‘‘nationalrate’’ paid on deposits of comparable size andmaturity for deposits accepted outside the insti-tution’s normal market area. The national rate iseither 120 or 130 basis points of the currentyield on similar-maturity U.S. Treasury obliga-tions, depending on whether the deposit is FDICinsured or more than half uninsured (the portionof the deposit that is in excess of the FDIC-insured limit, as detailed in the rule).

If an FDIC-insured bank is adequately capi-talized and does not have a waiver from theFDIC, it may not use a broker to obtain deposits.The following rate restrictions on deposits alsoapply: (1) the deposit rates may be no more than75 basis points over the effective yield ondeposits of comparable size and maturity withinthe bank’s normal market area and (2) thedeposit rates may not be based on a ‘‘national’’rate.

Undercapitalized bank. A bank is deemed tobe undercapitalized if it—

• has a total risk-based capital ratio that is lessthan 8.0 percent;

• has a tier 1 risk-based capital ratio that is lessthan 4.0 percent;

• has a leverage ratio that is less than 4.0 per-cent;6 or

• has a leverage ratio that is less than 3.0 per-

5. For deposits obtained through Internet solicitations, thedetermination of the bank’s ‘‘normal market area’’ is particu-larly problematic and difficult.

6. An exception is available when (1) the bank the (theinsured depository institution) has a leverage ratio of 3.0percent or greater, (2) the bank is rated composite 1 under theCAMELS rating system following its most-recent bank exami-nation, and (3) the bank is not experiencing or anticipatingsignificant growth.



cent, if the bank is rated composite 1 under theCAMELS rating system in the most recentexamination of the bank and is not experienc-ing or anticipating significant growth.

An undercapitalized insured depository institu-tion may not accept, renew, or roll over anybrokered deposit. Also, an undercapitalizedinsured depository institution (and any employeeof the institution) may not solicit deposits byoffering an effective yield that exceeds by morethan 75 basis points the prevailing effectiveyields on insured deposits of comparable matu-rity in the institution’s normal market area or inthe market area in which such deposits are beingsolicited.

Each examination should include a review forcompliance with the FDIC’s limitations on theacceptance of brokered deposits and guidelineson interest payments. The use of brokered depos-its should be reviewed during all on-site exami-nations, even in those institutions not subject tothe FDIC’s restrictions. Given the potential risksinvolved in using brokered deposits, the exami-nation should focus on the—

• rate of growth and the credit quality of theloans or investments funded by brokereddeposits;

• corresponding quality of loan files, documen-tation, and customer credit information;

• ability of bank management to adequatelyevaluate and administer these credits andmanage the resulting growth;

• degree of interest-rate risk involved in thefunding activities and the existence of a pos-sible mismatch in the maturity or rate sensi-tivity of assets and liabilities;

• composition and stability of the depositsources and the role of brokered deposits inthe bank’s overall funding position andstrategy; and

• effect of brokered deposits on the bank’sfinancial condition and whether the use ofbrokered deposits constitutes an unsafe andunsound banking practice.

The examiner should identify relevant concernsin the examination report when brokered depos-its amount to 5 percent or more of the bank’stotal deposits.

Risk-Management Expectations forBrokered Deposits

On May 11, 2001, the Federal Reserve Board andthe other federal banking agencies (the agencies)issued a Joint Agency Advisory on Brokered andRate-Sensitive Deposits. The advisory sets forththe following risk-management guidelines forbrokered deposits. The bank’s management isexpected to implement risk-management sys-tems that are commensurate in complexity withthe liquidity and funding risks that the bankundertakes. (See SR-01-14.) Such systems shouldincorporate the following principles:

• Proper funds-management policies. A goodpolicy should generally provide for forwardplanning, establish an appropriate cost struc-ture, and set realistic limitations and businessstrategies. It should clearly convey the board’srisk tolerance and should not be ambiguousabout who holds responsibility for funds-management decisions.

• Adequate due diligence when assessing depositbrokers. Bank management should implementadequate due diligence procedures beforeentering any business relationship with adeposit broker. The agencies do not regulatedeposit brokers.

• Due diligence in assessing the potential risk toearnings and capital associated with brokeredor other rate-sensitive deposits, and prudentstrategies for their use. Bankers should man-age highly sensitive funding sources carefully,avoiding excessive reliance on funds that maybe only temporarily available or which mayrequire premium rates to retain.

• Reasonable control structures to limit fundingconcentrations. Limit structures should con-sider typical behavioral patterns for depositorsor investors and be designed to control exces-sive reliance on any significant source(s) ortype of funding. This includes brokered fundsand other rate-sensitive or credit-sensitivedeposits obtained through the Internet or othertypes of advertising.

• Management information systems (MIS) thatclearly identify nonrelationship or higher-costfunding programs and allow management totrack performance, manage funding gaps, andmonitor compliance with concentration and



other risk limits. At a minimum, MIS shouldinclude a listing of funds obtained througheach significant program, rates paid on eachinstrument and an average per program, infor-mation on maturity of the instruments, andconcentration or other limit monitoring andreporting. Management also should ensurethat brokered deposits are properly reported inthe bank’s Consolidated Reports of Conditionand Income.7

• Contingency funding plans that address therisk that these deposits may not ‘‘roll over’’and provide a reasonable alternative fundingstrategy. Contingency funding plans shouldfactor in the potential for changes in marketacceptance if reduced rates are offered onrate-sensitive deposits. The potential for trig-gering legal limitations that restrict the bank’saccess to brokered deposits under PromptCorrective Action (PCA) standards, and theeffect that this would have on the bank’sliability structure, should also be factored intothe plan.

Examiners should assess carefully the liquidity-risk management framework at all banks. Bankswith meaningful reliance on brokered or otherrate-sensitive deposits should receive the appro-priate level of supervisory attention. Examinersshould not wait for PCA provisions to be trig-gered or the viability of the bank to come intoquestion, before raising relevant safety-and-soundness issues with regard to the use of thesefunding sources. If a determination is made thata bank’s use of these funding sources is not safeand sound, or that these risks are excessive orthat they adversely affect the bank’s condition,then the examiner or central point of contactshould recommend to the Reserve Bank man-agement that it consider taking immediate appro-priate supervisory action. The following repre-sent potential red flags that may indicate theneed to take such action to ensure the risksassociated with brokered or other rate-sensitivefunding sources are managed appropriately:

• ineffective management or the absence ofappropriate expertise

• a newly chartered institution with few rela-

tionship deposits and an aggressive growthstrategy

• inadequate internal audit coverage• inadequate information systems or controls• identified or suspected fraud• high on- or off-balance-sheet growth rates• use of rate-sensitive funds not in keeping with

the bank’s strategy• inadequate consideration of risk, with man-

agement focus exclusively on rates• significant funding shifts from traditional fund-

ing sources• the absence of adequate policy limitations on

these kinds of funding sources• high loan delinquency rate or deterioration in

other asset-quality indicators• deterioration in the general financial condition

of the institution• other conditions or circumstances warranting

the need for administrative action

Check Kiting

Check kiting occurs when—

• a depositor with accounts at two or morebanks draws checks against the uncollectedbalance at one bank to take advantage of thefloat—that is, the time required for the bank ofdeposit to collect from the paying bank, and

• the depositor initiates the transaction with theknowledge that sufficient collected funds willnot be available to support the amount of thechecks drawn on all of the accounts.

The key to this deceptive practice, the mostprevalent type of check fraud, is the ability todraw against uncollected funds. However, draw-ing against uncollected funds in and of itselfdoes not necessarily indicate kiting. Kiting onlyoccurs when the aggregate amount of drawingsexceeds the sum of the collected balances in allaccounts. Nevertheless, since drawing againstuncollected funds is the initial step in the kitingprocess, management should closely monitorthis activity. The requirements of RegulationCC, Availability of Funds and Collection ofChecks, increased the risk of check kiting, andshould be addressed in a bank’s policies andprocedures.

By allowing a borrower to draw againstuncollected funds, the bank is extending creditthat should be subject to an appropriate approval

7. See the FFIEC bank Call Report and Instructions forConsolidated Reports of Condition and Income, ScheduleRC-E—Deposit Liabilities.



process. Accordingly, management shouldpromptly investigate unusual or unauthorizedactivity since the last bank to recognize checkkiting and pay on the uncollected funds suffersthe loss. Check kiting is illegal and all suspectedor known check kiting operations should bereported pursuant to established Federal Reservepolicy. Banks should maintain internal controlsto preclude loss from kiting, and the examinershould remember that in most cases kiting is notcovered under Blanket Bond Standard Form 24.

Delayed Disbursement Practices

Although Regulation CC, Availability of Fundsand Collection of Checks, stipulates time framesfor funds availability and return of items, delayeddisbursement practices (also known as remotedisbursement practices) can present certain risks,especially concerning cashier’s checks, whichhave next-day availability. Delayed disburse-ment is a common cash management practicethat consists of arrangements designed to delaythe collection and final settlement of checks bydrawing checks on institutions located substan-tial distances from the payee or on institutionslocated outside the Federal Reserve cities whenalternate and more efficient payment arrange-ments are available. Such practices deny deposi-tors the availability of funds to the extent thatfunds could otherwise have been available ear-lier. A check drawn on an institution remotefrom the payee often results in increased possi-bilities of check fraud and in higher processingand transportation costs for return items.

Delayed disbursement arrangements couldgive rise to supervisory concerns because a bankmay unknowingly incur significant credit riskthrough such arrangements. The remote locationof institutions offering delayed disbursementarrangements often increases the collection timefor checks by at least a day. The primary risk ispayment against uncollected funds, which couldbe a method of extending unsecured credit to adepositor. Absent proper and complete docu-mentation regarding the creditworthiness of thedepositor, paying items against uncollected fundscould be considered an unsafe or unsound bank-ing practice. Furthermore, such loans, even ifproperly documented, might exceed the bank’slegal lending limit for loans to one customer.

Examiners should routinely review a bank’spractices in this area to ensure that such prac-

tices are conducted prudently. If undue orundocumented credit risk is disclosed or iflending limits are exceeded, appropriate correc-tive action should be taken.

Deposit Sweep Programs orMaster-Note Arrangements

Deposit sweep programs or master-note arrange-ments (sweep programs) can be implemented ona bank level or on a parent bank holdingcompany (BHC) level. On a bank level, thesesweep programs exist primarily to facilitate thecash-management needs of bank customers,thereby retaining customers who might other-wise move their account to an entity offeringhigher yields. On a BHC level, the sweepprograms are maintained with customers at thebank level, and the funds are upstreamed to theparent as part of the BHC’s funding strategy.Sweep programs use an agreement with thebank’s deposit customers (typically corporateaccounts) that permits these customers to rein-vest amounts in their deposit accounts above adesignated level in overnight obligations of theparent bank holding company, another affiliateof the bank, or a third party. These obligationsinclude instruments such as commercial paper,program notes, and master-note agreements.(See SR-90-31.)

The disclosure agreement regarding the saleof the nondeposit debt obligations should includea statement indicating that these instruments arenot federally insured deposits or obligations ofor guaranteed by an insured depository institu-tion. In addition, banks and their subsidiariesthat have issued or plan to issue nondeposit debtobligations should not market or sell theseinstruments in any public area of the bank whereretail deposits are accepted, including any lobbyarea of the bank. This requirement exists toconvey the impression or understanding that thepurchase of such obligations by retail depositorsof the subsidiary bank can, in the event ofdefault, result in losses to individuals whobelieved they had acquired federally insured orguaranteed obligations.

Bank Policies and Procedures

Banking organizations with sweep programsshould have adequate policies, procedures, andinternal controls in place to ensure that the



activity is conducted in a manner consistent withsafe and sound banking principles and in accor-dance with all banking laws and regulations.Bank policies and procedures should furtherensure that deposit customers participating in asweep program are given proper disclosures andinformation. When a sweep program is used aspart of a funding strategy for a BHC or anonbank affiliate, examiners should ensure thatliquidity and funding strategies are carried out ina prudent manner.

Application of Deposit Proceeds

In view of the extremely short-term maturity ofmost swept funds, banks and BHCs are expectedto exercise great care when investing the pro-ceeds. Banks, from whom deposit funds areswept, have a fiduciary responsibility to theircustomers to ensure that such transactions areconducted properly. Appropriate uses of theproceeds of deposit sweep funds are limited toshort-term bank obligations, short-term U.S.government securities, or other highly liquid,readily marketable, investment-grade assets thatcan be disposed of with minimal loss of princi-pal.8 When deposit sweep funds are invested inU.S. government securities, appropriate agree-ments must be in place, required disclosuresmust be made, and daily confirmations must beprovided to the customer in accordance with therequirements of the Government Securities Actof 1986. Use of such proceeds to finance mis-matched asset positions, such as those involvingleases, loans, or loan participations, can lead toliquidity problems and are not consideredappropriate. The absence of a clear ability toredeem overnight or extremely short-term liabili-ties when they become due should generally beviewed as an unsafe and unsound bankingactivity.

Funding Strategies

A key principle underlying the Federal Reserve’ssupervision of banking organizations is thatBHCs operate in a way that promotes thesoundness of their subsidiary banks. BHCs areexpected to avoid funding strategies or practicesthat could undermine public confidence in theliquidity or stability of their banks. Any fundingstrategy should maintain an adequate degree ofliquidity at both the parent level and the subsid-iary bank level. Bank management should avoid,to the extent possible, allowing sweep programsto serve as a source of funds for inappropriateuses at the BHC or at an affiliate. Concerns existin this regard because funding mismatches canexacerbate an otherwise manageable period offinancial stress and, in the extreme, underminepublic confidence in a banking organization’sviability.

Funding Programs

In developing and carrying out funding pro-grams, BHCs should give special attention tothe use of overnight or extremely short-termliabilities, since a loss of confidence in theissuing organization could lead to an immediatefunding problem. Thus BHCs relying on over-night or extremely short-term funding sourcesshould maintain a sufficient level of superior-quality assets (at a level at least equal to theamount of the funding sources’) that can beimmediately liquidated or converted to cashwith minimal loss.

Dormant Accounts

A dormant account is one in which customer-originated activity has not occurred for a prede-termined period of time. Because of this inac-tivity, dormant accounts are frequently the targetof malfeasance and should be carefully con-trolled by a bank. Bank management shouldestablish standards that specifically outline thebank’s policy for the effective control of dor-mant accounts, addressing—

• the types of deposit categories that couldcontain dormant accounts, including demand,savings, and official checks;

• the length of time without customer-originatedactivity that qualifies an account to be identi-fied as dormant;

8. Some banking organizations have interpreted languagein a 1987 letter signed by the secretary of the Board ascondoning funding practices that may not be consistent withthe principles set forth in a subsequent supervisory letter datedSeptember 21, 1990, as well as with prior Board rulings. The1987 letter involved a limited set of facts and circumstancesthat pertained to a particular banking organization; it did notestablish or revise Federal Reserve policies on the proper useof the proceeds of short-term funding sources. In any event,banking organizations should no longer rely on the 1987 letterto justify the manner in which they use the proceeds of sweepprograms. Banking organizations employing sweep programsare expected to ensure that these programs conform with thepolicies in this manual section.



• the controls exercised over the accounts andtheir signature cards, that is, prohibitingrelease of funds by a single bank employee;and

• the follow-up by the bank when ordinary bankmailings, such as account statements andadvertising flyers, are returned to the bankbecause of changed addresses or other reasonsfor failure to deliver.

Employee Deposit Accounts

Historically, examiners have discovered variousirregularities and potential malfeasance throughreview of employee deposit accounts. As aresult, bank policy should establish standardsthat segregate or specially encode employeeaccounts and should encourage periodic internalsupervisory review. In light of these concerns,examiners should review related bank proce-dures and practices, taking appropriate measureswhen warranted.

Overdrafts

The size, frequency, and duration of deposit-account overdrafts are matters that should begoverned by bank policy and controlled byadequate internal controls, practices, andprocedures. Overdraft authority should beapproved in the same manner as lending author-ity and should never exceed the employee’slending authority. Systems for monitoring andreporting overdrafts should emphasize a second-ary level of administrative control that isdistinct from other lending functions so accountofficers who are less than objective do not allowinfluential customers to exploit their overdraftprivileges. A bank’s payment of overdrafts ofexecutive officers and directors of the bank isgenerally prohibited under Regulation O. (See12 CFR 215.4(e).) It is the board of directors’responsibility to review overdrafts as theywould any other extension of credit. Overdraftsoutstanding for more than 60 days, lackingmitigating circumstances, should be consideredfor charge-off. See SR-05-3/CA-05-2 and sec-tion 2130.1 on the February 18, 2005,Interagency Joint Guidance on OverdraftProtection Programs.

Payable-Through Accounts

A payable-through account is an accommoda-tion offered to a correspondent bank or othercustomer by a U.S. banking organization wherebydrafts drawn against client subaccounts at thecorrespondent are paid upon presentation by theU.S. banking institution. The subaccount holdersof the payable-through bank are generally non–U.S. residents or owners of businesses locatedoutside of the United States. Usually the con-tract between the U.S. banking organization andthe payable-through bank purports to create acontractual relationship solely between the twoparties to the contract. Under the contract, thepayable-through bank is responsible for screen-ing subaccount holders and maintaining ade-quate records with respect to such holders. Theexaminer should be aware of the potential effectof money laundering.

Public Funds

Public funds generally represent deposits of theU.S. government, as well as state and politicalsubdivisions, and typically require collateral inthe form of securities to be pledged againstthem. A bank’s reliance upon public funds cancause potential liquidity concerns if the aggre-gate amount, as a percentage of total deposits, ismaterial relative to the bank’s asset-liabilitymanagement practices. Another factor that cancause potential liquidity concerns relates to thevolatile nature of these deposits.

This volatility occurs because the volume ofpublic funds normally fluctuates on a seasonalbasis due to timing differences between taxcollections and expenditures. A bank’s ability toattract public funds is typically based upon thegovernment entity’s assessment of three keypoints:

• the safety and soundness of the institutionwith which the funds have been placed

• the yield on the funds being deposited• that such deposits are placed with a bank that

can provide or arrange the best banking ser-vice at the least cost

Additionally, banks that offer competitive inter-est rates and provide collection, financial advi-sory, underwriting, and data processing servicesat competitive costs are frequently chosen asdepositories. Public funds deposits acquired



through political influence should be regarded asparticularly volatile. As a result, an examinershould pay particular attention to assessing thevolatility of such funds in conjunction with thereview of liquidity.

Zero-Balance Accounts

Zero-balance accounts (ZBAs) are demanddeposit accounts used by a bank’s corporatecustomers through which checks or drafts arereceived for either deposit or payment. The totalamount received on any particular day is offsetby a corresponding debit or credit to the accountbefore the close of business to maintain thebalance at or near zero. ZBAs enable a corporatetreasurer to effectively monitor cash receipts anddisbursements. For example, as checks arrivefor payment, they are charged to a ZBA with theunderstanding that funds to cover the checkswill be deposited before the end of the bankingday. Several common methods used to coverchecks include—

• wire transfers;• depository transfer checks, a bank-prepared

payment instrument used to transfer moneyfrom a corporate account in one bank toanother bank;

• concentration accounts, a separate corporate

demand deposit account at the same bank usedto cover deficits or channel surplus fundsrelative to the ZBA; or

• extended settlement, a cash-managementarrangement that does not require the corpo-rate customer to provide same-day funds forpayment of its checks.

Because checks are covered before the closeof business on the day they arrive, the bank’sexposure is not reflected in the financial state-ment. The bank, however, assumes risk bypaying against uncollected funds, thereby creat-ing unsecured extensions of credit during theday (which is referred to as a daylight overdraftbetween the account holder and the bank). Ifthese checks are not covered, an overdraft occurs,which will be reflected on the bank’s financialstatement.

The absence of prudent safeguards and a lackof full knowledge of the creditworthiness ofthe depositor may expose the bank to large,unwarranted, and unnecessary risks. Moreover,the magnitude of unsecured credit risk mayexceed prudent limits. Examiners should rou-tinely review cash-management policies andprocedures to ensure that banks do not engagein unsafe and unsound banking practices, mak-ing appropriate comments in the report ofexamination, as necessary.



Deposit AccountsExamination ObjectivesEffective date November 2006 Section 3000.2

1. To determine if the policies, practices, pro-cedures, and internal controls regardingdeposit accounts are adequate.

2. To determine if the bank’s managementimplemented adequate risk-management sys-tems for brokered and rate-sensitive depositsthat are commensurate with the liquidity andfunding risks the bank has undertaken.

3. To determine if the bank’s policies, practices,procedures, and internal controls (includingcompliance oversight, management report-ing, and staff training) for account relation-ships involving foreign governments, foreignembassies, and foreign political figures (aswell as foreign-currency customer depositaccounts) are adequate for the varied risksposed by these accounts.

4. To determine if bank officers and employeesare operating in conformance with the bank’sestablished guidelines.

5. To evaluate the deposit structure and deter-mine its characteristics and volatility.

6. To determine the scope and adequacy of theaudit function.

7. To determine compliance with applicablelaws and regulations.

8. To initiate corrective action when policies,practices, procedures, or internal controls aredeficient, or when violations of laws orregulations are noted.

Commercial Bank Examination Manual November 2006Page 1

Deposit AccountsExamination ProceduresEffective date April 2012 Section 3000.3

1. Determine the scope of the examination ofthe deposit-taking function. In so doing,consider the findings of prior examinations,related work prepared by internal andexternal auditors, deficiencies in internalcontrols noted within other bank functions,and the requirements of examiners assignedto review the asset/liability managementand interest-rate risk aspects of the bank.

2. If required by the scope, implement the‘‘Deposit Accounts’’ internal controlquestionnaire.

3. Test the deposit function for compliancewith policies, procedures, and internal con-trols in conjunction with performing theremaining examination procedures. Also,obtain a listing of any deficiencies noted inthe latest internal or external audit review,then determine if appropriate correctionshave been made.

4. In conducting the examination, use avail-able bank copies of printouts plus transac-tions journals or other visual media tominimize expense to the bank. However, ifcopies of these reports are not available,determine what information is necessary tocomplete the examination procedures andrequest that information from the bank.

Obtain or prepare, as applicable, thereports indicated below, which are used fora variety of purposes, including theassessment of deposit volatility and liquidity,the assessment of the adequacy of internalcontrols, the verification of information onrequired regulatory reports, and the assess-ment of loss.a. For demand deposits and other transac-

tion accounts:• trial balance• overdrafts• unposted items• nonsufficient-funds (NSF) report• dormant accounts• public funds• uncollected funds• due to banks• trust department funds• significant activity• suspected kiting report

• matured certificates of deposit withoutan automatic renewal feature

• large-balance reportb. For official checks:

• trial balance(s)• exception list

c. For savings accounts:• trial balance• unposted items• overdrafts• dormant accounts• public funds• trust department funds• large-balance report

d. For other time deposits:• trial balance(s)• large-balance report• unposted items• public funds• trust department funds• money market accounts

e. For certificates of deposit:• trial balance(s)• unposted items• public funds• certificates of $100,000 or more• negotiable certificates of deposit• maturity reports• matured certificates of deposit

f. For deposit sweep programs or master-note arrangements, list individually bydeposit type and amount.

g. For brokered deposits, list individuallyby deposit type, including amount andrate.

h. For bank-controlled accounts:• reconcilement records for all such

accounts• names and extensions of individuals

authorized to make entries to suchaccounts

• name and phone extension of recon-cilement clerk(s)

i. For the bank’s foreign-currency cus-tomer deposit accounts and the depositaccounts for foreign governments,embassies, and political figures:• list of accounts and currency type• list of currency transactions over

$10,000 for each account, and thecopies of their Currency Transaction

Commercial Bank Examination Manual April 2012Page 1

Report or its equivalent, since the pre-vious examination (See 31 CFR1010.330 and its examples.)

• the most recent internal audit reportcovering the review of those accounts,the risks associated with the accounts,the internal controls over thoseaccounts, and the staff’s completion ofthe Currency Transaction Report

• the completed copies of the Report ofForeign (Non-U.S.) Currency Depos-its, Form 2915, that have been submit-ted since the previous examination

5. Review the reconcilement of all types ofdeposit accounts. Verify the balances todepartment controls and the general ledger.a. Determine if reconciliation items are

legitimate and if they clear within areasonable time frame.

b. Retain custody of all trial balances untilitems outstanding are resolved.

6. Review the reconciliation process for bank-controlled accounts, such as official checksand escrow deposits, by—a. determining if reconciling items are

legitimate and if they clear within areasonable time frame;

b. scanning activity in such accounts todetermine the potential for improperdiversion of funds for various uses, suchas—• political contributions,• loan payments (principal and interest),

or• personal use; and

c. determining if checks are being pro-cessed before their related credits.

7. Review the bank’s operating proceduresand reconciliation process relative to sus-pense accounts. Determine if—a. the disposition process of unidentified

items is completed in a timely fashion;b. reports are generated periodically to

inform management of the type, age, andamount of items in such accounts; and

c. employees responsible for clearingsuspense-account items are not shiftingthe items between accounts.

8. Evaluate the effectiveness of the writtenpolicies and procedures and of manage-ment’s reporting methods regarding over-drafts and drawings against uncollectedfunds.a. Concerning overdrafts, determine if—

• officer-approval limits have beenestablished, and

• a formal system of review and approvalis in effect.

b. Determine whether the depository insti-tution has an overdraft-protection pro-gram and if it has adequate written poli-cies and procedures to address the credit,operational, and other risks associatedwith those programs. See the February18, 2005, interagency Joint Guidance onOverdraft Protection Programs (SR-05-3/CA-05-2). If the bank provides over-draft protection, perform the followingprocedures:• Obtain a master list of all depositors

with formal overdraft protection.• Obtain a trial balance indicating

advances outstanding and compare itwith the master list to ensure compli-ance with approved limits.

• Cross-reference the trial balance ormaster list to examiner loan line sheets.

• Review credit files on significant for-mal agreements not cross-referencedabove.

• Ascertain whether there is ongoingmonitoring of overdrafts to identifycustomers who may pose an unduecredit risk to the bank.

• Find out if the bank has incorporatedinto its overdraft-protection programprudent risk-management practices per-taining to account repayment and thesuspension of a customer’s overdraft-protection services when the customerdoes not satisfy repayment and eligi-bility requirements.

• Determine whether overdrafts are prop-erly and accurately reported accordingto generally accepted accounting prin-ciples on the bank’s financial state-ments and on its Reports of Conditionand Income (Call Reports). Verify thatoverdrafts are reported as loans on theReport of Condition.

• Verify the existence of the bank’sloss-estimation procedures for over-draft and fee balances. Determine ifthe procedures are adequately rigorousand if losses are properly accountedfor as part of (1) the allowance for loanand lease losses (ALLL) or (2) the lossallowance for uncollectible fees (alter-natively, the bank may recognize only

3000.3 Deposit Accounts: Examination Procedures

April 2012 Commercial Bank Examination ManualPage 2

that portion of earned fees estimated tobe collectible), if applicable.1

• When applicable, validate (1) whetherthe bank’s overdraft commitments havebeen assigned the correct conversionfactor, (2) whether they are accuratelyrisk- weighted by obligor, and (3) ifthe commitment terms comply withthe risk-based capital guidelines.

• Determine whether the bank hasobtained assurances from its legalcounsel that its overdraft-protectionprogram is fully compliant with allapplicable federal and state laws andregulations, including the Federal TradeCommission Act.

• When the bank contracts with third-party vendors to do information tech-nology work, determine if the bankconducted proper due diligence beforeentering into the contract and that itfollowed the November 28, 2000,guidance on the Risk Management ofOutsourced Technology Services. (SeeSR-00-17.)

c. Concerning drawings against uncol-lected funds, determine if—• the uncollected-funds report reflects

balances as uncollected until they areactually received;

• management is comparing reports ofsignificant changes in balances andactivity volume with uncollected-fundsreports;

• management knows the reasons why adepositor is frequently drawing againstuncollected funds;

• a reporting system to inform seniormanagement of significant activity inthe uncollected-funds area has beeninstituted; and

• appropriate employees clearly under-stand the mechanics of drawing againstuncollected funds and the risksinvolved, especially in the area ofpotential check-kiting operations.

d. After completing steps 8.a., 8.b., and8.c.—• cross-reference overdraft and

uncollected-funds reports to examiner

loan line sheets;• review the credit files of depositors

with significant overdrafts, if avail-able, or the credit files of depositorswho frequently draw significantamounts against uncollected funds, forthose depositors not cross-referencedin the preceding step;

• request management to charge off over-drafts deemed to be uncollectible; and

• submit a list of the following items tothe appropriate examiner:— overdrafts considered loss, indicat-

ing borrower and amount— aggregate amounts overdrawn

30 days or more past due, forinclusion in past-due statistics

9. Review the bank’s deposit development andretention policy, which is often included inthe funds-management policy.a. Determine if the policy addresses the

deposit structure and related interestcosts, including the percentages of timedeposits and demand deposits of—• individuals,• corporations, and• public entities.

b. Determine if the policy requires periodicreports to management comparing theaccuracy of projections with results.

c. Assess the reasonableness of the policy,and ensure that it is routinely reviewedby management.

10. If a deposit sweep program or master-notearrangement exists, review the minutes ofthe board of directors for approval of relatedpolicies and procedures.

11. For banks with deposit sweep programs ormaster-note arrangements (sweep programs),compare practices for adherence to approvedpolicies and procedures. Review thefollowing:a. The purpose of the sweep program: Is it

strictly a customer-accommodation trans-action, or is it intended to fund certainassets at the holding company level orat an affiliate? Review funding trans-actions in light of liquidity and fund-ing needs of the banking organization byreferring to section 4020.1.

b. The eligibility requirements used by thebank to determine the types of customersand accounts that may participate in asweep program, including—• a list of customers participating in

1. Institutions may charge off uncollectible overdraft feesagainst the ALLL if such fees are recorded with overdraftbalances as loans and if estimated credit losses on the fees areprovided for in the ALLL.

Deposit Accounts: Examination Procedures 3000.3


sweep programs, with dollar amountsof deposit funds swept on the date ofexamination, and

• the name of the recipient(s) of sweptfunds.— If the recipient is an affiliate of the

bank, include a schedule of theinstruments into which the fundswere swept, including the effectivematurity of these instruments.

— If the recipient is an unaffiliatedthird party, determine if the bankadequately evaluates the thirdparty’s financial condition at leastannually. Also, verify if a fee isreceived by the bank for the trans-action. If so, determine that thefee is disclosed in customerdocumentation.

c. Whether the proceeds of sweep pro-grams are invested only in short-termbank obligations; short-term U.S. govern-ment securities; or other highly liquid,readily marketable, investment-gradeassets that can be disposed of with mini-mal loss of principal.

d. Whether the bank and its subsidiarieshave issued or plan to issue nondepositdebt obligations in any public area ofthe bank where retail deposits areaccepted, including any lobby area ofthe bank.

e. Completed sweep-program documents todetermine the following:• Signed documents boldly disclose that

the instrument into which deposit fundswill be swept is not insured by theFDIC and is not an obligation of, orguaranteed by, the bank.

• Proper authorization for the instrumentexists between the customer and anauthorized representative of the bank.

• Signed documents properly disclosethe name of the obligor and the type ofinstrument into which the depositor’sfunds will be swept. If funds are beingswept into U.S. government securitiesheld by the banking organization,verify that adequate confirmations areprovided to customers in accordancewith the Government Securities Act of1986. (This act requires that all trans-actions subject to a repurchase agree-ment be confirmed in writing at theend of the day of initiation and that

the confirmation confirms specificsecurities. If any other securities aresubstituted that result in a change ofissuer, maturity date, par amount, orcoupon rate, another confirmation mustbe issued at the end of the day duringwhich the substitution occurred.Because the confirmation or safekeep-ing receipt must list specific securities,‘‘pooling’’ of securities for any type ofsweep program involving governmentsecurities is not permitted. Addition-ally, if funds are swept into otherinstruments, similar confirmation pro-cedures should be applied.)

• Conditions of the sweep program arestated clearly, including the dollaramount (minimum or maximumamounts and incremental amounts),time frame of sweep, time of day thesweep transaction occurs, fees pay-able, transaction confirmation notice,prepayment terms, and terminationnotice.

• The length of any single transactionunder sweep programs in effect has notexceeded 270 days and the amount is$25,000 or more (as stipulated by SECpolicy). Ongoing sweep-program dis-closures should occasionally be sent tothe customer to ensure that the termsof the program are updated and thecustomer understands the terms.

f. Samples of advertisements (newspaper,radio, television spots, etc.) by the bankfor sweep programs to determine if theadvertisements—• boldly disclose that the instrument into

which deposit funds are swept is notinsured by the FDIC and is not anobligation of, or guaranteed by, thebank, and

• are not enclosed with insured depositstatements mailed to customers.

g. Whether the sweep program has had anegative effect on bank liquidity or hasthe potential to undermine public confi-dence in the bank.• Review the bank’s federal funds and

borrowing activities to ascertainwhether borrowings appear high. If so,compare the bank’s borrowing activitywith daily balances of aggregate sweeptransactions on selected dates to see ifa correlation exists.



• If sweep activity is significant, comparethe rates being paid on swept depositswith the yields received on the investedfunds and with the rates on otherovernight funding instruments, such asfederal funds, to determine if they arereasonable.

12. Forward the following to the examinerassigned to asset/liability management:a. the amount of any deposit decline or

deposit increase anticipated by manage-ment (the time period will be determinedby the examiner performing asset/liabilitymanagement)

b. a listing by name and amount of anydepositor controlling more than 1 per-cent of total deposits

c. a listing, if available, by name andamount of any deposits held solelybecause of premium rates paid (brokereddeposits)

d. the aggregate amount of brokereddeposits

e. a maturity schedule of certificates ofdeposit, detailing maturities within thenext 30, 60, 90, 180, and 360 days

f. an assessment of the overall characteris-tics and volatility of the deposit structure

13. Analyze UBPR data on deposits and relatedexpense ratios, and compare with peer-group norms to determine—a. variations from the norm, andb. trends in the deposit structure with

respect to—• growth patterns, and• shifts between deposit categories.

14. Assess the volatility and the composition ofthe bank’s deposit structure.a. Review the list of time certificates of

deposit of $100,000 or more and relatedmanagement reports, including those onbrokered deposits, to determine—• whether concentrations of maturing

deposits exist;• whether a concentration of deposits to

a single entity exists;• the aggregate dollar volume of accounts

of depositors outside the bank’s nor-mal service area, if significant, and thegeographic areas from which any sig-nificant volume emanates;

• the aggregate dollar volume of CDsthat have interest rates higher thancurrent publicly quoted rates withinthe market;

• whether the bank is paying currentmarket rates on CDs;

• the dollar amount of brokered CDs, ifany; and

• the dollar volume of deposits obtainedas a result of special promotions.

b. Federal Deposit Insurance CorporationImprovement Act of 1991 (12 USC1831F).• If the bank is undercapitalized, as

defined in the FDIC’s regulation onbrokered deposits, ensure that it is notaccepting brokered deposits. (See 12CFR 337.6.)

• If the bank is only adequately capital-ized, as defined in the FDIC’s regula-tion and is accepting brokered depos-its, ensure that a waiver authorizingacceptance of such deposits has beenobtained from the FDIC and that thebank is in compliance with the interest-rate restrictions. (See 12 CFR337.6(b)(2) and (3).)

c. Determine if the bank has risk-management systems to monitor and con-trol its liquidity and funding risks thatare associated with the bank’s brokeredand rate-sensitive deposits.

d. Ascertain if the bank’s risk-management systems for its brokeredand rate-sensitive deposits are adequateand if they are commensurate with thecomplexity of its liquidity and fundingrisks. Determine if the bank has thefollowing:• proper funds-management policies;• adequate due diligence when assess-

ing the risks associated with depositbrokers;

• due diligence in assessing the potentialrisk to earnings and capital associatedwith brokered or other rate-sensitivedeposits, and prudent strategies fortheir use;

• reasonable control structures to limitfunding concentrations;

• management information systems (MIS)that clearly identify nonrelationship orhigher-cost funding programs that allowmanagement to track performance,manage funding gaps, and monitorcompliance with concentration andother risk limits; and

• contingency funding plans that ad-dress the risk that these deposits may



not ‘‘roll over’’ and provide a reason-able alternative funding strategy.

e. Review public funds and the bank’smethod of acquiring such funds to assesswhether the bank uses competitive bid-ding in setting the interest rate paid onpublic deposits. If so, does the bankconsider variables in addition to ratespaid by competition in determining pric-ing for bidding on public deposits?

f. Review appropriate trial balances for allother deposits (demand, savings, andother time deposits). Review manage-ment reports that relate to large depositsfor individuals, partnerships, corpora-tions, and related deposit accounts todetermine whether a deposit concentra-tion exists.• Select, at a minimum, the 10 largest

accounts to determine if the retentionof those accounts depends on—— criticizable loan relationships;— liberal service accommodations,

such as permissive overdrafts anddrawings against uncollected funds;

— interbank correspondent relation-ships;

— deposits obtained as a result ofspecial promotions; and

— a recognizable trend with respectto—• frequent significant balance

fluctuations,• seasonal fluctuations, and• nonseasonal increases or de-

creases in average balances.g. Elicit management’s comments to deter-

mine, to the extent possible—• the potential renewal of large CDs that

mature within the next 12 months;• if public fund deposits have been

obtained through political influence;• if a significant dollar volume of

accounts is concentrated in customersengaged in a single business or indus-try; and

• if there is a significant dollar volumeof deposits from customers who do notreside within the bank’s service area.

15. Obtain information on competitive pres-sures and economic conditions and evaluatethat information, along with current deposittrends, to estimate its effect on the bank’sdeposit structure.

16. Perform the following procedures to test for

compliance with the applicable laws andregulations listed below:a. Regulation O (12 CFR 215), Loans to

Executive Officers, Directors, and Prin-cipal Shareholders of Member Banks.Review the overdraft listing to ensurethat the bank has not paid an overdraft onany account of an executive officer ordirector, unless the payment is madeaccording to—• a written, preauthorized, interest-

bearing extension of a credit plan thatprovides a method of repayment, or

• a written, preauthorized transfer fromanother account of that executive offi-cer or director.

Payment of inadvertent overdrafts in anaggregate amount of $1,000 or less is notprohibited, provided the account is notoverdrawn more than five business daysand the executive officer or director ischarged the same fee charged to othercustomers in similar circumstances. Over-drafts are extensions of credit and mustbe included when considering each insid-er’s lending limits and other extension-of-credit restrictions, as well as whenconsidering the aggregate lending limitfor all outstanding extensions of creditby the bank to all insiders and theirrelated interests.

b. 12 USC 1972(2), Loans to ExecutiveOfficers, Directors, and Principal Share-holders of Correspondent Banks. Reviewthe overdraft listing to ensure that nopreferential overdrafts exist from the bankunder examination to the executive offi-cers, directors, or principal shareholdersof the correspondent bank.

c. Section 22(e) of the Federal Reserve Act(12 USC 376), Interest on Deposits ofDirectors, Officers, and Employees.Obtain a list of deposit accounts, withaccount numbers, of directors, officers,attorneys, and employees. Review theaccounts for any exceptions to standardpolicies on service charges and interestrates paid that would suggest self-dealingor preferential treatment.

d. Sections 23A and 23B of the FederalReserve Act (12 USC 371c), and Regu-lation W. Determine the existence ofany non-intraday overdrawn affiliateaccounts. If such overdrawn accounts areidentified, review for compliance with



sections 23A and 23B of the act and withRegulation W.

e. Regulation D (12 CFR 204), ReserveRequirements of Depository Institutions.Review the accuracy of the deposit dataused in the bank’s reserve-requirementcalculation for the examination date.When a bank issues nondeposit, unin-sured obligations that are classified as‘‘deposits’’ in the calculation of reserverequirements, examiners should deter-mine if these items are properly catego-rized. Ascertain that the TT&L remit-tance option is included in thecomputations for reserve requirements.

f. 12 USC 501 and 18 USC 1004, FalseCertification of Checks. Compare severalcertified checks by date, amount, andpurchaser with the depositors’ namesappearing on uncollected-funds and over-draft reports of the same dates to deter-mine that the checks were certifiedagainst collected funds.

g. Uniform Commercial Code 4-108, Bank-ing Hours and Processing of Items.• Determine the bank’s cutoff hour,

after which items received areincluded in the processing for the next‘‘banking day,’’ to ensure that the cutoffhour is not earlier than 2:00 p.m.

• If the bank’s cutoff hour is before 2:00p.m., advise management that fail-ure to process items received before a2:00 p.m. cutoff may result in civilliability for delayed handling of thoseitems.

h. Local escheat laws. Determine if thebank is adhering to the local escheat lawswith regard to all forms of dormantdeposits, including official checks.

17. If applicable, determine if the bank isappropriately monitoring and limiting the

foreign-exchange risk associated withforeign-currency deposits.

18. For a bank that accepts accounts fromforeign governments, embassies, and politi-cal figures, evaluate—a. the existence and effectiveness of the

bank’s policies, procedures, complianceoversight, and management reportingwith regard to such foreign accounts;

b. whether the bank and its staff have thenecessary controls, as well as the ability,to manage the risks associated with suchforeign accounts;

c. whether the bank’s board of directorsand staff can ensure full compliance withits obligations under the Bank SecrecyAct, as amended by the USA Patriot Act,and its regulations;

d. the adequacy of the level of training ofthe bank’s personnel responsible for man-aging the risks associated with such for-eign accounts and for ensuring that thebank is and remains in compliance withthe requirements of the applicable lawsand regulations; and

e. the effectiveness of the bank’s programthat communicates its policies and pro-cedures for such foreign accounts toensure that foreign government, embassy,and political-figure customers are fullyinformed of the requirements of applica-ble U.S laws and regulations.

19. Discuss overall findings with bank manage-ment. Prepare report comments on—a. policy deficiencies,b. noncompliance with policies,c. weaknesses in supervision and reporting,d. violations of laws and regulations, ande. possible conflicts of interest.

20. Update workpapers with any informationthat will facilitate future examinations.



Deposit AccountsInternal Control QuestionnaireEffective date November 2004 Section 3000.4

Review the bank’s internal controls, policies,practices, and procedures for demand and timedeposit accounts. The bank’s systems should bedocumented completely and concisely andshould include, where appropriate, narrativedescriptions, flow charts, copies of forms used,and other pertinent information.

For large institutions or those institutions thathave individual demand and time deposit book-keeping functions, the examiner should consideradministering this questionnaire separately foreach function, as applicable.

Questions pertain to both demand and timedeposits unless otherwise indicated. Negativeresponses to the questions in this section shouldbe explained, and additional procedures deemednecessary should be discussed with the examiner-in-charge. Items marked with an asterisk requiresubstantiation by observation or testing.

OPENING DEPOSIT ACCOUNTS

*1. Are new-account documents prenumbered?a. Are new-account documents issued in

strict numerical sequence?b. Are the opening of new accounts and

access to unused new-account recordsand certificate of deposit (CD) formshandled by an employee who is not ateller or who cannot make internalentries to customer accounts or thegeneral ledger?

*2. Does the institution have a written ‘‘know-your-customer’’ policy?a. Do new-account applications require

sufficient information to clearly identifythe customer?

b. Are ‘‘starter’’ checks issued onlyafter the verification of data on newtransaction-account applications?

c. Are checkbooks and statements mailedonly to the address of record? If not, isa satisfactory explanation and descrip-tion obtained for any other mailingaddress (post office boxes, a friend orrelative, etc.)?

d. Are the employees responsible for open-ing new accounts trained to screendepositors for signs of check kiting?

*3. Does the bank perform periodic inven-

tories of new-account documents and CDs,and do the inventories include an account-ability of numbers issued out of sequenceor canceled prior to issuance?

*4. Are CDs signed by a properly authorizedindividual?

5. Are new-account applications and signa-ture cards reviewed by an officer?

CLOSING DEPOSIT ACCOUNTS

1. Are signature cards for closed accountspromptly pulled from the active-accountfile and placed in a closed file?

2. Are closed-account lists prepared? If so,how frequently?

3. Is the closed-account list circulated toappropriate management?

4. Is verification of closed accounts, in theform of statements of ‘‘goodwill’’ letters,required? Are such letters mailed underthe control of someone other than a telleror an individual who can make internalentries to an account (such as a privatebanker or branch manager)?

*5. For redeemed CDs:a. Are the CDs stamped paid?b. Is the disposition of proceeds docu-

mented to provide a permanent recordas well as a clear audit trail?

c. Are penalty calculations on CDs and onother time deposits that are redeemedbefore maturity rechecked by a secondemployee?

*6. Except for deposit-account agreements thatauthorize the transfer of deposited funds toother nondemand deposit accounts, arematured CDs that are not automaticallyrenewable classified as demand depositson the Call Report and on the Report ofTransaction Accounts, Other Deposits andVault Cash (FR 2900)?

DEPOSIT-ACCOUNT RECORDS

*1. Does the institution have documentationsupporting a current reconcilement of eachdeposit-account category recorded on itsgeneral ledger, including customer accounts


and bank-controlled accounts such asdealer reserves, escrow, Treasury tax andloan, etc.? (Prepare separate workpapersfor demand and time accounts, listing eachaccount and the date and frequency ofreconcilement, the general-ledger balance,the subsidiary-ledger balance, adjustments,and unexplained differences.)

*2. Are reconciliations performed by an indi-vidual or group not directly engaged inaccepting or preparing transactions or indata entry to customers’ accounts?

*3. If the size of the bank precludes fullseparation of duties between data entryand reconcilement, are reconcilementduties rotated on a formal basis, and is arecord maintained to support such action?

*4. Are reconciliations reviewed by appropri-ate independent management, especially incircumstances when full separation ofduties is not evident?

*5. Are periodic reports prepared for manage-ment, and do the reports provide an agingof adjustments and differences and detailthe status of significant adjustments anddifferences?

*6. Has management adequately addressed anysignificant or long-outstanding adjust-ments or differences?

*7. Is the preparation of input and the postingof subsidiary demand deposit records per-formed or adequately reviewed by personswho do not also—a. accept or generate transactions?b. issue official checks or handle funds-

transfer transactions?c. prepare or authorize internal entries

(return items, reversals, and directcharges, such as loan payments)?

d. prepare supporting documents requiredfor disbursements from an account?

e. perform maintenance on the accounts,such as changes of address, stop pay-ments, holds, etc.?

*8. Are in-process, suspense, interoffice, andother accounts related to deposit accountscontrolled or closely monitored by personswho do not have posting or reconcilementduties?

*9. Are periodic reports prepared for manage-ment on open items in suspense and onin-process, interoffice, overdrawn, andother deposit accounts, and do the reportsinclude aging of items and the status ofsignificant items?

10. If the bank’s bookkeeping system is notautomated, are deposit bookkeepersrotated?

11. Does the bank segregate the depositaccount files of—a. employees and officers?b. directors?c. the business interests of employees and

officers, or interests controlled byemployees and officers?

d. the business interests of directors, orinterests controlled by directors?

e. foreign goverments, embassies, andpolitical figures?

*12. Are posting and check filing separatedfrom statement preparation?

13. Are statements mailed or delivered to allcustomers as required by the bank’ sdeposit-account agreement?

*14. Are customer transaction and interest state-ments mailed in a controlled environmentthat precludes any individual from receiv-ing any statement not specifically autho-rized by the customer or the institution’spolicy (for example, dormant-accountstatements)?

DORMANT ACCOUNTS ANDRETURNED MAIL

*1. Does the bank have formal policies andprocedures for the handling of customers’transaction and interest statements that arereturned as undeliverable? Does thepolicy—a. require that statements be periodically

mailed on dormant accounts? If so, howoften?

b. prohibit the handling of dormant-account statements by (1) employees ofthe branch where the account is assigned,(2) the account officer, and (3) otherindividuals with exclusive control ofaccounts?

c. require positive action to follow up onobtaining new addresses?

d. place statements and signature cards foraccounts for which contact cannot bere-established (the mail is returned morethan once or is marked ‘‘ deceased’’ )into a controlled environment?

e. require the bank to change the addresson future statements to the department

3000.4 Deposit Accounts: Internal Control Questionnaire

November 2004 Commercial Bank Examination ManualPage 2

of the bank (the controlled environ-ment) designated to receive returnedmail?

f. require a written request from the cus-tomer and verification of the customer’ssignature before releasing an accountfrom the controlled environment?

*2. Are accounts for which contact cannot bere-established and that do not reflect recentactivity removed from active files andclearly classified as dormant?

*3. Before returning a dormant account toactive status, are transactions reactivatingthe account verified, and are independentconfirmations obtained directly from thecustomer?

*4. Does transfer from dormant to active sta-tus require the approval of an officer whocannot approve transactions on dormantaccounts?

INACTIVE ACCOUNTS

1. Are demand accounts that have been inac-tive for one year, and time accounts thathave been inactive for three years, classi-fied as inactive? If not, state the timeperiod for classifying a demand or timeaccount as inactive.

2. Does the bank periodically review theinactive accounts to determine if theyshould be placed in a dormant status, andare decisions to keep such accounts inactive files documented?

HOLD MAIL

*1. Does the institution have a formal policyand procedure for handling statements anddocuments that a customer requests not tobe mailed but that will be picked up at alocation within the institution? Does thepolicy—a. require that statements will not be held

by an individual (an account officer,branch manager, bookkeeper, etc.) whocould establish exclusive control overentries to and the delivery of statementsfor customer accounts?

b. discourage such pickup arrangementsand grant them only after the customerprovides a satisfactory reason for thearrangement?

c. require the customer to sign a statementdescribing the purpose of the requestand the proposed times for pickup, anddesignate the individuals authorized topick up the statement?

d. require the maintenance of signaturecards for individuals authorized to pickup statements, and compare the autho-rized signatures with those who sign forstatements held for pickup?

e. prohibit the delivery of statements toofficers and employees requiring spe-cial attention unless it is part of theformal ‘‘ hold-mail’’ function?

*2. Is a central record of hold-mail arrange-ments maintained in a control area thatdoes not originate entries to customers’accounts? Does the record identify eachhold-mail arrangement, the designatedlocation for pickup, and the scheduledpickup times? Does the control area—a. maintain current signature cards of

individuals authorized to pick upstatements?

b. obtain signed receipts showing the dateof pickup, and compare the receiptswith the signature cards?

c. follow up on the status of statementsnot picked up as scheduled?

*3. Does management review activity in hold-mail accounts that have not been picked upfor extended periods of time (for example,one year), and, when there is no activity,place the accounts in a dormant status?

OVERDRAFTS

*1. Are overdraft authorization limits for offi-cers formally established?

*2. Does the bank require an authorized offi-cer to approve overdrafts?

*3. Is an overdraft listing prepared daily fordemand deposit and time transactionaccounts?

4. For banks processing overdrafts that arenot automatically approved (a ‘‘ pay none’’system), is the nonsufficient-funds reportcirculated among bank officers?

*5. Are overdraft listings circulated amongthe officers?

6. Are the statements of accounts with largeoverdrafts reviewed for irregularities andprompt repayment?

Deposit Accounts: Internal Control Questionnaire 3000.4


7. Is an aged record of large overdraftsincluded in the monthly report to the boardof directors or its committee, and does thereport include the overdraft originationdate?

8. Is there an established schedule of servicecharges?

UNCOLLECTED FUNDS

*1. Does the institution generate a daily reportof drawings against uncollected funds fordemand deposit and time transactionaccounts?a. Is the computation of uncollected funds

positions based on reasonable check-collection criteria?

b. Can the reports, or a separate accountactivity report, be used to detect potentialkiting conditions?

c. If reports are not generated for timetransaction accounts, is a system inplace to control drawings against uncol-lected funds?

*2. Do authorized officers review theuncollected-funds reports and approvedrawings against uncollected funds withinestablished limits?

*3. Are accounts that frequently appear on theuncollected-funds or kite-suspect reportsreviewed regardless of account balances?(For example, accounts with simultaneouslarge debits and credits can reflect lowbalances.)

ACCOUNTS FOR FOREIGNGOVERNMENTS, EMBASSIES,AND POLITICAL FIGURES

1. For bank relationships with a foreign gov-ernment, embassy, or political figure:

a. Has the board of directors establishedstandards and guidelines for manage-ment to use when evaluating whether ornot the bank should accept such newaccounts?

b. Are the standards and guidelines con-sistent with the bank’s—• own business objectives,• assessment of the varying degrees of

risks associated with particular for-

eign accounts or lines of business,and

• capacity to manage those risks?c. Does the bank have adequate internal

controls and compliance oversight sys-tems to monitor and manage the vary-ing degrees of risks associated withsuch foreign accounts? Do these inter-nal controls and compliance systemsensure full compliance with the BankSecrecy Act, as amended by the USAPatriot Act, and its respectiveregulations?

d. Does the bank have personnel that aresufficiently trained in the managementof such risks and in the requirements ofapplicable laws and regulations?

e. Does the bank have policies and proce-dures for ensuring that such foreign-account customers receive adequatecommunications from the bank? Com-munications should ensure that thesecustomers are made fully aware of therequirements of U.S laws and regula-tions to which the bank is subject.

f. Does the bank seek to structure itsrelationships with such foreign-accountcustomers so as to minimize the vary-ing degrees of risks these customersmay pose?

OTHER MATTERS

*1. Are account-maintenance activities(changes of address, status changes, ratechanges, etc.) separated from data entryand reconciling duties?

*2. Do all internal entries other than servicecharges require the approval of appropri-ate supervisory personnel?

*3. If not included in the internal or externalaudit program, are employees’ and offi-cers’ accounts, accounts of employees’and officers’ business interests, and accountscontrolled by employees and officers peri-odically reviewed for unusual or prohib-ited activity?

*4. For unidentified deposits:a. Are deposit slips kept under dual

control?b. Is the disposition of deposit slips

approved by an appropriate officer?*5. For returned checks, unposted items, and



other rejects:a. Are daily listings of such items

prepared?b. Are all items reviewed daily, and is

disposition of items required within areasonable time period? If so, indicatethe time period.

c. Are reports prepared for managementthat show items not disposed of withinthe established time frames?

6. Are customers immediately notified in writ-ing of deposit errors?

7. Does the bank require a customer’s signa-ture for stop-payment orders?

8. For automatic transfer accounts:a. Are procedures in effect that require

officer approval for transfers in excessof the savings balance?

b. For nonautomated systems, are trans-fers made by employees who do notalso handle cash, execute external fundstransfers, issue official checks singly, orpost subsidiary records?

9. For telephone transfer accounts:a. Do depositors receive an individual

identification code for use in makingtransfers?

b. Are transfers made by employees whodo not also handle cash, execute exter-nal funds transfers, issue official checkssingly, or post subsidiary records?

*10. If not included in the internal or externalaudit program, are accrual balances for thevarious types of deposits verified periodi-cally by an authorized official? If so,indicate how often.

*11. Are accounts with a ‘‘ hold-balance’’status—those accounts on which courtorders have been placed, those pledged assecurity to customers’ loans, those pend-ing the clearing of a large check, those forwhich the owner is deceased, and those forwhich the passbook has been lost—‘‘ lockedout’’ for transactions unless the transactionis approved by appropriate management?

12. For passbook accounts:a. Do all entries to passbooks contain

teller identification?b. Under a window-posting system, are

recording media and passbooks postedsimultaneously?

c. Are tellers prohibited from holding cus-tomers’ savings passbooks?

d. If customers’ passbooks are held, arethey maintained under the institution’s

‘‘ hold-mail’’ program and kept underdual control?

e. Are customers prohibited from with-drawing funds without a passbook? Ifnot, state the policy.

13. For withdrawals from savings or othertime accounts:a. Are withdrawal tickets canceled daily?b. Are procedures in place to preclude

overdrafts?c. Are procedures in effect to place holds

on, and to check for holds on, withdraw-als over a stated amount? If so, indicatethe amount.

14. For signature cards on demand and timeaccounts:a. Are procedures in effect to guard against

the substitution of false signatures?Describe the procedures.

b. Are signature cards stored to precludephysical damage?

c. Are signatures compared for withdraw-als and cashed checks? Describe theprocedures.

OFFICIAL CHECKS, MONEYORDERS, AND CERTIFIEDCHECKS

*1. Are separate general-ledger accounts main-tained for each type of official check?

*2. For each type of check issued:a. Are multicopy checks and certified-

check forms used? If not, aredetailed registers of disbursed checksmaintained?

b. Are all checks prenumbered and issuedin sequence?

c. Is check preparation and issuanceseparate from recordkeeping?

d. Is the signing of checks in advanceprohibited?

e. Do procedures prohibit the issuance ofa check before the credit is processed?

*3. Is the list authorizing bank personnel tosign official checks kept current? Does thelist include changes in authorization limits,delete employees who no longer work atthe bank, and indicate employees added tothe list?

*4. Are appropriate controls in effect overcheck-signing machines (if used) and cer-tification stamps?

Deposit Accounts: Internal Control Questionnaire 3000.4


*5. Are voided checks and voided certified-check forms promptly defaced and filedwith paid checks?

*6. If reconcilements are not part of the over-all deposit-reconciliation function—a. are outstanding checks listed and rec-

onciled regularly to the general ledger?If so, state how often.

b. is permanent evidence of reconcile-ments maintained?

c. is there clear separation between thepreparation of checks, data entry, andcheck reconcilement?

d. are the reconcilements reviewed regu-larly by an authorized officer?

e. are reconcilement duties rotated on aformal basis in institutions where sizeprecludes the full separation of dutiesbetween data entry and reconcilement?

f. are authorized signatures and endorse-ments checked by the filing clerk?

*7. For supplies of official checks:a. Are records of unissued official checks

maintained centrally and at each loca-tion storing them?

b. Are periodic inventories of unissuedchecks independently performed?

c. Do the inventories include a descriptionof all checks issued out of sequence?

d. If users are assigned a supply, is thatsupply replenished on a consignmentbasis?

*8. Are procedures in effect to preclude certi-fication of checks drawn against uncol-lected funds?

TREASURY TAX AND LOANACCOUNTS (31 CFR 203)

1. Do transfers from the remittance-optionaccount to the Federal Reserve Bank occurthe next business day after deposit?

2. When the note option is used, do transfersfrom the Treasury Tax and Loan (TT&L)demand deposit account occur the next

business day after deposit?*3. Has the TT&L-account reconcilement

been completed in a timely manner andapproved by a supervisor?

4. Has adequate collateral been pledged tosecure the TT&L account?

AUDIT

*1. Are deposit-account activities audited on asufficiently frequent basis?

*2. Does the scope of the audit programrequire, and do audit records support, sub-stantive testing or quantitative measure-ments of deposit-account activities that, ata minimum, include the matters set forth inthis questionnaire?

*3. Does the audit program include a compre-hensive confirmation program with thecustomers of each deposit category main-tained by the institution?

*4. Do audit department records support theexecution of the confirmation program,and do the records reflect satisfactoryfollow-up of responses and of requestsreturned as undeliverable?

*5. Are audit and prior-examination recom-mendations for deposit-account activitiesappropriately addressed?

CONCLUSION

*1. Does the foregoing information provide anadequate basis for evaluating internal con-trol in that deficiencies in areas not cov-ered by this questionnaire do not signifi-cantly impair any controls? Explainnegative answers briefly, and indicate anyadditional examination procedures deemednecessary.

*2. Are internal controls adequate on the basisof a composite evaluation, as evidenced byanswers to the foregoing questions?



Borrowed FundsEffective date October 2008 Section 3010.1

Borrowed funds are a common and practicalmethod for banks of all sizes to meet customers’needs and enhance banking operations. For thepurposes of this section, borrowings excludelong-term subordinated debt, such as capitalnotes and debentures (discussed in ‘‘Assessmentof Capital Adequacy,’’ section 3020.1). Borrow-ings may exist in a number of forms, both on adirect and indirect basis. Common sources ofdirect bank borrowings include Federal HomeLoan Bank credit lines, federal funds purchased,loans from correspondent banks, repurchaseagreements, negotiable certificates of deposit,and borrowings from the Federal Reserve dis-count window. These are discussed in somedetail below. Other borrowings include billspayable to the Federal Reserve, interest-bearingdemand notes issued to the U.S. Treasury (theTreasury tax and loan note option account),mortgages payable, due bills, and other types ofborrowed securities. Indirect forms of borrow-ings include customer paper rediscounted andassets sold with the bank’s endorsement orguarantee or subject to a repurchase agreement.

The primary reasons a bank may borrowinclude the following:

• To meet the temporary or seasonal loan ordeposit withdrawal needs of its customers, ifthe borrowing period is temporary and thebank is quickly restored to a position in whichthe quantity of its principal earning assets andcash reserves is in proper relation to therequirements of its normal depositvolume.

• To meet large and unanticipated deposit with-drawals that may arise during periods ofeconomic distress. The examiner should dis-tinguish between ‘‘large and unanticipateddeposit withdrawals’’ and a predeterminablecontraction of deposits, such as the cessationof activities in a resort community or thewithdrawal of funds on which the bankreceived adequate prior withdrawal notice.Those situations should be met through amplecash reserves and readily convertible assetsrather than borrowing.

• To manage liabilities effectively. Generally,the effective use of this type of continuousborrowing is limited to money-center or largeregional banks.

It is important to analyze each borrowing on

its own merit to determine its purpose, effective-ness, and stability. Some of the more frequentlyused sources of borrowings are discussed below.

COMMON SOURCES OFBORROWINGS

Federal Home Loan Bank Borrowings

The Federal Home Loan Bank (FHLB) origi-nally served solely as a source of borrowings tosavings and loan companies. With the imple-mentation of the Financial Institutions Reform,Recovery, and Enforcement Act of 1989(FIRREA), FHLB’s lending capacity wasexpanded to include banks.

Compared with borrowings from the discountwindow of the Reserve Banks, borrowings fromthe FHLB have fewer conditions. Both short-term and long-term borrowings, with maturitiesranging from overnight to 30 years, are avail-able to institutions at generally competitiveinterest rates. The flexibility of the facilityenables bank management to use this source offunds for the purpose of asset/liability manage-ment, and it allows management to secure afavorable interest-rate spread. For example,FHLB borrowings may provide a lower-costalternative to the conventional deposit, particu-larly in a highly competitive local market.

Management should be capable of explainingthe purpose of the borrowing transaction. Theborrowing transaction should then be analyzedto determine whether the arrangement achievedthe stated purpose or whether the borrowings area sign of liquidity deficiencies. Further, theborrowing agreement between the institutionand the FHLB should be reviewed to determinethe asset collateralizing the borrowings and thepotential risks presented by the agreement. Insome instances, the borrowing agreement mayprovide for collateralization by all assets notalready pledged for other purposes.

The types of collateral necessary to obtain anFHLB loan include residential mortgage loansand mortgage-backed securities. The compositerating of an institution is a factor in both theapproval for obtaining an FHLB loan and thelevel of collateral required.

Commercial Bank Examination Manual October 2008Page 1

Federal Funds Purchased

The day-to-day use of federal funds is a rathercommon occurrence, and federal funds are con-sidered an important money market instrument.Many regional and money-center banks, actingin the capacity of correspondents to smallercommunity banks, function as both providersand purchasers of federal funds and, in theprocess of these transactions, often generate asmall return.

A brief review of bank reserves is essential toa discussion of the federal funds market. As acondition of membership in the Federal ReserveSystem, member banks are required to maintaina portion of their deposits as reserves. Reservescan take the form of vault cash and deposits inthe Reserve Bank. The amount of these reservebalances is reported weekly or quarterly andcomputed on the basis of the daily averagedeposit balances. For institutions that reporttheir reserves on a weekly basis, requiredreserves are computed on the basis of dailyaverage balances of deposits and Eurocurrencyliabilities during a 14-day period ending everysecond Monday. Institutions that report theirreserves on a quarterly basis compute theirreserve requirement on the basis of their dailyaverage deposit balances during a seven-daycomputation period that begins on the thirdTuesday of March, June, September, and Decem-ber. (See 12 CFR 204.3(c)–(d).)

Since member banks do not receive intereston the reserves, banks prefer to keep excessbalances at a minimum to achieve the maximumutilization of funds. To accomplish this goal,banks carefully analyze and forecast their dailyreserve position. Changes in the volume ofrequired reserves occur frequently as the resultof deposit fluctuations. Deposit increases requiremember banks to maintain more reserves; con-versely, deposit decreases require less reserves.

The most frequent type of federal fundstransaction is unsecured for one day and repay-able the following business day. The rate isusually determined by overall money marketrates as well as by the available supply of anddemand for funds. In some instances, when theselling and buying relationship between twobanks is quite continuous, something similar toa line of credit may be established on a funds-availability basis. Although the most commonfederal funds transaction is unsecured, the sell-ing of funds can also be secured and for longer

periods of time. Agency-based federal fundstransactions are discussed in ‘‘Bank DealerActivities,’’ section 2030.1.

Loans from Correspondent Banks

Small and medium-sized banks often negotiateloans from their principal correspondent banks.The loans are usually for short periods and maybe secured or unsecured.

Repurchase Agreements

The terms ‘‘repurchase agreement’’1 (repo) and‘‘reverse repurchase agreement’’ refer to a typeof transaction in which a money market partici-pant acquires immediately available funds byselling securities and simultaneously agreeing torepurchase the securities after a specified time ata given price, which typically includes interestat an agreed-on rate. Such a transaction is calleda repo when viewed from the perspective of thesupplier of the securities (the borrower), and areverse repo or matched sale-purchase agree-ment when described from the point of view ofthe supplier of funds (the lender).

Frequently, instead of resorting to direct bor-rowings, a bank may sell assets to another bankor some other party and simultaneously agree torepurchase the assets at a specified time or aftercertain conditions have been met. Bank securi-ties as well as loans are often sold under a repoto generate temporary working funds. Thesekind of agreements are often used because therate on this type of borrowing is less than therate on unsecured borrowings, such as federalfunds purchased.

The usual terms for the sale of securitiesunder a repo require that, after a stated period oftime, the seller repurchase the securities at apredetermined price or yield. A repo commonlyincludes a near-term maturity (overnight or afew days) and is usually arranged in large-dollaramounts. The lender or buyer is entitled toreceive compensation for use of the funds pro-vided to its counterparty. The interest rate paidon a repo is negotiated based on the rates on theunderlying securities. U.S. government andagency securities are the most common type of

1. See sections 2015.1, 2020.1, and 4170.1.

3010.1 Borrowed Funds

October 2008 Commercial Bank Examination ManualPage 2

instruments sold under repurchase agreements,since those types of repos are exempt fromreserve requirements.

Although standard overnight and term repoarrangements in Treasury and federally relatedagency securities are most prevalent, marketparticipants sometimes alter various contractprovisions to accommodate specific investmentneeds or to provide flexibility in the designationof collateral. For example, some repo contractsallow substitutions of the securities subject tothe repurchase commitment. These are called‘‘dollar repurchase agreements’’ (dollar rolls),and the initial seller’s obligation is to repurchasesecurities that are substantially similar, but notidentical, to the securities originally sold.Another common repo arrangement is called a‘‘flex repo,’’ which, as implied by the name,provides a flexible term to maturity. A flex repois a term agreement between a dealer and amajor customer in which the customer buyssecurities from the dealer and may sell some ofthem back before the final maturity date.

Bank management should be aware of certainconsiderations and potential risks of repurchaseagreements, especially when entering into large-dollar-volume transactions with institutionalinvestors or brokers. Both parties in a term repoarrangement are exposed to interest-rate risk. Itis a fairly common practice to have the collateralvalue of the underlying securities adjusted dailyto reflect changes in market prices and to main-tain the agreed-on margin. Accordingly, if themarket value of the repo securities declinesappreciably, the borrower may be asked toprovide additional collateral. Conversely, if themarket value of the securities rises substantially,the lender may be required to return the excesscollateral to the borrower. If the value of theunderlying securities exceeds the price at whichthe repurchase agreement was sold, the bankcould be exposed to the risk of loss if the buyeris unable to perform and return the securities.This risk would obviously increase if the secu-rities are physically transferred to the institutionor broker with which the bank has entered intothe repurchase agreement. Moreover, if thesecurities are not returned, the bank could beexposed to the possibility of a significant write-off, to the extent that the book value of thesecurities exceeds the price at which the securi-ties were originally sold under the repurchaseagreement. For this reason, banks should avoidpledging excessive collateral and obtain suffi-cient financial information on and analyze the

financial condition of those institutions andbrokers with whom they engage in repurchasetransactions.

‘‘Retail repurchase agreements’’ (retail repos)2

for a time were a popular vehicle for somecommercial banks to raise short-term funds andcompete with certain instruments offered bynonbanking competitors. For booking purposes,a retail repo is a debt incurred by the issuingbank that is collateralized by an interest in asecurity that is either a direct obligation of orguaranteed as to principal and interest by theU.S. government or an agency thereof. Retailrepos are issued in amounts not exceeding$100,000 for periods of less than 90 days. Withthe advent of money market certificates issuedby commercial banks, the popularity of the retailrepo declined.

Both retail and large-denomination, whole-sale repurchase agreements are in many respectsequivalent to short-term borrowings at marketrates of interest. Therefore, banks engaging inrepurchase agreements should carefully evaluatetheir interest-rate-risk exposure at various matu-rity levels, formulate policy objectives in lightof the institution’s entire asset and liability mix,and adopt procedures to control mismatchesbetween assets and liabilities. The degree towhich a bank borrows through repurchase agree-ments also should be analyzed with respect to itsliquidity needs, and contingency plans shouldprovide for alternative sources of funds.

Negotiable Certificates of Deposit

Certificates of deposit (CDs) have not beenlegally defined as borrowings and continue to bereflected as deposits for reporting purposes.However, the fundamental distinction between anegotiable money market CD as a deposit or asa borrowing is nebulous at best; in fact, thenegotiable money market CD is widely recog-nized as the primary borrowing vehicle formany banks. Dependence on CDs as sources offunds is discussed in ‘‘Deposit Accounts,’’ sec-tion 3000.1.

2. See sections 2015.1, 2020.1, and 4170.1.

Borrowed Funds 3010.1


Borrowings from the Federal Reserve

In accordance with the Board’s Regulation A(12 CFR 201), the Federal Reserve Banks gen-erally make credit available through the pri-mary, secondary, and seasonal credit programsto any depository institution that maintains trans-action accounts or nonpersonal time deposits.3

However, the Federal Reserve expects deposi-tory institutions to rely on market sources offunds for their ongoing funding needs and to usethese credit programs as a backup source offunding rather than a routine one. An institutionthat borrows primary credit may use those fundsto finance sales of federal funds, but secondaryand seasonal credit borrowers may not act as themedium or agent of another depository institu-tion in receiving Federal Reserve credit exceptwith the permission of the lending FederalReserve Bank.

A Federal Reserve Bank is not obligated toextend credit to any depository institution butmay lend to a depository institution either bymaking an advance secured by acceptable col-lateral or by discounting certain types of paperdescribed in the Federal Reserve Act. AlthoughReserve Banks now always extend credit in theform of an advance, the Federal Reserve’s creditfacility nonetheless is known colloquially as the‘‘discount window.’’ Before lending to a deposi-tory institution, a Reserve Bank can require anyinformation it believes is appropriate to ensurethat the assets tendered as collateral are accept-able. A Reserve Bank also should determineprior to lending whether the borrowing institu-tion is undercapitalized or critically undercapi-talized. Operating Circular No. 10, ‘‘Lending,’’establishes the credit and security terms forborrowings from the Federal Reserve.

Primary Credit

Reserve Banks may extend primary credit on avery short term basis (typically overnight) todepository institutions that the Reserve Banksjudge to be in generally sound financial condi-tion. Reserve Banks extend primary credit at arate above the target federal funds rate of theFederal Open Market Committee. Minimaladministrative requirements apply to requestsfor overnight primary credit, unless some aspectof the credit request appears inconsistent withthe conditions of primary credit (for example, ifa pattern of behavior indicates strongly that aninstitution is using primary credit other than as abackup source of funding). Reserve Banks alsomay extend primary credit to eligible institu-tions for periods of up to several weeks if suchfunding is not available from other sources.However, longer-term extensions of primarycredit will be subject to greater administrationthan are overnight loans.

Reserve Banks determine eligibility for pri-mary credit according to a uniform set of criteriathat also is used to determine eligibility fordaylight credit under the Board’s Policy State-ment on Payments System Risk. These criteriaare based mainly on examination ratings andcapitalization, although Reserve Banks also mayuse supplementary information, including market-based information when available. Specifically,an institution that is at least adequately capital-ized and rated CAMELS 1 or 2 (or SOSA 1 andROCA 1, 2, or 3) almost certainly would beeligible for primary credit. An institution that isat least adequately capitalized and rated CAMELS3 (or SOSA 2 and ROCA 1, 2, or 3) generallywould be eligible. An institution that is at leastadequately capitalized and rated CAMELS 4 (orSOSA 1 or 2 and ROCA 4 or 5) would beeligible only if an ongoing examination indi-cated a substantial improvement in condition.An institution that is not at least adequatelycapitalized, or that is rated CAMELS 5 (orSOSA 3 regardless of the ROCA rating), wouldnot be eligible for primary credit.

Secondary Credit

Secondary credit is available to institutions thatdo not qualify for primary credit. Secondarycredit is available as a backup source of liquidityon a very short term basis, provided that the loanis consistent with a timely return to a reliance on

3. In unusual and exigent circumstances and after consul-tation with the Board, a Reserve Bank may extend credit toindividuals, partnerships, and corporations that are not deposi-tory institutions if, in the judgment of the Reserve Bank, creditis not available from other sources and failure to obtain creditwould adversely affect the economy. A Reserve Bank mayextend credit to a nondepository entity in the form of anadvance only if the advance is secured by a direct obligationof the United States or a direct obligation of, or an obligationthat is fully guaranteed as to principal and interest by, anyagency of the United States. An extension of credit secured byany other type of collateral must be in the form of a discountand must be authorized by an affirmative vote of at least fivemembers of the Board.



market sources of funds. Longer-term secondarycredit is available if necessary for the orderlyresolution of a troubled institution, although anysuch loan would have to comply with additionalrequirements for lending to undercapitalized andcritically undercapitalized institutions. Unlikethe primary credit program, secondary credit isnot a minimal administration facility becauseReserve Banks must obtain sufficient informa-tion about a borrower’s financial situation toensure that an extension of credit complies withthe conditions of the program. Secondary creditis available at a rate above the primary creditrate.

Seasonal Credit

Seasonal credit is available under limited con-ditions to meet the needs of depository institu-tions that have seasonal patterns of movement indeposits and loans but that lack ready access tonational money markets. In determining a deposi-tory institution’s eligibility for seasonal credit,Reserve Banks consider not only the institu-tion’s historical record of seasonal fluctuationsin loans and deposits, but also the institution’srecent and prospective needs for funds and itsliquidity conditions. Generally, only very smallinstitutions with pronounced seasonal fundingneeds will qualify for seasonal credit. Seasonalcredit is available at a flexible rate that takes intoaccount the rate for market sources of funds.

Collateral Requirements

All loans advanced by the Reserve Bank mustbe secured to the satisfaction of the ReserveBank. Collateral requirements are governed byOperating Circular No. 8. Reserve Banks re-quire a perfected security interest in all collat-eral pledged to secure loans. Satisfactory collat-eral generally includes U.S. government andfederal-agency securities, and, if they are ofacceptable quality, mortgage notes covering one-to four-family residences; state and local gov-ernment securities; and business, consumer, andother customer notes. Traditionally, collateral isheld in the Reserve Bank vault. Under certaincircumstances, collateral may be retained on theborrower’ s premises under a borrower-in-custody arrangement, or it may be held on theborrower’s premises under the Reserve Bank’sexclusive custody and control in a field ware-

house arrangement. Collateral may also be heldat the borrowing institution’s correspondent oranother third party. All book-entry collateralmust be held at the Federal Reserve Bank.Definitive collateral, not in bearer form, must beproperly assigned and endorsed.

Lending to Undercapitalized andCritically Undercapitalized DepositoryInstitutions

Credit from any Reserve Bank to an institutionthat is ‘‘ undercapitalized’’ may be extended oroutstanding for no more than 60 days duringwhich the institution is undercapitalized in any120-day period.4 An institution is consideredundercapitalized if it is not critically undercapi-talized under section 38 of the Federal DepositInsurance Act (the FDI Act) but is either deemedundercapitalized under that provision and itsimplementing regulations or has received a com-posite CAMELS rating of 5 as of the mostrecent examination. A Reserve Bank may makeor have outstanding advances or discounts to aninstitution that is deemed ‘‘ critically undercapi-talized’’ under section 38 of the FDI Act and itsimplementing regulations only during the five-dayperiod beginning on the date the institutionbecame critically undercapitalized or after con-sultation with the Board.

INTERNATIONAL BORROWINGS

International borrowings may be direct or indi-rect. Common forms of direct international bor-rowings include loans and short-term call moneyfrom foreign banks, borrowings from the Export-Import Bank of the United States, and over-drawn nostro (due from foreign banks—demand)accounts. Indirect forms of borrowing includenotes and trade bills rediscounted with thecentral banks of various countries; notes, accep-tances, import drafts, or trade bills sold with thebank’s endorsement or guarantee; notes andother obligations sold subject to repurchaseagreements; and acceptance pool participations.

4. Generally, a Reserve Bank also may lend to an under-capitalized institution during 60 calendar days after receipt ofa certificate of viability from the Chairman of the Board ofGovernors or after consultation with the Board.

Borrowed Funds 3010.1

Commercial Bank Examination Manual May 2003Page 5

ANALYZING BORROWINGS

If a bank borrows extensively or in largeamounts, the examiner should thoroughly ana-lyze the borrowing activity. An effective analy-sis includes a review of the bank’s reserverecords, both required and maintained, to deter-mine the frequency of deficiencies at the closingof reserve periods. The principal sources ofborrowings, range of amounts, frequency, lengthof time indebted, cost, and reasons for theborrowings should be explored. The actual useof the funds should be verified.

Examiners should also analyze changes in abank’s borrowing position for signs of deterio-ration in its borrowing ability and overall cred-itworthiness. One indication of deterioration isthe payment of large fees to money brokers toobtain funds because the bank is having diffi-culty obtaining access to conventional sourcesof borrowings. These ‘‘ brokered deposits’’ areusually associated with small banks since they

do not generally have ready access to alternativesources of funds available to larger institutionsthrough the money and capital markets. Bro-kered deposits generally carry higher interestrates than alternative sources, and they tend tobe particularly susceptible to interest-rate changesin the overall financial market. For furtherdiscussion of brokered deposits, see ‘‘ DepositAccounts,’’ section 3000.1.

Other indicators of deterioration in a bank’sborrowing ability and overall creditworthinessinclude, but are not limited to, requests forcollateral on previously unsecured credit lines orincreases in collateral margins, the payment ofabove-market interest rates, or a shortening ofmaturities that is inconsistent with manage-ment’s articulated balance-sheet strategies. Ifthe examiner finds that a bank’s borrowingposition is not properly managed, appropriatecomments should be included in the report ofexamination.


May 2003 Commercial Bank Examination ManualPage 6

Borrowed FundsExamination ObjectivesEffective date May 1996 Section 3010.2

1. To determine if the policies, practices, pro-cedures, and internal controls for borrowedfunds are adequate.

2. To determine if bank officers are operating inconformance with the established guidelines.

3. To determine the scope and adequacy of theaudit function.

4. To determine compliance with laws andregulations.

5. To initiate corrective action when policies,practices, procedures, or internal controls aredeficient or when violations of laws or regu-lations have been noted.


Borrowed FundsExamination ProceduresEffective date October 2008 Section 3010.3

1. If selected for implementation, complete orupdate the Borrowed Funds section of theInternal Control Questionnaire.

2. Based on the evaluation of internal controlsand the work performed by the internal/external auditors, determine the scope of theexamination.

3. Test for compliance with policies, practices,procedures, and internal controls in conjunc-tion with performing the remaining exami-nation procedures. Also obtain a listing ofany audit deficiencies noted in the latestreview done by internal/external auditorsfrom the examiner assigned to ‘‘InternalControl’’ and determine if appropriate cor-rections have been made.

4. Obtain the listing of accounts related todomestic and international borrowed fundsfrom the examiner assigned to ‘‘Examina-tion Strategy.’’

5. Prepare or obtain a listing of borrowings, bytype, and—a. agree or reconcile balances to depart-

ment controls and general ledger, andb. review reconciling items for reason-

ableness.6. From consultation with the examiners

assigned to the various loan areas, deter-mine that the following schedules werereviewed in the lending departments andthat there was no endorsement, guarantee,or repurchase agreement which wouldconstitute a borrowing:a. participations soldb. loans sold in full since the preceding

examination7. Based on the information obtained in steps

5 and and 6, and through observation anddiscussion with management and otherexamining personnel, determine that all bor-rowings are properly reflected on the booksof the bank.

8. If the bank engages in any form of borrow-ing which requires written borrowingagreement(s), complete the following:a. Prepare or update a carry-forward work-

paper describing the major terms of eachborrowing agreement, and determine thatthe bank is complying with those terms.

b. Review terms of past and present bor-

rowing agreements for indications ofdeteriorating credit position by noting—• recent substantive changes in borrow-

ing agreements,• increases in collateral to support bor-

rowing transactions,• general shortening of maturities,• interest rates exceeding prevailing mar-

ket rates,• frequent changes in lenders, and• large fees paid to money brokers.

c. If the bank has obtained funds frommoney brokers (brokered deposits),determine—• why such deposits were originally

obtained,• who the deposits were obtained from,• what the funds are used for,• the relative cost of brokered deposits

in comparison to alternate sources offunds, and

• the overall effect of the use ofbrokered deposits on the bank’s con-dition and whether there appear to beany abuses related to the use of suchdeposits.

d. If there is an indication that the bank’scredit position has deteriorated, ascertainwhy.

9. If the bank engages in the issuance of retailrepurchase agreements (retail repos), checkfor compliance with section 4170.1; also2015.1 and 2020.1.

10. Determine the purpose of each type ofborrowing and conclude whether the bank’sborrowing posture is justified in light ofits financial condition and other relevantcircumstances.

11. Provide the examiner assigned to ‘‘Asset/Liability Management’’ the followinginformation:a. A summary and an evaluation of the

bank’s borrowing policies, practices, andprocedures. The evaluation should giveconsideration to whether the bank—• evaluates interest-rate-risk exposure at

various maturity levels;• formulates policy objectives in light of

the entire asset and liability mix, andliquidity needs;

• has adopted procedures to control mis-


matches between assets and liabilities;and

• has contingency plans for alternatesources of funds in the event of arun-off of current funding sources.

b. An evaluation of the bank’s adherence toestablished policies and procedures.

c. A repricing maturity schedule ofborrowings.

d. A listing of prearranged federal fundslines and other lines of credit. Indicatethe amount currently available underthose lines, i.e., the unused portion of thelines.

e. The amount of any anticipated decline inborrowings over the nextday period. (The time period will bedetermined by the examiner assigned to‘‘Asset/Liability Management.’’)

12. Prepare a list of all borrowings by category,on a daily basis for the period since thelast examination. Also, include on the listshort-term or overnight money marketlending activities such as federal fundssold and securities purchased under resaleagreement. For each category on the list,compute for the period betweenexaminations—a. high point

b. low pointc. average amounts outstandingd. frequency of borrowing and lending activ-

ity, expressed in terms of number of days13. Prepare, in appropriate report form, and

discuss with appropriate management—a. the adequacy of written policies regard-

ing borrowings;b. the manner in which bank officers are

operating in conformance with estab-lished policy;

c. the existence of any unjustified borrow-ing practices;

d. any violation of laws or regulations; ande. recommended corrective action when

policies, practices, or procedures aredeficient; violations of laws or regula-tions exist; or when unjustified borrow-ing practices are being pursued.

14. Update the workpapers with any informa-tion that will facilitate future examinations.

15. Review the market value of collateral andcollateral-control arrangements for repur-chase agreements to ensure that excessivecollateral has not been pledged and that thebank is not exposed to excessive creditrisks.

3010.3 Borrowed Funds: Examination Procedures


Borrowed FundsInternal Control QuestionnaireEffective date March 1984 Section 3010.4

Review the bank’s controls, policies, practicesand procedures for obtaining and servicing bor-rowed funds. The bank’s system should bedocumented in a complete and concise mannerand should include, where appropriate, narrativedescriptions, flowcharts, copies of forms usedand other pertinent information. Items markedwith an asterisk require substantiation by obser-vation or testing.

POLICY

1. Has the board of directors approved awritten policy which:a. Outlines the objectives of bank

borrowings?b. Describes the bank’s borrowing philos-

ophy relative to risk considerations,i.e., leverage/growth, liquidity/income?

c. Provides for risk diversification in termsof staggered maturities rather than solelyon cost?

d. Limits borrowings by amount outstand-ing, specific type or total interestexpense?

e. Limits or restricts execution of borrow-ings by bank officers?

f. Provides a system of reporting require-ments to monitor borrowing activity?

g. Requires subsequent approval oftransactions?

h. Provides for review and revision ofestablished policy at least annually?

RECORDS

*2. Does the bank maintain subsidiary recordsfor each type of borrowing, includingproper identification of the obligee?

*3. Is the preparation, addition and posting ofthe subsidiary borrowed funds records per-formed or adequately reviewed by personswho do not also:a. Handle cash?b. Issue official checks and drafts?

c. Prepare all supporting documentsrequired for payment of debt?

*4. Are subsidiary borrowed funds recordsreconciled with the general ledger accountsat an interval consistent with borrowingactivity, and are the reconciling itemsinvestigated by persons, who do not also:a. Handle cash?b. Prepare or post to the subsidiary bor-

rowed funds records?

INTEREST

*5. Are individual interest computationschecked by persons who do not haveaccess to cash?

6. Is an overall test of the total interest paidmade by persons who do not have accessto cash?

7. Are payees on the checks matched torelated records of debt, note or debentureowners?

8. Are corporate resolutions properly pre-pared as required by creditors and arecopies on file for reviewing personnel?

9. Are monthly reports furnished to the boardof directors reflecting the activity of bor-rowed funds, including amounts outstand-ing, interest rates, interest paid to date andanticipated future activity?

CONCLUSION

10. Is the foregoing information an adequatebasis for evaluating internal control in thatthere are no significant deficiencies inareas not covered in this questionnairethat impair any controls? Explain negativeanswers briefly, and indicate any addi-tional examination procedures deemednecessary.

11. Based on a composite evaluation, asevidenced by answers to the foregoingquestions, internal control is considered(adequate/inadequate).

Commercial Bank Examination Manual March 1994Page 1

Complex Wholesale BorrowingsEffective date May 2001 Section 3012.1

Commercial banks rely on wholesale borrow-ings obtained from a number of financial inter-mediaries, including Federal Home Loan Banks,other commercial banks, and securities firms.These borrowings frequently have attractive fea-tures and pricing. If properly assessed andprudently managed, they can enhance a bank’sfunding options and assist in controlling interest-rate and liquidity risks. Some of the reasons thatbanks use these types of borrowings include theinitial low cost of funds when compared withother liabilities with similar maturities. At thesame time, certain wholesale borrowings havebecome more complex, and some structuresinclude various types of embedded options.1 Ifnot thoroughly assessed and prudently managed,these more complex funding instruments havethe potential over time to significantly increase abank’s sensitivity to market and liquidity risks.Maturity mismatches or the embedded optionsthemselves can, in some circumstances, ad-versely affect a bank’s financial condition, espe-cially when the terms and conditions of theborrowings are misunderstood.

A growing use of wholesale borrowings,combined with the risks associated with thecomplex structures of some of these borrowings,makes it increasingly important for bank super-visors to assess the risks and risk-managementprocesses associated with these sources of funds.The supervisory guidance provided below supple-ments and expands upon existing general guid-ance on bank funding and borrowings.2 Whereappropriate, examiners should (1) review theprovisions of each significant borrowing agree-ment between the bank and the wholesale insti-tution, (2) determine what assets collateralize

the borrowing (or borrowings), and (3) identifythe potential risks presented by the agreement.(See SR-01-8.)

In addition to determining if a bank followsthe sound-practice guidance for bank liabilitymanagement and funding in general, supervisorsshould take the following steps, as appropriate,when assessing a bank that has material amountsof wholesale borrowings:

• Review the bank’s borrowing contracts forembedded options or other features that mayaffect the bank’s liquidity and sensitivity tomarket risks. In addition, examiners shouldreview the collateral agreements for fees,collateral-maintenance requirements (includ-ing triggers for increases in collateral), andother features that may affect the bank’sliquidity and earnings.

• Assess the bank’s management processes foridentifying and monitoring the risks of thevarious terms of each borrowing contract,including penalties and option features overthe expected life of the contract. Examinersshould review for evidence that the bank’smanagement, or an independent third party,completed stress tests (1) before the bankentered into the borrowing agreement (oragreements) and (2) periodically thereafter. Ifthe bank relies on independent third-partytesting, examiners should verify that manage-ment reviewed and accepted the underlyingassumptions and test results. In any case,management should not be relying solely onthe wholesaler’s stress-test results. Also, thestress tests employed should cover a reason-able range of contractual triggers and externalevents. Such triggers or events include interest-rate changes that may result in the exercise ofembedded options or the bank’s terminationof the agreement, which may entail prepay-ment penalties. In general, stress-test resultsshould depict the potential impact of thesevariables on the individual borrowing facility,as well as on the overall earnings and liquidityposition of the bank.

• Evaluate management processes for control-ling risks, including interest-rate risks arisingfrom the borrowings and liquidity risks. Propercontrols include (1) hedges or other plans forminimizing the adverse effects of penalties orinterest-rate changes and other triggers forembedded options and (2) contingent funding

1. Wholesale borrowings with embedded options may havevariable interest payments or average lives or redemptionvalues that depend on external measures such as referencerates, indexes, or formulas. Embedded options include putable,callable, convertible, and variable rate advances with caps,floors, collars, step-ups, or amortizing features. In addition,these types of borrowings may contain prepayment penalties.

2. See the supervisory guidance for ‘‘Borrowed Funds,’’section 3010.1; ‘‘Asset/Liability Management,’’ section 4020.1;and ‘‘Interest-Rate Risk Management,’’ section 4090.1. Seealso the Trading and Capital-Markets Activities Manual,sections 2030.1, ‘‘Liquidity Risk,’’ and 3010.1, ‘‘Interest-RateRisk Management.’’ In general, this guidance collectivelycalls for supervisors to analyze the purpose, effectiveness,concentration exposure, and stability of borrowings and toassess bank management’s understanding of liquidity andinterest-rate risks associated with borrowing and fundingstrategies.


plans if borrowings or lines are terminatedbefore the original expected maturity.

• Determine whether the asset/liability manage-ment committee or board of directors, asappropriate, is fully informed of the risks andramifications of complex wholesale-borrowingagreements before engaging in the transac-tions and on an ongoing basis.

• Determine whether funding strategies forwholesale borrowings, especially those withembedded options, are consistent with boththe portfolio objectives of the bank and thelevel of sophistication of the bank’s riskmanagement. Banks without the technicalknowledge and whose risk-management sys-tems are insufficient to adequately identify,assess, monitor, and control the risks of com-

plex wholesale borrowings should not beusing this funding.

Reliance on wholesale borrowings is consistentwith safe and sound banking when managementunderstands the risks of these activities and hassystems and procedures in place to properlymonitor and control the risks. Supervisors andexaminers, however, should take appropriatesteps to follow up on institutions that use com-plex funding instruments without adequatelyunderstanding their risks or without proper risk-management systems and controls. Examinersshould also seek corrective action when fundingmechanisms or strategies are inconsistent withprudent funding needs and objectives.

3012.1 Complex Wholesale Borrowings


Complex Wholesale BorrowingsExamination ObjectivesEffective date May 2001 Section 3012.2

1. To review the terms of wholesale-borrowingcontracts to identify embedded options orother features that may affect the bank’sliquidity and sensitivity to market risks.

2. To assess management’s technical knowl-edge, systems, and processes for identifying,assessing, monitoring, and controlling therisks (including liquidity risk and interest-rate risk) associated with wholesale borrow-ing, and to assess the bank’s stress-testingpractices and contingency-funding plans.

3. To determine if the bank’s board of directorsor its asset/liability management committeeis fully aware of the risks associated with andramifications of engaging in complexwholesale-borrowing agreements.

4. To ascertain whether the bank’s wholesale-borrowing funding and hedging strategies areconsistent with its portfolio objectives andthe level of management’s sophistication.


Complex Wholesale BorrowingsExamination ProceduresEffective date May 2001 Section 3012.3

1. Review the bank’s borrowing contracts toidentify embedded options or other featuresthat may affect the bank’s liquidity andsensitivity to market risks. Also review thecollateral agreements to determine what fees,collateral-maintenance requirements (includ-ing triggers for increases in collateral), andother agreed-upon features may affect thebank’s liquidity and earnings.

2. Assess the bank’s management processes foridentifying and monitoring the risks of thevarious terms of each borrowing contract,including penalties and option features overthe expected life of the contract.a. Obtain and examine evidence to deter-

mine whether the bank’s management, oran independent third party, completedstress tests before the bank entered intothe borrowing agreement (or agreements)and periodically thereafter.

b. If the bank relies on independent third-party testing, verify that management

reviewed and accepted the underlyingassumptions and test results.

3. Evaluate the management processes for con-trolling risks, including (1) interest-rate risksarising from the borrowings and (2) liquidityrisks.

4. Determine if the asset/liability managementcommittee or board of directors, as appropri-ate, is fully informed of the risks and rami-fications of complex wholesale-borrowingagreements both before engaging in the trans-actions and on an ongoing basis.

5. Determine if funding strategies for whole-sale borrowings, especially those withembedded options, are consistent with boththe portfolio objectives of the bank and thelevel of sophistication of the bank’s riskmanagement.

6. Seek the corrective action taken by the insti-tution when funding mechanisms or strate-gies are inconsistent with prudent fundingneeds and objectives.


Deferred Compensation AgreementsEffective date May 2005 Section 3015.1

As part of their executive compensation andretention programs, banks and other financialinstitutions (collectively referred to in this sec-tion as ‘‘institutions’’) often enter into deferredcompensation agreements with selected employ-ees. These agreements are generally structuredas nonqualified retirement plans for federalincome tax purposes and are based on individualagreements with selected employees.

Institutions often purchase bank-owned lifeinsurance (BOLI) in connection with many oftheir deferred compensation agreements. (Seesections 4042.1 and 2210.1 for an explanation ofthe accounting for BOLI transactions). BOLImay produce attractive tax-equivalent yieldsthat offset some or all of the costs of theagreements.

Deferred compensation agreements are com-monly referred to as indexed retirement plans(IRPs) or as revenue-neutral plans. The institu-tion’s designated management and accountingstaff that is responsible for the institution’sfinancial reporting must regularly review theaccounting for deferred compensation agree-ments to ensure that the obligations under theagreements are appropriately measured andreported in accordance with generally acceptedaccounting principles (GAAP). In so doing, themanagement and accounting staff should applyand follow Accounting Principles Board Opin-ion No. 12, ‘‘Omnibus Opinion—1967,’’ asamended by Statement of Financial AccountingStandards No. 106 (FAS 106), ‘‘Employers’Accounting for Postretirement Benefits OtherThan Pensions’’ (hereafter referred to as APB12).

IRPs are one type of deferred compensationagreement that institutions enter into withselected employees. IRPs are typically designedso that the spread each year, if any, between thetax-equivalent earnings on the BOLI coveringan individual employee and a hypothetical earn-ings calculation is deferred and paid to theemployee as a post-retirement benefit. Thisspread is commonly referred to as excess earn-ings. The hypothetical earnings are computed onthe basis of a predefined variable index rate (forexample, the cost of funds or the federal fundsrate) times a notional amount. The notionalamount is typically the amount the institutioninitially invested to purchase the BOLI plussubsequent after-tax benefit payments actuallymade to the employee. By including the after-

tax benefit payments and the amount initiallyinvested to purchase the BOLI in the notionalamount, the hypothetical earnings reflect anestimate of what the institution could haveearned if it had not invested in the BOLI orentered into the IRP with the employee. Eachemployee’s IRP may have a different notionalamount on which the index is based. The indi-vidual IRP agreements also specify the retire-ment age and vesting provisions, which can varyfrom employee to employee.

An IRP agreement typically requires theexcess earnings that accrue before an employ-ee’s retirement to be recorded in a separateliability account. Once the employee retires, thebalance in the liability account is generally paidto the employee in equal, annual installmentsover a set number of years (for example, 10 or15 years). These payments are commonlyreferred to as the primary benefit or pre-retirement benefit.

An employee may also receive the excessearnings that are earned after his or her retire-ment. This benefit may continue until theemployee’s death and is commonly referred toas the secondary benefit or post-retirement bene-fit. The secondary benefit is paid annually, oncethe employee has retired, and is in addition tothe primary benefit.

Examiners should be aware that some insti-tutions may not be correctly accounting for theobligations under an IRP. Because many insti-tutions were incorrectly accounting for IRPs, thefederal banking and thrift agencies issued onFebruary 11, 2004, an Interagency Advisory onAccounting for Deferred Compensation Agree-ments and Bank-Owned Life Insurance. (SeeSR-04-4.) The guidance is stated here, exceptfor the information on the reporting of deferredcompensation agreement obligations in the bankCall Reports and on changes in accounting forthose agreements. Examiners should determinewhether an institution’s deferred compensationagreements are correctly accounted for. If theaccounting is incorrect, assurance should beobtained from the institution’s management thatcorrections will be made in accordance withGAAP and the advisory’s instructions forchanges in accounting. The examiner’s findingsshould be reported in the examination report.Also report the nature of the accounting errorsand the estimated financial impact that correct-ing the errors will have on the institution’s


financial statements, including its earnings andcapital position.

ACCOUNTING FOR DEFERREDCOMPENSATION AGREEMENTS,INCLUDING IRPs

Deferred compensation agreements with selectemployees under individual contracts generallydo not constitute post-retirement income plans(that is, pension plans) or post-retirement healthand welfare benefit plans. The accounting forindividual contracts that, when taken together,do not represent a post-retirement plan shouldfollow APB 12. If the individual contracts, takentogether, are equivalent to a plan, the planshould be accounted for under Statement ofFinancial Accounting Standards No. 87,‘‘Employers’ Accounting for Pensions,’’ or underFAS 106.

APB 12 requires that an employer’s obliga-tion under a deferred compensation agreementbe accrued according to the terms of the indi-vidual contract over the required service periodto the date the employee is fully eligible toreceive the benefits, or the full eligibility date.Depending on the individual contract, the fulleligibility date may be the employee’s expectedretirement date, the date the employee enteredinto the contract, or a date between these twodates. APB 12 does not prescribe a specificaccrual method for the benefits under deferredcompensation contracts, stating only that the‘‘cost of those benefits shall be accrued over thatperiod of the employee’s service in a systematicand rational manner.’’ The amounts to be accruedeach period should result in a deferred compen-sation liability at the full eligibility date thatequals the then-present value of the estimatedbenefit payments to be made under the indi-vidual contract.

APB 12 does not specify how to select thediscount rate to measure the present value of theestimated benefit payments. Therefore, otherrelevant accounting literature must be consid-ered in determining an appropriate discount rate.An institution’s incremental borrowing rate1 and

the current rate of return on high-quality fixed-income debt securities2 should be the acceptablediscount rates to measure deferred compensa-tion agreement obligations. An institution mustselect and consistently apply a discount-ratepolicy that conforms with GAAP.

For each IRP, an institution should calculatethe present value of the expected future benefitpayments under the IRP at the employee’s fulleligibility date. The expected future benefitpayments can be reasonably estimated. Theyshould be based on reasonable and supportableassumptions and should include both the pri-mary benefit and, if the employee is entitled toexcess earnings that are earned after retirement,the secondary benefit. The estimated amount ofthese benefit payments should be discountedbecause the benefits will be paid in periodicinstallments after the employee retires. Thenumber of periods the primary and any second-ary benefit payments should be discounted maydiffer because the discount period for each typeof benefit payment should be based on thelength of time during which each type of benefitwill be paid, as specified in the IRP.

After the present value of the expected futurebenefit payments has been determined, the insti-tution should accrue an amount of compensationexpense and a liability each year from the datethe employee enters into the IRP until the fulleligibility date. The amount of these annualaccruals should be sufficient to ensure that adeferred compensation liability equal to thepresent value of the expected benefit paymentsis recorded by the full eligibility date. Anymethod of deferred compensation accountingthat does not recognize some expense for theprimary benefit and any secondary benefit ineach year from the date the employee enters intothe IRP until the full eligibility date is notconsidered to be systematic and rational.

Vesting provisions should be reviewed toensure that the full eligibility date is properlydetermined because this date is critical to themeasurement of the liability estimate. BecauseAPB 12 requires that the present value of theexpected benefit payments be recorded by thefull eligibility date, institutions also need toconsider changes in market interest rates toappropriately measure deferred compensation

1. Accounting Principles Board Opinion No. 21, ‘‘Intereston Receivables and Payables,’’ paragraph 13, states in partthat ‘‘the rate used for valuation purposes will normally be atleast equal to the rate at which the debtor can obtain financingof a similar nature from other sources at the date of thetransaction.’’

2. FAS 106, paragraph 186, states that ‘‘[t]he objective ofselecting assumed discount rates is to measure the singleamount that, if invested at the measurement date in a portfolioof high-quality debt instruments, would provide the necessaryfuture cash flows to pay the accumulated benefits when due.’’

3015.1 Deferred Compensation Agreements


liabilities. Therefore, to comply with APB 12,institutions should periodically review both theirestimates of the expected future benefits underIRPs and the discount rates used to compute thepresent value of the expected benefit payments,and revise those estimates and rates, whenappropriate.

Deferred compensation agreements, includ-ing IRPs, may include noncompete provisionsor provisions requiring employees to performconsulting services during post-retirement years.If the value of the noncompete provisions can-not be reasonably and reliably estimated, novalue should be assigned to the noncompeteprovisions in recognizing the deferred compen-sation liability. Institutions should allocate aportion of the future benefit payments to con-sulting services to be performed in post-retirement years only if the consulting servicesare determined to be substantive. Factors toconsider in determining whether post-retirementconsulting services are substantive include butare not limited to (1) whether the services arerequired to be performed, (2) whether there is aneconomic benefit to the institution, and(3) whether the employee forfeits the benefitsunder the agreement for failure to perform suchservices.

APPENDIX—EXAMPLES OFACCOUNTING FOR DEFERREDCOMPENSATION AGREEMENTS

The following are examples of the full-eligibility-date accounting requirements for a basic deferredcompensation agreement. The assumptions usedin these examples are for illustrative purposesonly. An institution must consider the terms ofits specific agreements, the current interest-rateenvironment, and current mortality tables indetermining appropriate assumptions to use inmeasuring and recognizing the present value ofthe benefits payable under its deferred compen-sation agreements.

Institutions that enter into deferred compen-sation agreements with employees, particularlymore-complex agreements (such as IRPs), shouldconsult with their external auditors and theirrespective Federal Reserve Bank to determinethe appropriate accounting for their specificagreements.

Example 1: Fully Eligible atAgreement Inception

A company enters into a deferred compensationagreement with a 55-year-old employee who hasworked five years for the company. The agree-ment states that, in exchange for the employee’spast and future services and for his or herservice as a consultant for two years afterretirement, the company will pay an annualbenefit of $20,000 to the employee, commenc-ing on the first anniversary of the employee’sretirement. The employee is fully eligible for thedeferred compensation benefit payments at theinception of the agreement, and the consultingservices are not substantive.

Other key facts and assumptions used in deter-mining the benefits payable under the agreementand in determining the liability and expense thecompany should record in each period are sum-marized in the following table:

Expected retirement age 60Number of years to expected

retirement age 5Discount rate (%) 6.75Expected mortality age based on

present age 70

At the employee’s expected retirement date, thepresent value of a lifetime annuity of $20,000that begins on that date is $142,109 (computedas $20,000 times 7.10545, the factor for thepresent value of 10 annual payments at 6.75percent). At the inception date of the agreement,the present value of that annuity of $102,514(computed as $142,109 times 0.721375, thefactor for the present value of a single paymentin five years at 6.75 percent) is recognized ascompensation expense because the employee isfully eligible for the deferred compensationbenefit at that date.

The following table summarizes one system-atic and rational method of recognizing theexpense and liability under the deferred com-pensation agreement:

Deferred Compensation Agreements 3015.1


A B C D(B + C)

E F(E + D – A)

YearBenefit

payment ($)Service

component ($)Interest

component ($)Compensation

expense ($)

Beginning-of-year

liability ($)

End-of-year

liability ($)

0 – 102,514 – 102,514 – 102,514

1 – – 6,920 6,920 102,514 109,434

2 – – 7,387 7,387 109,434 116,821

3 – – 7,885 7,885 116,821 124,706

4 – – 8,418 8,418 124,706 133,124

5 – – 8,985 8,985 133,124 142,109

6 20,000 – 9,593 9,593 142,109 131,702

7 20,000 – 8,890 8,890 131,702 120,592

8 20,000 – 8,140 8,140 120,592 108,732

9 20,000 – 7,339 7,339 108,732 96,071

10 20,000 – 6,485 6,485 96,071 82,556

11 20,000 – 5,572 5,572 82,556 68,128

12 20,000 – 4,599 4,599 68,128 52,727

13 20,000 – 3,559 3,559 52,727 36,286

14 20,000 – 2,449 2,449 36,286 18,735

15 20,000 – 1,265 1,265 18,735 0

Totals 200,000 102,514 97,486 200,000

The following entry would be made at theinception date of the agreement (the final day ofyear 0) to record the service component of thecompensation expense and related deferred com-pensation agreement liability:

Debit Credit

Compensation expense $102,514

Deferred compensation liability $102,514

[To record the column B service component]

In each period after the inception date of theagreement, the company would adjust thedeferred compensation liability for the interestcomponent and any benefit payment. In addi-tion, the company would reassess the assump-tions used in determining the expected futurebenefits under the agreement and the discountrate used to compute the present value of theexpected benefits in each period after the incep-

tion of the agreement, and revise the assump-tions and rate, as appropriate.

Assuming that no changes were necessary tothe assumptions used to determine the expectedfuture benefits under the agreement or to thediscount rate used to compute the present valueof the expected benefits, the following entrywould be made in year 1 to record the interestcomponent of the compensation expense:



Debit Credit



[To record the column C interest component (computed by multiplying the prior-yearcolumn F balance by the discount rate)]

Similar entries (but for different amounts) wouldbe made in year 2 through year 15 to record theinterest component of the compensation expense.

The following entry would be made in year 6to record the payment of the annual benefit:

Debit Credit


Cash $20,000

[To record the column A benefit payment]

Similar entries would be made in year 7 throughyear 15 to record the payment of the annualbenefit.

Example 2: Fully Eligible atRetirement Date

If the terms of the contract described in example1 had stated that the employee is only entitled toreceive the deferred compensation benefit if thesum of the employee’s age and years of serviceequals 70 or more at the date of retirement, theemployee would be fully eligible for the deferredcompensation benefit at age 60, after renderingfive more years of service. At the employee’sexpected retirement date, the present value of alifetime annuity of $20,000 that begins on thefirst anniversary of that date is $142,109 (com-puted as $20,000 times 7.10545, the factor forthe present value of 10 annual payments at 6.75percent). The company would accrue this amountin a systematic and rational manner over thefive-year period from the date it entered into theagreement to the date the employee is fullyeligible for the deferred compensation benefit.Under one systematic and rational method, theannual service component accrual would be$24,835 (computed as $142,109 divided by

5.72213, the factor for the future value of fiveannual payments at 6.75 percent).

Other key facts and assumptions used indetermining the benefits payable under the agree-ment and in determining the liability and expensethe company should record in each period aresummarized in the following table:

Expected retirement age 60Number of years to expected

retirement age 5Discount rate (%) 6.75Expected mortality age based on

present age 70

The following table summarizes one systematicand rational method of recognizing the expenseand liability under the deferred compensationagreement:



A B C D(B + C)

E F(E + D – A)

YearBenefit

payment ($)Service

component ($)Interest

component ($)Compensation

expense ($)

Beginning-of-year

liability ($)

End-of-year

liability ($)

1 – 24,835 – 24,835 – 24,835

2 – 24,835 1,676 26,511 24,835 51,346

3 – 24,835 3,466 28,301 51,346 79,647

4 – 24,835 5,376 30,211 79,647 109,858

5 – 24,835 7,416 32,251 109,858 142,109

6 20,000 – 9,593 9,593 142,109 131,702

7 20,000 – 8,890 8,890 131,702 120,592

8 20,000 – 8,140 8,140 120,592 108,732

9 20,000 – 7,339 7,339 108,732 96,071

10 20,000 – 6,485 6,485 96,071 82,556

11 20,000 – 5,572 5,572 82,556 68,128

12 20,000 – 4,599 4,599 68,128 52,727

13 20,000 – 3,559 3,559 52,727 36,286

14 20,000 – 2,449 2,449 36,286 18,735

15 20,000 – 1,265 1,265 18,735 0

Totals 200,000 124,175 75,825 200,000

No entry would be made at the inception date ofthe agreement. The following entry would bemade in year 1 to record the service componentof the compensation expense and related deferredcompensation agreement liability:

Debit Credit



[To record the column B service component]

Similar entries would be made in year 2 throughyear 5 to record the service component of thecompensation expense.

In each subsequent period, until the date theemployee is fully eligible for the deferred com-pensation benefit, the company would adjust thedeferred compensation liability for the totalexpense (the service and interest components).In each period after the full eligibility date, thecompany would adjust the deferred compensa-

tion liability for the interest component and anybenefit payment. In addition, the company wouldreassess the assumptions used in determiningthe expected future benefits under the agreementand the discount rate used to compute thepresent value of the expected benefits in eachperiod after the inception of the agreement, andrevise the assumptions and rate, as appropriate.

Assuming no changes were necessary to theassumptions used to determine the expected



future benefits under the agreement or to thediscount rate used to compute the present valueof the expected benefits, the following entrywould be made in year 2 to record the interestcomponent of the compensation expense:

Debit Credit



[To record the column C interest component (computed by multiplying the prior-year column Fbalance by the discount rate)]

Similar entries (but for different amounts) wouldbe made in year 3 through year 15 to record theinterest component of the compensation expense.

The following entry would be made in year 6to record the payment of the annual benefit:

Debit Credit


Cash $20,000

[To record the column A benefit payment]

Similar entries would be made in year 7 throughyear 15 to record the payment of the annualbenefit.



Assessment of Capital AdequacyEffective date April 2011 Section 3020.1

Although both bank directors and bank regula-tors must look carefully at the quality of bankassets and management and at the ability of thebank to control costs, evaluate risks, and main-tain proper liquidity, capital adequacy is the areathat triggers the most regulatory action, espe-cially in view of prompt corrective action. Theprimary function of capital is to support thebank’s operations, act as a cushion to absorbunanticipated losses and declines in asset valuesthat could otherwise cause a bank to fail, andprovide protection to uninsured depositors anddebt holders in the event of liquidation. Abank’s solvency promotes public confidence inthe bank and the banking system as a whole byproviding continued assurance that the bankwill continue to honor its obligations and pro-vide banking services. By exposing stockhold-ers to a larger percentage of any potential loss,higher capital levels also reduce the subsidyprovided to banks by the federal safety net.Capital regulation is particularly importantbecause deposit insurance and other elements ofthe federal safety net provide banks with anincentive to increase their leverage beyondwhat the market—in the absence of depositorprotection—would permit. Additionally, highercapital levels can reduce the need for regulatorysupervision, thereby lowering costs to the bank-ing industry and the government.

The Federal Reserve uses two ratios to helpassess the capital adequacy of state members:the risk-based capital ratio and the tier 1 lever-age ratio. State member banks may also besubject to separate capital requirements imposedby state banking supervisors.

OVERVIEW OF THE RISK-BASEDCAPITAL MEASURE FOR STATEMEMBER BANKS

The Federal Reserve’s risk-based capital guide-lines (the guidelines) focus principally on thecredit risk associated with the nature of banks’on- and off-balance-sheet exposures and on thetype and quality of banks’ capital. The risk-based capital guidelines apply to all state mem-ber banks. The information provided in thissection should be used in conjunction with theguidelines, which are found in Regulation H(12 CFR 208, appendix A).

The risk-based capital guidelines provide a

definition of capital and a framework for calcu-lating risk-weighted assets by assigning assetsand off-balance-sheet items to broad categoriesof credit risk. A bank’s risk-based capital ratio iscalculated by dividing its qualifying capital (thenumerator of the ratio) by its risk-weightedassets (the denominator). The definition ofqualifying capital is outlined below, as are theprocedures for calculating risk-weighted assets.

The major objectives of the risk-based capitalguidelines are to make regulatory capital require-ments more sensitive to differences in credit-riskprofiles among banking organizations; to factoroff-balance-sheet exposures into the assessmentof capital adequacy; to minimize disincentivesto holding liquid, low-risk assets; and to achievegreater consistency in the evaluation of thecapital adequacy of major banking organizationsworldwide.

The guidelines set forth minimum supervi-sory capital standards that apply to all statemember banks on a consolidated basis. Mostbanks are expected to operate with capital levelsabove the minimum ratios. Banking organiza-tions that are undertaking significant expansionor that are exposed to high or unusual levels ofrisk are expected to maintain capital well abovethe minimum ratios; in such cases, the FederalReserve may specify a higher minimum require-ment. In addition, the risk-based capital ratio isused as a basis for categorizing institutions forpurposes of prompt corrective action.1

For most institutions, the risk-based capitalratio focuses principally on broad categories ofcredit risk, although the framework for assign-ing assets and off-balance-sheet items to riskcategories does incorporate elements of transferrisk as well as limited instances of interest-rateand market risk.2 The framework incorporatesrisks arising from traditional banking activitiesas well as risks arising from nontraditionalactivities. The ratio does not, however, incorpo-rate other factors that can affect an institution’sfinancial condition. These factors include over-all interest-rate exposure; liquidity, funding, andmarket risks; the quality and level of earnings;

1. See section 4133.1, ‘‘Prompt Corrective Action.’’2. A small number of institutions are required to hold

capital to support their exposure to market risk. For moreinformation, see the ‘‘Market-Risk Measure’’ subsection below,SR-09-1, ‘‘Application of the Market Risk Rule in BHCs andSMBs,’’ or the Federal Reserve’s Trading and Capital-Markets Activities Manual, section 2110.1, ‘‘Capital Adequacy.’’


investment, loan portfolio, and other concentra-tions of credit; certain risks arising from nontra-ditional activities; the effectiveness of loan andinvestment policies; and management’s overallability to monitor and control financial andoperating risks, including the risks presented byconcentrations of credit and nontraditionalactivities. An overall assessment of capitaladequacy must take into account these otherfactors, including, in particular, the level andseverity of problem and classified assets as wellas a bank’s exposure to declines in the economicvalue of its capital due to changes in interestrates. For this reason, the final supervisoryjudgment on a bank’s capital adequacy maydiffer significantly from conclusions that mightbe drawn solely from the level of its risk-basedcapital ratio.

DEFINITION OF CAPITAL

For the purpose of risk-based capital, a bank’stotal capital consists of two types of compo-nents: ‘‘core capital elements’’ (which areincluded in tier 1 capital) and ‘‘supplementarycapital elements’’ (which are included in tier 2capital). To qualify as an element of tier 1 ortier 2 capital, a capital instrument must beunsecured and may not contain or be covered byany covenants, terms, or restrictions that areinconsistent with safe and sound bankingpractices.

Tier 1 capital is generally defined as the sumof core capital elements. Core capital elementsconsist of common stock; related surplus; andretained earnings, including capital reserves andadjustments for the cumulative effect of foreigncurrency translation, net of any treasury stock;less net unrealized holding losses on available-for-sale equity securities with readily determin-able fair values. For this purpose, net unrealizedholding gains on such equity securities and netunrealized holding gains (losses) on available-for-sale debt securities are not included in com-mon stockholders’ equity.

The Components of QualifyingCapital

Core capital elements (tier 1 capital). The tier 1component of a bank’s qualifying capital mustrepresent at least 50 percent of qualifying total

capital and may consist of the following itemsthat are defined as core capital elements:

1. Common stockholders’ equity,2. Qualifying noncumulative perpetual pre-

ferred stock (including related surplus), and2. Minority interest in the equity accounts of

consolidated subsidiaries.

Tier 1 capital is generally defined as the sum ofcore capital elements less any amounts of good-will, other intangible assets, interest-only stripsreceivables and nonfinancial equity investmentsthat are required to be deducted.

Common stockholders’ equity. For purposes ofcalculating the risk-based capital ratio, commonstockholders’ equity is limited to common stock;related surplus; and retained earnings, includingcapital reserves and adjustments for the cumu-lative effect of foreign currency translation, netof any treasury stock; less net unrealized hold-ing losses on available-for-sale equity securitieswith readily determinable fair values. For thispurpose, net unrealized holding gains on suchequity securities and net unrealized holdinggains (losses) on available-for-sale debt securi-ties are not included in common stockholders’equity.

Perpetual preferred stock. Perpetual preferredstock is defined as preferred stock that does nothave a maturity date, that cannot be redeemed atthe option of the holder of the instrument, andthat has no other provisions that will requirefuture redemption of the issue. Consistent withthese provisions, any perpetual preferred stockwith a feature permitting redemption at theoption of the issuer may qualify as capital onlyif the redemption is subject to prior approval ofthe Federal Reserve. In general, preferred stockwill qualify for inclusion in capital only if it canabsorb losses while the issuer operates as agoing concern (a fundamental characteristic ofequity capital) and only if the issuer has theability and legal right to defer or eliminatepreferred dividends.

The only form of perpetual preferred stockthat state member banks may consider as anelement of tier 1 capital is noncumulative per-petual preferred. While the guidelines allow forthe inclusion of noncumulative perpetual pre-ferred stock in tier 1, it is desirable from asupervisory standpoint that voting commonstockholders’ equity remain the dominant form

3020.1 Assessment of Capital Adequacy


of tier 1 capital. Thus, state member banksshould avoid overreliance on preferred stock ornon-voting equity elements within tier 1. Tier 1capital elements represent the highest form ofcapital, namely, permanent equity.

Tier 2 capital consists of a limited amount ofthe allowance for loan and lease losses; per-petual preferred stock and related surplus that donot qualify for inclusion in tier 1 capital; certainother hybrid capital instruments; mandatory con-vertible securities; and limited amounts of termsubordinated debt, intermediate-term preferredstock, including related surplus, long-term pre-ferred stock with an original term of 20 years ormore, and unrealized holding gains on qualify-ing equity securities.

Capital investments in unconsolidated bank-ing and finance subsidiaries, and reciprocalholdings of other banking organizations’ capitalinstruments, are deducted from a bank’s capital.The sum of tier 1 and tier 2 capital less anydeductions makes up total capital, which is thenumerator of the total risk-based capital ratio.The maximum amount of tier 2 capital that maybe included in a bank’s qualifying total capital islimited to 100 percent of tier 1 capital (net ofgoodwill, other intangible assets, and interest-only strips receivables and nonfinancial equityinvestments that are required to be deducted).

RISK-WEIGHTING PROCESS

Each asset and off-balance-sheet item is assignedto one of four broad risk categories based on theperceived credit risk of the obligor or, if rel-evant, the guarantor or type of collateral. Theserisk categories are assigned weights of 0 per-cent, 20 percent, 50 percent, and 100 percent.The majority of items fall into the 100 percentrisk-weight category. A brief explanation of thecomponents of each category follows. For moredetailed information, see the capital adequacyguidelines.

Risk Categories

Category 1: Zero Percent

Category 1 includes cash (domestic and foreign)owned and held in all offices of the bank or intransit, as well as gold bullion held in the bank’sown vaults or in another bank’s vaults on anallocated basis to the extent it is offset by goldbullion liabilities. The category also includes all

direct claims on (including securities, loans, andleases), and the portions of claims that aredirectly and unconditionally guaranteed by, thecentral governments of the Organisation forEconomic Co-operation and Development(OECD) countries and U.S. government agen-cies, as well as all direct local currency claimson, and the portions of local currency claims thatare directly and unconditionally guaranteed by,the central governments of non-OECD coun-tries, to the extent that the bank has liabilitiesbooked in that currency. A claim is not consid-ered to be unconditionally guaranteed by acentral government if the validity of the guar-antee depends on some affirmative action by theholder or a third party. Generally, securitiesguaranteed by the U.S. government or its agen-cies that are actively traded in financial markets,such as Government National Mortgage Asso-ciation (GNMA) securities, are considered to beunconditionally guaranteed. This zero percentcategory also includes claims collateralized(1) by cash on deposit in the bank or (2) bysecurities issued or guaranteed by OECD centralgovernments or (3) by U.S. government agen-cies for which a positive margin of collateral ismaintained on a daily basis, fully taking intoaccount any change in the bank’s exposure tothe obligor or counterparty under a claim inrelation to the market value of the collateral heldin support of that claim.

Category 2: 20 percent

Category 2 includes cash items in the process ofcollection, both foreign and domestic; short-term claims on (including demand deposits),and the portions of short-term claims that areguaranteed by, U.S. depository institutions andforeign banks; and long-term claims on, and theportions of long-term claims that are guaranteedby, U.S. depository institutions and OECD banks.This category also includes the portions ofclaims that are conditionally guaranteed byOECD central governments and U.S. govern-ment agencies, as well as the portions of localcurrency claims that are conditionally guaran-teed by non-OECD central governments, to theextent that the bank has liabilities booked in thatcurrency. In addition, this category includesclaims on, and the portions of claims that areguaranteed by, U.S. government–sponsored agen-cies and claims on, and the portions of claimsguaranteed by, the International Bank for

Assessment of Capital Adequacy 3020.1


Reconstruction and Development (the WorldBank), the International Finance Corporation,the Inter-American Development Bank, theAsian Development Bank, the African Develop-ment Bank, the European Investment Bank, theEuropean Bank for Reconstruction and Devel-opment, the Nordic Investment Bank, and othermultilateral lending institutions or regionaldevelopment banks in which the U.S. govern-ment is a shareholder or contributing member.General obligation claims on, or portions ofclaims guaranteed by the full faith and credit of,states or other political subdivisions of theUnited States or other countries of the OECD-based group are also assigned to this category.Category 2 also includes the portions of claims(including repurchase transactions) that are(1) collateralized by cash on deposit in the bankor by securities issued or guaranteed by OECDcentral governments or U.S. government agen-cies that do not qualify for the zero percentrisk-weight category; (2) collateralized by secu-rities issued or guaranteed by U.S. government–sponsored agencies; or (3) collateralized bysecurities issued by multilateral lending institu-tions or regional development banks in whichthe U.S. government is a shareholder or contrib-uting member.

This risk category also includes claims on, 3a

or guaranteed by, a qualifying securities firmincorporated in the United States or other coun-tries that are members of the OECD-basedgroup of countries 3b provided that (1) the quali-fying securities firm has a long-term issuercredit rating, or a rating on at least one issue oflong-term debt, in one of the three highestinvestment-grade rating categories from anationally recognized statistical rating organiza-tion or (2) the claim is guaranteed by the firm’s

parent company and the parent company hassuch a rating. If ratings are available from morethan one rating agency, the lowest rating will beused to determine whether the rating require-ment has been met. This category also includesa collateralized claim on a qualifying securitiesfirm in such a country, without regard to satis-faction of the rating standard, provided that theclaim arises under a contract that (1) is areverse-repurchase/repurchase agreement orsecurities-lending/borrowing transaction exe-cuted using standard industry documentation;(2) is collateralized by debt or equity securitiesthat are liquid and readily marketable; (3) ismarked to market daily; (4) is subject to a dailymargin-maintenance requirement under the stan-dard industry documentation; and (5) can beliquidated, terminated, or accelerated immedi-ately in bankruptcy or a similar proceeding, andthe security or collateral agreement will not bestayed or avoided, under applicable law of therelevant jurisdiction. 3c


Category 3 includes loans fully secured by firstliens on one- to four-family residential proper-ties (either owner-occupied or rented), or onmultifamily residential properties, that meet cer-tain criteria. To be included in category 3, loansmust have been made in accordance with pru-dent underwriting standards, be performing inaccordance with their original terms, and not be90 days or more past due or carried in nonac-crual status. For the purposes of the 50 percentrisk category, a loan modified on a permanent ortrial basis solely pursuant to the U.S. Depart-ment of the Treasury’s Home Affordable Mort-gage Program will be considered to be perform-ing in accordance with its original terms. Thefollowing additional criteria must be applied to aloan secured by a multifamily residential prop-erty that is included in this category: (1) allprincipal and interest payments on the loan musthave been made on time for at least the year

3a. Claims on a qualifying securities firm that are instru-ments the firm, or its parent company, uses to satisfy itsapplicable capital requirements are not eligible for this riskweight.

3b. With regard to securities firms incorporated in theUnited States, qualifying securities firms are those securitiesfirms that are broker–dealers registered with the Securities andExchange Commission (SEC) and are in compliance with theSEC’s net capital rule, 17 CFR 240.15c3-1. With regard tosecurities firms incorporated in any other country in theOECD-based group of countries, qualifying securities firmsare those securities firms that a bank is able to demonstrate aresubject to consolidated supervision and regulation (coveringtheir direct and indirect subsidiaries, but not necessarily theirparent organizations) comparable to that imposed on banks inOECD countries. Such regulation must include risk-basedcapital requirements comparable to those applied to banksunder the Basel Accord.

3c. For example, a claim is exempt from the automatic stayin bankruptcy in the United States if it arises under a securitiescontract or a repurchase agreement subject to section 555 or559 of the Bankruptcy Code, respectively (11 USC 555 or559); a qualified financial contract under section 11(e)(8) ofthe Federal Deposit Insurance Act (12 USC 1821(e)(8)); or anetting contract between financial institutions under sections401–407 of the Federal Deposit Insurance CorporationImprovement Act of 1991 (12 USC 4401–4407) or theBoard’s Regulation EE (12 CFR 231).



preceding placement in this category, or, in thecase of an existing property owner who isrefinancing a loan on that property, all principaland interest payments on the loan being refi-nanced must have been made on time for at leastthe year preceding placement in this category;(2) amortization of the principal and interestmust occur over a period of not more than 30years, and the minimum original maturity forrepayment of principal must not be less thanseven years; and (3) the annual net operatingincome (before debt service) generated by theproperty during its most recent fiscal year mustnot be less than 120 percent of the loan’s currentannual debt service (115 percent if the loan isbased on a floating interest rate) or, in the case ofa cooperative or other not-for-profit housingproject, the property must generate sufficientcash flow to provide comparable protection tothe institution. Also included in category 3 areprivately issued mortgage-backed securities, pro-vided that (1) the structure of the security meetsthe criteria described in section III.B.3. of therisk-based measure of the capital guidelines (12CFR 208, appendix A); (2) if the security isbacked by a pool of conventional mortgages onone- to four-family residential or multifamilyresidential properties, each underlying mortgagemeets the criteria described above for eligibilityfor the 50 percent risk category at the time thepool is originated; (3) if the security is backedby privately issued mortgage-backed securities,each underlying security qualifies for the 50 per-cent risk category; and (4) if the security isbacked by a pool of multifamily residentialmortgages, principal and interest payments onthe security are not 30 days or more past due.Privately issued mortgage-backed securities thatdo not meet these criteria or that do not qualifyfor a lower risk weight are generally assigned tothe 100 percent risk category.

Also assigned to category 3 are revenue(nongeneral obligation) bonds or similar obliga-tions, including loans and leases, that are obli-gations of states or other political subdivisionsof the United States (for example, municipalrevenue bonds) or other countries of the OECD-based group, but for which the governmententity is committed to repay the debt withrevenues from the specific projects financed,rather than from general tax funds. Credit-equivalent amounts of derivative contractsinvolving standard risk obligors (that is, obli-gors whose loans or debt securities would beassigned to the 100 percent risk category) are

included in the 50 percent category, unless theyare backed by collateral or guarantees that allowthem to be placed in a lower risk category.


All assets not included in the categories aboveare assigned to category 4, which comprisesstandard risk assets. The bulk of the assetstypically found in a loan portfolio would beassigned to the 100 percent category.

Category 4 includes long-term claims on, andthe portions of long-term claims that are guar-anteed by, non-OECD banks, and all claims onnon-OECD central governments that entail somedegree of transfer risk. This category includesall claims on foreign and domestic private-sector obligors not included in the categoriesabove (including loans to nondepository finan-cial institutions and bank holding companies);claims on commercial firms owned by the publicsector; customer liabilities to the bank on accep-tances outstanding that involve standard riskclaims; investments in fixed assets, premises,and other real estate owned; common and pre-ferred stock of corporations, including stockacquired for debts previously contracted; allstripped mortgage-backed securities and similarinstruments; and commercial and consumer loans(except those assigned to lower risk categoriesdue to recognized guarantees or collateral andloans secured by residential property that qualifyfor a lower risk weight). This category alsoincludes claims representing capital of a quali-fying securities firm.

This category also includes industrial-development bonds and similar obligationsissued under the auspices of states or politicalsubdivisions of the OECD-based group of coun-tries for the benefit of a private party or enter-prise when that party or enterprise, not thegovernment entity, is obligated to pay the prin-cipal and interest. All obligations of states orpolitical subdivisions of countries that do notbelong to the OECD-based group are alsoassigned to category 4. The following assets areassigned a risk weight of 100 percent if theyhave not been deducted from capital: invest-ments in unconsolidated companies, joint ven-tures, or associated companies; instruments thatqualify as capital that are issued by other bank-ing organizations; and any intangibles, includ-ing those that may have been grandfathered intocapital.



Application of the Risk Weights

The appropriate aggregate dollar value of theamount in each risk category is multiplied by therisk weight associated with that category. Theresulting weighted values for each of the riskcategories are added together. The resulting sumis the bank’s total risk-weighted assets and is thedenominator of the risk-based capital ratio.

Risk Weighting of Off-Balance-SheetItems

Off-balance-sheet items are incorporated intothe risk-based capital ratio through a two-stepprocess. First, an on-balance-sheet ‘‘credit-equivalent amount’’ is calculated, generally bymultiplying the face amount of the item by acredit-conversion factor (except for direct-creditsubsitutes and recourse obligations). Most off-balance-sheet items are assigned to one of thefive credit-conversion factors: 0 percent, 10 per-cent, 20 percent, 50 percent, or 100 percent.These factors are intended to reflect the riskcharacteristics of the activity in terms of anon-balance-sheet equivalent. Second, once thecredit-equivalent amount of the off-balance-sheet item is calculated, the resultant credit-equivalent amount is assigned to the appropriaterisk category according to the obligor or, ifrelevant, the guarantor, the nature of any collat-eral, or external credit ratings. Briefly, the credit-conversion factors are as follows:

• Items with a zero percent credit-conversionfactor include unused portions of commit-ments (with the exception of asset-backedcommercial paper (ABCP) liquidity facilities)with an original maturity of one year or less,or which are unconditionally cancelable at anytime, provided a separate credit decision ismade before each drawing under the facility.

• Items with a 10 percent credit-conversionfactor include unused portions of eligibleABCP liquidity facilities with an originalmaturity of one year or less.

• Items with a 20 percent credit-conversionfactor include short-term, self-liquidatingtrade-related contingencies that arise from themovement of goods.

• Items with a 50 percent credit-conversionfactor include transaction-related contingen-cies, which include bid bonds, performance

bonds, warranties, standby letters of creditrelated to particular transactions, and perfor-mance standby letters of credit, as well asacquisitions of risk participations in perfor-mance standby letters of credit. In addition,this credit-conversion factor includes unusedportions of commitments, including eligibleABCP liquidity facilities, with an originalmaturity exceeding one year; revolving-underwriting facilities; note-issuance facili-ties; and other similar arrangements.

• Items with a 100 percent credit-conversionfactor include, except as otherwise providedwithin the risk-based capital guidelines, direct-credit substitutes, recourse obligations, saleand repurchase agreements, ineligible ABCPliquidity facilities, and forward agreements, aswell as securities lent where the securitieslender is at risk of loss.

See the risk-based capital guidelines for moreinformation on the use, treatment, and applica-tion of credit-conversions factors for off-balance-sheet items and transactions.

For derivative contracts, the credit-equivalentamount for each contract is determined bymultiplying the notional principal amount of theunderlying contract by a credit-conversion fac-tor and adding the resulting product (which is anestimate of potential future exposure) to thepositive mark-to-market value of the contract(which is the current exposure). A contract witha negative mark-to-market value is treated ashaving a current exposure of zero. Whereappropriate, a bank may offset positive andnegative mark-to-market values of derivativecontracts entered into with a single counterpartysubject to a qualifying, legally enforceable,bilateral netting arrangement.

As a general rule, if the terms of a claim canchange, the claim should be assigned to the riskcategory appropriate to the highest risk optionavailable under the terms of the claim. Forexample, in a collateralized loan where theborrower has the option to withdraw the collat-eral before the loan is due, the loan would betreated as an uncollateralized claim for risk-based capital purposes. Similarly, a commitmentthat can be drawn down in the form of a loan ora standby letter of credit would be treated as acommitment to make a standby letter of credit,the higher risk option available under the termsof the commitment.

When an item may be assigned to more thanone category, that item generally is assigned to



the lowest eligible risk category. For example, amortgage originated by the bank for which a100 percent Federal Housing Administrationguarantee has been obtained would be assignedthe 20 percent risk weight that is appropriate toclaims conditionally guaranteed by a U.S. gov-ernment agency, rather than the 100 percent riskweight that is appropriate to high loan-to-valuesingle-family mortgages.

While the primary determinant of the riskcategory of a particular on-balance-sheet assetor off-balance-sheet credit-equivalent amount isthe obligor, collateral or guarantees may be usedto a limited extent to assign an item to a lowerrisk category than would be available to theobligor. The only forms of collateral that arerecognized for risk-based capital purposes arecash on deposit in the lending bank;4 securitiesissued or guaranteed by the central governmentsof the OECD-based group of countries,5 U.S.government agencies, or U.S. government–sponsored agencies; and securities issued bymultilateral lending institutions or regionaldevelopment banks in which the U.S. govern-ment is a shareholder or contributing member.In order for a claim to be considered collateral-ized for risk-based capital purposes, the under-lying arrangements must provide that the claimwill be secured by recognized collateral through-out its term. A commitment may be consideredcollateralized for risk-based capital purposes tothe extent that its terms provide that advancesmade under the commitment will be securedthroughout their term.

The extent to which qualifying securities arerecognized as collateral is determined by theircurrent market value. The full amount of a claim

for which a positive margin (that is, greater than100 percent of the claim) of recognized collat-eral is maintained daily may qualify for azero percent risk weight. The full amount of aclaim that is 100 percent secured by recognizedcollateral may be assigned to the 20 percent riskcategory. For partially secured obligations, thesecured portion is assigned a 20 percent riskweight. Any unsecured portion is assigned therisk weight appropriate for the obligor or guar-antor, if any. The extent to which an off-balance-sheet item is secured by collateral is determinedby the degree to which the collateral covers theface amount of the item before it is converted toa credit-equivalent amount and assigned to arisk category. For derivative contracts, thisdetermination is made in relation to the credit-equivalent amount.

The only guarantees that are recognized forrisk-based capital purposes are those providedby central or state and local governments of theOECD-based group of countries, U.S. govern-ment agencies, U.S. government–sponsoredagencies, multilateral lending institutions orregional development banks in which the UnitedStates is a shareholder or contributing member,U.S. depository institutions, and foreign banks.If an obligation is partially guaranteed, theportion that is not fully covered is assigned therisk weight appropriate to the obligor or to anycollateral. An obligation that is covered by twotypes of guarantees having different risk weightsis apportioned between the two risk categoriesappropriate to the guarantors.

Minimum Risk-Based Capital Ratios

Banks are expected to meet a minimum ratio ofcapital to risk-weighted assets of 8 percent, withat least 4 percent taking the form of tier 1capital. Banks that do not meet the minimumrisk-based capital ratios, or that are consideredto lack sufficient capital to support their activi-ties, are expected to develop and implementcapital plans acceptable to the Federal Reservefor achieving adequate levels of capital.6 Suchplans should satisfy the provisions of the guide-lines or established arrangements that the Fed-eral Reserve has agreed on with designated

4. There is a limited exception to the rule that cash must beon deposit in the lending bank to be recognized as collateral.A bank participating in a syndicated credit secured by cash ondeposit in the lead bank may treat its pro rata share of thecredit as collateralized, provided that it has a perfected interestin its pro rata share of the collateral.

5. The OECD-based group of countries comprises all fullmembers of the Organization for Economic Cooperation andDevelopment (OECD), as well as countries that have con-cluded special lending arrangements with the InternationalMonetary Fund (IMF) associated with the Fund’s GeneralArrangements to Borrow. The OECD’s thirty member coun-tries include Australia, Austria, Belgium, Canada, CzechRepublic, Denmark, Finland, France, Germany, Greece, Hun-gary, Iceland, Ireland, Italy, Japan, Korea, Luxembourg,Mexico, Netherlands, New Zealand, Norway, Poland, Portu-gal, Slovak Republic, Spain, Sweden, Switzerland, Turkey,United Kingdom, and United States. Any country that hasrescheduled its external sovereign debt within the previousfive years is not considered to be part of the OECD-basedgroup of countries for risk-based capital purposes.

6. Under the prompt-corrective-action framework, banksthat do not meet the minimum risk-based capital ratio areconsidered undercapitalized and must file capital-restorationplans that meet certain requirements.



banks. In addition, such banks should avoidany actions, including increased risk taking orunwarranted expansion, that would lower orfurther erode their capital positions. In thesecases, examiners are to review and comment onbanks’ capital plans and their progress in meet-ing, and continuing to maintain, the minimumrisk-based capital requirements.

The bank’s board of directors and seniormanagement should be encouraged to establishcapital levels and ratios that are consistent withthe bank’s overall financial profile. When assess-ing the bank’s capital adequacy, it is appropriateto include comments on risk-based capital in theopen section of the examination report. Exam-iner comments should address the adequacy ofthe bank’s plans and progress toward meetingthe relevant target ratios.

Market-Risk Rule

Institutions are responsible for identifying theirtrading and other market risks and for imple-menting a sound risk-management program com-mensurate with those risks. Such programsshould include appropriate quantitative metricsas well as ongoing qualitative analysis per-formed by competent, independent risk-management staff. At a minimum, institutionsshould reassess annually and adjust their market-risk management programs, taking into accountchanging firm strategies, market developments,organizational incentive structures, and evolv-ing risk-management techniques.

In August 1996, the Federal Reserve amendedits risk-based capital framework to incorporate ameasure for market risk for state member banks.The market-risk rule is found in Regulation H(12 CFR 208), appendix E. Under the market-risk rule, certain institutions with significantexposure to market risk must measure that riskusing their internal value-at-risk (VaR) measure-ment model and, subject to parameters in themarket-risk rule, hold sufficient levels of capitalto cover the exposure. The market-risk ruleapplies to any insured state member bank whosetrading activity (the gross sum of its tradingassets and liabilities) equals (1) 10 percent ormore of its total assets or (2) $1 billion or more.On a case-by-case basis, the Federal Reservemay require an institution that does not meetthese criteria to comply with the market-riskrule if deemed necessary for safety-and-soundness reasons. The Federal Reserve may

also exclude an institution that meets the criteriaif such exclusion is deemed to be consistent withsafe and sound banking practices.

The market-risk rule supplements the risk-based capital rules for credit risk; an institutionapplying the market-risk rule remains subject tothe requirements of the credit-risk rules but mustadjust its risk-based capital ratio to reflect mar-ket risk. In January 2009, the Board issuedSR-09-1, ‘‘Application of the Market Risk Rulein Bank Holding Companies and State MemberBanks,’’ which reiterated some of the market-risk rule’s core requirements, provided guidanceon certain technical aspects of the rule, andclarified several issues. SR-09-1 discusses (1) thecore requirements of the market-risk rule, (2) themarket-risk rule capital computational require-ments, and (3) the communication and FederalReserve requirements in order for a bank to useits VaR models. A bank that is applying themarket-risk rule must hold capital to support itsexposure to two types of risk: (1) general marketrisk arising from broad fluctuations in interestrates, equity prices, foreign exchange rates, andcommodity prices, including risk associated withall derivative positions, and (2) specific riskarising from changes in the market value of debtand equity positions in the trading account dueto factors other than broad market movements,including the credit risk of an instrument’sissuer. A bank’s covered positions include alltrading-account positions as well as all foreign-exchange and commodity positions, whether ornot they are in the trading account. Banks thatare subject to the market-risk capital rules areprecluded from applying those rules to positionsheld in the bank’s trading book that act, in formor in substance, as liquidity facilities supportingasset-backed commercial paper (ABCP). (Seethe definition of covered positions in appendixE, section 2(a).) Any facility held in the tradingbook whose primary function, in form or insubstance, is to provide liquidity to ABCP—even if the facility does not qualify as an eligibleABCP liquidity facility under the rule—will besubject to the banking-book risk-based capitalrequirements. Specifically, organizations will berequired to convert the notional amount of alltrading-book positions that provide liquidity toABCP to credit-equivalent amounts by applyingthe appropriate banking-book credit-conversionfactors. For example, the full notional amount ofall eligible ABCP liquidity facilities with anoriginal maturity of one year or less will besubject to a 10 percent conversion factor, as



described previously, regardless of whether thefacility is carried in the trading account or thebanking book.

Market Risk Rule Provisions forSecurities Lending

On February 6, 2006, the Board approved arevision to Regulation H for its market-riskmeasure of the capital adequacy guidelines. (See12 CFR 208, appendix E.) The amendmentlessened and aligned the capital requirement ofstate member banks (those that have adopted themarket-risk rule) to the risk involved with cer-tain cash collateral that is posted in connectionwith securities-borrowing transactions. 6a It alsobroadened the scope of counterparties for whichfavorable capital treatment would be applied.(See 71 Fed. Reg. 8932, February 22, 2006.) Fora detailed description of the market-risk mea-sure, see the Federal Reserve’s Trading andCapital-Markets Activities Manual, section2110.1.

Advanced Approaches Rule

The Board adopted an advanced capital adequacyframework, effective April 1, 2008, that imple-ments, in the United States, the revised interna-tional capital framework (Basel II) developed bythe Committee on Banking Supervision (See 12CFR 208, appendix F or 72 Fed. Reg. 69287).The rule provides a risk-based capital frame-work that permits state member banks (SMBs)to use an internal ratings-based approach tocalculate credit-risk capital requirements andadvanced measurement approaches (AMA) inorder to calculate regulatory operational-riskcapital requirements. See also the revisionseffective March 29, 2010, at 75 Fed. Reg.4636. 6b

AMA Interagency Guidance forOperational Risk

On June 3, 2011, the federal banking agencies(the agencies) issued Interagency Guidance onthe Advanced Measurement Approaches forOperational Risk to address and clarify imple-mentation issues related to the AMA in applyingthe agencies’ advanced capital adequacy frame-work. This guidance focuses on the combinationand use of the required AMA data elements—(1) internal operational loss event data; (2) exter-nal operational loss event data; (3) businessenvironment and internal control factors; and(4) scenario analysis, which is discussed ingreater detail. Governance and validation arealso discussed since they ensure the integrity ofa bank’s AMA framework. (See SR-11-8 and itsattachment.)

Establishment of a Risk-Based CapitalFloor

Section 171(b)(2) of the Dodd-Frank Wall StreetReform and Consumer Protection Act (Dodd-Frank Act) requires the agencies to establishminimum leverage and risk-based capital require-ments on a consolidated basis for insured deposi-tory institutions, depository institution holdingcompanies, 6c and nonbank financial companiessupervised by the Board. These capital require-ments cannot be less than the generally applica-ble capital requirements that apply to insureddepository institutions. 6d

On June 28, 2011, the agencies published afinal rule (effective July 28, 2011) that amendedthe advanced approaches rules with a permanentfloor equal to the minimum risk-based capitalrequirements under the general risk-based capi-

6a. See the Board staff’s August 21, 2007, legal interpre-tation as to the appropriate risk-based capital risk weight to beapplied to certain collateralized loans of cash.

6b. The revisions address the Financial Accounting Stan-dards Board’s adoption of Statements of Financial AccountingStandards Nos. 166 (ASC topic 860, ‘‘Transfers and Servic-ing’’) and 167 (ASC subtopic 810-10, ‘‘Consolidation—Overall’’). These accounting standards make substantivechanges to how banking organizations account for manyitems, including securitized assets, that had been previouslyexcluded from these organizations’ balance sheets.

6c. Section 171 of the Dodd-Frank Act (Pub. L. 111-203,section 171, 124 Stat. 1376, 1435-38 (2010)) defines ‘‘deposi-tory institution holding company’’ to mean a bank holdingcompany or a savings and loan holding company (as thoseterms are defined in section 3 of the Federal Deposit InsuranceAct) that is organized in the United States, including any bankor savings and loan holding company that is owned orcontrolled by a foreign organization, but does not include theforeign organization. (See section 171 of the Dodd-Frank Act,12 USC 5371.)

6d. The ‘‘generally applicable’’ capital requirements arethose established by the federal banking agencies to apply toinsured depository institutions, regardless of total asset size orforeign exposure, under the prompt corrective action provi-sions of the Federal Deposit Insurance Act. See 12 USC5371(a).



tal rules. (See the Board’s press release and 76Fed. Reg. 37620, June 28, 2011.) Bankingorganizations subject to the advanced approachesrules are required to, each quarter, calculate andcompare their minimum tier 1 and total risk-based capital ratios as calculated under thegeneral risk-based capital rules with the sameratios as calculated under the advancedapproaches risk-based capital rules. They are tocompare the lower of the two tier 1 risk-basedcapital ratios and the lower of the two totalcapital ratios to the minimum tier 1 ratio require-ment and total capital ratio requirement of theadvanced approaches rules to determine whetherthe minimum capital requirements are met. 6e

The amendment prevents the minimum capitalrequirements for a banking organization that hasadopted the advanced approaches rule fromdeclining below the minimum capital require-ments that apply to insured depository institutions.

Documentation

Banks are expected to have adequate systemsin place to compute their risk-based capitalratios. Such systems should be sufficient todocument the composition of the ratios to be usedfor regulatory reporting and other supervisorypurposes. Generally, supporting documentationwill be expected to establish how banks track andreport their capital components and on- andoff-balance-sheet items that are assigned prefer-ential risk weights, that is, risk weights less than100 percent. Where a bank has inadequatedocumentation to support its assignment of apreferential risk weight to a given item, it may benecessary for examiners to assign an appropriatehigher weight to that item. Examiners areexpected to verify that banks are correctlyreporting the information requested on theReports of Condition and Income, which are usedin computing banks’ risk-based capital ratios.

SUPERVISORY CONSIDERATIONSFOR CALCULATING ANDEVALUATING RISK-BASEDCAPITAL

Certain requirements and factors should be con-sidered in assessing the risk-based capital ratiosand the overall capital adequacy of banks. Analy-

sis of these requirements and factors may havea material impact on the amount of capital banksmust hold to appropriately support certainactivities for on- and off-balance-sheet items,and this analysis must be used in assessingcompliance with the guidelines. The require-ments and factors to be considered relate tocertain capital elements, capital adjustments,balance-sheet activities, off-balance-sheet activi-ties, and the overall assessment of capitaladequacy.

Federal Reserve Review of a CapitalInstrument

If the terms and conditions of a particularinstrument cause uncertainty as to how theinstrument should be treated for capital pur-poses, it may be necessary to consult withFederal Reserve staff for a final determination.The Federal Reserve will, on a case-by-casebasis, determine whether a capital instrumenthas characteristics that warrant its inclusion intier 1 or tier 2 capital, as well as determine anyquantitative limit on the amount of an instru-ment that will be counted as an element of tier 1or tier 2 capital. In making this determination,the Federal Reserve will consider the similarityof the instrument to instruments explicitly treatedin the guidelines, the ability of the instrument toabsorb losses while the bank operates as a goingconcern, the maturity and redemption featuresof the instrument, and other relevant terms andfactors.

Redemptions of Capital

Redemptions of permanent equity or other capi-tal instruments before their stated maturity couldhave a significant impact on a bank’s overallcapital structure. Consequently, a bank consid-ering such a step should consult with the FederalReserve before redeeming any equity or debtcapital instrument (before maturity) if itsredemption could have a material effect on thelevel or composition of the institution’s capitalbase.7

6e. 12 CFR 208, appendix F, section 3.

7. Consultation would not ordinarily be necessary if aninstrument was redeemed with the proceeds of, or replaced by,a like amount of a similar or higher-quality capital instrumentand if the organization’s capital position is considered fullyadequate by the Federal Reserve.



Capital Elements

This subsection discusses the characteristics ofthe principal types of capital elements. It alsocovers terms and conditions that may disqualifyan instrument from inclusion in a particularelement of capital.

Common Stockholders’ Equity

Common stockholders’ equity includes commonstock; related surplus; and retained earnings,including capital reserves and adjustments forthe cumulative effect of foreign-currency trans-lation, net of any treasury stock. A capitalinstrument that is not permanent or that haspreference with regard to liquidation or thepayment of dividends is not deemed to becommon stock, regardless of whether it is calledcommon stock. Other preferences may also callinto question whether the capital instrument iscommon stock. Close scrutiny should be paid tothe terms of common-stock issues of banks thathave issued more than one class of commonstock. If preference features are found in one ofthe classes, that class generally should not betreated as common stock.

From a supervisory standpoint, it is desirablethat voting common stockholders’ equity remainthe dominant form of tier 1 capital. Accordingly,the risk-based capital guidelines state that banksshould avoid overreliance on nonvoting equityelements in tier 1 capital. Nonvoting equityelements can arise in connection with commonstockholders’ equity when a bank has two classesof common stock, one voting and the othernonvoting. Alternatively, one class may haveso-called super-voting rights entitling the holderto substantially more votes per share than theother class. In this case, the super-voting sharesmay have so many votes per share that thevoting power of the other shares is effectivelyoverwhelmed.

Banks that have nonvoting, or effectivelynonvoting, common equity and tier 1 perpetualpreferred stock in excess of their voting com-mon stock are clearly overrelying on nonvotingequity elements in tier 1 capital. In such cases, itmay be appropriate to reallocate some of thenonvoting equity elements from tier 1 capital totier 2 capital.

Perpetual Preferred Stock

The risk-based capital guidelines define per-petual preferred stock as preferred stock that hasno maturity date, cannot be redeemed at theoption of the holder, and has no other provisionsthat will require future redemption of the issue.Perpetual preferred stock qualifies for inclusionin capital only if it can absorb losses while theissuer operates as a going concern and only ifthe issuer has the ability and legal right to deferor eliminate preferred dividends.

Perpetual preferred stock with a feature per-mitting redemption at the option of the issuermay qualify for tier 1 or unlimited tier 2 capitalonly if the redemption is subject to prior approvalof the Federal Reserve. An issue that is convert-ible at the option of the issuer into another issueof perpetual preferred stock or a lower form ofcapital, such as subordinated debt, is consideredto be redeemable at the option of the issuer.Accordingly, such a conversion must be subjectto prior Federal Reserve approval.

Banks may include perpetual preferred stockin tier 1 capital only if the stock is noncumula-tive. A noncumulative issue may not permit theaccruing or payment of unpaid dividends in anyform, including the form of dividends payable incommon stock. Perpetual preferred stock thatcalls for the accumulation and future payment ofunpaid dividends is deemed to be cumulative,regardless of whether it is called noncumulative,and it is generally includable in tier 2 capital.

Perpetual preferred stock (including auction-rate preferred) in which the dividend rate is resetperiodically based, in whole or in part, on thebank’s financial condition or credit standing isexcluded from tier 1 capital but may generallybe included in tier 2 capital. The obligationunder such instruments to pay out higher divi-dends when a bank’s condition deteriorates isinconsistent with the essential precept that capi-tal should provide both strength and loss-absorption capacity to a bank during periods ofadversity.

Ordinarily, fixed-rate preferred stock and tra-ditional floating- or adjustable-rate preferredstock—in which the dividend rate adjusts inrelation to an independent index based solely ongeneral market interest rates and is in no waytied to the issuer’s financial condition—do notraise significant supervisory concerns, espe-cially when the adjustable-rate instrument isaccompanied by reasonable spreads and caprates. Such instruments may generally be


Commercial Bank Examination Manual October 2011Page 10.1

included in tier 1 capital, provided they arenoncumulative.

Some preferred-stock issues incorporate cer-tain features that raise serious questions aboutwhether these issues will truly serve as apermanent, or even long-term, source of capital.Such features include so-called exploding-ratemechanisms, or similar mechanisms, in which,after a specified period, the dividend rate auto-matically increases to a level that could createan incentive for the issuer to redeem the instru-ment. Perpetual preferred stock with this type offeature could cause the issuing bank to be facedwith higher dividend requirements at a futuredate when the bank may be experiencing finan-cial difficulties; it is generally not includable intier 1 capital.

Traditional convertible perpetual preferredstock, which the holder can convert into a fixednumber of common shares at a preset price,ordinarily does not raise supervisory concernsand generally qualifies as tier 1 capital, providedthe stock is noncumulative. However, forms ofpreferred stock that the holder must or canconvert into common stock at the market priceprevailing at the time of conversion do raisesupervisory concerns. Such preferred stock maybe converted into an increasing number ofcommon shares as the bank’s condition deterio-rates and as the market price of the commonstock falls. The potential conversion of suchpreferred stock into common stock could pose athreat of dilution to the existing common share-holders. The threat of dilution could make theissuer reluctant to sell new common stock, or itcould place the issuer under strong marketpressure to redeem or repurchase the convertiblepreferred stock. Such convertible preferred stockshould generally be excluded from tier 1 capital.

Perpetual preferred stock issues may includeother provisions or pricing mechanisms thatwould provide significant incentives or pres-sures for the issuer to redeem the stock for cash,especially at a time when the issuer is in aweakened financial condition. As a general mat-ter, an issue that contains such features would beineligible for tier 1 treatment.

While no formal limit is placed on the amountof noncumulative perpetual preferred stock thatmay be included in tier 1 capital, the guidelinesstate that banks should avoid overreliance onpreferred stock and other nonvoting equity ele-ments in tier 1 capital. A bank that includes intier 1 capital perpetual preferred stock in anamount in excess of its voting common stock is

clearly overrelying on perpetual preferred stockin tier 1 capital. In such cases, it may beappropriate to reallocate the excess amount ofperpetual preferred stock from tier 1 capital totier 2 capital.

Forward Equity Transactions

Banking organizations have engaged in varioustypes of forward transactions involving the repur-chase of their common stock. In these transac-tions, the banking organization enters into anarrangement with a counterparty, usually aninvestment bank or another commercial bank,under which the counterparty purchases com-mon shares of the banking organization, eitherin the open market or directly from the institu-tion. The banking organization agrees that it willrepurchase those shares at an agreed-on forwardprice at a later date (typically three years or lessfrom the execution date of the agreement).These transactions are used to ‘‘lock in’’ stockrepurchases at price levels that are perceived tobe advantageous, and they are a means ofmanaging regulatory capital ratios.

Some banking organizations have treatedshares under forward equity arrangements as tier1 capital. However, because these transactionscan impair the permanence of the shares andtypically have certain features that are undesir-able from a supervisory point of view, sharescovered by these arrangements have qualitiesthat are inconsistent with tier 1 capital status.Accordingly, any common stock covered byforward equity transactions entered into after theissuance of SR-01-27 (November 9, 2001), otherthan those specified for deferred compensationor other employee benefit plans, will be excludedfrom the tier 1 capital of a state member bank,even if executed under a currently existingmaster agreement. The amount to be excluded isequal to the common stock, surplus, and retainedearnings associated with the shares. This guid-ance does not apply to shares covered undertraditional stock buyback programs that do notinvolve forward agreements.

Minority Interest in Equity Accounts ofConsolidated Subsidiaries

Minority interest in equity accounts of consoli-dated subsidiaries is included in tier 1 capitalbecause, as a general rule, this interest repre-


October 2011 Commercial Bank Examination ManualPage 10.2

sents equity that is freely available to absorblosses in operating subsidiaries whose assets areincluded in a bank’s risk-weighted asset base.While not subject to an explicit sublimit withintier 1, banks are expected to avoid using minor-ity interest as an avenue for introducing intotheir capital structures elements that might nototherwise qualify as tier 1 capital (such ascumulative or auction-rate perpetual preferredstock) or that would, in effect, result in anexcessive reliance on preferred stock withintier 1 capital. If a bank uses minority interest inthese ways, supervisory concerns may warrantreallocating some of the bank’s minority interestin equity accounts of consolidated subsidiariesfrom tier 1 to tier 2 capital.

Whenever a bank has included perpetualpreferred stock of an operating subsidiaryin minority interest, a possibility exists that suchcapital has been issued in excess of the subsid-iary’s needs, for the purpose of raising cheapercapital for the bank. Stock issued under thesecircumstances may, in substance if not in legalform, be secured by the subsidiary’s assets.If the subsidiary fails, the outside preferredinvestors would have a claim on the subsidiary’sassets that is senior to the claim that the bank,as a common shareholder, has on those assets.Therefore, as a general matter, issuances inexcess of a subsidiary’s needs do not qualify forinclusion in capital. The possibility that asecured arrangement exists should be consid-ered if the subsidiary on-lends significantamounts of funds to the parent bank, is unusu-ally well capitalized, has cash flow in excessof its operating needs, holds a significantamount of assets with minimal credit risk(for example, U.S. Treasury securities) that arenot consistent with its operations, or has issuedpreferred stock at a significantly lower rate thanthe parent could obtain for a direct issue.

Some banks may use a nonoperating subsid-iary or special-purpose entity (SPE) to issueperpetual preferred stock to outside investors.Such a subsidiary may be set up offshore so abank can receive favorable tax treatment for thedividends paid on the stock. In such arrange-ments, a strong presumption exists that the stockis, in effect, secured by the assets of the subsid-iary. It has been agreed internationally that abank may not include in its tier 1 capitalminority interest in the perpetual preferred stockof nonoperating subsidiaries. Furthermore, suchminority interest may not be included in tier 2capital unless a bank can conclusively prove that

the stock is unsecured. Even if the bank’saccountants have permitted the bank to accountfor perpetual preferred stock issued through anSPE as stock of the bank, rather than as minorityinterest in the equity accounts of a consolidatedsubsidiary, the stock may not be included intier 1 capital and most likely is not includable intier 2 capital.

Banks may also use operating or nonoperat-ing subsidiaries to issue subordinated debt. Aswith perpetual preferred stock issued throughsuch subsidiaries, a possibility exists that suchdebt is in effect secured and therefore notincludable in capital.

Minority Interests in Small BusinessInvestment Companies

Minority interests in small business investmentcompanies (SBICs), in investment funds thathold nonfinancial equity investments, and insubsidiaries engaged in nonfinancial activitiesare not included in a bank’s tier 1 or total capitalbase if the bank’s interest in the company orfund is held under the legal authorities listed insection II.B.5.b. of the capital guidelines (12CFR 208, appendix A).

Allowance for Loan and Lease Losses

The allowance for loan and lease losses is areserve that has been established through acharge against earnings to absorb anticipated,but not yet identified, losses on loans or lease-financing receivables. The allowance excludesallocated transfer-risk reserves and reserves cre-ated against identified losses. Neither of thesetwo types of reserves is includable in capital.The amount of the allowance for loan and leaselosses that is includable in tier 2 capital islimited to 1.25 percent of risk-weighted assets.

Net Unrealized Holding Gains (Losses)on Securities Available for Sale

The Financial Accounting Standards Board’sStatement No. 115 (FAS 115), ‘‘Accounting forCertain Investments in Debt and Equity Securi-ties,’’ created a new common stockholders’equity account known as ‘‘net unrealized hold-ing gains (losses) on securities available forsale.’’ Although this equity account is consid-


Commercial Bank Examination Manual October 2011Page 10.3

ered to be part of a bank’s GAAP equity capital,this account should not be included in a bank’sregulatory capital calculations. There are excep-tions, however, to this rule. A bank that legallyholds equity securities in its available-for-saleportfolio8 may include up to 45 percent of the

8. Although banks are generally not allowed to hold equitysecurities except in lieu of debts previously contracted andcertain mutual fund holdings, some banks have grandfatheredholdings of equity securities in accordance with provisions ofthe National Bank Act, passed in the 1930s.


October 2011 Commercial Bank Examination ManualPage 10.4

pretax net unrealized holding gains on thosesecurities in tier 2 capital. These equity securi-ties must be valued in accordance with generallyaccepted accounting principles and have readilydeterminable fair values. Unrealized holdinggains may not be included in tier 2 capital if theFederal Reserve determines that the equitysecurities were not prudently valued. Moreover,if a bank experiences unrealized holding lossesin its available-for-sale equity portfolio, theselosses must be deducted from tier 1 capital.

Mandatory Convertible Debt Securities

Mandatory convertible debt securities are essen-tially subordinated-debt securities that receivespecial capital treatment because a bank hascommitted to repay the principal from proceedsobtained through the issuance of equity. Banksmay include such securities (net of any stockissued that has been dedicated to their retire-ment) in the form of equity contract notes orequity commitment notes9 issued before May15, 1985, as unlimited elements of tier 2 capital,provided that the criteria set forth in 12 CFR225, appendix B, are met. Consistent with thesecriteria, mandatory convertible notes are subjectto a maximum maturity of 12 years, and a bankmust receive Federal Reserve approval beforeredeeming (or repurchasing) such securitiesbefore maturity. The terms of the securitiesshould note that such approval is required.

If a bank has issued common or perpetualpreferred stock and dedicated the proceeds tothe retirement or redemption of mandatory con-vertibles,10 the portion of mandatory convert-ibles covered by the dedication no longer carriesa commitment to issue equity and is effectivelyrendered into ordinary subordinated debt.Accordingly, the amount of the stock dedicatedis netted from the amount of mandatory convert-ibles includable as unlimited tier 2 capital. Theportion of such securities covered by dedica-

tions should be included in capital as subordi-nated debt, subject to amortization in the lastfive years of its life and limited, together withother subordinated debt and intermediate-termpreferred stock, to 50 percent of tier 1 capital.For example, a bank has an outstanding equitycontract note for $1 million and issues $300,000of common stock, dedicating the proceeds to theretirement of the note. The bank would includethe $300,000 of common stock in its tier 1capital. The $700,000 of the equity contract notenot covered by the dedication would be treatedas an unlimited element of the bank’s tier 2capital. The $300,000 of the note covered by thededication would be treated as subordinateddebt.

In some cases, the indenture of a mandatoryconvertible debt issue may require the bank toset up segregated trust funds to hold the pro-ceeds from the sale of equity securities dedi-cated to pay off the principal of the manda-tory convertibles at maturity. The portion ofmandatory convertible securities covered bythe amount of such segregated trust funds isconsidered secured and may therefore not beincluded in capital. The maintenance of sucha separate segregated fund for the redemptionof mandatory convertibles exceeds the require-ments of 12 CFR 225, appendix B. Accord-ingly, if a bank, with the agreement of thedebtholders, seeks regulatory approval to elimi-nate the fund, the approval normally should begiven unless supervisory concerns warrantotherwise.

Subordinated Debt and Intermediate-TermPreferred Stock

To qualify as supplementary capital, subordi-nated debt and intermediate-term preferredstock must have an original average maturity ofat least five years. The average maturity of anobligation whose principal is repayable inscheduled periodic payments (for example, aso-called ‘‘ serial-redemption issue’’ ) is theweighted average of the maturities of all suchscheduled repayments. If the holder has theoption to require the issuer to redeem, repay, orrepurchase the instrument before the originalstated maturity, maturity is defined as the earli-est possible date on which the holder can put theinstrument back to the issuing bank. This datemay be much earlier than the instrument’s statedmaturity date. In the last five years before the

9. Equity contract notes are debt securities that obligate theholder to take common or perpetual preferred stock forrepayment of principal. Equity commitment notes are redeem-able only with the proceeds from the sale of common orperpetual preferred stock.

10. Such a dedication generally must be made in thequarter in which the new common or perpetual preferred stockis issued. There are no restrictions on the actual use of theproceeds of dedicated stock. For example, stock issued underdividend-reinvestment plans or issued to finance acquisitionsmay be dedicated to the retirement of mandatory convertibledebt securities.



maturity of a limited-life instrument, the out-standing amount includable in tier 2 capitalmust be discounted by 20 percent a year. Theaggregate amount of subordinated debt andintermediate-term preferred stock that may beincluded in tier 2 capital is limited to 50 percentof tier 1 capital.

Consistent with longstanding Federal Reservepolicy, a bank may not repay, redeem, or repur-chase a subordinated debt issue without the priorwritten approval of the Federal Reserve. Theterms of the debt indenture should note thatsuch approval is required. The Federal Reserverequires this approval to prevent a deterioratinginstitution from redeeming capital at a timewhen it needs to conserve its resources and toensure that subordinated debtholders in a failingbank are not paid before depositors.

Close scrutiny should be given to terms thatpermit the holder to accelerate payment ofprincipal upon the occurrence of certain events.The only acceleration clauses acceptable in asubordinated-debt issue included in tier 2 capitalare those that are triggered by the issuer’sinsolvency, that is, the appointment of a receiver.Terms that permit the holder to acceleratepayment of principal upon the occurrence ofother events jeopardize the subordination of thedebt since such terms could permit debtholdersin a troubled institution to be paid out beforethe depositors. In addition, debt whose termspermit holders to accelerate payment of princi-pal upon the occurrence of events other thaninsolvency does not meet the minimum five-year maturity requirement for debt capitalinstruments. Holders of such debt have the rightto put the debt back to the issuer upon theoccurrence of the named events, which couldhappen on a date well in advance of the debt’sstated maturity.

Close scrutiny should also be given to theterms of those debt issues in which an event ofdefault is defined more broadly than insolvencyor a failure to pay interest or principal when due.There is a strong possibility that such terms areinconsistent with safe and sound banking prac-tice, so the debt issue should not be includedin capital. Concern is heightened where anevent of default gives the holder the right toaccelerate payment of principal or where otherborrowings exist that contain cross-defaultclauses. Some events of default, such as issuingjumbo certificates of deposit or making addi-tional borrowings in excess of a certain amount,may unduly restrict the day-to-day operations of

the bank. Other events of default, such aschange of control of the bank or disposal of abank subsidiary, may limit the flexibility ofmanagement or banking supervisors to work outthe problems of a troubled bank. Still otherevents of default, such as failure to maintaincertain capital ratios or rates of return or to limitthe amount of nonperforming assets or charge-offs to a certain level, may be intended to allowthe debtholder to be made whole before adeteriorating institution becomes truly troubled.Debt issues that include any of these types ofevents of default are not truly subordinated andshould not be included in capital. Likewise,banks should not include debt issues in capitalthat otherwise contain terms or covenants thatcould adversely affect the liquidity of the issuer;unduly restrict management’s flexibility to runthe organization, particularly in times of finan-cial difficulty; or limit the regulator’s ability toresolve problem-bank situations.

Debt issues, including mandatory convertiblesecurities, in which interest payments are tied tothe financial condition of the borrower shouldgenerally not be included in capital. The interestpayments may be linked to the financial condi-tion of an institution through various ways, suchas (1) an auction-rate mechanism; (2) a presetschedule mandating interest-rate increases, eitheras the credit rating of the bank declines or overthe passage of time;11 or (3) a term that raisesthe interest rate if payment is not made in atimely fashion. These debt issues raise concernsbecause as the financial condition of a bankdeclines, it faces ever-increasing payments onits credit-sensitive subordinated debt at a timewhen it most needs to conserve its resources.Thus, credit-sensitive debt does not providethe support expected of a capital instrument toan institution whose financial condition isdeteriorating; rather, the credit-sensitive featurecan accelerate depletion of the institution’sresources and increase the likelihood of default

11. Although payment on debt whose interest rate increasesover time may not on the surface appear to be directly linkedto the financial condition of the issuing bank, such debt(sometimes referred to as expanding- or exploding-rate debt)has a strong potential to be credit-sensitive in substance.Banks whose financial condition has strengthened are morelikely to be able to refinance the debt at a lower rate than thatmandated by the preset increase, whereas banks whose con-dition has deteriorated are less likely to do so. Moreover, justwhen these latter institutions would be in the most need ofconserving capital, they would be under strong pressure toredeem the debt as an alternative to paying higher rates andwould therefore accelerate the depletion of their resources.



on the debt. While such terms may be acceptablein perpetual preferred stock qualifying for tier 2capital, they are not acceptable in a capital debtissue because a bank in a deteriorating financialcondition does not have the option available inequity issues of eliminating the higher paymentswithout going into default.

When a bank has included subordinated debtissued by an operating or nonoperating subsid-iary in its capital, a possibility exists that thedebt is in effect secured, and thus not includablein capital. Further details on arrangementsregarding a bank’s issuance of capital instru-ments through subsidiaries are discussed in anearlier subsection, ‘‘Minority Interest in EquityAccounts of Consolidated Subsidiaries.’’

Capital Adjustments

Intangible Assets

Goodwill and other intangible assets. Certainintangible assets are deducted from a bank’scapital for the purpose of calculating the risk-based capital ratio.12 Those assets include good-will and certain other identifiable assets. Theseassets are deducted from the sum of the corecapital components (tier 1 capital).

The only identifiable intangible assets that areeligible to be included in—that is, not deductedfrom—a bank’s capital are marketable mortgage-servicing assets (MSAs), nonmortgage-servicingassets (NMSAs), and purchased credit-cardrelationships (PCCRs).13 The total amount ofMSAs and PCCRs that may be included in abank’s capital, in the aggregate, cannot exceed100 percent of tier 1 capital. The total amount ofNMSAs and PCCRs is subject to a separateaggregate sublimit of 25 percent of tier 1 capital.In addition, the total amount of credit-enhancinginterest-only strips (I/Os) (both purchased and

retained) that may be included in capital cannotexceed 25 percent of tier 1 capital. Amounts ofMSAs, NMSAs, PCCRs, and credit-enhancingI/Os (both retained and purchased) in excess ofthese limitations, as well as all other identifiableintangible assets, including core deposit intan-gibles and favorable leaseholds, are to bededucted from a bank’s core capital elements indetermining tier 1 capital. However, identifiableintangible assets (other than MSAs and PCCRs)acquired on or before February 19, 1992, gen-erally will not be deducted from capital forsupervisory purposes, although they will con-tinue to be deducted for applications purposes.

For purposes of calculating the limitations onMSAs, NMSAs, PCCRs, and credit-enhancingI/Os, tier 1 capital is defined as the sum of corecapital elements, net of goodwill and net of allidentifiable intangible assets other than MSAs,NMSAs, and PCCRs. This calculation of tier 1 isbefore the deduction of any disallowedMSAs, any disallowed NMSAs, any disallowedPCCRs, any disallowed credit-enhancing I/Os(both purchased and retained), any disalloweddeferred tax assets, and any nonfinancial equityinvestments.

Banks may elect to deduct disallowed mort-gage servicing assets, disallowed non-mortgageservicing assets, and disallowed credit-enhancingI/Os (both purchased and retained) on a basis thatis net of any associated deferred tax liability.Deferred tax liabilities netted in this mannercannot also be netted against deferred tax assetswhen determining the amount of deferred taxassets that are dependent on future taxableincome.

Banks must review the book value of goodwilland other intangible assets at least quarterly andmake adjustments to these values as necessary.The fair value of MSAs, NMSAs, and PCCRsmust also be determined at least quarterly. Thisdetermination of fair value should includeadjustments for any significant changes inoriginal valuation assumptions, including changesin prepayment estimates or account-attritionrates. Examiners will review both the book valueand fair value assigned to these assets, as well assupporting documentation during the examina-tion process. The Federal Reserve may require,on a case-by-case basis, an independent valua-tion of a bank’s intangible assets or credit-enhancing I/Os.

Value limitation. The amount of eligible servic-ing assets and PCCRs that a bank may include in

12. Negative goodwill is a liability and is therefore nottaken into account in the risk-based capital framework.Accordingly, a bank may not offset goodwill to reduce theamount of goodwill it must deduct from tier 1 capital.

13. Purchased mortgage-servicing rights (PMSRs) no lon-ger exist under the most recent accounting rules that apply toservicing of assets. Under these rules (Financial AccountingStandards Board statements No. 122, ‘‘Accounting for Mort-gage Servicing Rights,’’ and No. 140, ‘‘Accounting for Trans-fers and Servicing of Financial Assets and Extinguishments ofLiabilities’’), organizations are required to recognize separateservicing assets (or liabilities) for the contractual obligation toservice financial assets that entities have either sold orsecuritized with servicing retained.



capital is further limited to the lesser of 90 per-cent of their fair value, or 100 percent of theirbook value, as adjusted for capital purposes inaccordance with the instructions in the commer-cial bank Consolidated Report of Condition andIncome (call report). The amount of I/Os that abank may include in capital shall be its fairvalue. If both the application of the limits onMSAs, NMSAs, and PCCRs and the adjustmentof the balance-sheet amount for these assetswould result in an amount being deducted fromcapital, the bank would deduct only the greaterof the two amounts from its core capital ele-ments in determining tier 1 capital.

Consistent with longstanding Federal Reservepolicy, banks experiencing substantial growth,whether internally or by acquisition, are expectedto maintain strong capital positions substantiallyabove minimum supervisory levels, withoutsignificant reliance on intangible assets orcredit-enhancing I/Os.

An arrangement whereby a bank enters into alicensing or leasing agreement or similar trans-action to avoid booking an intangible assetshould be subject to particularly close scrutiny.Normally, such arrangements will be dealt withby adjusting the bank’s capital calculationappropriately. In making an overall assessmentof a bank’s capital adequacy for applicationspurposes, the institution’s quality and composi-tion of capital are considered together with itsholdings of tangible and intangible assets.

Credit-enhancing interest-only strips receiv-ables (I/Os). Credit-enhancing I/Os are on-balance-sheet assets that, in form or substance,represent the contractual right to receive someor all of the interest due on transferred assets.I/Os expose the bank to credit risk directly orindirectly associated with transferred assets thatexceeds a pro rata share of the bank’s claim onthe assets, whether through subordination pro-visions or other credit-enhancement techniques.Such I/Os, whether purchased or retained andincluding other similar ‘‘spread’’ assets, may beincluded in, that is, not deducted from, a bank’scapital subject to the fair value and tier 1limitations. (See sections II.B.1.d. and e. of thecapital guidelines (12 CFR 208, appendix A).)

Both purchased and retained credit-enhancing I/Os, on a non-tax-adjusted-basis, areincluded in the total amount that is used for pur-poses of determining whether a bank exceedsthe tier 1 limitation. In determining whether anI/O or other types of spread assets serve as a

credit enhancement, the Federal Reserve willlook to the economic substance of thetransaction.

Disallowed Deferred Tax Assets

In response to the Financial Accounting Stan-dards Board’s Statement No. 109 (FAS 109),‘‘Accounting for Income Taxes,’’ the FederalReserve adopted a limit on the amount of certaindeferred tax assets that may be included in (thatis, not deducted from) tier 1 capital for risk-based and leverage capital purposes. Under therule, certain deferred tax assets can only berealized if an institution earns taxable income inthe future. Those deferred tax assets are limited,for regulatory capital purposes, to the amountthat the institution expects to realize within oneyear of the quarter-end report date (based on itsprojections of future taxable income for thatyear) or to 10 percent of tier 1 capital, whicheveris less.

The reported amount of deferred tax assets,net of any valuation allowance for deferred taxassets, in excess of the lesser of these twoamounts is to be deducted from a bank’s corecapital elements in determining tier 1 capital.For purposes of calculating the 10 percent limi-tation, tier 1 capital is defined as the sum of corecapital elements, net of goodwill and net of allidentifiable intangible assets other than MSAs,NMSAs, and PCCRs, but before the deductionof any disallowed MSAs, any disallowedNMSAs, any disallowed PCCRs, any disal-lowed credit-enhancing I/Os, any disalloweddeferred tax assets, and any nonfinancial equityinvestments.

To determine the amount of expected deferredtax assets realizable in the next 12 months, abank should assume that all existing temporarydifferences fully reverse as of the report date.Projected future taxable income should notinclude net operating-loss carry-forwards to beused during that year or the amount of existingtemporary differences a bank expects to reversewithin the year. Such projections should includethe estimated effect of tax-planning strategiesthat the organization expects to implement torealize net operating losses or tax-credit carry-forwards that would otherwise expire during theyear. A new 12-month projection does not haveto be prepared each quarter. Rather, on interimreport dates, the future-taxable-income projec-tions may be used for their current fiscal year,



adjusted for any significant changes that haveoccurred or are expected to occur.

Deferred tax assets that can be realized fromtaxes paid in prior carry-back years or fromfuture reversals of temporary differences aregenerally not limited. For banks that have aparent, however, this amount may not exceedthe amount the bank could reasonably expect itsparent to refund. The disallowed deferred taxassets are subtracted from tier 1 capital and alsofrom risk-weighted assets.

Nonfinancial Equity Investments

In general, a bank must deduct from its corecapital elements the sum of the appropriatepercentages (as determined below) of theadjusted carrying value of all nonfinancial equityinvestments held by it or its direct or indirectsubsidiaries. An equity investment includes thepurchase, acquisition, or retention of any equityinstrument (including common stock, preferredstock, partnership interests, interests in limited-liability companies, trust certificates, and war-rants and call options that give the holder theright to purchase an equity instrument), anyequity feature of a debt instrument (such as awarrant or call option), and any debt instrumentthat is convertible into equity.14 The FederalReserve may treat any other instrument (includ-ing subordinated debt) as an equity investmentif, in its judgment, the instrument is the func-tional equivalent of equity or exposes the statemember bank to essentially the same risks as anequity instrument.

A nonfinancial equity investment, subject tothe risk-based capital rule (the rule), is an equityinvestment in a nonfinancial company madeunder the following authorities:

• the authority to invest in SBICs under section302(b) of the Small Business Investment Actof 1958 (15 USC 682(b))

• the portfolio investment provisions of Regu-lation K (12 CFR 211.8(c)(3)), including theauthority to make portfolio investments throughEdge and agreement corporations

A nonfinancial company is an entity that engagesin any activity that has not been determined tobe permissible for the bank to conduct directly,or to be financial in nature or incidental to

financial activities under section 4(k) of theBank Holding Company Act (12 USC 1843(k)).The rule does not apply to investments made incompanies that engage solely in banking andfinancial activities, nor does it apply to invest-ments made by a state bank under the authorityin section 24(f) of the Federal Deposit InsuranceAct (FDI Act). The higher capital charges alsodo not apply to equity securities acquired andheld by a bank as a bona fide hedge of an equityderivatives transaction it entered into lawfully,or to equity securities that are acquired insatisfaction of a debt previously contracted andthat are held and divested in accordance withapplicable law. The adjusted carrying value ofthese investments is not included in determiningthe total amount of nonfinancial equity invest-ments held by the bank. (See SR-02-4 for ageneral discussion of the risk-based and lever-age capital rule changes.)

The bank must deduct from its core capitalelements the sum of the appropriate percentages,as stated in table 1, of the adjusted carryingvalue of all nonfinancial equity investments heldby the bank or its direct or indirect subsidiaries.The amount of the percentage deduction increasesas the aggregate amount of nonfinancial equityinvestments held by the bank increases as apercentage of its tier 1 capital.

The ‘‘adjusted carrying value’’ of investmentsis the aggregate value at which the investmentsare carried on the balance sheet of the bank,reduced by (1) any unrealized gains on thoseinvestments that are reflected in such carryingvalue but excluded from the bank’s tier 1 capitaland (2) associated deferred tax liabilities. Forexample, for investments held as available-for-sale (AFS), the adjusted carrying value of theinvestments would be the aggregate carryingvalue of the investments (as reflected on theconsolidated balance sheet of the bank) less anyunrealized gains on those investments that areincluded in other comprehensive income and notreflected in tier 1 capital, and associated deferredtax liabilities.15 The total adjusted carrying valueof any nonfinancial equity investment that issubject to deduction is excluded from the bank’srisk-weighted assets and for purposes of com-puting the denominator of the bank’s risk-based

14. This requirement generally does not apply to invest-ments in nonconvertible senior or subordinated debt.

15. Unrealized gains on AFS equity investments may beincluded in supplementary capital to the extent permitted bythe capital guidelines. In addition, the unrealized losses onAFS equity investments are deducted from tier 1 capital.



Table 1—Deduction for Nonfinancial Equity Investments

Aggregate adjusted carrying value ofall nonfinancial equity investmentsheld directly or indirectly by thebank (as a percentageof the tier 1 capital of the bank)1

Deduction from core capital elements (asa percentage of the adjusted carryingvalue of the investment)

Less than 15 percent 8 percent15 percent to 24.99 percent 12 percent25 percent and above 25 percent

1. For purposes of calculating the adjusted carrying valueof nonfinancial equity investments as a percentage of tier 1capital, tier 1 capital is defined as the sum of core capitalelements net of goodwill and net of all identifiable intangibleassets other than MSAs, NMSAs, and PCCRs, but before

the deduction for any disallowed MSAs, any disallowedNMSAs, any disallowed PCCRs, any disallowed creditenhancing I/Os (both purchased and retained), any disalloweddeferred tax assets, and any nonfinancial equity investments.

capital ratio.16 The total adjusted carryingvalue is also deducted from average total con-solidated assets when computing the leverageratio.

The deductions are applied on a marginalbasis to the portions of the adjusted carryingvalue of nonfinancial equity investments thatfall within the specified ranges of the parentbank’s tier 1 capital. The rule sets forth a‘‘stair-step’’ approach under which each tier ofcapital charges applies, on a marginal basis, tothe adjusted carrying value of the bank’s aggre-gate nonfinancial equity investment portfoliothat falls within the specified ratios of theorganization’s tier 1 capital. The stair-stepapproach reflects the fact that the financial risksto a bank from equity investment activitiesincrease as the level of these activities accountsfor a larger portion of the bank’s capital, earn-ings, and activities. For example, if the adjustedcarrying value of all nonfinancial equity invest-ments held by a bank equals 20 percent of its tier1 capital, then the amount of the deductionwould be 8 percent of the adjusted carryingvalue of all investments up to 15 percent of thebank’s tier 1 capital, and 12 percent of theadjusted carrying value of all investments inexcess of 15 percent of the bank’s tier 1capital.

With respect to consolidated SBICs, someequity investments may be in companies that areconsolidated for accounting purposes. For invest-ments in a nonfinancial company that is consoli-dated for accounting purposes under GAAP, thebank’s adjusted carrying value of the investmentis determined under the equity method ofaccounting (net of any intangibles associatedwith the investment that are deducted from thebank’s core). Even though the assets of thenonfinancial company are consolidated foraccounting purposes, these assets (as well as thecredit-equivalent amounts of the company’s off-balance-sheet items) should be excluded fromthe bank’s risk-weighted assets for regulatorycapital purposes.

The capital adequacy guidelines for statemember banks establish minimum risk-basedcapital ratios. Banks are at all times expected tomaintain capital commensurate with the leveland nature of the risks to which they areexposed. The risk to a bank from nonfinancialequity investments increases with its concentra-tion in such investments, and strong capitallevels above the minimum requirements areparticularly important when a bank has a highdegree of concentration in nonfinancial equityinvestments (for example, in excess of 50 per-cent of tier 1 capital).

The Federal Reserve will monitor banks andapply heightened supervision, as appropriate, toequity investment activities, including where thebank has a high degree of concentration innonfinancial equity investments, to ensure thateach bank maintains capital levels that areappropriate in light of its equity investmentactivities. In addition, the Federal Reserve may

16. For example, if 8 percent of the adjusted carrying valueof a nonfinancial equity investment is deducted from tier 1capital, the entire adjusted carrying value of the investmentwill be excluded from risk-weighted assets when calculatingthe denominator for the risk-based capital ratio, and fromaverage total consolidated assets when computing the lever-age ratio.



impose capital levels established by the capitaladequacy rules, in light of the nature or perfor-mance of a particular organization’s equityinvestments or the sufficiency of the organiza-tion’s policies, procedures, and systems to moni-tor and control the risks associated with itsequity investments.

SBIC investments. Investments may be made bybanks in or through SBICs under section 4(c)(5)of the BHC Act and section 302(b) of the SmallBusiness Investment Act. No deduction isrequired for nonfinancial equity investments thatare held by a bank (1) through one or moreSBICs that are consolidated with the bank or(2) in one or more SBICs that are not consoli-dated with the bank, to the extent that all suchinvestments, in the aggregate, do not exceed15 percent of the bank’s tier 1 capital. Anynonfinancial equity investment that is heldthrough or in an SBIC and that is not required tobe deducted from tier 1 capital will be assigneda 100 percent risk weight and included in thebank’s consolidated risk-weighted assets.17

To the extent the adjusted carrying value ofall nonfinancial equity investments that a bankholds through one or more SBICs that areconsolidated with the bank, or in one or moreSBICs that are not consolidated with the bank,exceeds, in the aggregate, 15 percent of thebank’s tier 1 capital, the appropriate percentageof such amounts (as set forth in table 1) must bededucted from the bank’s core capital elements.In addition, the aggregate adjusted carryingvalue of all nonfinancial equity investments heldthrough a consolidated SBIC and in a noncon-solidated SBIC (including any investments for

which no deduction is required) must be includedin determining, for purposes of table 1, the totalamount of nonfinancial equity investments heldby the bank in relation to its tier 1 capital.

Grandfather provisions. No deduction is requiredto be made for the adjusted carrying value ofany nonfinancial equity investment (or portionof such an investment) that the bank madebefore March 13, 2000, or that the bank made onor after this date pursuant to a binding writtencommitment18 entered into before March 13,2000, provided that in either case the bank hascontinuously held the investment since the rel-evant investment date.19 A nonfinancial equityinvestment made before March 13, 2000,includes any shares or other interests the bankreceived through a stock split or stock dividendon an investment made before March 13, 2000,provided the bank provides no consideration forthe shares or interests received and the transac-tion does not materially increase the bank’sproportional interest in the company. The exer-cise on or after March 13, 2000, of options orwarrants acquired before March 13, 2000, is notconsidered to be an investment made beforeMarch 13, 2000, if the bank provides anyconsideration for the shares or interests receivedupon exercise of the options or warrants. Anynonfinancial equity investment (or portionthereof) that is not required to be deducted fromtier 1 capital must be included in determiningthe total amount of nonfinancial equity invest-ments held by the bank in relation to its tier 1

17. If a bank has an investment in an SBIC that isconsolidated for accounting purposes but that is not whollyowned by the bank, the adjusted carrying value of the bank’snonfinancial equity investments through the SBIC is equal tothe bank’s proportionate share of the adjusted carrying valueof the SBIC’s equity investments in nonfinancial companies.The remainder of the SBIC’s adjusted carrying value (that is,the minority interest holders’ proportionate share) is excludedfrom the risk-weighted assets of the bank. If a bank has aninvestment in an SBIC that is not consolidated for accountingpurposes, and the bank has current information that identifiesthe percentage of the SBIC’s assets that are equity invest-ments in nonfinancial companies, the bank may reduce theadjusted carrying value of its investment in the SBIC propor-tionately to reflect the percentage of the adjusted carryingvalue of the SBIC’s assets that are not equity investments innonfinancial companies. If a bank reduces the adjusted carry-ing value of its investment in a nonconsolidated SBIC toreflect financial investments of the SBIC, the amount of theadjustment will be risk-weighted at 100 percent and includedin the bank’s risk-weighted assets.

18. A ‘‘binding written commitment’’ means a legallybinding written agreement that requires the bank to acquireshares or other equity of the company, or make a capitalcontribution to the company, under terms and conditions setforth in the agreement. Options, warrants, and other agree-ments that give a bank the right to acquire equity or make aninvestment, but do not require the bank to take such actions,are not considered a binding written commitment for purposesof this provision.

19. For example, if a bank made an equity investment in100 shares of a nonfinancial company before March 13, 2000,the adjusted carrying value of that investment would not besubject to a deduction. However, if the bank made anyadditional equity investment in the company after March 13,2000, such as by purchasing additional shares of the company(including through the exercise of options or warrants acquiredbefore or after March 13, 2000) or by making a capitalcontribution to the company, and such investment was notmade pursuant to a binding written commitment entered intobefore March 13, 2000, the adjusted carrying value of theadditional investment would be subject to a deduction. Inaddition, if the bank sold and repurchased, after March 13,2000, 40 shares of the company, the adjusted carrying value ofthose 40 shares would be subject to a deduction under thisprovision.



capital for purposes of table 1. In addition, anynonfinancial equity investment (or portionthereof) that is not required to be deducted fromtier 1 capital will be assigned a 100 percent riskweight and included in the bank’s consolidatedrisk-weighted assets. The following exampleillustrates these calculations.

A bank has $1 million in tier 1 capital and hasnonfinancial equity investments with an aggre-gate adjusted carrying value of $375,000. Ofthis amount, $100,000 represents the adjustedcarrying value of investments made beforeMarch 13, 2000, and an additional $175,000represents the adjusted carrying value of invest-ments made through the bank’s wholly ownedSBIC. The $100,000 in investments made beforeMarch 13, 2000, and $150,000 of the bank’sSBIC investments would not be subject to therule’s marginal capital charges. These amountsare considered for purposes of determining themarginal charge that applies to the bank’s cov-ered investments (including the $25,000 of non-exempt SBIC investments). In this case, the totalamount of the bank’s tier 1 capital deductionwould be $31,250. This figure is 25 percent of$125,000, which is the amount of the bank’stotal nonfinancial equity portfolio subject to therule’s marginal capital charges. The average tier1 capital charge on the bank’s entire nonfinan-cial equity portfolio would be 8.33 percent.

Investments in Unconsolidated Bankingand Finance Subsidiaries and OtherSubsidiaries

Generally, debt and equity capital investmentsand any other instruments deemed to be capitalin unconsolidated banking and finance subsidi-aries20 are to be deducted from the consolidatedcapital of the parent bank, regardless of whetherthe investment is made by the parent bank or itsdirect or indirect subsidiaries.21 Fifty percent ofthe investment is to be deducted from tier 1capital and 50 percent from tier 2 capital. Whentier 2 capital is not sufficient to absorb the

portion (50 percent) of the investment allocatedto it, the remainder (up to 100 percent) is to bededucted from tier 1 capital.

Advances to banking and finance subsidiaries(that is, loans, extensions of credit, guarantees,commitments, or any other credit exposures) notconsidered as capital are included in risk-weighted assets at the 100 percent risk weight(unless recognized collateral or guarantees dic-tate weighting at a lower percentage). However,such advances may be deducted from the parentbank’s consolidated capital where examinersfind that the risks associated with the advancesare similar to the risks associated with capitalinvestments, or if such advances possess riskfactors that warrant an adjustment to capital forsupervisory purposes. These risk factors couldinclude the absence of collateral support or theclear intention of banks to allow the advances toserve as capital to subsidiaries regardless ofform.

Although the Federal Reserve does not auto-matically deduct investments in other unconsoli-dated subsidiaries or investments in joint ven-tures and associated companies,22 the level andnature of such investments should be closelymonitored. Resources invested in these entitiessupport assets that are not consolidated with therest of the bank and therefore may not begenerally available to support additional lever-age or absorb losses of affiliated institutions.Close monitoring is also necessary becauseexperience has shown that banks often standbehind the losses of affiliated institutions toprotect the reputation of the organization as awhole. In some cases, this support has led tolosses that have exceeded the investments insuch entities.

Accordingly, for risk-based capital purposes,a bank may be required, on a case-by-case basis,to (1) deduct such investments from total capi-tal; (2) apply an appropriate risk-weighted chargeagainst the bank’s pro rata share of the assetsof the affiliated entity; (3) consolidate the entityon a line-by-line basis; or (4) operate with arisk-based capital ratio above the minimum.In determining the appropriate capital treatmentfor such actions, the Federal Reserve willgenerally take into account whether (1) the bankhas significant influence over the financial or

20. A banking and finance subsidiary is generally definedas any company engaged in banking or finance in which theparent organization holds directly or indirectly more than50 percent of the outstanding voting stock, or any suchcompany which is otherwise controlled or capable of beingcontrolled by the parent organization.

21. An exception to this deduction is to be made for sharesacquired in the regular course of securing or collecting a debtpreviously contracted in good faith.

22. Such entities are defined in the instructions to the callreport. Associated companies and joint ventures are generallydefined as companies in which the bank owns 20 to 50 percentof the voting stock.



managerial policies or operations of the affili-ated entity, (2) the bank is the largest investor inthe entity, or (3) other circumstances prevail(such as the existence of significant guaran-tees from the bank) that appear to closely tiethe activities of the affiliated company to thebank.

Reciprocal Holdings of BankingOrganizations’ Capital Instruments

Reciprocal holdings are intentional cross-holdings resulting from formal or informalarrangements between banking organizations toswap or exchange each other’s capital instru-ments. Such holdings of other banking organi-zations’ capital instruments are to be deductedfrom the total capital of an organization for thepurpose of determining the total risk-basedcapital ratio. Holdings of other banking organi-zations’ capital instruments taken in satisfac-tion of debts previously contracted or thatconstitute stake-out investments that complywith the Federal Reserve’s policy statement onnonvoting equity investments (12 CFR 225.143)are not deemed to be intentional cross-holdingsand are therefore not deducted from a bank’scapital.

On-Balance-Sheet Activities

Claims on, and Guaranteed by, OECDCentral Governments

The risk-based capital guidelines assign a zeropercent risk weight to all direct claims (includingsecurities, loans, and leases) on the centralgovernments of the OECD-based group ofcountries and U.S. government agencies. Gen-erally, the only direct claims banks have on theU.S. government and its agencies take the formof Treasury securities. Zero-coupon, that is,single-payment, Treasury securities trading un-der the U.S. Treasury’s Separately TradedRegistered Interest and Principal (STRIP) pro-gram are assigned to the zero percent riskcategory. A security that has been stripped by aprivate-sector entity, such as a brokerage firm, isconsidered an obligation of that entity and isaccordingly assigned to the 100 percent riskcategory.

Claims that are directly and unconditionallyguaranteed by an OECD-based central govern-

ment or a U.S. government agency are alsoassigned to the zero percent risk category. Claimsthat are directly but conditionally guaranteed areassigned to the 20 percent risk category. A claimis considered to be conditionally guaranteed bya central government if the validity of theguarantee depends on some affirmative actionby the holder or a third party. Generally, secu-rities guaranteed by the U.S. government or itsagencies that are actively traded in financialmarkets are considered to be unconditionallyguaranteed. These include Government NationalMortgage Association (GNMA or Ginnie Mae)and Small Business Administration (SBA)securities.

A limited number of U.S. government agency–guaranteed loans are deemed to be uncondition-ally guaranteed and can be assigned to the zeropercent risk category. These include most loansguaranteed by the Export-Import Bank (Exim-bank),23 loans guaranteed by the U.S. Agencyfor International Development (AID) under itsHousing Guaranty Loan Program, SBA loanssubject to a secondary participation guaranty inaccordance with SBA form 1086, and FarmersHome Administration (FmHA) loans subject toan assignment guaranty agreement in accor-dance with FmHA form 449-36.

Apart from the exceptions noted in the pre-ceding paragraph, loans guaranteed by the U.S.government or its agencies are considered to beconditionally guaranteed. The guaranteed por-tion of such loans is assigned to the 20 percentrisk category. These include, but are not limitedto, loans guaranteed by the Commodity CreditCorporation (CCC), the Federal HousingAdministration (FHA), the Overseas PrivateInvestment Corporation (OPIC), the Departmentof Veterans Affairs (VA), and, except as indi-cated above, the FmHA and SBA. Loan guaran-tees offered by OPIC often guarantee againstpolitical risk. However, only that portion of aloan guaranteed by OPIC against commercial orcredit risk may receive a preferential 20 percentrisk weight. The portion of government trustcertificates issued to provide funds for the refi-nancing of foreign military sales loans made bythe Federal Financing Bank or the DefenseSecurity Assistance Agency that are indirectlyguaranteed by the U.S. government also qualifyfor the 20 percent risk weight.

23. Loans guaranteed under Eximbank’s Working CapitalGuarantee Program, however, receive a 20 percent riskweight.



Most guaranteed student loans are guaranteedby a state agency or nonprofit organization thatdoes not have the full faith and credit backingof the state. The loans are then indirectly guar-anteed or reinsured by the U.S. government’sGuaranteed Student Loan Program. Under theprogram, a minimum percentage of the loan isreinsured, but a higher percentage could beguaranteed if the bank has experienced an over-all low default rate on guaranteed student loans.Only the portion of the loan covered by theminimum guarantee under the program may beassigned to the 20 percent risk category; theremainder should be assigned a 100 percent riskweight.

Claims on, or Guaranteed by, a U.S.Government–Sponsored Agency

U.S. government–sponsored agencies are agen-cies originally established or chartered by thefederal government to serve public purposesspecified by the U.S. Congress. Such agenciesgenerally carry out functions performed directlyby the central government in other countries.The obligations of government-sponsored agen-cies generally are not explicitly guaranteed bythe full faith and credit of the U.S. government.Claims (including securities, loans, and leases)on, or guaranteed by, such agencies are assignedto the 20 percent risk category. U.S. government–sponsored agencies include, but are not limitedto, the College Construction Loan InsuranceAssociation, Farm Credit Administration, Fed-eral Agricultural Mortgage Corporation, FederalHome Loan Bank System, Federal Home LoanMortgage Corporation (FHLMC or FreddieMac), Federal National Mortgage Association(FNMA or Fannie Mae), Financing Corporation(FICO), Postal Service, Resolution Funding Cor-poration (REFCORP), Student Loan MarketingAssociation (SLMA or Sallie Mae), Smithso-nian Institution, and Tennessee Valley Authority(TVA).

Loans Secured by First Liens on One- toFour-Family Residential Properties andMultifamily Residential Properties

Qualifying loans on one- to four-family residen-tial properties, either owner-occupied or rented(as defined in the instructions to the call report),are accorded a 50 percent risk weight under the

guidelines. Also eligible for the 50 percent riskweight are loans to builders with substantialproject equity for the construction of one- tofour-family residences that have been presoldunder firm contracts to purchasers who haveobtained firm commitments for permanent quali-fying mortgage loans and have made substantialearnest-money deposits.

In addition, qualifying multifamily residentialloans that meet certain criteria may be assignedto the 50 percent risk category. These criteria areas follows: All principal and interest paymentsmust have been made on time for at least oneyear preceding placement in the 50 percent riskcategory, amortization of the principal andinterest must occur within 30 years, the mini-mum original maturity for repayment of princi-pal cannot be less than seven years, and annualnet operating income (before debt service) gen-erated by the property during the most recentfiscal year must not be less than 120 percent ofthe loan’s current annual debt service (115 per-cent if the loan is based on a floating interestrate). In the case of cooperative or other not-for-profit housing projects, the property must gen-erate sufficient cash flow to provide comparableprotection to the bank.

To ensure that only qualifying residentialmortgage loans are assigned to this preferentialrisk weight, examiners are to review the one-to four-family and multifamily residential realestate loans that are included in the 50 percentrisk category. Such loans are not eligible forpreferential treatment unless they meet the fol-lowing criteria: The loans are made subject toprudent underwriting standards, the loans areperforming in accordance with their originalterms and are not delinquent for 90 days or moreor carried on nonaccrual status, and the loan-to-value ratios are conservative.24 For the purposeof this last criterion, the loan-to-value ratioshould be based on the value of the propertydetermined by the most current appraisal or, ifappropriate, the most current evaluation. Nor-mally, this would be the appraisal or evaluationperformed at the time the loan was originated.25

If a bank has assigned a 50 percent riskweight to residential mortgage loans made for

24. A conservative loan-to-value ratio for loans secured bymultifamily residential property must not exceed 80 percent(or 75 percent if the loan is based on a floating interest rate).

25. When both first and junior liens are held by the bankand no intervening liens exist, these transactions are treated assingle loans secured by a first lien for the purpose ofdetermining the loan-to-value ratio.



the purpose of speculative real estate develop-ment or whose eligibility for such preferentialtreatment is otherwise questionable, and theamounts of nonqualifying loans are readily iden-tifiable, such loans should be reassigned to the100 percent risk-weight category. If materialevidence exists that a bank has assigned apreferential risk weight to residential mortgageloans of questionable eligibility, but the amountof the inappropriately weighted amount cannotbe readily identified, the overall evaluation ofthe bank’s capital adequacy should reflect ahigher capital requirement than would otherwisebe the case.

Accrued Interest

Banks normally report accrued interest on loansand securities in ‘‘ Other Assets’’ on the CallReport. The majority of banks will risk-weightthe entire amount of accrued interest at 100 per-cent. However, for risk-based capital purposes,a bank is permitted to allocate accrued interestamong the risk categories associated with theunderlying claims, provided the bank has sys-tems in place to carry out such an allocationaccurately.

Off-Balance-Sheet Activities

Off-balance-sheet transactions include recourseobligations, direct-credit substitutes, residualinterests, and asset- and mortgage-backed secu-rities. The treatments for direct-credit substi-tutes, assets transferred with recourse, and secu-rities issued in connection with assetsecuritizations and structured financings aredescribed later in this section. The terms assetsecuritizations or securitizations, as used in thissubsection, include structured financings, as wellas asset-securitization transactions.

Assets Sold with Recourse

For risk-based capital adequacy purposes, abank must hold capital against assets sold withrecourse if the bank retains any risk of loss. Toqualify as an asset sale with recourse, a transferof assets must first qualify as a sale according tothe GAAP criteria set forth in paragraph 14 ofthe Financial Accounting Standards Board’sStatement No. 140 (FAS 140), ‘‘Accounting for

Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.’’ These criteriaare summarized in the definition of ‘‘ transfers offinancial assets’’ in the glossary to the commer-cial bank Call Report instructions. If a transferof assets does not meet these criteria, the assetsmust remain on the bank’s balance sheet and aresubject to the standard risk-based capital charge.

If a transfer of assets qualifies as a sale underGAAP but the bank retains any risk of loss orobligation for payment of principal or interest,then the transfer is considered to be a sale withrecourse. A more detailed definition of an assetsale with recourse may be found in the definitionof ‘‘ sales of assets for risk-based capital pur-poses’’ in the glossary to the commercial bankCall Report instructions. Although the assets areremoved from a bank’s balance sheet in an assetsale with recourse, the credit-equivalent amountis assigned to the risk category appropriate tothe obligor in the underlying transaction, afterconsidering any associated guaranties or collat-eral. This assignment also applies when thecontractual terms of the recourse agreementlimit the seller’s risk to a percentage of the valueof the assets sold or to a specific dollar amount.

If, however, the risk retained by the seller islimited to some fixed percentage of any lossesthat might be incurred and there are no otherprovisions resulting in the direct or indirectretention of risk by the seller, the maximumamount of possible loss for which the sellingbank is at risk (the stated percentage times theamount of assets to which the percentage applies)is subject to risk-based capital requirements.The remaining amount of assets transferredwould be treated as a sale that is not subject tothe risk-based capital requirements. For exam-ple, a seller would treat a sale of $1 million inassets with a recourse provision that the sellerand buyer proportionately share in losses incurredon a 10 percent and 90 percent basis, respec-tively, and with no other retention of riskby the seller, as a $100,000 asset sale withrecourse and a $900,000 sale not subject torisk-based capital requirements.

There are several exceptions to the generalreporting rule for recourse transactions. The firstexception applies to recourse transactions forwhich the amount of recourse the institution iscontractually liable for is less than the capitalrequirement for the assets transferred under therecourse agreement. For such transactions, abank must hold capital equal to its maximumcontractual recourse obligation. For example,



assume an institution transfers a $100 pool ofcommercial loans and retains a recourse obliga-tion of 2 percent. Ordinarily, the bank would besubject to an 8 percent capital charge, or $8.Because the recourse obligation is only 2 per-cent, however, the bank would be required tohold capital of $2 against the recourse exposure.This capital charge may be reduced further bythe balance of any associated noncapital GAAPrecourse liability account.

A second exception to the general rule appliesto the transfer of small-business loans and to thetransfer of leases on personal property withrecourse. A bank that is considered to be wellcapitalized according to the Federal Reserve’sprompt-corrective-action framework shouldinclude in risk-weighted assets only the amountof retained recourse—instead of the entireamount of assets transferred—in connection witha transfer of small-business loans or a transfer ofleases on personal property with recourse, pro-vided two conditions are met. First, the transac-tion must be treated as a sale under GAAP;second, the bank must establish a noncapitalreserve that is sufficient to cover the bank’sestimated liability under the recourse arrange-ment. With the Board’s approval, this exceptionmay also apply to a bank that is considered to beadequately capitalized under the prompt-corrective-action framework. The total outstand-ing amount of recourse retained under suchtransactions may not exceed 15 percent of abank’s total risk-based capital without Boardapproval.

Definitions

The capital adequacy guidelines provide specialtreatment for recourse obligations, direct-creditsubstitutes, residual interests, and asset- andmortgage-backed securities involved in asset-securitization activities. A brief discussion ofsome of the primary definitions follows.

Credit derivatives. Credit derivative means acontract that allows one party (the protectionpurchaser) to transfer the credit risk of an assetor off-balance-sheet credit exposure to anotherparty (the protection provider). The value of acredit derivative is dependent, at least in part, onthe credit performance of a ‘‘ reference asset.’’

Credit-enhancing representations and warran-ties. When a bank transfers assets, including

servicing rights, it customarily makes represen-tations and warranties concerning those assets.When a bank purchases loan-servicing rights,it may also assume representations and warran-ties made by the seller or a prior servicer. Theserepresentations and warranties give certain rightsto other parties and impose obligations on theseller or servicer of the assets. To the extent abank’s representations and warranties functionas credit enhancements to protect asset purchas-ers or investors from credit risk, they are con-sidered as recourse or direct-credit substitutes.

The Federal Reserve’ s risk-based capitaladequacy rule is consistent with the agencies’long-standing recourse treatment of representa-tions and warranties that effectively guaranteethe performance or credit quality of transferredloans. However, banks typically make a numberof factual warranties that are unrelated to theongoing performance or credit quality of trans-ferred assets. These warranties entail opera-tional risk, as opposed to the open-ended creditrisk inherent in a financial guaranty, and arenot considered recourse or a direct-credit sub-stitute. Warranties that create operational riskinclude warranties that assets have been under-written or collateral appraised in conformitywith identified standards, as well as warrantiesthat provide for the return of assets in instancesof incomplete documentation, fraud, ormisrepresentation.

Warranties can impose varying degrees ofoperational risk. For example, a warranty thatasset collateral has not suffered damage frompotential hazards entails a risk that is offset tosome extent by prudent underwriting practicesrequiring the borrower to provide hazard insur-ance to the bank. A warranty that asset collateralis free of environmental hazards may presentacceptable operational risk for certain typesof properties that have been subject to environ-mental assessment, depending on the circum-stances. The appropriate limits for these opera-tional risks are monitored through supervisionof a bank’s loan-underwriting, -sale, and-servicing practices. Also, a bank that pro-vides warranties to loan purchasers and inves-tors must include associated operational risks inits risk management of exposures arising fromloan-sale or securitization-related activities.Banks should be prepared to demonstrate toexaminers that operational risks are effectivelymanaged.

Recourse or direct-credit-substitute treatmentis required for warranties providing assurances



about the actual value of asset collateral, includ-ing that the market value corresponds to itsappraised value or that the appraised value willbe realized in the event of foreclosure and sale.Warranties such as these, which make represen-tations about the future value of a loan or relatedcollateral, constitute an enhancement of theloan transferred, and thus are recourse arrange-ments or direct-credit substitutes. When a sellerrepresents that it ‘‘ has no knowledge’’ of cir-cumstances that could cause a loan to be otherthan investment quality, the representation is notrecourse. Banks may limit recourse exposurewith warranties that directly address the condi-tion of the asset at the time of transfer (thatis, creation of an operational warranty) andby monitoring compliance with stated underwrit-ing standards. Alternatively, banks might createwarranties with exposure caps that would permitit to take advantage of the low-level-recourserule.

The definition of credit-enhancing represen-tations and warranties excludes warranties—such as early-default clauses and similar war-ranties that permit the return of, or premium-refund clauses covering, one- to four-familyresidential first mortgage loans that qualify for a50 percent risk weight for a maximum period of120 days from the date of transfer. These war-ranties may cover only those loans that wereoriginated within one year of the date of transfer.

A premium-refund clause is a warranty thatobligates a seller who has sold a loan at a pricein excess of par, that is, at a premium, to refundthe premium, either in whole or in part, if theloan defaults or is prepaid within a certainperiod of time. Premium-refund clauses thatcover assets guaranteed, in whole or in part, bythe U.S. government, a U.S. government agency,or a government-sponsored enterprise are notincluded in the definition of credit-enhancingrepresentations and warranties, provided thepremium-refund clauses are for a period not toexceed 120 days from the date of transfer. Thedefinition also does not include warranties thatpermit the return of assets in instances ofmisrepresentation, fraud, or incompletedocumentation.

Early-default clauses. Early-default clauses typi-cally give the purchaser of a loan the right toreturn the loan to the seller if the loan becomes30 or more days delinquent within a statedperiod after the transfer, for example, fourmonths after transfer. Once the stated period has

expired, the early-default clause will no longertrigger recourse treatment, provided there are noother provisions that constitute recourse.

Direct-credit substitutes. The term direct-creditsubstitute refers to an arrangement in which abank assumes, in form or in substance, creditrisk associated with an on- or off-balance-sheetasset or exposure that was not previously ownedby the bank (third-party asset), and the riskassumed by the bank exceeds the pro rata shareof its interest in the third-party asset. If the bankhas no claim on the third-party asset, then thebank’s assumption of any credit risk on thethird-party asset is a direct-credit substitute.

The term direct-credit substitute explicitlyincludes items such as purchased subordinatedinterests, agreements to cover credit losses thatarise from purchased loan-servicing rights, creditderivatives, and lines of credit that providecredit enhancement. Some purchased subordi-nated interests, such as credit-enhancing I/Ostrips, are also residual interests for regulatorycapital purposes.

Direct-credit substitutes include, but are notlimited to—

• financial standby letters of credit that supportfinancial claims on a third party that exceed abank’s pro rata share of losses in the financialclaim;

• guarantees, surety arrangements, credit deriva-tives, and similar instruments backing finan-cial claims that exceed a bank’s pro rata sharein the financial claim;

• purchased subordinated interests or securitiesthat absorb more than their pro rata share oflosses from the underlying assets;

• credit derivative contracts under which thebank assumes more than its pro rata share ofcredit risk on a third-party exposure;

• loans or lines of credit that provide creditenhancement for the financial obligations ofan account party;

• purchased loan-servicing assets if the serviceris responsible for credit losses or if the ser-vicer makes or assumes credit-enhancing rep-resentations and warranties with respect to theloans serviced (mortgage-servicer cashadvances that meet the conditions of sectionIII.B.3.a.x. of the guidelines (12 CFR 208,appendix A) are not direct-credit substitutes);

• clean-up calls on third-party assets (clean-upcalls that are 10 percent or less of the originalpool balance that are exercisable at the option



of the bank are not direct-credit substitutes);and

• liquidity facilities that provide liquidity sup-port to ABCP (other than eligible ABCPliquidity facilities).

Clean-up calls. A clean-up call is an option thatpermits a servicer or its affiliate (which may bethe originator) to take investors out of theirpositions in a securitization before all of thetransferred loans have been repaid. The serviceraccomplishes this by repurchasing the remain-ing loans in the pool once the pool balance hasfallen below some specified level. This option ina securitization raises long-standing agency con-cerns that a bank may implicitly assume acredit-enhancing position by exercising theoption when the credit quality of the securitizedloans is deteriorating. An excessively largeclean-up call facilitates a securitization servic-er’s ability to take investors out of a pool toprotect them from absorbing credit losses, andthus may indicate that the servicer has retainedor assumed the credit risk on the underlyingpool of loans.

Generally, clean-up calls (whether or not theyare exercised) are treated as recourse and direct-credit substitutes. The purpose of treating largeclean-up calls as recourse or direct-credit sub-stitutes is to ensure that a bank is not able toprovide credit support to the trust investors byrepaying its investment when the credit qualityof the pool is deteriorating without holdingcapital against the exposure. The focus shouldbe on the arrangement itself and not the exerciseof the call. Thus, the existence, not the exercise,of a clean-up call that does not meet the require-ments of the risk-based capital rule will triggertreatment as a recourse obligation or a direct-credit substitute. A clean-up call can function asa credit enhancement because its existence pro-vides the opportunity for a bank (as servicer oran affiliate of a servicer) to provide creditsupport to investors by taking an action that iswithin the contractual terms of the securitizationdocuments.

Because clean-up calls can also serve anadministrative function in the operation of asecuritization, a limited exemption exists forthese options. When an agreement permits abank that is a servicer or an affiliate of theservicer to elect to purchase loans in a pool, theagreement is not considered a recourse obliga-tion or a direct-credit substitute if the agreementpermits the banking organization to purchase the

remaining loans in a pool when the balance ofthose loans is equal to or less than 10 percent ofthe original pool balance. This treatment willalso apply to clean-up calls written with refer-ence to less than 10 percent of the outstandingprincipal amount of securities. If, however, anagreement permits the remaining loans to berepurchased when their balance is greater than10 percent of the original pool balance, theagreement is considered to be a recourse obli-gation or a direct-credit substitute. The exemp-tion from recourse or direct-credit-substitutetreatment for a clean-up call of 10 percent orless recognizes the real market need to be able tocall a transaction when the costs of keeping itoutstanding are burdensome. However, to mini-mize the potential for using such a feature as ameans of providing support for a troubled port-folio, a bank that exercises a clean-up callshould not repurchase any loans in the pool thatare 30 days or more past due. Alternatively, thebank should repurchase the loans at the lower oftheir estimated fair value or their par value plusaccrued interest.

Banks that repurchase assets pursuant to aclean-up call may do so based on an aggregatefair value for all repurchased assets. Banks donot have to evaluate each individual loan remain-ing in the pool at the time a clean-up call isexercised to determine fair value. Rather, theoverall repurchase price should reflect the aggre-gate fair value of the assets being repurchased sothat the bank is not overpaying for the assetsand, in so doing, providing credit support to thetrust investors. Examiners will review the termsand conditions relating to the repurchase arrange-ments in clean-up calls to ensure that transac-tions are done at the lower of fair value or parvalue plus accrued interest. Banks should beable to support their fair-value estimates. If theFederal Reserve concludes that a bank hasrepurchased assets at a price that exceeds thelower of these two amounts, the clean-up callprovisions in its future securitizations may betreated as recourse obligations or direct-creditsubstitutes. Regardless of the size of the clean-upcall, the Federal Reserve will closely scrutinizeand take appropriate supervisory action for anytransaction in which the bank repurchases dete-riorating assets for an amount greater than areasonable estimate of their fair value.

Eligible ABCP liquidity facility. An eligibleABCP liquidity facility is a liquidity facility thatsupports ABCP, in form or in substance, and is



subject to an asset-quality test at the time ofdraw that precludes funding against assets thatare 90 days or more past due or in default. Inaddition, if the assets that an eligible ABCPliquidity facility is required to fund against areexternally rated assets or exposures at the incep-tion of the facility, the facility can be used tofund only those assets or exposures that areexternally rated investment grade at the time offunding. Notwithstanding the eligibility require-ments set forth in the two preceding sentences, aliquidity facility will be considered an eligibleABCP liquidity facility if the assets that arefunded under the liquidity facility and which donot meet the eligibility requirements are guar-anteed, either conditionally or unconditionally,by the U.S. government or its agencies or by thecentral government of an OECD country.

Externally rated. Externally rated is a termwhich means that an instrument or obligationhas received a credit rating from a nationallyrecognized statistical rating organization.

Face amount. The face amount is the notionalprincipal, or face value, amount of an off-balance-sheet item; the amortized cost of anasset not held for trading purposes; and the fairvalue of a trading asset.

Financial asset. A financial asset is cash or othermonetary instrument, evidence of debt, evidenceof an ownership interest in an entity, or acontract that conveys a right to receive orexchange cash or another financial instrumentfrom another party.

Financial standby letters of credit. A finan-cial standby letter of credit means a letterof credit or similar arrangement that representsan irrevocable obligation to a third-partybeneficiary—

• to repay money borrowed by, advanced to, orfor the account of a second party (the accountparty), or

• to make payment on behalf of the accountparty, in the event that the account party failsto fulfill its obligation to the beneficiary.

Spread accounts that function as credit-enhancing interest-only strips. A spread accountis an on-balance-sheet asset that functions as acredit enhancement and that can represent aninterest in expected interest and fee cash flows

derived from assets an organization has sold intoa securitization. In those cases, the spreadaccount is considered to be a ‘‘ credit-enhancinginterest-only strip’’ and is subject to the concen-tration limit. (See SR-02-16.) However, anyportion of a spread account that represents aninterest in cash that has already been collectedand is held by the trustee is a ‘‘ residual interest’’subject to dollar-for-dollar capital, but is not acredit-enhancing interest-only strip subject tothe concentration limit. For example, assumethat a bank books a single spread-account assetthat is derived from two separate cash-flowstreams:

• A receivable from the securitization trust thatrepresents cash that has already accumulatedin the spread account. In accordance with thesecuritization documents, the cash will bereturned to the bank at some date in the futureafter having been reduced by amounts used toreimburse investors for credit losses. Based onthe date when the cash is expected to be paidout to the bank, the present value of this assetis currently estimated to be $3.

• A projection of future cash flows that areexpected to accumulate in the spread account.In accordance with the securitization docu-ments, the cash, to the extent collected, willalso be returned to the bank at some date inthe future after having been reduced byamounts used to reimburse investors for creditlosses. Based on the date when the cash isexpected to be paid out to the bank, thepresent value of this asset is currently esti-mated to be $2.

Both components of the above spread accountare considered to be residual interests under thecurrent capital standards because both representon-balance-sheet assets subject to more thantheir pro rata share of losses on the underlyingportfolio of sold assets. However, the $2 assetthat represents the bank’s retained interest infuture cash flows exposes the organization to agreater degree of risk because the $2 assetpresents additional uncertainty as to whether itwill ever be collected. This additional uncer-tainty associated with the recognition of futuresubordinated excess cash flows results in the $2asset being treated as a credit-enhancing interest-only strip, a subset of residual interests.

The face amount of all of the bank’s credit-enhancing interest-only strips is first subject to a25 percent of tier 1 capital concentration limit.



Any portion of this face amount that exceeds25 percent of tier 1 capital is deducted from tier1 capital. This limit will affect both a bank’srisk-based and leverage capital ratios. Theremaining face amount of the bank’s credit-enhancing interest-only strips, as well as theface amount of the spread-account receivablefor cash already held in the trust, is subject to thedollar-for-dollar capital requirement establishedfor residual interests, which affects only therisk-based capital ratios.

Credit-enhancing interest-only strips. A credit-enhancing interest-only (I/O) strip is anon-balance-sheet asset that, in form or substance,(1) represents the contractual right to receivesome or all of the interest due on transferredassets and (2) exposes the bank to credit risk thatexceeds its pro rata claim on the underlyingassets, whether through subordination provi-sions or other credit-enhancing techniques. Thus,credit-enhancing I/O strips include any balance-sheet asset that represents the contractual rightto receive some or all of the remaining interestcash flow generated from assets that have beentransferred into a trust (or other special-purposeentity), after taking into account trustee andother administrative expenses, interest paymentsto investors, servicing fees, reimbursements toinvestors for losses attributable to the beneficialinterests they hold, and reinvestment incomeand ancillary revenues26 on the transferred assets.Credit-enhancing I/O strips are generally carriedon the balance sheet at the present value of theexpected net cash flow that the banking organi-zation reasonably expects to receive in futureperiods on the assets it has securitized, adjustedfor some level of prepayments if relevant to thatasset class, and discounted at an appropriatemarket interest rate. Typically, when assets aretransferred in a securitization transaction that isaccounted for as a sale under GAAP, the account-ing recognition given to the credit-enhancingI/O strip on the seller’s balance sheet results inthe recording of a gain on the portion of thetransferred assets that has been sold. This gain isrecognized as income, thus increasing the bank’scapital position. The economic substance of atransaction will be used to determine whether aparticular interest cash flow functions as a credit-enhancing I/O strip, and the Federal Reservereserves the right to identify other cash flows or

spread-related assets as credit-enhancing I/Ostrips on a case-by-case basis. For example,including some principal payments with interestand fee cash flows will not otherwise negate theregulatory capital treatment of that asset as acredit-enhancing I/O strip. Credit-enhancing I/Ostrips include both purchased and retainedinterest-only strips that serve in a credit-enhancing capacity, even though purchased I/Ostrips generally do not result in the creation ofcapital on the purchaser’s balance sheet.

Loan-servicing arrangements. The definitionsof recourse and direct-credit substitute coverloan-servicing arrangements if the bank, as ser-vicer, is responsible for credit losses associatedwith the serviced loans. However, cash advancesmade by residential mortgage servicers to ensurean uninterrupted flow of payments to investorsor the timely collection of the mortgage loansare specifically excluded from the definitions ofrecourse and direct-credit substitute, providedthe residential mortgage servicer is entitled toreimbursement for any significant advances andthis reimbursement is not subordinate to otherclaims. To be excluded from recourse and direct-credit-substitute treatment, the bank, as servicer,should make an independent credit assessmentof the likelihood of repayment of the serviceradvance before advancing funds, and shouldonly make such an advance if prudent lendingstandards are met. Risk-based capital is assessedonly against the amount of the cash advance,and the advance is assigned to the risk-weightcategory appropriate to the party obligated toreimburse the servicer.

If a residential mortgage servicer is not entitledto full reimbursement, then the maximum pos-sible amount of any nonreimbursed advances onany one loan must be contractually limited to aninsignificant amount of the outstanding principalon that loan. Otherwise, the servicer’s obligationto make cash advances will not be excludedfrom the definitions of recourse and direct-creditsubstitute. Banks that act as servicers shouldestablish policies on servicer advances and usediscretion in determining what constitutes an‘‘ insignificant’’ servicer advance. The FederalReserve will exercise its supervisory authorityto apply recourse or direct-credit-substitute treat-ment to servicer cash advances that expose abank, acting as servicer, to excessive levels ofcredit risk.

Liquidity facility. A liquidity facility refers to a26. According to FAS 140, ancillary revenues include such

revenues as late charges on the transferred assets.



legally binding commitment to provide liquiditysupport to ABCP by lending to, or purchasingassets from, any structure, program, or conduitin the event that funds are required to repaymaturing ABCP.

Mortgage-servicer cash advance. A mortgage-servicer cash advance represents funds that aresidential mortgage loan servicer advances toensure an uninterrupted flow of payments,including advances made to cover foreclosurecosts or other expenses to facilitate the timelycollection of the loan.

A mortgage-servicer cash advance is not arecourse obligation or a direct-credit substituteif—

• the servicer is entitled to full reimbursementand this right is not subordinated to otherclaims on the cash flows from the underlyingasset pool; or

• for any one loan, the servicer’s obligation tomake nonreimbursable advances is contractu-ally limited to an insignificant amount of theoutstanding principal balance of that loan.

Nationally recognized statistical rating organi-zation (NRSRO). An NRSRO is an entity that isrecognized by the Division of Market Regula-tion of the Securities and Exchange Commission(or any successor division) (the commission) asa nationally recognized statistical rating organi-zation for various purposes, including the com-mission’s uniform net capital requirements forbrokers and dealers.

Recourse. Recourse means the retention by abank, in form or in substance, of any credit riskdirectly or indirectly associated with an asset ithas transferred that exceeds a pro rata share ofthe bank’s claim on the asset. If a bank has noclaim on a transferred asset, then the retention ofany risk of credit loss is recourse. A recourseobligation typically arises when a bank transfersassets and retains an explicit obligation to repur-chase the assets or absorb losses due to a defaulton the payment of principal or interest or anyother deficiency in the performance of the under-lying obligor or some other party. The definitionof recourse is consistent with the banking agen-cies’ long-standing use of this term, and incor-porates existing agency practices regarding reten-tion of risk in asset sales.

Second-lien positions do not, in most circum-stances, constitute recourse for the bank receiv-

ing the third-party enhancement. Second mort-gages or home equity loans generally will not beconsidered recourse arrangements unless theyactually function as credit enhancements.

Third-party enhancements (for example,insurance protection) purchased by the origina-tor of a securitization for the benefit of investorsalso do not generally constitute recourse. Thepurchase of enhancements for a securitization,when the bank is completely removed from anycredit risk, will not, in most instances, constituterecourse. However, if the purchase or premiumprice is paid over time and the size of thepayment is a function of the third-party’s lossexperience on the portfolio, such an arrange-ment indicates an assumption of credit risk andwould be considered recourse.

Recourse may also exist implicitly if a bankprovides credit enhancement beyond any con-tractual obligation to support assets it has sold.The following are examples of recourse arrange-ments:

• credit-enhancing representations and warran-ties made on the transferred assets

• loan-servicing assets retained pursuant to anagreement under which the bank will beresponsible for credit losses associated withthe loans being serviced (mortgage-servicercash advances that meet the conditions ofsection III.B.3.a.x. of the guidelines (12 CFR208, appendix A) are not recoursearrangements)

• retained subordinated interests that absorbmore than their pro rata share of losses fromthe underlying assets

• assets sold under an agreement to repurchase,if the assets are not already included on thebalance sheet

• loan strips sold without contractual recourse,when the maturity of the transferred loan isshorter than the maturity of the commitmentunder which the loan is drawn

• credit derivatives issued that absorb more thanthe bank’s pro rata share of losses from thetransferred assets

• clean-up calls at inception that are greater than10 percent of the balance of the original poolof transferred loans (clean-up calls that are10 percent or less of the original pool balancethat are exercisable at the option of the bankare not recourse arrangements)

• liquidity facilities that provide liquidity sup-port to ABCP (other than eligible ABCPliquidity facilities)



Residual interests. Residual interests are definedas any on-balance-sheet asset (1) that representsan interest (including a beneficial interest)created by a transfer that qualifies as a sale (inaccordance with GAAP) of financial assets,whether through a securitization or otherwise,and (2) that exposes a bank to credit risk directlyor indirectly associated with the transferredassets that exceeds a pro rata share ofthe bank’s claim on the asset, whether throughsubordination provisions or other credit-enhancement techniques. Residual interests gen-erally do not include interests purchased from athird party, except for credit-enhancing I/O strips.Examples of residual interests (assets) includecredit-enhancing I/Os; spread accounts; cash-collateral accounts; retained subordinated inter-ests; accrued but uncollected interest on trans-ferred assets that, when collected, will beavailable to serve in a credit-enhancing capac-ity; and similar on-balance-sheet assets thatfunction as a credit enhancement. The functional-based definition reflects the fact that securitiza-tion structures vary in the way they use certainassets as credit enhancements. Residual intereststherefore include any retained on-balance-sheetasset that functions as a credit enhancement in asecuritization, regardless of how a bank refers tothe asset in financial or regulatory reports.

In general, the definition of residual interestsincludes only an on-balance-sheet asset thatrepresents an interest created by a transfer offinancial assets treated as a sale under GAAP, inaccordance with FAS 140. Interests retained in asecuritization or transfer of assets accounted foras a financing under GAAP are generallyexcluded from the definition of residual interest.In the case of GAAP financings, the transferredassets remain on the transferring bank’s balancesheet and are, therefore, directly included inboth the leverage and risk-based capital calcu-lations. Further, when a transaction is treated asa financing, no gain is recognized from anaccounting standpoint.

Sellers’ interests generally do not function asa credit enhancement. Thus, if a seller’s interestshares losses on a pro rata basis with investors,such an interest would not be considered aresidual interest. However, banks should recog-nize that sellers’ interests that are structured toabsorb a disproportionate share of losses will beconsidered residual interests.

The definition of residual interest also includesovercollateralization and spread accounts becausethese accounts are susceptible to the potential

future credit losses within the loan pools thatthey support, and thus are subject to valuationinaccuracies. Spread accounts and overcollater-alizations that do not meet the definition ofcredit-enhancing I/O strips generally do notexpose a bank to the same level of risk ascredit-enhancing I/O strips, and thus are excludedfrom the concentration limit.

The capital treatment for a residual interestapplies when a bank effectively retains the riskassociated with that residual interest, even if theresidual is sold. The economic substance of thetransaction will be used to determine whetherthe bank has transferred the risk associated withthe residual-interest exposure. Banks that trans-fer the risk on residual interests, either directlythrough a sale or indirectly through guaranteesor other credit-risk-mitigation techniques, andthen reassume this risk in any form will berequired to hold risk-based capital as though theresidual interest remained on the bank’s books.For example, if a bank sells an asset that is anon-balance-sheet credit enhancement to a thirdparty and then writes a credit derivative to coverthe credit risk associated with that asset, theselling bank must continue to risk-weight, andhold capital against, that asset as a residualinterest as if the asset had not been sold.

Risk participation. Risk participation means aparticipation in which the originating partyremains liable to the beneficiary for the fullamount of an obligation (for example, a direct-credit substitute) notwithstanding that anotherparty has acquired a participation in thatobligation.

Securitization. Securitization is the pooling andrepackaging by a special-purpose entity of assetsor other credit exposures into securities that canbe sold to investors. Securitization includestransactions that create stratified credit-risk posi-tions whose performance is dependent on anunderlying pool of credit exposures, includingloans and commitments.

Sponsor. A sponsor refers to a bank that estab-lishes an ABCP program; approves the sellerspermitted to participate in the program; approvesthe asset pools to be purchased by the program;or administers the program by monitoring theassets, arranging for debt placement, compilingmonthly reports, or ensuring compliance withthe program documents and with the program’scredit and investment policy.



Structured finance program. A structured financeprogram refers to a program where receivableinterests and asset-backed securities issued bymultiple participants are purchased by a special-purpose entity that repackages those exposuresinto securities that can be sold to investors.Generally, structured finance programs allocatecredit risks between the participants and thecredit enhancement provided to the program.

Recourse Obligations, Direct-CreditSubstitutes, Residual Interests, andAsset- and Mortgage-BackedSecurities

The risk-based capital treatment for recourseobligations, direct-credit substitutes, and asset-and mortgage-backed securities in connectionwith asset securitizations and structured financ-ings is described below. The capital treatmentdescribed in this subsection applies to the bank’sown positions.27

For banks that comply with the market-riskrules, except for liquidity facilities supportingABCP (in form or in substance), positions in thetrading book that arise from asset securitiza-tions, including recourse obligations, residualinterests, and direct-credit substitutes, should betreated according to the market-risk rules. How-ever, these banks remain subject to the 25 per-cent concentration limit for credit-enhancing I/Ostrips.

Credit-Equivalent Amount

The credit-equivalent amount for a recourseobligation or a direct-credit substitute is the fullamount of the credit-enhanced assets for whichthe bank directly or indirectly retains or assumescredit risk, multiplied by a 100 percent conver-sion factor. This treatment, however, does notapply to externally rated positions, senior posi-tions not externally rated, residual interests,certain internally rated positions, and certainsmall-business loans and leases on personalproperty transferred with recourse.

Risk-Weight Factor for Off-Balance-SheetRecourse Obligations and Direct-CreditSubstitutes

To determine the bank’s risk-weight factor foroff-balance-sheet recourse obligations and direct-credit substitutes, the credit-equivalent amountis assigned to the risk category appropriate tothe obligor in the underlying transaction, afterconsidering any associated guarantees or collat-eral. For a direct-credit substitute that is anon-balance-sheet asset (for example, a pur-chased subordinated security), a bank must cal-culate risk-weighted assets using the amount ofthe direct-credit substitute and the full amountof the assets it supports, that is, all the moresenior positions in the structure. Direct-creditsubstitutes that have been syndicated or inwhich risk participations have been conveyed oracquired are considered off-balance-sheet itemsthat are converted at a 100 percent conversionfactor. (See section III.D.1. of the guidelines (12CFR 208, appendix A) for more capital-treatmentdetails.)

Ratings-Based Approach—ExternallyRated Positions

Each loss position in an asset-securitizationstructure functions as a credit enhancement forthe more senior loss positions in the structure. Amultilevel ratings-based approach is used toassess capital requirements on recourse obliga-tions, residual interests (except credit-enhancingI/O strips), direct-credit substitutes, and seniorand subordinated securities in asset securitiza-tions. The approach uses credit ratings from therating agencies to measure relative exposure tocredit risk and determine the associated risk-based capital requirement. Using these creditratings provides a way to use determinations ofcredit quality that are relied on by investors andother market participants to differentiate theregulatory capital treatment for loss positionsrepresenting different gradations of risk.

Under the ratings-based approach, the capitalrequirement for a position is computed by mul-tiplying the face amount of the position by theappropriate risk weight, determined in accor-dance with the following tables.28 Table 2 maps

27. The treatment also applies to banks that hold positionsin their trading book but that are not otherwise subject to themarket-risk rules.

28. The rating designations (for example, AAA, BBB, A-1,and P-1) used in the tables are illustrative only and do notindicate any preference for, or endorsement of, any particularrating-agency designation system.



Table 2—Risk-Weight Assignments for Externally Rated Long-Term Positions

Long-term rating categoryRating-designation

examples Risk weight

Highest or second-highest investment grade AAA, AA 20 percentThird-highest investment grade A 50 percentLowest investment grade BBB 100 percentOne category below investment grade BB 200 percent

Table 3—Risk-Weight Assignments for Externally Rated Short-Term Positions

Short-term rating categoryRating-designation


Highest investment grade A-1, P-1 20 percentSecond-highest investment grade A-2, P-2 50 percentLowest investment grade A-3, P-3 100 percent

long-term ratings to the appropriate risk weights.Table 3 maps short-term ratings for asset-backedcommercial paper to the appropriate risk weights.The Federal Reserve has the authority, however,to override the use of certain ratings or theratings on certain instruments, either on a case-by-case basis or through broader supervisorypolicy, if necessary or appropriate to address therisk that an instrument poses to a bank.

The ratings-based approach can be used forcertain designated asset-backed securities(including asset-backed commercial paper),recourse obligations, direct-credit substitutes,and residual interests (other than credit-enhancing I/O strips). Credit-enhancing I/O stripshave been excluded from the ratings-basedapproach because of their high risk profile.While the ratings-based approach is availablefor both traded and untraded positions, theapproach applies different requirements to eachtype of position.

Ratings-Based Qualification forCorporate Bonds or Other Securities

Corporate bonds or other securities not relatedin any way to a securitization or structuredfinance program do not qualify for the ratings-based approach. Only mortgage- and asset-backedsecurities, recourse obligations, direct-credit sub-stitutes, and residual interests (except credit-

enhancing I/O strips) retained, assumed, or issuedin connection with a securitization or structuredfinance program qualify for the ratings-basedapproach.

Corporate debt instruments, municipal bonds,and other securities that are not related to asecuritization or structured finance program donot meet these definitions, and thus do notqualify for the ratings-based approach.

Traded Positions

A traded position is only required to be rated byone rating agency. A traded position is definedas a position that is externally rated and isretained, assumed, or issued in connection withan asset securitization, where there is a reason-able expectation that, in the near future, therating will be relied on by unaffiliated investorsto purchase the position or will be relied on byan unaffiliated third party to enter into a trans-action involving the position, such as a pur-chase, loan, or repurchase agreement.

For a traded position that has received anexternal rating on a long-term position that isone grade below investment grade or better, orthat has received a short-term rating that isinvestment grade, the bank multiplies the faceamount of the position by the appropriate riskweight, determined in accordance with tables 2and 3. Stripped mortgage-backed securities and



other similar instruments, such as interest-onlyor principal-only strips that are not creditenhancements, must be assigned to the 100 per-cent risk category. If a traded position hasreceived more than one external rating, thelowest single rating will apply. Moreover, if arating changes, the bank must use the newrating.

Table 3, for short-term ratings, is not identicalto table 2, for long-term ratings, because therating agencies do not assign short-term ratingsusing the same methodology as they use forlong-term ratings. Each short-term rating cate-gory covers a range of longer-term rating cate-gories.29 For example, a P-1 rating could map toa long-term rating that is as high as Aaa or aslow as A3.

Externally Rated, Nontraded Positions

For a rated, but untraded, position to be eligiblefor the ratings-based approach, it must meetcertain conditions. To qualify, the position(1) must be rated by more than one ratingagency; (2) must have received an externalrating on a long-term position that is one gradebelow investment grade or better or, fora short-term position, a rating that is investmentgrade or better by all rating agencies providing arating; (3) must have ratings that are publiclyavailable; and (4) must have ratings that arebased on the same criteria used to rate tradedsecurities. If the ratings are different, the lowestsingle rating will determine the risk-weight category to which the position will beassigned. This treatment does not apply to acredit-enhancing I/O strip.

Split or Partially Rated Instruments

For instruments that have been assigned sepa-rate ratings for principal and interest (split orpartially rated instruments), the Federal Reservewill apply to the entire instrument the riskweight that corresponds to the lowest compo-nent rating. For example, a purchased subordi-nated security whose principal component israted BBB, but whose interest component israted B, is subject to the gross-up treatmentaccorded to direct-credit substitutes rated B or

lower. Similarly, if a portion of an instrument isunrated, the entire position will be treated as if itwas unrated. In addition to this regulatory capi-tal treatment, the Federal Reserve may also, asappropriate, adversely classify and require write-downs for an other-than-temporary impairmenton unrated and below-investment-grade securi-ties, including split or partially rated securities.(See SR-02-16.)

Senior Positions Not Externally Rated

A position that is not externally rated (anunrated position), but that is senior or preferredin all respects (including collateralization andmaturity) to a rated position that is traded, istreated as if it had the rating assigned to therated position. The bank must satisfy the FederalReserve that such treatment is appropriate. Seniorunrated positions qualify for the risk weightingof the subordinated rated positions in the samesecuritization transaction as long as the subor-dinated rated position (1) is traded and (2) remainsoutstanding for the entire life of the unratedposition, thus providing full credit support untilthe unrated position matures.

Recourse obligations and direct-credit substi-tutes (other than residual interests) that do notqualify for the ratings-based approach (or for theinternal-ratings, program-ratings, or computer-program-ratings approaches outlined below)receive ‘‘ gross-up’’ treatment, that is, the bankholding the position must hold capital againstthe amount of the position, plus all more seniorpositions, subject to the low-level-exposurerequirement.30 This grossed-up amount is placedinto a risk-weight category according to theobligor or, if relevant, according to the guarantoror nature of the collateral. The grossed-upamount multiplied by both the risk weight and8 percent is never greater than the full capitalcharge that would otherwise be imposed on the

29. See, for example, Moody’s Global Ratings Guide, June2001, p.3.

30. Gross-up treatment means that a position is combinedwith all more senior positions in the transaction. The result isthen risk-weighted based on the obligor or, if relevant, theguarantor or the nature of the collateral. For example, if a bankretains a first-loss position (other than a residual interest) in apool of mortgage loans that qualify for a 50 percent riskweight, the bank would include the full amount of the assetsin the pool, risk-weighted at 50 percent, in its risk-weightedassets for purposes of determining its risk-based capital ratio.The low-level-exposure rule provides that the dollar amountof risk-based capital required for assets transferred withrecourse should not exceed the maximum dollar amount forwhich a bank is contractually liable.



assets if they were on the banking organization’sbalance sheet.31

Residual Interests

Credit-Enhancing I/O Strips

After applying the concentration limit to credit-enhancing I/O strips (both purchased andretained), a bank must maintain risk-based capi-tal for a credit-enhancing I/O strip (both pur-chased and retained), regardless of the externalrating on that position, equal to the remainingamount of the credit-enhancing I/O strip (net ofany existing associated deferred tax liability),even if the amount of risk-based capital requiredto be maintained exceeds the full risk-basedcapital requirement for the assets transferred.Transactions that, in substance, result in theretention of credit risk associated with a trans-ferred credit-enhancing I/O strip will be treatedas if the credit-enhancing I/O strip was retainedby the bank and not transferred.

Other Residual Interests

Residual interests that are not eligible for theratings-based approach receive dollar-for-dollartreatment. Dollar-for-dollar treatment means,effectively, that one dollar in total risk-basedcapital must be held against every dollar of aresidual interest retained on the balance sheet(net of any existing associated deferred taxliability), even if the amount of risk-basedcapital required to be maintained exceeds thefull risk-based capital requirement for the assetstransferred. This capital treatment applies to allresidual interests, except for credit-enhancingI/O strips that have already been deducted fromtier 1 capital under the concentration limit.32

Transactions that, in substance, result in theretention of credit risk associated with a trans-ferred residual interest will be treated as if theresidual interest was retained by the bank andnot transferred.

When the aggregate capital requirement forresidual interests and other recourse obligationsin connection with the same transfer of assetsexceeds the full risk-based capital requirementfor those assets, a bank must maintain risk-basedcapital equal to the greater of the risk-basedcapital requirement for the residual interest orthe full risk-based capital requirement for theassets transferred.

Accrued Interest Receivables Held onCredit Card Securitizations

In a typical credit card securitization, an insti-tution transfers a pool of credit card receivablesto a trust, as well as the rights to receive futurepayments of principal, interest, and fee incomefrom those receivables. If a securitization trans-action qualifies as a sale under FAS 140, theselling institution removes the receivables thatwere sold from its reported assets and continuesto carry any retained interests in the transferredreceivables on its balance sheet; the right tothese future cash flows should be reported as anaccrued interest receivable (AIR) asset.33 ,34 Anyaccrued amounts (cash flows) the institutioncollects (for example, accrued fees and financecharges) generally must be transferred to thetrust and will be used first by the trustee for thebenefit of third-party investors to satisfy moresenior obligations and for the payment of trustexpenses (such as servicing fees, investor-certificate interest, and investor-principal charge-offs). Any remaining excess fee and financecharges will flow back to the seller.

Because the AIR asset constitutes a subordi-nated residual (retained) interest in the trans-31. For assets that are assigned to the 100 percent risk-

weight category, the minimum capital charge is 8 percent ofthe amount of assets transferred, and banking organizationsare required to hold 8 cents of capital for every dollar of assetstransferred with recourse. For assets that are assigned to the50 percent risk-weight category, the minimum capital chargeis 4 cents of capital for every dollar of assets transferred withrecourse.

32. Residual interests that are retained or purchased credit-enhancing I/O strips are first subject to a capital concentrationlimit of 25 percent of tier 1 capital. For risk-based capitalpurposes (but not for leverage capital purposes), once thisconcentration limit is applied, a banking organization mustthen hold dollar-for-dollar capital against the face amount ofcredit-enhancing I/O strips remaining.

33. The AIR represents fees and finance charges that havebeen accrued on receivables that the institution has securitizedand sold to other investors. For example, in credit cardsecuritizations, this accrued interest receivable asset mayinclude both finance charges billed but not yet collected andfinance charges accrued but not yet billed on the securitizedreceivables.

34. Some institutions may categorize part or all of thisreceivable as a loan, a ‘‘ due from trust’’ account, a retainedinterest in the trust, or as part of an interest-only stripreceivable.



ferred securitized assets, it meets the definitionof recourse exposure for risk-based capital pur-poses. Recourse exposures (such as the AIRasset) require risk-based capital against the full,risk-weighted amount of the assets transferredwith recourse, subject to the low-level-recourserule.35 The AIR asset serves as a creditenhancement to protect third-party investors inthe securitization from credit losses, and it meetsthe definition of a residual interest under therisk-based capital adequacy rules for the treat-ment of recourse arrangements. Under thoserules, an institution must hold dollar-for-dollarcapital against residual interests, even if thatamount exceeds the full equivalent risk-basedcapital charge on the transferred assets.36 Theinstitution is expected to hold risk-based capitalin an amount consistent with the subordinatednature of the AIR asset.

In accounting for the sale, the AIR asset istreated as a subordinated retained interest ofcredit card receivables when computing the gainor loss on sale. Consistent with GAAP, thismeans that the value of the AIR, at the date oftransfer, must be adjusted based on its relativefair (market) value. This adjustment will typi-cally result in the carrying amount of the AIRbeing lower than its book (face) value prior tosecuritization. The AIR should be reported inregulatory reports as ‘‘ Other Assets’’ and not asa loan receivable. (See SR-02-12 and SR-02-22).

Other Unrated Positions

A position (but not a residual interest) main-tained in connection with a securitization andthat is not rated by a rating agency may berisk-weighted based on the bank’ s internaldetermination of the credit rating of the position,as specified in table 4, multiplied by the faceamount of the position. The bank may use threeapproaches to determine the capital require-ments for certain unrated direct-credit substi-tutes and recourse obligations. Under each of

these approaches, the bank must satisfy theFederal Reserve that the use of the approach isappropriate for the particular bank and for theexposure being evaluated. The risk weight thatmay be applied to an exposure under thesealternative approaches is limited to a minimumof 100 percent.

Internal Risk-Rating Systems forAsset-Backed Commercial PaperPrograms

A bank that has a qualifying internal risk-ratingsystem can use that system to apply the ratings-based approach to its unrated direct-credit sub-stitutes in asset-backed commercial paper pro-grams. Internal risk ratings could be used toqualify such a credit enhancement for a riskweight of 100 percent or 200 percent under theratings-based approach, but not for a risk weightof less than 100 percent.

Most sophisticated banking organizations thatparticipate extensively in the asset-securitizationbusiness assign internal risk ratings to theircredit exposures, regardless of the form of theexposure. Usually, internal risk ratings morefinely differentiate the credit quality of a bank-ing organization’s exposures than the categoriesthe banking agencies use to evaluate credit riskduring bank examinations (pass, substandard,doubtful, or loss). An individual bank’s internalrisk ratings may be associated with a certainprobability of default, loss in the event ofdefault, and loss volatility.

The credit enhancements that sponsors obtainfor their commercial paper conduits are rarelyrated or traded. If an internal risk-ratingsapproach were not available for these unratedcredit enhancements, the provider of theenhancement would have to obtain two ratingssolely to avoid the gross-up treatment that wouldotherwise apply to nontraded positions in assetsecuritizations for risk-based capital purposes.However, before a provider of an enhancementdecides whether to provide a credit enhance-ment for a particular transaction (and at whatprice), the provider will generally perform itsown analysis of the transaction to evaluate theamount of risk associated with the enhancement.An internal risk-ratings approach, therefore, ispotentially less costly than a ratings-basedapproach that relies exclusively on ratings bythe rating agencies for the risk weighting ofthese positions.

35. The low-level-recourse rule limits the maximum risk-based capital requirement to the lesser of a banking organi-zation’s maximum contractual exposure or the full capitalcharge against the outstanding amount of assets transferredwith recourse.

36. For a complete description of the appropriate capitaltreatment for recourse, residual interests, and credit-enhancinginterest-only strips, see ‘‘ Recourse, Direct Credit Substitutes,and Residual Interests in Asset Securitizations,’’ 66 Fed. Reg.59614 (November 29, 2001).



Table 4—Risk-Weight Assignments for Unrated Positions Using theAlternative Approaches1

Rating categoryRating-designation


Highest or second-highest investment grade AAA, AA 100 percentThird-highest investment grade A 100 percentLowest investment grade BBB 100 percentOne category below investment grade BB 200 percent

1. such as the internal ratings approach

Internal risk ratings that correspond to therating categories of the rating agencies can bemapped to risk weights under the FederalReserve’s capital standards. This mapping canbe done in a way that would make it possible todifferentiate the riskiness of various unrateddirect-credit substitutes in asset-backed commer-cial paper programs based on credit risk. Theuse of internal risk ratings, however, may raiseconcerns about the accuracy and consistency ofthe ratings, especially because the mapping ofratings to risk-weight categories will give banksan incentive to rate their risk exposures in a waythat minimizes the effective capital requirement.A bank engaged in asset-backed commercialpaper securitization activities that wishes to usethe internal risk-ratings approach must thereforebe able to demonstrate to the satisfaction of theFederal Reserve, before relying on its internalratings, that the bank’s internal credit-risk ratingsystem is adequate. Adequate internal risk-rating systems usually have the followingcharacteristics:

• The internal risk ratings are an integral part ofan effective risk-management system thatexplicitly incorporates the full range of risksarising from the bank’s participation in secu-ritization activities. The system must alsofully take into account the effect of suchactivities on the bank’s risk profile and capitaladequacy.

• The ratings link to measurable outcomes, suchas the probability that a position will experi-ence any losses, the expected losses on thatposition in the event of default, and the degreeof variance in losses given default on thatposition.

• The ratings separately consider the risk asso-ciated with the underlying loans and borrow-

ers, as well as the risk associated with thespecific positions in a securitization transaction.

• The ratings identify gradations of risk among‘‘ pass’’ assets, and not just among assets thathave deteriorated to the point that they fallinto ‘‘ watch’’ grades. Although it is not nec-essary for a bank to use the same categories asthe rating agencies, its internal ratings mustcorrespond to the ratings of the rating agen-cies so that the Federal Reserve can determinewhich internal risk rating corresponds to eachrating category of the rating agencies. A bankwould be responsible for demonstrating, to thesatisfaction of the Federal Reserve, how theseratings correspond with the rating-agency stan-dards that are used as the framework for theasset-securitization portion of the risk-basedcapital rule. This correlation is necessary sothat the mapping of credit ratings to risk-weight categories in the ratings-based approachcan be applied to internal ratings.

• The ratings classify assets into each risk gradeusing clear, explicit criteria, even for subjec-tive factors.

• Independent credit-risk-management or loan-review personnel assign or review the credit-risk ratings. These personnel should haveadequate training and experience to ensurethat they are fully qualified to perform thisfunction.

• An internal audit procedure periodically veri-fies that internal risk ratings are assignedin accordance with the bank’s establishedcriteria.37

37. The audit may be performed by any group within theorganization that is qualified to audit the system and isindependent of both the group that makes the decision toextend credit to the asset-backed commercial paper programand the groups that develop and maintain the internal credit-risk rating system. (See SR-02-16.)



• The performance of internal ratings is trackedover time to evaluate how well risk grades arebeing assigned, make adjustments to the rat-ing system when the performance of the ratedpositions diverges from assigned ratings, andadjust individual ratings accordingly.

• Credit-risk rating assumptions are consistentwith, or more conservative than, the credit-risk rating assumptions and methodologies ofthe rating agencies.

If it determines that a bank’s rating system isnot adequate, the Federal Reserve may precludethe bank from applying the internal risk-ratingsapproach to new transactions for risk-basedcapital purposes until the deficiencies have beenremedied. Additionally, depending on the sever-ity of the problems identified, the FederalReserve may decline to rely on the internal riskratings that the bank had applied to previoustransactions for purposes of determining itsregulatory capital requirements.

Ratings of Specific Unrated Positions inStructured Financing Programs

A bank may also use a rating obtained from arating agency for an unrated direct-credit sub-stitute or recourse obligation (other than aresidual interest) that is assumed or retained inconnection with a structured finance program, ifa rating agency has reviewed the terms of theprogram (according to the specifications set bythe rating agency) and stated a rating for posi-tions associated with the program. If the pro-gram has options for different combinations ofassets, standards, internal credit enhancements,and other relevant factors, and if the ratingagency specifies ranges of rating categories tothem, the bank may apply the rating categorythat corresponds to the bank’s position. To relyon a program rating, the bank must demonstrateto the Federal Reserve’s satisfaction that thecredit-risk rating assigned to the program meetsthe same standards generally used by ratingagencies for rating traded positions.

The bank must also demonstrate to the Fed-eral Reserve’s satisfaction that the criteria under-lying the rating agency’s assignment of ratingsfor the structured financing program are satisfiedfor the particular position. If a bank participatesin a securitization sponsored by another party,the Federal Reserve may authorize the bank touse this approach based on a programmatic

rating obtained by the sponsor of the program.Banks with limited involvement in securitiza-

tion activities may find the above alternative tobe useful. In addition, some banks extensivelyinvolved in securitization activities already relyon ratings of the credit-risk positions under theirsecuritization programs as part of their risk-management practices. Such banks can rely onthese ratings for regulatory capital purposes ifthe ratings are part of a sound overall risk-management process and the ratings reflect therisk of nontraded positions to the banks.

This approach in a structured financing pro-gram can be used to qualify a direct-creditsubstitute or recourse obligation (but not aresidual interest) for a risk weight of 100 percentor 200 percent of the face value of the positionunder the ratings-based approach, but not for arisk weight of less than 100 percent.

Credit-Assessment Computer Programs

A bank (particularly a bank with limited involve-ment in securitization activities) may use aninternal ratings-based approach if it is using anacceptable credit-assessment computer pro-gram, developed by a rating agency, to deter-mine the rating of a direct-credit substitute or arecourse obligation (but not a residual interest)issued in connection with a structured financeprogram. To be used by a bank for risk-basedcapital purposes, a computer program must havebeen developed by a rating agency. Further, thebank must demonstrate to the satisfaction of theFederal Reserve that the computer program’scredit assessments correspond credibly and reli-ably to the rating standards of the rating agen-cies for traded positions in securitizations andwith the rating of traded positions in the finan-cial markets. The latter would generally beshown if investors and other market participantssignificantly used the computer program forrisk-assessment purposes. In addition, the bankmust demonstrate to the Federal Reserve’s sat-isfaction that the program was designed to applyto its particular direct-credit substitute or recourseexposure and that it has properly implementedthe computer program. In general, sophisticatedbanks with extensive securitization activitiesshould use this approach only if the computerprogram is an integral part of their risk-management systems and if the bank’s systemsfully capture the risks from its securitizationactivities. This computer-program approach can



be used to qualify a direct-credit substitute orrecourse obligation (but not a residual interest)for a risk weight of 100 percent or 200 percentof the face value of the position under theratings-based approach, but not for a risk weightof less than 100 percent.

Limitations on Risk-Based CapitalRequirements

Low-Level Exposure

If a bank’s maximum contractual exposure toloss retained or assumed in connection with arecourse obligation or a direct-credit substitute,except for a residual interest, is less than theeffective risk-based capital requirement for theenhanced assets, the risk-based capital require-ment is limited to the maximum contractualexposure, less any recourse liability accountestablished in accordance with GAAP. Thislimitation does not apply when a bank providescredit enhancement beyond any contractual obli-gation to support assets it has sold.

Mortgage-Related Securities orParticipation Certificates Retained in aMortgage Loan Swap

If a bank holds a mortgage-related security or aparticipation certificate as a result of a mortgageloan swap with recourse, capital is required tosupport the recourse obligation plus the percent-age of the mortgage-related security or partici-pation certificate that is not covered by therecourse obligation. The total amount of capitalrequired for the on-balance-sheet asset and therecourse obligation, however, is limited to thecapital requirement for the underlying loans,calculated as if the bank continued to hold theloans as on-balance-sheet assets.

Related On-Balance-Sheet Assets

If a recourse obligation or a direct-credit substi-tute also appears as a balance-sheet asset, thebalance-sheet asset is not included in a bank’srisk-weighted assets to the extent the value ofthe balance-sheet asset is already included in theoff-balance-sheet credit-equivalent amount forthe recourse obligation or direct-credit substi-tute. In the case of loan-servicing assets and

similar arrangements with embedded recourseobligations or direct-credit substitutes, both theon-balance-sheet assets and the related recourseobligations and direct-credit substitutes must beseparately risk-weighted and incorporated intothe risk-based capital calculation.

Asset-Backed Commercial Paper ProgramAssets and Related Minority Interests

An asset-backed commercial paper (ABCP) pro-gram typically is a program through which abank provides funding to its corporate custom-ers by sponsoring and administering abankruptcy-remote special-purpose entity thatpurchases asset pools from, or extends loans to,those customers.38 The asset pools in an ABCPprogram might include, for example, tradereceivables, consumer loans, or asset-backedsecurities. The ABCP program raises cash toprovide funding to the bank’s customers, pri-marily (that is, more than 50 percent of theABCP’s issued liabilities) through the issuanceof externally rated commercial paper into themarket. Typically, the sponsoring bank providesliquidity and credit enhancements to the ABCPprogram. These enhancements aid the programin obtaining high credit ratings that facilitate theissuance of the commercial paper.39

Under the Board’s risk-based capital rule, abank that qualifies as a primary beneficiary andmust consolidate an ABCP program that isdefined as a variable interest entity under GAAPmay not exclude the consolidated ABCP pro-gram’s assets from risk-weighted assets when itconsolidates ABCP program assets. The bankmust assess the appropriate risk-based capitalcharge against any exposures of the bank arisingin connection with such ABCP programs, includ-ing direct-credit substitutes, recourse obliga-tions, residual interests, liquidity facilities, andloans, in accordance with sections III.B.5., III.C.,and III.D. of the risk-based capital rule (12 CFR

38. The definition of ABCP program generally includesstructured investment vehicles (entities that earn a spread byissuing commercial paper and medium-term notes and usingthe proceeds to purchase highly rated debt securities) andsecurities arbitrage programs.

39. A bank is considered the sponsor of an ABCP programif it establishes the program; approves the sellers permitted toparticipate in the program; approves the asset pools to bepurchased by the program; or administers the program bymonitoring the assets, arranging for debt placement, compil-ing monthly reports, or ensuring compliance with the programdocuments and with the program’s credit and investmentpolicy.



208, appendix A). A bank sponsoring a programissuing ABCP that does not meet the rule’sdefinition of an ABCP program must include theprogram’s assets in the institution’s risk-weighted asset base.

Liquidity facilities supporting ABCP. Liquidityfacilities supporting ABCP often take the formof commitments to lend to, or purchase assetsfrom, the ABCP programs in the event thatfunds are needed to repay maturing commercialpaper. Typically, this need for liquidity is due toa timing mismatch between cash collections onthe underlying assets in the program and sched-uled repayments of the commercial paper issuedby the program.

A bank that provides liquidity facilities toABCP is exposed to credit risk regardless ofthe term of the liquidity facilities. For example,an ABCP program may require a liquidity fa-cility to purchase assets from the program atthe first sign of deterioration in the credit qual-ity of an asset pool, thereby removing suchassets from the program. In such an event, adraw on the liquidity facility exposes the bankto credit risk.

Short-term commitments with an originalmaturity of one year or less expose banks to alower degree of credit risk than longer-termcommitments. This difference in the degree ofcredit risk is reflected in the risk-based capitalrequirement for the different types of exposure.The Board’s capital guidelines impose a 10 per-cent credit-conversion factor on eligible short-term liquidity facilities supporting ABCP. A50 percent credit-conversion factor applies toeligible long-term ABCP liquidity facilities.These credit-conversion factors apply regardlessof whether the structure issuing the ABCP meetsthe rule’s definition of an ABCP program. Forexample, a capital charge would apply to aneligible short-term liquidity facility that pro-vides liquidity support to ABCP where theABCP constitutes less than 50 percent of thesecurities issued by the program, thus causingthe issuing structure not to meet the rule’sdefinition of an ABCP program. However, if abank (1) does not meet this definition and mustinclude the program’s assets in its risk-weightedasset base or (2) otherwise chooses to includethe program’s assets in risk-weighted assets,then no risk-based capital requirement will beassessed against any liquidity facilities providedby the bank that support the program’s ABCP.Ineligible liquidity facilities will be treated as

recourse obligations or direct-credit substitutesfor the purposes of the Board’s risk-based capi-tal guidelines.

The resulting credit-equivalent amount wouldthen be risk-weighted according to the under-lying assets or the obligor, after considering anycollateral or guarantees, or external credit rat-ings, if applicable. For example, if an eligibleshort-term liquidity facility providing liquiditysupport to ABCP covered an asset-backed secu-rity (ABS) externally rated AAA, then thenotional amount of the liquidity facility wouldbe converted at 10 percent to an on-balance-sheet credit-equivalent amount and assigned tothe 20 percent risk-weight category appropriatefor AAA-rated ABS.40

Overlapping exposures to an ABCP program. Abank may have multiple overlapping exposuresto a single ABCP program (for example, both aprogram-wide credit enhancement and multiplepool-specific liquidity facilities to an ABCPprogram that is not consolidated for risk-basedcapital purposes). A bank must hold risk-basedcapital only once against the assets covered bythe overlapping exposures. Where the overlap-ping exposures are subject to different risk-based capital requirements, the bank must applythe risk-based capital treatment that results inthe highest capital charge to the overlappingportion of the exposures.

For example, assume a bank provides aprogram-wide credit enhancement that wouldabsorb 10 percent of the losses in all of theunderlying asset pools in an ABCP program andpool-specific liquidity facilities that cover100 percent of each of the underlying assetpools. The bank would be required to holdcapital against 10 percent of the underlying assetpools because it is providing the program-widecredit enhancement. The bank would also berequired to hold capital against 90 percent ofthe liquidity facilities it is providing to each ofthe underlying asset pools.

If different banks have overlapping exposuresto an ABCP program, however, each organiza-tion must hold capital against the entire maxi-mum amount of its exposure. As a result, whileduplication of capital charges will not occur forindividual banks, some systemic duplicationmay occur where multiple banking organiza-

40. See section 4030.1 and also the Board staff’s October12, 2007, legal interpretation regarding the risk-based capitaltreatment of ABCP liquidity facilities.



tions have overlapping exposures to the sameABCP program.

Asset-quality test. For a liquidity facility, eithershort- or long-term, that supports ABCP notto be considered a recourse obligation or adirect-credit substitute, it must meet the rule’sdefinition of an eligible ABCP liquidity facil-ity. An eligible ABCP liquidity facility mustmeet a reasonable asset-quality test that, amongother things, precludes funding assets that are90 days or more past due or in default. Whenassets are 90 days or more past due, they typi-cally have deteriorated to the point where thereis an extremely high probability of default.Assets that are 90 days past due, for example,often must be placed on nonaccrual status in ac-cordance with the agencies’ Uniform RetailCredit Classification and Account ManagementPolicy.41 Further, they generally must also beclassified substandard under that policy.

The rule’s asset-quality test specificallyallows a bank to reflect certain guaranteesproviding credit protection to the bank provid-ing the liquidity facility. In particular, the‘‘days-past- due limitation’’ is not applied withrespect to assets that are either conditionally orunconditionally guaranteed by the U.S. govern-ment or its agencies or by another OECDcentral government. To qualify as an eligibleABCP liquidity facility, if the assets covered bythe liquidity facility are initially externally rated(at the time the facility is provided), the facil-ity can be used to fund only those assets that areexternally rated investment grade at the time offunding.

The practice of purchasing assets that areexternally rated below investment grade out ofan ABCP program is considered the equivalentof providing credit protection to the commercialpaper investors. Thus, liquidity facilities permit-ting purchases of below-investment-grade secu-rities will be considered either recourse obliga-tions or direct-credit substitutes. However, the‘‘investment-grade’’ limitation is not applied inthe asset-quality test with respect to assets thatare conditionally or unconditionally guaranteedby the U.S. government or its agencies or byanother OECD central government. If the asset-quality tests are not met (that is, if a bankactually funds through the liquidity facility assetsthat do not satisfy the facility’s asset-qualitytests), the liquidity facility will be considered a

recourse obligation or a direct-credit substituteand generally will be converted at 100 percent.

Risk-Based Capital Treatment ofCertain Off-Balance-Sheet Items andCertain Other Types of Transactions

Distinction Between Financial andPerformance Standby Letters of Credit

For risk-based capital purposes, the vast major-ity of standby letters of credit a bank issues areconsidered financial in nature. On the one hand,in issuing a financial standby letter of credit, abank guarantees that the account party willfulfill a contractual financial obligation thatinvolves payment of money. On the other hand,in issuing a performance standby letter of credit,a bank guarantees that the account party willfulfill a contractual nonfinancial obligation, thatis, an obligation that does not entail the paymentof money. For example, a standby letter of creditthat guarantees that an insurance company willpay as required under the terms of a policy isdeemed to be financial and is converted at100 percent, while a letter of credit that guaran-tees a contractor will pave a street according tocertain specifications is deemed to be perfor-mance related and is converted at 50 percent.Financial standby letters of credit have a higherconversion factor in large part because, unlikeperformance standby letters of credit, they tendto be drawn down only when the account party’sfinancial condition has deteriorated.

Participations of Off-Balance-SheetTransactions

If a standby letter of credit or commitment hasbeen participated to other institutions in theform of a syndication, as defined in the instruc-tions to the Call Report, that is, if each bank is

41. See 65 Fed. Reg. 36904 (June 12, 2000).



responsible only for its pro rata share of loss andthere is no recourse to the originating bank, eachbank includes only its pro rata share of thestandby or commitment in its risk-based capitalcalculation.

The treatment differs, however, if the partici-pation takes the form of a conveyance of a riskparticipation. In such a participation, the origi-nating bank remains liable to the beneficiary forthe full amount of the standby or commitment ifthe institution that has acquired the participationfails to pay when the instrument is drawn. Underthis arrangement, the originating bank is exposedto the credit risk of the institution that hasacquired the conveyance rather than that of theaccount party. Accordingly, for risk-based capi-tal purposes, the originating bank should con-vert the full amount of the standby or commit-ment to an on-balance-sheet credit-equivalentamount. The credit-equivalent amount of theportion of the credit that has not been conveyedis assigned to the risk category appropriate tothe obligor, after giving effect to any collateralor guarantees. The portion that has been con-veyed is assigned either to the same risk cate-gory as the obligor or to the risk categoryappropriate to the institution acquiring the par-ticipation, whichever category carries the lowerrisk weight. Any remainder is assigned to therisk category appropriate to the obligor, guaran-tor, or collateral. For example, the pro rata shareof the full amount of the assets supported, inwhole or in part, by a direct-credit substituteconveyed as a risk participation to a U.S. domes-tic depository institution or foreign bank isassigned to the 20 percent risk category. Riskparticipations with a remaining maturity of overone year that are conveyed to non-OECD banksare to be assigned to the 100 percent riskcategory, unless a lower risk category is appro-priate to the obligor, guarantor, or collateral.

Commitments

Commitments are defined as any legally bindingarrangements that obligate a bank to extendcredit in the form of loans or leases; to purchaseloans, securities, or other assets; or to participatein loans and leases. Commitments also includeoverdraft facilities, revolving credit, home equityand mortgage lines of credit, eligible ABCPliquidity facilities, and similar transactions. Nor-mally, commitments involve a written contractor agreement and a commitment fee, or some

other form of consideration. Commitments areincluded in weighted-risk assets regardless ofwhether they contain ‘‘ material adverse change’’clauses or other provisions that are intended torelieve the issuer of its funding obligation undercertain conditions. In the case of commitmentsstructured as syndications, where the bank isobligated solely for its pro rata share, only thebank’s proportional share of the syndicatedcommitment is taken into account in calculatingthe risk-based capital ratio.

Commitments to make off-balance-sheet trans-actions. As specified in the instructions to theCall Report, a commitment to make a standbyletter of credit is considered to be a standbyletter of credit. Accordingly, such a commitmentshould be converted to an on-balance-sheetcredit-equivalent amount at 100 percent if it isa commitment to make a financial standby let-ter of credit or at 50 percent if it is a commit-ment to make a performance standby letter ofcredit.

A commitment to make a commitment istreated as a single commitment whose maturityis the combined maturity of the two commit-ments. For example, a 6-month commitment tomake a 1-year commitment is considered to be asingle 18-month commitment. Since the matu-rity is over one year, such a commitment wouldreceive the 50 percent conversion factor appro-priate to long-term commitments, rather than thezero percent conversion factor that would beaccorded to separate unrelated short-term com-mitments of six months and one year.

A commitment to make a commercial letter ofcredit may be treated either as a commitment oras a commercial letter of credit, whicheverresults in the lower conversion factor. Normally,this would mean that a commitment under oneyear to make a commercial letter of credit wouldbe treated as a commitment and converted atzero percent, while a similar commitment ofover one year would be treated as a commercialletter of credit and converted at 20 percent.

If a commitment facility is structured so thatit can be drawn down in several forms, such asa standby letter of credit, a loan, or a commer-cial letter of credit, the entire facility should betreated as a commitment to extend credit in theform that incurs the highest capital charge.Thus, if a facility could be drawn down in any ofthe three forms just cited, the entire facilitywould be treated as a commitment to issue astandby letter of credit and would be converted



at 100 percent, rather than treated as a commit-ment to make a loan or commercial letter ofcredit, which would have a lower conversionfactor.

Unused commitments. Except for eligible ABCPliquidity facilities,42 unused portions of commit-ments, including underwriting commitments, andcommercial and consumer credit commitmentsthat have an original maturity of one year or lessare converted at zero percent.

Unused commitments that have an originalmaturity of over one year are converted at50 percent. For this purpose, original maturity isdefined as the length of time between the datethe commitment is issued and the earliest dateon which (1) the bank has the permanent abilityto, at its option, unconditionally cancel43 (with-out cause) the commitment44 and (2) the bank isscheduled to (and as a normal practice actuallydoes) review the facility to determine whetherthe unused commitment should be extended. (Itshould be noted that the term of any loanadvances that can be made under a commitmentis not taken into account in determining thecommitment’s maturity.) Under this definitionof original maturity, commitments with a nomi-nal original maturity of more than one year canbe treated as having a maturity of one year orless for risk-based capital purposes only if theissuing bank (1) has full and unconditionaldiscretion to cancel the commitment withoutcause and without notice on each and every dayafter the first year and (2) conducts at leastannually a formal credit review of the commit-ment, including an assessment of the creditquality of the obligor.

It should be noted that a bank is not deemedable to unconditionally cancel a commitmentif it is required to give, or is presumed to berequired to give, any advance notice of cancel-lation. Accordingly, so-called evergreen com-mitments, which require the bank to give

advance notice of cancellation to the obligor orwhich permit the commitment to roll over auto-matically (that is, on the same terms and withouta thorough credit review) unless the bank givesnotice otherwise, are not unconditionally can-celable. Thus, any such commitment whoseterm from date of issuance could exceed oneyear is subject to the 50 percent conversionfactor.

A bank may issue a commitment that expireswithin one year, with the understanding that thecommitment will be renewed upon expirationsubject to a thorough credit review of theobligor. Such a commitment may be convertedat zero percent only if (1) the renegotiationprocess is carried out in good faith, involves afull credit assessment of the obligor, and allowsthe bank flexibility to alter the terms and con-ditions of the new commitment; (2) the bank hasabsolute discretion to decline renewal or exten-sion of the commitment; and (3) the renegoti-ated commitment expires within 12 monthsfrom the time it is made. Some commitmentscontain unusual renegotiation arrangements thatwould give the borrower a considerable amountof advance notice that a commitment would notbe renewed. Provisions of this kind can have theeffect of creating a rolling commitment arrange-ment that should be treated for risk-based capitalpurposes as a long-term commitment and shouldtherefore be converted to a credit-equivalentamount at 50 percent. Normally, the renegotia-tion process should take no more than six toeight weeks, and in many cases it should take ashorter period of time. The renegotiation periodshould immediately precede the expiration dateof the commitment and should be reasonablyshort and appropriate to the complexity of thetransaction. The reasons for provisions in acommitment arrangement that would appear toallow for a protracted renegotiation period shouldbe thoroughly documented by the bank andreviewed by the examiner.

As mentioned above, a commitment to makea commitment is treated as a single commitmentwhose maturity is the combined maturity of thetwo commitments. Although such commitmentswhose combined maturity is in excess of oneyear are generally considered long-term, if thecustomer has a bona fide business reason forrequesting a new commitment to supersede theunexpired one, such as an unanticipated increasein the volume of business or a change in thecustomer’s cash flow and credit needs, then thecommitment would not automatically be consid-

42. Unused portions of eligible ABCP liquidity facilitieswith an original maturity of one year of less are converted at10 percent.

43. A bank’s option to cancel a commitment under amaterial adverse change clause is not considered to be anoption to unconditionally cancel a commitment.

44. In the case of consumer home equity or mortgage linesof credit secured by liens on one- to four-family residentialproperties, the bank is deemed able to unconditionally cancelthe commitment for the purpose of this criterion if, at itsoption, it can prohibit additional extensions of credit, reducethe credit lines, and terminate the commitment to the fullextent permitted by relevant federal law.



ered long-term. However, if the bank exhibits apattern and practice of extending short-termcommitments before their expiration—either forone customer or more broadly within the bank—then such extended commitments would beviewed as long-term. This treatment generallywould apply to all commitments, including tra-ditional commercial paper liquidity lines.

Other criteria for determining whether afacility is short- or long-term include the actuallevel of risk associated with the transaction andwhether that level of risk is more characteristicof a long-term (as opposed to a short-term)commitment. Liquidity facilities issued in con-nection with asset-backed commercial paperprograms, when judged by these criteria, seemto possess risk characteristics that are less thanthose associated with typical short-term com-mercial loan commitments. One of these char-acteristics is the short-term nature of the secu-ritized receivables. The receivables that aresecuritized in asset-backed commercial paperprograms tend to be of very short averagematurity—often in the range of 30 to 60 days.Advances under asset-backed commercial paperliquidity facilities generally are very rare, andwhen such advances are made, it is against poolsof very high-quality performing receivables thatwould generally liquidate very quickly. Thesefacilities are further protected against credit riskby significant amounts of overcollateralization,as well as other credit enhancements.

A series of short-term commitments wouldgenerally be treated as a single commitmentwhose original maturity is the combined matu-rities of the individual commitments in theseries. Also, a commitment may be structured tobe drawn down in a number of tranches, someexercisable in one year or less and others exer-cisable in over one year. The full amount of sucha commitment is deemed to be over one yearand converted at 50 percent. Some long-termcommitments may permit the customer to drawdown varying amounts at different times toaccommodate, for example, seasonal borrowingneeds. The 50 percent conversion factor shouldbe applied to the maximum amount that couldbe drawn down under such commitments.

Credit-Equivalent Computations forDerivative Contracts

Applicable derivative contracts. Credit-equivalent amounts are computed for each of the

following off-balance-sheet contracts:

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

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

rates that gives rise to similar credit risks(including when-issued securities and for-ward deposits accepted)

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

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

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

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

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

ties that gives rise to similar credit risks• credit derivatives

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

Exceptions. Exchange-rate contracts with anoriginal maturity of 14 or fewer calendar daysand derivative contracts traded on exchangesthat require daily receipt and payment of cash-variation margin may be excluded from therisk-based ratio calculation. Gold contracts areaccorded the same treatment as exchange-ratecontracts, except that gold contracts with anoriginal maturity of 14 or fewer calendar daysare included in the risk-based ratio calculation.Over-the-counter options purchased are includedand treated in the same way as other derivativecontracts.

Calculation of credit-equivalent amounts. Thecredit-equivalent amount of a derivative con-tract (excluding credit derivatives) that is notsubject to a qualifying bilateral netting contractis equal to the sum of—



Table 5—Conversion-Factor Matrix

Remaining maturityInterest-

rate

Foreign-exchange-

rateand gold Equity

Preciousmetals

(excludinggold)

Othercommodity(excludingpreciousmetals)

One year or less 0.0 1.0 6.0 7.0 10.0

Over one to five years 0.5 5.0 8.0 7.0 12.0

Over five years 1.5 7.5 10.0 8.0 15.0

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

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

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

The potential future credit exposure of acontract, including a contract with a negativemark-to-market value, is estimated by multiply-ing the notional principal amount of the contractby a credit-conversion factor. Banks should use,subject to examiner review, the effective ratherthan the apparent or stated notional amount inthis calculation. The conversion factors (in per-cent) are in table 5. The Board has noted thatthese conversion factors, which are based onobserved volatilities of the particular types ofinstruments, are subject to review and modifi-cation in light of changing volatilities or marketconditions.

For a contract that is structured such thaton specified dates any outstanding exposure issettled and the terms are reset so that the mar-ket value of the contract is zero, the remainingmaturity is equal to the time until the next resetdate. Such resetting interest-rate contracts musthave a minimum conversion factor of0.5 percent.

For a contract with multiple exchanges ofprincipal, the conversion factor is multiplied bythe number of remaining payments in the con-

tract. A derivative contract not included in thedefinitions of interest-rate, exchange-rate, equity,or commodity contracts is included in the risk-based capital calculation and is subject to thesame conversion factors as a commodity, exclud-ing precious metals.

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

Avoidance of double-counting. In certain cases,credit exposures arising from derivative con-tracts may be reflected, in part, on the balancesheet. To avoid double counting these exposuresin the assessment of capital adequacy and,perhaps, assigning inappropriate risk weights,examiners may need to exclude counterpartycredit exposures arising from the derivativeinstruments covered by the guidelines frombalance-sheet assets when calculating a bank’srisk-based capital ratios. This exclusion willeliminate the possibility that an organizationcould be required to hold capital against both anoff-balance-sheet and on-balance-sheet amountfor the same item. This treatment is not accordedto margin accounts and accrued receivablesrelated to interest-rate and exchange-ratecontracts.

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

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

• its positive market value included inthe off-balance-sheet risk-based capitalcalculation.



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

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

Netting of swaps and similar contracts. Nettingrefers to the offsetting of positive and negativemark-to-market values in the determination of acurrent exposure to be used in the calculation ofa credit-equivalent amount. Any legally enforce-able form of bilateral netting (that is, nettingwith a single counterparty) of derivative con-tracts is recognized for purposes of calculatingthe credit-equivalent amount provided that—

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

• the bank obtains written and reasoned legalopinions that in the event of a legal challenge—including one resulting from default, insol-vency, liquidation, or similar circumstances—the relevant court and administrative authoritieswould find the bank’s exposure to be such anet amount under—— the law of the jurisdiction in which the

counterparty is chartered or the equiva-

lent location in the case of noncorporateentities, and if a branch of the counter-party is involved, then also under the lawof the jurisdiction in which the branch islocated;

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

— the law that governs the netting contract;• the bank establishes and maintains procedures

to ensure that the legal characteristics ofnetting contracts are kept under review in lightof possible changes in relevant law; and

• the bank maintains documentation in its filesthat is adequate to support the netting of ratecontracts, including a copy of the bilateralnetting contract and necessary legal opinions.

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

By netting individual contracts for the pur-pose of calculating credit-equivalent amounts ofderivative contracts, a bank represents that it hasmet the requirements of the risk-based measureof the capital adequacy guidelines for bankholding companies and that all the appropriatedocuments are in the organization’s files andavailable for inspection by the Federal Reserve.The Federal Reserve may determine that abank’s files are inadequate or that a nettingcontract, or any of its underlying individualcontracts, may not be legally enforceable. Ifsuch a determination is made, the netting con-tract may be disqualified from recognition forrisk-based capital purposes, or underlying indi-vidual contracts may be treated as though theyare not subject to the netting contract.

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

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

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

The net current exposure of the netting con-tract is determined by summing all positive andnegative mark-to-market values of the indi-vidual contracts included in the netting contract.If the net sum of the mark-to-market values is



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

Gross potential future exposure (Agross) iscalculated by summing the estimates of poten-tial future exposure for each individual contractsubject to the qualifying bilateral netting con-tract. The effects of the bilateral netting contracton the gross potential future exposure are rec-ognized through the application of a formulathat results in an adjusted add-on amount (Anet).The formula, which employs the ratio of netcurrent exposure to gross current exposure(NGR), is expressed as—

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

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

Under the aggregate approach, the NGR is theratio of the sum of all the net current exposuresfor qualifying bilateral netting contracts to thesum of all the gross current exposures for thosenetting contracts (each gross current exposure iscalculated in the same manner as in thecounterparty-by-counterparty approach). Netnegative mark-to-market values for individualcounterparties may not be used to offsetnet positive current exposures for othercounterparties.

A bank must consistently use either thecounterparty-by-counterparty approach or theaggregate approach to calculate the NGR.Regardless of the approach used, the NGRshould be applied individually to each qualify-

ing bilateral netting contract to determine theadjusted add-on for that netting contract.

In the event a netting contract covers con-tracts that are normally excluded from the risk-based ratio calculation—for example, exchange-rate contracts with an original maturity of 14 orfewer calendar days or instruments traded onexchanges that require daily payment and receiptof cash-variation margin—an institution mayelect to either include or exclude all mark-to-market values of such contracts when determin-ing net current exposure, provided the methodchosen is applied consistently.

Examiners should review the netting of off-balance-sheet derivative contracts used by bankswhen calculating or verifying risk-based capitalratios to ensure that the positions of such con-tracts are reported gross, unless the net positionsof those contracts reflect netting arrangementsthat comply with the netting requirements listedpreviously.

Credit Derivatives

Credit derivatives are off-balance-sheet arrange-ments that allow one party (the beneficiary) totransfer credit risk of a reference asset—whichthe beneficiary may or may not own—to anotherparty (the guarantor).45 Many banks increas-ingly use these instruments to manage theiroverall credit-risk exposure. In general, creditderivatives have three distinguishing features:

• the transfer of the credit risk associated with areference asset through contingent paymentsbased on events of default and, usually, theprices of instruments before, at, and shortlyafter default (reference assets most often takethe form of traded sovereign and corporatedebt instruments or syndicated bank loans)

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

• the use of an International Swap DerivativesAssociation (ISDA) master agreement and thelegal format of a derivatives contract

45. Credit derivatives generally fall into three basic trans-action types: total-rate-of-return swaps, credit-default swaps,and credit-default or credit-linked notes. For a more in-depthdescription of these types of credit derivatives, see the FederalReserve’s Trading and Capital-Markets Activities Manual,section 4350.1, ‘‘ Credit Derivatives,’’ as well as SR-96-17.



For risk-based capital purposes, total-rate-of-return swaps and credit-default swaps generallyshould be treated as off-balance-sheet direct-credit substitutes.46 The notional amount of acontract should be converted at 100 percent todetermine the credit-equivalent amount to beincluded in the risk-weighted assets of a guar-antor.47 A bank that provides a guarantee througha credit derivative transaction should assign itscredit exposure to the risk category appropriateto the obligor of the reference asset or anycollateral. On the other hand, a bank that ownsthe underlying asset upon which effective creditprotection has been acquired through a creditderivative may, under certain circumstances,assign the unamortized portion of the underlyingasset to the risk category appropriate to theguarantor (for example, the 20 percent riskcategory if the guarantor is an OECD bank).

Whether the credit derivative is considered aneligible guarantee for purposes of risk-basedcapital depends on the actual degree of creditprotection. The amount of credit protectionactually provided by a credit derivative may belimited depending on the terms of the arrange-ment. In this regard, for example, a relativelyrestrictive definition of a default event or amateriality threshold that requires a comparablyhigh percentage of loss to occur before theguarantor is obliged to pay could effectivelylimit the amount of credit risk actually trans-ferred in the transaction. If the terms of thecredit derivative arrangement significantly limitthe degree of risk transference, then the benefi-ciary bank cannot reduce the risk weight of the‘‘ protected’’ asset to that of the guarantor bank.On the other hand, even if the transfer of creditrisk is limited, a bank providing limited creditprotection through a credit derivative shouldhold appropriate capital against the underlyingexposure while it is exposed to the credit risk ofthe reference asset.

A bank providing a guarantee through a creditderivative may mitigate the credit risk associ-ated with the transaction by entering into anoffsetting credit derivative with anothercounterparty—a so-called back-to-back posi-tion. A bank that has entered into such a positionmay treat the first credit derivative as beingguaranteed by the offsetting transaction for risk-based capital purposes. Accordingly, the notionalamount of the first credit derivative may beassigned to the risk category appropriate to thecounterparty providing credit protection throughthe offsetting credit derivative arrangement (forexample, the 20 percent risk category if thecounterparty is an OECD bank).

In some instances, the reference asset in thecredit derivative transaction may not be identi-cal to the underlying asset for which the bene-ficiary has acquired credit protection. For exam-ple, a credit derivative used to offset the creditexposure of a loan to a corporate customer mayuse as the reference asset a publicly tradedcorporate bond of that customer, with the creditquality of the bond serving as a proxy for theon-balance-sheet loan. In such a case, the under-lying asset would still generally be consideredguaranteed for capital purposes, as long as boththe underlying asset and the reference asset areobligations of the same legal entity and have thesame level of seniority in bankruptcy. In addi-tion, a bank offsetting credit exposure in thismanner would be obligated to demonstrate toexaminers that (1) there is a high degree ofcorrelation between the two instruments; (2) thereference instrument is a reasonable and suffi-ciently liquid proxy for the underlying asset sothat the instruments can be reasonably expectedto behave in a similar manner in the event ofdefault; and (3) at a minimum, the referenceasset and underlying asset are subject to mutualcross-default provisions. A bank that uses acredit derivative that is based on a referenceasset that differs from the protected underlyingasset must document the credit derivative beingused to offset credit risk, and must link itdirectly to the asset or assets whose credit riskthe transaction is designed to offset. The docu-mentation and the effectiveness of the creditderivative transaction are subject to examinerreview. A bank providing credit protectionthrough such an arrangement must hold capitalagainst the risk exposures that are assumed.

Some credit derivative transactions providecredit protection for a group or basket of refer-ence assets and call for the guarantor to absorb

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

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



losses on only the first asset in the group thatdefaults. Once the first asset in the group defaults,the credit protection for the remaining assetscovered by the credit derivative ceases. Ifexaminers determine that the credit risk for thebasket of assets has effectively been transferredto the guarantor and the beneficiary bankingorganization owns all of the reference assetsincluded in the basket, then the beneficiary mayassign the asset with the smallest dollar amountin the group—if less than or equal to thenotional amount of the credit derivative—to therisk category appropriate to the guarantor. Con-versely, a bank extending credit protectionthrough a credit derivative on a basket of assetsmust assign the contract’s notional amount ofcredit exposure to the highest risk categoryappropriate to the assets in the basket.

In addition to holding capital against creditrisk, a bank that is subject to the market-risk rule(see ‘‘ Market-Risk Measure’’ earlier in thissection) must hold capital against market riskfor credit derivatives held in its trading account.(For a description of market-risk capital require-ments for credit derivatives, see SR-97-18.)

Using Credit Derivativesto Synthetically Replicate CollateralizedLoan Obligations

Credit derivatives can be used to syntheticallyreplicate collateralized loan obligations (CLOs).Banking organizations (BOs) can use CLOs andtheir synthetic variants to manage their balancesheets and, in some instances, transfer credit riskto the capital markets. Such transactions alloweconomic capital to be more efficiently allo-cated, resulting in, among other things, improvedshareholders’ returns.

The issue for BOs is how synthetic CLOsshould be treated under the risk-based andleverage capital guidelines.48 Supervisors andexaminers need to fully understand these com-plex structures and identify the relative degreeof transference and retention of the securitizedportfolio’s credit risk. They must determinewhether the institution’s regulatory capital isadequate given the retained credit exposures.

A CLO is an asset-backed security that isusually supported by a variety of assets, includ-ing whole commercial loans, revolving-credit

facilities, letters of credit, banker’s acceptances,or other asset-backed securities. In a typicalCLO transaction, the sponsoring banking orga-nization (SBO) transfers the loans and otherassets to a bankruptcy-remote special-purposevehicle (SPV), which then issues asset-backedsecurities consisting of one or more classes ofdebt. This type of transaction represents aso-called cash-flow CLO. It enables the spon-soring institution (SI) to reduce its leverage andrisk-based capital requirements, improve itsliquidity, and manage credit concentrations.

The first synthetic CLO (issued in 1997) usedcredit-linked notes (CLNs).49 Rather than trans-ferring assets to the SPV, the sponsoring bankissued CLNs to the SPV, individually referenc-ing the payment obligation of a particular com-pany, or ‘‘ reference obligor.’’ The notionalamount of the CLNs issued equaled the dollaramount of the reference assets the sponsor washedging on its balance sheet. Other structureshave evolved that use credit-default swaps totransfer credit risk and create different levels ofrisk exposure, but that hedge only a portion ofthe notional amount of the overall referenceportfolio.50

Traditional CLO structures usually transferassets into the SPV. In synthetic securitizations,the underlying exposures that make up thereference portfolio remain in the institution’sbanking book.51 The credit risk is transferredinto the SPV through credit-default swaps orCLNs. The institution is thus able to maintainclient confidentiality and avoid sensitiveclient-relationship issues that arise from loan-transfer-notification requirements, loan-assignment provisions, and loan-participationrestrictions.

Corporate credits are assigned to the 100 per-cent risk-weighted asset category. In the case ofhigh-quality investment-grade corporate expo-sures, the associated 8 percent capital require-ment may exceed the economic capital that thesponsoring bank sets aside to cover the credit

48. See SR-99-32 and its November 15, 1999, attachment,an FRB-OCC capital interpretation on synthetic CLOs.

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

50. A credit-default swap is similar to a financial standbyletter of credit in that the institution writing the swap provides,for a fee, credit protection against credit losses associated witha default on a specified reference asset or pool of assets.

51. ‘‘ Banking book’’ refers to nontrading accounts. See thedefinition of ‘‘ trading accounts’’ in the glossary for theinstructions to the bank Call Report.



risk of the transaction. Therefore, one of theapparent motivations behind CLOs and othersecuritizations is to more closely align the SI’sregulatory capital requirements with the eco-nomic capital required by the market.

Synthetic CLOs can raise questions abouttheir capital treatment when calculating therisk-based and leverage capital ratios. Capitaltreatments for three synthetic CLO transactionsfollow. They are discussed from the perspectiveof the investors and the SBOs.

Transaction 1—Entire notional amount of thereference portfolio is hedged. In the first type ofsynthetic securitization, the SBO, through asynthetic CLO, hedges the entire notional amountof a reference-asset portfolio. An SPV acquiresthe credit risk on a reference portfolio by pur-chasing CLNs issued by the SBO. The SPVfunds the purchase of the CLNs by issuing aseries of notes in several tranches to third-partyinvestors. The investor notes are in effect col-lateralized by the CLNs. Each CLN representsone obligor and the bank’s credit-risk exposureto that obligor, which could take the form ofbonds, commitments, loans, and counterpartyexposures. Since the noteholders are exposed tothe full amount of credit risk associated with theindividual reference obligors, all of the creditrisk of the reference portfolio is shifted from thesponsoring bank to the capital markets. Thedollar amount of notes issued to investors equalsthe notional amount of the reference portfolio.

In the example shown in figure 1, this amount is$1.5 billion.

If any obligor linked to a CLN in the SPVdefaults, the SI will call the individual CLN andredeem it based on the repayment terms speci-fied in the note agreement. The term of eachCLN is set so that the credit exposure (to whichit is linked) matures before the maturity of theCLN, which ensures that the CLN will be inplace for the full term of the exposure to whichit is linked.

An investor in the notes issued by the SPV isexposed to the risk of default of the underlyingreference assets, as well as to the risk that the SIwill not repay principal at the maturity of thenotes. Because of the linkage between the creditquality of the SI and the issued notes, a down-grade of the sponsor’s credit rating most likelywill result in the notes also being downgraded.Thus, a BO investing in this type of syntheticCLO should assign the notes to the higher of therisk categories appropriate to the underlyingreference assets or the issuing entity.

For purposes of risk-based capital, the SBOsmay treat the cash proceeds from the sale ofCLNs that provide protection against underlyingreference assets as cash collateralizing theseassets.52 This treatment would permit the refer-

52. The CLNs should not contain terms that would signifi-cantly limit the credit protection provided against the under-lying reference assets, for example, a materiality thresholdthat requires a relatively high percentage of loss to occur

Figure 1—Transaction 1

Bank SPV

$1.5 billion Holds portfoliocredit portfolio of CLNs

$1.5 billion cashproceeds

$1.5 billionof CLNsissued by

bank

$1.5 billioncash proceeds

$1.5 billionof notes

X-year Y-yearnotes notes



ence assets, if carried on the SI’s books, to beassigned to the zero percent risk category to theextent that their notional amount is fully collat-eralized by cash. This treatment may be appliedeven if the cash collateral is transferred directlyinto the general operating funds of the institu-tion and is not deposited in a segregated account.The synthetic CLO would not confer any bene-fits to the SBO for purposes of calculating itstier 1 leverage ratio because the reference assetsremain on the organization’s balance sheet.

Transaction 2—High-quality, senior risk posi-tion in the reference portfolio is retained. In thesecond type of synthetic CLO transaction, theSBO hedges a portion of the reference portfolioand retains a high-quality, senior risk positionthat absorbs only those credit losses in excess ofthe junior-loss positions. In some recent syn-thetic CLOs, the SBO has used a combination ofcredit-default swaps and CLNs to essentiallytransfer to the capital markets the credit risk ofa designated portfolio of the organization’s creditexposures. Such a transaction allows the SI toallocate economic capital more efficiently and tosignificantly reduce its regulatory capitalrequirements.

In the structure illustrated in figure 2, theSBO purchases default protection from an SPVfor a specifically identified portfolio of banking-book credit exposures, which may include let-ters of credit and loan commitments. The creditrisk on the identified reference portfolio (whichcontinues to remain in the sponsor’s bankingbook) is transferred to the SPV through the useof credit-default swaps. In exchangefor the credit protection, the SI pays the SPVan annual fee. The default swaps on each of theobligors in the reference portfolio are struc-tured to pay the average default losses on allsenior unsecured obligations of defaultedborrowers.

To support its guarantee, the SPV sells CLNsto investors and uses the cash proceeds topurchase U.S. government Treasury notes. TheSPV then pledges the Treasuries to the SBO tocover any default losses.53 The CLNs are oftenissued in multiple tranches of differing seniorityand in an aggregate amount that is significantlyless than the notional amount of the referenceportfolio. The amount of notes issued typicallyis set at a level sufficient to cover some multipleof expected losses, but well below the notionalamount of the reference portfolio being hedged.

before CLN payments are adversely affected, or a structuringof CLN post-default payments that does not adequately passthrough credit-related losses on the reference assets to inves-tors in the CLNs.

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


Bank

$5 billioncredit portfolio

Default payment andpledge of Treasuries

$5 billion of credit-default swapsand annual fee

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



There may be several levels of loss in thistype of synthetic securitization. The first-lossposition may consist of a small cash reserve,sufficient to cover expected losses. The cashreserve accumulates over a period of years andis funded from the excess of the SPV’s income(that is, the yield on the Treasury securities plusthe credit-default-swap fee) over the interestpaid to investors on the notes. The investors inthe SPV assume a second-loss position throughtheir investment in the SPV’s senior and juniornotes, which tend to be rated AAA and BB,respectively. Finally, the SBO retains a high-quality, senior risk position that would absorbany credit losses in the reference portfolio thatexceed the first- and second-loss positions.

Typically, no default payments are made untilthe maturity of the overall transaction, regard-less of when a reference obligor defaults. Whileoperationally important to the SBO, this featurehas the effect of ignoring the time value ofmoney. Thus, the Federal Reserve expects thatwhen the reference obligor defaults under theterms of the credit derivative and when thereference asset falls significantly in value, theSBO should, in accordance with GAAP, makeappropriate adjustments in its regulatory reportsto reflect the estimated loss that takes intoaccount the time value of money.

For risk-based capital purposes, BOs invest-ing in the notes must assign them to the riskweight appropriate to the underlying referenceassets.54 The SBO for such transactions mustinclude in its risk-weighted assets its retainedsenior exposure in the reference portfolio, to theextent these underlying assets are held in itsbanking book. The portion of the referenceportfolio that is collateralized by the pledgedTreasury securities may be assigned a zeropercent risk weight. Unless the SBO meets thestringent minimum conditions for transaction 2that are outlined in the minimum conditionsexplanation below, the remainder of the port-folio should be risk-weighted according to theobligor of the exposures.

When the SI has virtually eliminated itscredit-risk exposure to the reference portfoliothrough the issuance of CLNs, and when theother stringent minimum conditions are met, theinstitution may assign the uncollateralized por-

tion of its retained senior position in the refer-ence portfolio to the 20 percent risk weight.However, to the extent that the reference port-folio includes loans and other on-balance-sheetassets, an SBO involved in such a syntheticsecuritization would not realize any benefits inthe determination of its leverage ratio.

In addition to the three stringent minimumconditions, the Federal Reserve may imposeother requirements as it deems necessary toensure that the SI has virtually eliminated all ofits credit exposure. Furthermore, the FederalReserve retains the discretion to increase therisk-based capital requirement assessed againstthe retained senior exposure in these structures,if the underlying asset pool deterioratessignificantly.

Federal Reserve staff will make a case-by-case determination, based on a qualitative review,as to whether the senior retained portion of anSBO’s synthetic securitization qualifies for the20 percent risk weight. The SI must be able todemonstrate that virtually all the credit risk ofthe reference portfolio has been transferred fromthe banking book to the capital markets. As theydo when BOs are engaging in more traditionalsecuritization activities, examiners must care-fully evaluate whether the institution is fullycapable of assessing the credit risk it retains inits banking book and whether it is adequatelycapitalized given its residual risk exposure. TheFederal Reserve will require the SBO to main-tain higher levels of capital if it is not deemed tobe adequately capitalized given the retainedresidual risks. In addition, an SI involved insynthetic securitizations must adequately dis-close to the marketplace the effect of the trans-action on its risk profile and capital adequacy.

The Federal Reserve may consider an SBO’sfailure to require the investors in the CLNs toabsorb the credit losses that they contractuallyagreed to assume to be an unsafe and unsoundbanking practice. In addition, such a failuregenerally would constitute ‘‘ implicit recourse’’or support to the transaction, which would resultin the SBO’s losing preferential capital treat-ment on its retained senior position.

If an SBO of a synthetic securitization doesnot meet the stringent minimum conditions, itmay still reduce the risk-based capital require-ment on the senior risk position retained in thebanking book by transferring the remainingcredit risk to a third-party OECD bank throughthe use of a credit derivative. Provided the creditderivative transaction qualifies as a guarantee

54. Under this type of transaction, if a structure exposesinvesting BOs to the creditworthiness of a substantive issuer,for example, the SI, then the investing institutions shouldassign the notes to the higher of the risk categories appropriateto the underlying reference assets or the SI.



under the risk-based capital guidelines, the riskweight on the senior position may be reducedfrom 100 percent to 20 percent. Institutions maynot enter into nonsubstantive transactions thattransfer banking-book items into the tradingaccount to obtain lower regulatory capitalrequirements.55

Minimum conditions. The following stringentminimum conditions are those that SIs mustmeet to use the synthetic securitization capitaltreatment for transaction 2. The Federal Reservemay impose additional requirements or condi-tions as deemed necessary to ascertain that theSBO has sufficiently isolated itself from thecredit-risk exposure of the hedged referenceportfolio.

• Condition 1—Demonstration of transfer ofvirtually all of the risk to third parties. Not alltransactions structured as synthetic securitiza-tions transfer the level of credit risk needed toreceive the 20 percent risk weight on theretained senior position. To demonstrate that atransfer of virtually all of the risk has beenachieved, institutions must—— produce credible analyses indicating a

transfer of virtually all of the credit risk tosubstantive third parties;

— ensure the absence of any early-amortization or other credit performance–contingent clauses;56

— subject the transaction to market disciplinethrough the issuance of a substantiveamount of notes or securities to the capitalmarkets;

— have notes or securities rated by a nation-ally recognized credit rating agency;

— structure a senior class of notes thatreceives the highest possible investment-grade rating, for example, AAA, from anationally recognized credit rating agency;

— ensure that any first-loss position retainedby the SI in the form of fees, reserves, or

other credit enhancements—which effec-tively must be deducted from capital—isno greater than a reasonable estimate ofexpected losses on the reference portfolio;and

— ensure that the SI does not reassume anycredit risk beyond the first-loss positionthrough another credit derivative or anyother means.

• Condition 2—Demonstration of ability toevaluate remaining banking-book risk expo-sures and provide adequate capital support.To ensure that the SI has adequate capital forthe credit risk of its unhedged exposures, aninstitution is expected to have adequate sys-tems that fully account for the effect of thosetransactions on its risk profiles and capitaladequacy. In particular, its systems should becapable of fully differentiating the nature andquality of the risk exposures an institutiontransfers from the nature and quality of therisk exposures it retains. Specifically, to gaincapital relief institutions are expected to—— have a credible internal process for grad-

ing credit-risk exposures, including(1) adequate differentiation of risk amongrisk grades, (2) adequate controls toensure the objectivity and consistency ofthe rating process, and (3) analysis orevidence supporting the accuracy orappropriateness of the risk-grading system;

— have a credible internal economic capital-assessment process that defines the insti-tution to be adequately capitalized at anappropriate insolvency probability and thatreadjusts, as necessary, its internal eco-nomic capital requirements to take intoaccount the effect of the synthetic-securitization transaction. In addition, theprocess should employ a sufficiently longtime horizon to allow necessary adjust-ments in the event of significant losses.The results of an exercise demonstratingthat the organization is adequately capital-ized after the securitization transactionmust be presented for examiner review;

— evaluate the effect of the transaction on thenature and distribution of the nontrans-ferred banking-book exposures. This analy-sis should include a comparison of thebanking book’s risk profile and economiccapital requirements before and after thetransaction, including the mix of expo-sures by risk grade and business or eco-nomic sector. The analysis should also

55. For instance, a lower risk weight would not be appliedto a nonsubstantive transaction in which the SI (1) enters intoa credit derivative transaction to pass the credit risk of thesenior retained portion held in its banking book to an OECDbank and then (2) enters into a second credit derivativetransaction with the same OECD bank, in which it reassumesinto its trading account the credit risk initially transferred.

56. Early-amortization clauses may generally be defined asfeatures that are designed to force a wind-down of a securi-tization program and rapid repayment of principal to asset-backed securities investors if the credit quality of the under-lying asset pool deteriorates significantly.



identify any concentrations of credit riskand maturity mismatches. Additionally,the bank must adequately manage andcontrol the forward credit exposure thatarises from any maturity mismatch. TheFederal Reserve retains the flexibility torequire additional regulatory capital if thematurity mismatches are substantiveenough to raise a supervisory concern.Moreover, as stated above, the SBO mustdemonstrate that it meets its internal eco-nomic capital requirement subsequent tothe completion of the synthetic securitiza-tion; and

— perform rigorous and robust forward-looking stress testing on nontransferredexposures (remaining banking-book loansand commitments), transferred exposures,and exposures retained to facilitate trans-fers (credit enhancements). The stress testsmust demonstrate that the level of creditenhancement is sufficient to protect thesponsoring bank from losses underscenarios appropriate to the specifictransaction.

• Condition 3—Provide adequate public disclo-sures of synthetic CLO transactions regardingtheir risk profile and capital adequacy. In their

10-K and annual reports, SIs must adequatelydisclose to the marketplace the accounting,economic, and regulatory consequences ofsynthetic CLO transactions. In particular,institutions are expected to disclose—— the notional amount of loans and commit-

ments involved in the transaction;— the amount of economic capital shed

through the transaction;— the amount of reduction in risk-weighted

assets and regulatory capital resulting fromthe transaction, both in dollar terms and interms of the effect in basis points on therisk-based capital ratios; and

— the effect of the transaction on the distri-bution and concentration of risk in theretained portfolio by risk grade and sector.

Transaction 3—Retention of a first-loss position.In the third type of synthetic transaction, theSBO may retain a subordinated position thatabsorbs first losses in a reference portfolio. TheSBO retains the credit risk associated with afirst-loss position and, through the use of credit-default swaps, passes the second- and senior-loss positions to a third-party entity, most oftenan OECD bank. The third-party entity, acting asan intermediary, enters into offsetting credit-


IntermediaryOECD Bank

Credit-default-swap fee

Default paymentand pledge of

Treasuries equalto $400 million tocover losses above

1% of thereference assets

SponsoringBank

$5 billion creditportfolio

Credit-default-swapfee (basis points per year)

Default payment andpledge of Treasuries

SPV

Holds $400 millionof pledged Treasuries

$400 millionof CLNs

$400 millionof cash

Seniornotes

Juniornotes



default swaps with an SPV, thus transferring itscredit risk associated with the second-loss posi-tion to the SPV.57 The SPV then issues CLNs tothe capital markets for a portion of the referenceportfolio and purchases Treasury collateral tocover some multiple of expected losses on theunderlying exposures. (See figure 3.)

Two alternative approaches could be used todetermine how the SBO should treat the overalltransaction for risk-based capital purposes. Thefirst approach employs an analogy to the low-level capital rule for assets sold with recourse.Under this rule, a transfer of assets with recoursethat contractually is limited to an amount lessthan the effective risk-based capital require-ments for the transferred assets is assessed atotal capital charge equal to the maximumamount of loss possible under the recourseobligation. If this rule was applied to an SBOretaining a 1 percent first-loss position on asynthetically securitized portfolio that wouldotherwise be assessed 8 percent capital, the SBOwould be required to hold dollar-for-dollar capi-tal against the 1 percent first-loss risk position.The SI would not be assessed a capital chargeagainst the second and senior risk positions.58

The second approach employs a literal read-ing of the capital guidelines to determine theSBO’s risk-based capital charge. In this instance,the one percent first-loss position retained by theSI would be treated as a guarantee, that is, adirect-credit substitute, which would be assessedan 8 percent capital charge against its face valueof one percent. The second-loss position, whichis collateralized by Treasury securities, wouldbe viewed as fully collateralized and subject to azero percent capital charge. The senior-lossposition guaranteed by the intermediary bankwould be assigned to the 20 percent risk cate-gory appropriate to claims guaranteed by OECDbanks.59

It is possible that the second approach mayresult in a higher risk-based capital requirementthan the dollar-for-dollar capital charge imposedby the first approach. This depends on whetherthe reference portfolio consists primarily ofloans to private obligors or of undrawn long-term commitments, which generally have aneffective risk-based capital requirement that isone-half of the requirement for loans, since suchcommitments are converted to an on-balance-sheet credit-equivalent amount using the 50 per-cent conversion factor. If the reference poolconsists primarily of drawn loans to privateobligors, then the capital requirement on thesenior loss position would be significantly higherthan if the reference portfolio contained onlyundrawn long-term commitments. As a result,the capital charge for the overall transactioncould be greater than the dollar-for-dollar capi-tal requirement set forth in the first approach.

SIs will be required to hold capital against aretained first-loss position in a synthetic securi-tization equal to the higher of the two capitalcharges resulting from application of the firstand second approaches, as discussed above.Further, although the SBO retains only the creditrisk associated with the first-loss position, it stillshould continue to monitor all the underlyingcredit exposures of the reference portfolio todetect any changes in the credit-risk profile ofthe counterparties. This is important to ensurethat the institution has adequate capital to pro-tect against unexpected losses. Examiners shoulddetermine whether the sponsoring bank has thecapability to assess and manage the retained riskin its credit portfolio after the synthetic securi-tization is completed. For risk-based capitalpurposes, BOs investing in the notes must assignthem to the risk weight appropriate to theunderlying reference assets.60

Reservation of Authority

The Federal Reserve reserves its authority todetermine, on a case-by-case basis, the appro-priate risk weight for assets and credit-equivalent

57. Because the credit risk of the senior position is nottransferred to the capital markets but remains with theintermediary bank, the SBO should ensure that its counter-party is of high credit quality, for example, at least investmentgrade.

58. A BO that sponsors this type of synthetic securitizationwould not realize any benefits with respect to the determina-tion of its leverage ratio since the reference assets remain onthe SI’s balance sheet.

59. If the intermediary is a BO, then it could place both setsof credit-default swaps in its trading account and, if subject tothe Federal Reserve’s market-risk capital rules, use its general-market-risk model and, if approved, specific-risk model tocalculate the appropriate risk-based capital requirement. If thespecific-risk model has not been approved, then the SBO

would be subject to the standardized specific-risk capitalcharge.

60. Under this type of transaction, if a structure exposesinvesting BOs to the creditworthiness of a substantive issuer,for example, the SI, then the investing institutions shouldassign the notes to the higher of the risk categories appropriateto the underlying reference assets or the SI.



amounts and the appropriate credit-conversionfactor for off-balance-sheet items. The FederalReserve’s exercise of this authority may resultin a higher or lower risk weight for an assetor credit-equivalent amount, or in a higher orlower credit-conversion factor for an off-balance-sheet item. This reservation of authorityexplicitly recognizes that the Federal Reserveretains sufficient discretion to ensure that banks,as they develop novel financial assets, willbe treated appropriately under the regulatorycapital standards. Under this authority, the Fed-eral Reserve reserves its right to assign riskpositions in securitizations to appropriate riskcategories on a case-by-case basis, if the creditrating of the risk position is determined to beinappropriate.

Board Approved Exceptions to Risk-BasedCapital Guidelines (Reservation ofAuthority) Involving Securities Lending

Securities lent by a bank are treated in one oftwo ways, depending upon whether the lenderis at risk of loss. If a bank, as agent for a cus-tomer, lends the customer’s securities and doesnot indemnify the customer against loss, thenthe transaction is excluded from the risk-basedcapital calculation. Alternatively, if a banklends its own securities or, acting as agent for acustomer, lends the customer’s securities andindemnifies the customer against loss, thetransaction is converted at 100 percent andassigned to the risk-weight category appropri-ate to the obligor, or, if applicable, to any col-lateral delivered to the lending bank or theindependent custodian acting on the lendingbank’s behalf. When a bank is acting as agentfor a customer in a transaction involving thelending or sale of securities that is collateral-ized by cash delivered to the bank, the transac-tion is deemed to be collateralized by cash ondeposit for purposes of determining the appro-priate risk-weight category, provided that(1) any indemnification is limited to no morethan the difference between the market value ofthe securities and the cash collateral receivedand (2) any reinvestment risk associated withthat cash collateral is borne by the customer.See the ‘‘Risk-Weighting Process’’ discussionin this section and also the discussion in sec-tion 2030.1 on bank dealer securities-lending or-borrowing transactions.

Certain agency securities-lending arrangements(May 2003 exception for ‘‘cash-collateral trans-actions’’). In response to a bank’s inquiry, theBoard issued a May 14, 2003, interpretation forthe risk-based capital treatment of certain Euro-pean agency securities’ lending arrangements inwhich the bank, acting as agent, lends securitiesof a client and receives cash collateral from theborrower. The transaction is marked-to-marketdaily and a positive margin of cash collateralrelative to the market value of the securities lentis maintained at all times. If the borrowingcounterparty defaults on the securities loanedthrough, for example, failure to post marginwhen required, the transaction is immediatelyterminated and the cash collateral is used by thebank to repurchase in the market the securitieslent in order to restore them to the client. Thebank indemnifies its client against the risk that,in the event of counterparty default, the amountof cash collateral may be insufficient to repur-chase the amount of securities lent. Thus, theindemnification is limited to the differencebetween the value of the cash collateral and therepurchase price of the replacement securities.In addition, the bank, again acting as agent,reinvests, on the client’s behalf, the cash collat-eral received from the borrower. The reinvest-ment transaction takes the form of a cash loan toa counterparty that is fully collateralized bygovernment or corporate securities (through, forexample, a reverse repurchase agreement). Likethe first transaction, the reinvestment transactionis subject to daily marking-to-market and remar-gining and is immediately terminable in theevent of counterparty default. The bank issuesan indemnification to the client against thereinvestment risk, which is similar to the indem-nification the bank gives on the originalsecurities-lending transaction.

The Federal Reserve Board’s current risk-based capital guidelines treat indemnificationsissued in connection with agency securities-lending activities as off-balance-sheet guaran-tees that are subject to capital charges. Under theguidelines, the bank’s first indemnification wouldreceive the risk weight of the securities-borrowing counterparty because of the bank’sindemnification of the client’s reinvestment riskon the cash collateral. (See 12 CFR 208, appen-dix A, section III.D.1.c.) The bank’s secondindemnification would receive the lower of therisk weight of the reverse repurchase counter-party or the collateral, unless it was fully collat-eralized with margin by OECD government



securities, which would qualify for a zero per-cent risk weight. (See 12 CFR 208, appendix A,sections III.D.1.a. and b.)

The bank inquired about the possibility ofassigning a zero percent risk weight for bothindemnifications, given the low risk they pose tothe bank. The Board approved an exception toits risk-based capital guidelines for the bank’sagency securities-lending transactions. The Boardapproved this exception under the reservation ofauthority provision contained in the guidelines.This provision permits the Board, on a case-by-case basis, to determine the appropriate riskweight for any asset or off-balance-sheet itemthat imposes risks on a bank that are incommen-surate with the risk weight otherwise specifiedin the guidelines. (See 12 CFR 208, appendix A,section III.A.)

This exception applies to the bank’s agencysecurities-lending transactions collateralized bycash where the bank indemnifies its clientagainst (1) the risk that, in the event of defaultby the securities borrower, the amount of cashcollateral may be insufficient to repurchase theamount of securities lent and (2) the reinvest-ment risk associated with lending the cashcollateral in a transaction fully collateralized bysecurities (for example, in a reverse repur-chase transaction).

The capital treatment the Board approved forthese transactions relies upon an economic mea-surement of the amount of risk exposure thebank has to each of its counterparties. Under thisapproved approach, the bank does not use thenotional amount of underlying transactions thatare subject to client indemnifications as theexposure amount for risk-based capital pur-poses. Rather, the bank must use an economicexposure amount that takes into account themarket value of collateral and the market pricevolatilities of (1) the instruments delivered bythe bank to the counterparty and (2) the instru-ments received by the bank from the counter-party. This approach builds on best practices ofbanks for measuring their credit exposureamounts for purposes of managing internalsingle-borrower exposure limits, as well as uponexisting concepts incorporated in the BaselAccord and the Board’s risk-based capital andmarket risk rules. The bank, under this excep-tion, is required to determine an unsecured loanequivalent amount for each of the counterpartiesto which, as agent, the bank lends securitiescollateralized by cash or lends cash collateral-ized by securities. As described below, the

unsecured loan equivalent amount will beassigned the risk weight appropriate to thecounterparty.

To determine the unsecured loan equivalentamount, the bank must add together its currentexposure to the counterparty and a measure forpotential future exposure (PFE) to the counter-party. The current exposure is the sum of themarket value of all securities and cash lent to thecounterparty under the bank’ s indemnifiedarrangements, less the sum of all securities andcash received from the counterparty as collateralunder the indemnified arrangements. The PFEcalculation is to be based on the market volatili-ties of the securities lent and the securitiesreceived, as well as any foreign exchange ratevolatilities associated with any cash or securitieslent or received.

The Board considered two methods for incor-porating market volatilities into the PFE calcu-lation: (1) the bank’s own estimates of thosevolatilities based on a year’s historical observa-tion of market prices with no recognition ofcorrelation effects or (2) a value-at-risk (VaR)type model. The bank was calculating daily,counterparty VAR estimates for its agency lend-ing transactions and it had a VaR model that hadbeen approved for purposes of the Board’smarket risk rule. The Board determined that thebankt could use a VaR model to calculate thePFE for each of its counterparties.

The bank must calculate the VaR using afive-day holding period and a 99th percentileone-tailed confidence interval based on marketprice data over a one-year historical observa-tion period. The data set used should be updatedno less frequently than once every three monthsand should be reassessed whenever marketprices are subject to material changes. For eachcounterparty, the bank is required to calculatedaily an unsecured loan equivalent amount,including the VaR PFE component. Thesecalculations will be subject to supervisoryreview to ensure they are in line with thequarter-end calculations used to determineregulatory capital requirements.

To qualify for the capital treatment outlinedabove, the securities-lending and cash loan trans-actions covered by the bank’s indemnificationmust meet the following conditions:

• the transactions are fully collateralized• any securities lent or taken as collateral are

eligible for inclusion in the trading book andare liquid and readily marketable



• any securities lent or taken as collateral aremarked-to-market daily

• the transactions are subject to a daily marginmaintenance requirement

Further, the transactions must be executedunder a bilateral netting agreement or an equiva-lent arrangement. These arrangements must(1) provide the non-defaulting party the right topromptly terminate and close out all transactionsunder the agreement upon an event of default,including insolvency or bankruptcy of the coun-terparty; (2) provide for the netting of gains andlosses on transactions (including the value ofany collateral) terminated and closed out underthe agreement so that a single net amount isowed by one party to the other; (3) allow for theprompt liquidation or setoff of collateral uponthe occurrence of an event of default; (4) beconducted, together with the rights arising fromthe conditions required in provisions 1 and 3above, under documentation that is legally bind-ing on all parties and legally enforceable in eachrelevant jurisdiction upon the occurrence of anevent of default and regardless of the counter-party’s insolvency or bankruptcy; and (5) beconducted under documentation for which thebank has completed sufficient legal review toverify it meets provision 4 above and for whichthe bank has a well-founded legal basis forreaching this conclusion.

With regard to the counterparty VaR modelthat the bank uses, the bank is required toconduct regular and rigorous backtesting proce-dures, subject to supervisory review, to ensurethe validity of the correlation factors used by thebank and the stability of these factors over time.The bank was not subject to a formal backtest-ing procedure requirement at the time the letterwas issued. However, if supervisory reviewdetermines that the bank’s counterparty VaRmodel or its backtesting procedures have mate-rial deficiencies and the bank does not takeappropriate and expeditious steps to rectify thosedeficiencies, supervisors may take action toadjust the bank’s capital calculations. Such actioncould range from imposing a multiplier on theVaR estimates of PFE calculated by the bank todisallowing the use of its counterparty VaRmodel and requiring use of the own estimatesapproach to determine the PFE component ofthe unsecured loan equivalent amounts.

The capital treatment that the Board ap-proved in the letter has been and will be madeavailable to similarly situated institutions that

request and receive Board approval for suchtreatment.

Certain agency securities-lending arrangements(August 2006 exception for ‘‘securities-collateraltransactions’’). In response to an inquiry madeby a bank, a Board interpretation was issued onAugust 15, 2006, which discussed the regulatorycapital treatment of certain securities-lendingtransactions. In these transactions, the bank,acting as agent for its clients, lends its clients’securities and receives liquid securities collat-eral in return (the securities-collateral transac-tions).61 Each securities loan is marked-to-market daily, and the bank calls for additionalmargin as needed to maintain a positive marginof collateral relative to the market value of thesecurities lent at all times. The bank also agreesto indemnify its clients against the risk that, inthe event of borrower default, the market valueof the securities collateral is insufficient torepurchase the amount of securities lent.

If the borrower were to default, the bankwould be in a position to terminate a securities-collateral transaction and sell the collateral inorder to purchase securities to replace the secu-rities that were originally lent. The bank’s expo-sure under a securities-collateral transactionwould be limited to the difference between thepurchase price of the replacement securities andthe market value of the securities collateral.

The bank requested that the Federal ReserveBoard approve another exception to the capitalguidelines that would permit the bank to mea-sure its exposure amounts for risk-based capitalpurposes with respect to the securities-collateraltransactions under the methodology of the bank’sprior May 14, 2003, approval (the prior approval).The Board, again, determined that, under itscurrent risk-based capital guidelines, the capitalcharges for these securities-lending arrange-ments would exceed the amount of economicrisk posed to the bank, which would result incapital charges that would be significantly out ofproportion to the risk posed. The Board there-fore approved an August 15, 2006, exception toits risk-based capital guidelines according to theprior approval, allowing the bank to compute itsregulatory capital for these transactions using aloan-equivalent methodology. In so doing, thebank would assign the risk weight of the coun-terparty to the exposure amount of all such

61. The liquid securities collateral includes governmentagency, government-sponsored entity, corporate debt or equity,or asset-backed or mortgage-backed securities.



transactions with the counterparty. Specifically,the Board granted the bank its request to use anunsecured loan equivalent amount (calculated ascurrent exposure plus a VaR-modeled PFE) forthe securities-collateral transactions for risk-based capital purposes. The Board approved theexception under the reservation authority provi-sion contained in its capital guidelines.

Overall Assessment of CapitalAdequacy

The following factors should be taken intoaccount in assessing the overall capital ade-quacy of a bank.

Capital Ratios

Capital ratios should be compared with regula-tory minimums and with peer-group averages.Banks are expected to have a minimum totalrisk-based capital ratio of 8 percent. However,because risk-based capital does not take explicitaccount of the quality of individual asset port-folios or the range of other types of risks towhich banks may be exposed, such as interest-rate, liquidity, market, or operational risks, banksare generally expected to operate with capitalpositions above the minimum ratios. Institutionswith high or inordinate levels of risk are alsoexpected to maintain capital well above theminimum levels.

The minimum tier 1 leverage ratio is 3 per-cent. However, an institution operating at ornear these levels is expected to have well-diversified risk, including no undue interest-raterisk exposure, excellent asset quality, highliquidity, and good earnings, and to generally beconsidered a strong banking organization, ratedcomposite 1 under the CAMELS rating systemof banks. For all but the most highly rated banksmeeting the above conditions, the minimumtier 1 leverage ratio is 3 percent plus an addi-tional cushion of at least 100 to 200 basis points.

Impact of Management

Strategic planning. One of management’s mostimportant functions is to lead the organizationby designing, implementing, and supporting aneffective strategic plan. Strategic planning is along-term approach to integrating asset deploy-

ment, funding sources, capital formation, man-agement, marketing, operations, and informa-tion systems to achieve success. Strategicplanning helps the organization more effectivelyanticipate and adapt to change. Managementmust also ensure that planning information aswell as corporate goals and objectives are effec-tively communicated throughout the organiza-tion. Effective strategic planning allows theinstitution to be more proactive than reactive inshaping its own future. The strategic plan shouldclearly outline the bank’s capital base, antici-pated capital expenditures, desirable capital level,and external capital sources. Each of these areasshould be evaluated in consideration of thedegree and type of risk that management and theboard of directors are willing to accept.

Growth. Capital is necessary to support a bank’sgrowth; however, it is the imposition of requiredcapital ratios that controls growth. Because abank has to maintain a minimum ratio of capitalto assets, it will only be able to grow so fast. Forexample, a rapid growth in a bank’s loan port-folio may be a cause of concern, for it couldindicate that a bank is altering its risk profile byreducing its underwriting standards.

Dividends. Examiners should review historicaland planned cash-dividend payout ratios to deter-mine whether dividend payments are impairingcapital adequacy.62 Excessive dividend payoutsmay result from several sources:

• If the bank is owned by a holding company,the holding company may be requiring exces-sive dividend payments from the bank to fundthe holding company’s debt-repayment pro-gram, expansion goals, or other cash needs.

• The bank’s board of directors may be underpressure from individual shareholders to pro-vide funds to repay bank stock debt or to usefor other purposes.

• Dividends may be paid or promised to supporta proposed equity offering.

Access to additional capital. Banks that do notgenerate sufficient capital internally may requireexternal sources of capital. Large, independentinstitutions may solicit additional funding fromthe capital markets. Smaller institutions mayrely on a bank holding company or a principalshareholder or control group to provide addi-

62. See also ‘‘ Dividends,’’ section 4070.1.



tional funds, or on the issuance of new capitalinstruments to existing or new investors. Cur-rent shareholders may resist efforts to obtainadditional capital by issuing new capital instru-ments because of the diluting effect of the newcapital. In deciding whether to approve obtain-ing additional capital in this manner, sharehold-ers must weigh the dilution against the possibil-ity that, without the additional funds, theinstitution may fail.

Under Federal Reserve policy, a bank holdingcompany is expected to serve as a source ofstrength to its subsidiary banks. A bank holdingcompany can fulfill this obligation by havingenough liquidity to inject funds into the bank orby having access to the same sources of addi-tional capital, that is, current or existing share-holders, as outlined above.

Financial Considerations

Capital levels and ratios should be evaluated inview of the bank’s overall financial condition,including the following areas.

Asset quality. The final supervisory judgment ona bank’s capital adequacy may differ signifi-cantly from conclusions that may be drawnsolely from the level of a bank’s risk-basedcapital ratio. Generally, the main reason for thisdifference is the evaluation of asset quality.Final supervisory judgment of a bank’s capitaladequacy should take into account examinationfindings, particularly those on the severity ofproblem and classified assets and investment orloan portfolio concentrations, as well as on theadequacy of the bank’s allowance for loan andlease losses.

Balance-sheet composition. A bank whose earn-ing assets are not diversified or whose creditculture is more risk-tolerant is generally expectedto operate with higher capital levels than asimilar-sized institution with well-diversified,less-risky investments.

Earnings. An adequately capitalized, growingbank should have a consistent pattern of capitalaugmentation by earnings retention. Poor earn-ings can have a negative effect on capitaladequacy in two ways. First, any losses absorbedby capital reduce the ability of the remainingcapital to fulfill that function. Second, the impactof losses on capital is magnified by the fact that

a bank generating losses is incapable of replen-ishing its capital accounts internally.

Funds management. A bank with undue levelsof interest-rate risk should be required tostrengthen its capital positions, even though itmay meet the minimum risk-based capital stan-dards. Assessments of capital adequacy shouldreflect banks’ appropriate use of hedging instru-ments. Other things being equal, banks that haveappropriately hedged their interest-rate exposurewill be permitted to operate with lower levels ofcapital than those banks that are vulnerable tointerest-rate changes. While the Federal Reservedoes not want to discourage the use of legitimatehedging vehicles, some instruments, in particu-lar interest-only strips (IOs) and principal-onlystrips (POs), raise concerns. IOs and POs havehighly volatile price characteristics as interestrates change, and they are generally not consid-ered appropriate investments for most banks.However, some sophisticated banks may havethe expertise and systems to appropriately useIOs and POs as hedging vehicles.

Off-balance-sheet items and activities. Oncefunded, off-balance-sheet items become subjectto the same capital requirements as on-balance-sheet items. A bank’s capital levels should besufficient to support the quality and quantity ofassets that would result from a significant por-tion of these items being funded within a shorttime.

Adequacy of and Compliance withCapital-Improvement Plans

Capital-improvement plans are required forbanks operating with capital ratios below regu-latory minimums as required by the prompt-corrective-action part of the Federal DepositInsurance Act, as well as for some banks oper-ating under supervisory actions. Examinersshould review any such plans and determinetheir adequacy and reasonableness, keeping inmind that banks may meet required capital-to-asset ratios in three ways:

• They may issue more capital. In doing so,banks must weigh the need for additionalcapital against the dilution of market valuethat will result.

• They may retain earnings rather than payingthem out as dividends.



• They may sell assets. By reducing the amountof total assets, a bank reduces the amount ofcapital necessary to meet the required ratios.

Inadequate Allowance for Loan andLease Losses

An inadequate allowance for loan and leaselosses (ALLL) will require an additional chargeto current income. Any charge to current incomewill reduce the amount of earnings available tosupplement tier 1 capital. Because the amount ofthe ALLL that can be included in tier 2 capital islimited to 1.25 percent of gross risk-weightedassets, an additional provision may increase theALLL level above this limit, thereby resulting inthe excess portion being excluded from tier 2capital.

Ineligible Collateral and Guarantees

The risk-based capital guidelines recognize onlylimited types of collateral and guarantees. Othertypes of collateral and guarantees may supportthe asset mix of the bank, particularly within itsloan portfolio. Such collateral or guaranteesmay serve to substantially improve the overallquality of a loan portfolio and other creditexposures, and should be considered in theoverall assessment of capital adequacy.

Market Value of Bank Stock

Examiners should review trends in the marketprice of the bank’s stock and whether stock istrading at a reasonable multiple of earnings or areasonable percentage (or multiple) of bookvalue. A bank’s low stock price may merely bean indication that it is undervalued, or it may beindicative of regional or industry-wide prob-lems. However, a low-valued stock may alsoindicate that investors lack confidence in theinstitution; such lack of support could impair thebank’s ability to raise additional capital in thecapital markets.

Subordinated Debt in Excess of Limits

The total of term subordinated debt andintermediate-term preferred stock that may be

included in tier 2 capital is limited to 50 percentof tier 1 capital. Amounts issued or outstandingin excess of this limit are not included in therisk-based capital calculation but should betaken into consideration when assessing thebank’s funding and financial condition.

Unrealized Asset Values

Banks often have assets on their books that arecarried at significant discounts below currentmarket values. The excess of the market valueover the book value (historical cost or acquisi-tion value) of assets such as investment securi-ties or banking premises may represent capitalto the bank. These unrealized asset values arenot included in the risk-based capital calculationbut should be taken into consideration whenassessing capital adequacy. Particular attentionshould be given to the nature of the asset, thereasonableness of its valuation, its marketability,and the likelihood of its sale.

Accounting for Defined Benefit Pensionand Other Postretirement Plans

In September 2006, the Financial AccountingStandards Board adopted the Statement of Finan-cial Accounting Standard No. 158, ‘‘EmployersAccounting for Defined Benefit Pension andOther Postretirement Plans’’ (FAS 158). Thestandard requires, as early as December 31,2006, that a bank, bank holding company, orother banking or thrift organization that spon-sors a single-employer defined benefit postre-tirement plan—such as a pension plan or healthcare plan—to recognize the overfunded or under-funded status of each such plan as an asset orliability on its balance sheet with correspondingadjustments recognized in accumulated othercomprehensive income (AOCI), a component ofequity capital. After a banking organizationinitially applies FAS 158, changes in the benefitplan asset or liability reported on the organiza-tion’s balance sheet will be recognized in theyear in which the changes occur and will resultin an increase or decrease in AOCI. Postretire-ment plan amounts carried in AOCI are adjustedas they are subsequently recognized in earningsas components of the plans’ net periodic benefitcost.

The Federal Reserve Board, along with otherfederal bank and thrift regulatory agencies (the



Agencies63), issued a joint press release onDecember 14, 2006, in which they announcedthat FAS 158 will not affect a banking organi-zations’ regulatory capital. The agencies decided,until they can determine otherwise through arulemaking, that banks should exclude fromregulatory capital any amounts recorded in AOCIresulting from the adoption and application ofFAS 158. The purpose of this exclusion is toneutralize the effect of the application of FAS158 on regulatory capital, including the report-ing of the risk-based and leverage capitalmeasures.

TIER 1 LEVERAGE RATIO FORSTATE MEMBER BANKS

The Federal Reserve has adopted a minimumratio of tier 1 capital to average total assets toassist in the assessment of the capital adequacyof state member banks. The principal objectiveof this measure (which is intended to be used asa supplement to the risk-based capital measure)is to place a constraint on the maximum degreeto which a state member bank can leverage itsequity capital base.

The guidelines implementing the tier 1 lever-age ratio are found in Regulation H (12 CFR208), appendix B, and apply to all state memberbanks on a consolidated basis. The ratio is to beused in the examination and supervisory pro-cess, as well as in the analysis of applicationsacted on by the Federal Reserve.

A bank’s tier 1 leverage ratio is calculated bydividing its tier 1 capital (the numerator of theratio) by its average total consolidated assets(the denominator of the ratio). For purposes ofcalculating this ratio during an examination,examiners may use the bank’s average totalassets as of the last Call Report date. The ratiowill be calculated using period-end assets when-ever necessary, on a case-by-case basis. For thepurpose of this leverage ratio, the definition oftier 1 capital as set forth in the risk-based capitalguidelines in appendix A of the Federal Reserve’sRegulation H is used. Average total consolidatedassets are defined as the quarterly average totalassets (defined net of the allowance for loan andlease losses) reported on the bank’s Reports ofCondition and Income (Call Reports), less good-

will; amounts of mortgage-servicing assets,nonmortgage-servicing assets, and purchasedcredit-card relationships that, in the aggregate,are in excess of 100 percent of tier 1 capital;amounts of nonmortgage-servicing assets andpurchased credit-card relationships that, in theaggregate, are in excess of 25 percent of tier 1capital; amounts of credit-enhancing interest-only strips that are in excess of 25 percent of tier1 capital; all other identifiable intangible assets;any investments in subsidiaries or associatedcompanies that the Federal Reserve determinesshould be deducted from tier 1 capital; deferredtax assets that are dependent on future taxableincome, net of their valuation allowance, inexcess of the limitations set forth in section II.B.of appendix A of Regulation H; and the amountof the total adjusted carrying value of nonfinan-cial equity investments that is subject to adeduction from tier 1 capital.

Under the tier 1 leverage ratio guidelines, theminimum level of tier 1 capital to total assets forstrong state member banks is 4 percent, unlessthey are rated composite 1 under the UFIRS(CAMELS) rating system of banks. Institutionsnot meeting these characteristics, as well asinstitutions with supervisory, financial, or opera-tional weaknesses, are expected to operate wellabove minimum capital standards. Institutionsexperiencing or anticipating significant growthare also expected to maintain capital ratios,including tangible capital positions, well abovethe minimum levels. Moreover, higher capitalratios may be required for any banking institu-tion if warranted by its particular circumstancesor risk profile. In all cases, institutions shouldhold capital commensurate with the level andnature of the risks, including the volume andseverity of problem loans, to which they areexposed.

A bank that does not have a 4 percentleverage ratio (3 percent if it is rated a compos-ite CAMELS 1) is considered undercapitalizedunder the prompt-corrective-action frameworkand must file a capital-restoration plan thatmeets certain requirements.

De Novo Banks

Initial capital in a de novo state member bankshould be reasonable in relation to the bank’slocation, business plan, competitive environ-ment, and state law. At a minimum, however, a

63. The Office of the Comptroller of the Currency, theFederal Deposit Insurance Corporation, and the Office ofThrift Supervision.



de novo bank must maintain a tangible tier 1leverage ratio (core capital elements minus allintangible assets divided by average total assetsminus all intangible assets) of 9 percent for thefirst three years of operations. The applicantmust provide projections of asset growth andearnings performance that reasonably supportthe bank’s ability to maintain this ratio without

reliance on additional capital injections. Eventhough a 9 percent tangible leverage ratio is notrequired after the third year, de novo banks areexpected to maintain capital ratios that arecommensurate with ongoing safety-and-soundness concerns and that are generally wellin excess of regulatory minimums. (See SR-91-17.)



Assessment of Capital AdequacyExamination ObjectivesEffective date May 2000 Section 3020.2

1. To determine the adequacy of capital.2. To determine compliance with the risk-

based and tier 1 leverage capital adequacyguidelines.

3. To determine if the policies, practices, andprocedures with regard to the capital ade-quacy guidelines are adequate.

4. To determine if the bank’s officers andemployees are operating in conformity withthe Board’s established capital adequacyguidelines.

5. To evaluate the propriety and consistency ofthe bank’s present and planned level ofcapitalization in light of the risk-based and

leverage capital guidelines, as well as exist-ing conditions and future plans.

6. To initiate corrective action when policies,procedures, or capital are deficient.

7. To evaluate whether—a. the institution is fully capable of assessing

the credit risk associated with the collat-eralized loan obligations (CLOs) it retainsin its banking book (nontrading accounts);and

b. the institution is adequately capitalizedgiven its residual risk exposure involvingCLOs.


Assessment of Capital AdequacyExamination ProceduresEffective date November 2004 Section 3020.3

VERIFICATION OF THERISK-BASED CAPITAL RATIO

Examiners should verify that the bank hasadequate systems in place to compute and docu-ment its risk-based capital ratios. Small bankswith capital ratios well in excess of establishedminimums may not have a system explicitlydesigned to capture risk-based capital informa-tion. In addition, depending on a bank’s currentcapital structure and ratios, all procedures maynot apply.

1. Verify that the bank is correctly reportingthe risk-based capital information requestedon the Reports of Condition and Income.

For the qualifying components of capital (theratio’s numerator):

2. Determine if management is adhering to theunderlying terms of any currently outstand-ing stock issues.

3. Review common stock to ensure that thebank is in compliance with the terms of anyunderlying agreements and to determine ifmore than one class exists. When more thanone class exists, review the terms for anypreference or nonvoting features. If theterms include such features, determinewhether the class of common stock qualifiesfor inclusion in tier 1 capital.

4. Review any perpetual and long-term pre-ferred stock for the following:a. Compliance with terms of the underlying

agreements carefully noting—• adherence to the cumulative or non-

cumulative nature of the stock and• adherence to any conversion rights.

b. Proper categorization as tier 1 or tier 2for capital adequacy purposes, noting thefollowing requirements:• Tier 1 perpetual preferred stock must

have the following characteristics:— no maturity date— cannot be redeemed at the option

of the holder— unsecured— ability to absorb losses— ability and legal right for issuer to

defer or eliminate dividends

— any issuer-redemption feature mustbe subject to prior Federal Reserveapproval

— noncumulative— fixed rate or traditional floating or

adjustable rate— must not contain features that would

require or create an incentive forthe issuer to redeem or repurchasethe instrument, such as an ‘‘explod-ing rate,’’ an auction-rate pricingmechanism, or a feature that allowsthe stock to be converted intoincreasing numbers of commonshares

• Perpetual preferred stock, includablewithin tier 2 capital without a sublimit,must have the characteristics listedabove for tier 1 perpetual preferredstock, but perpetual preferred stockdoes not otherwise qualify for inclu-sion in tier 1 capital. For example,cumulative or auction-rate perpetualpreferred stock, which does not qualifyfor tier 1 capital, may be includable intier 2 capital.

5. Verify that minority interest in equityaccounts of consolidated subsidiariesincluded in tier 1 capital consists only ofqualifying tier 1 capital elements. Deter-mine whether any perpetual preferred stockof a subsidiary that is included in minorityinterest is secured by the subsidiary’s assets;if so, that stock may not be included incapital.

6. Review the intermediate-term preferredstock and subordinated debt instrumentsincluded in capital for the following:a. Compliance with terms of the underlying

agreements, noting that subordinated debtcontaining the following terms may notbe included in capital:• interest payments tied to the bank’s

financial condition• acceleration clauses or broad condi-

tions of events of default that areinconsistent with safe and sound bank-ing practices

b. Compliance with restrictions on theinclusion of such instruments in capitalby verifying that the aggregate amount


of both types of instruments does notexceed 50 percent of tier 1 capital (net ofgoodwill) and that the portions includ-able in tier 2 capital possess the follow-ing characteristics:• unsecured• minimum five-year original weighted

average maturity• in the case of subordinated debt, con-

tains terms stating that the debt (1) isnot a deposit, (2) is not insured bya federal agency, (3) cannot beredeemed without prior approval fromthe Federal Reserve, and (4) is sub-ordinated to depositors and generalcreditors

c. Appropriate amortization, if the instru-ments have a remaining maturity of lessthan five years.

7. Determine, through review of minutes ofboard of directors meetings, if a stockoffering or subordinated debt issue is beingconsidered. If so, determine that manage-ment is aware of the risk-based capitalrequirements for inclusion in capital.

8. Review any mandatory convertible debtsecurities for the following:a. Compliance of the terms with the criteria

set forth in 12 CFR 225 (Regulation Y),appendix B.

b. Notification in the terms of agreementthat the redemption or repurchase ofsuch securities before maturity is subjectto prior approval from the FederalReserve.

c. The treatment of the portions of suchsecurities covered by the issuance ofcommon or perpetual preferred stockdedicated to the repayment of the secu-rities, bearing in mind the following:• The amount of the security covered by

dedicated stock should be treated assubordinated debt and is subject,together with other subordinated debtand intermediate-term preferred stock,to a sublimit within tier 2 capital of50 percent of tier 1 capital, as well asto amortization in the last five years oflife.

• The portion of a mandatory convert-ible security that is not covered bydedication qualifies for inclusion intier 2 capital without any sublimit andwithout being subject to amortizationin the last five years of life.

9. Verify that the amount of the allowance forloan and lease losses included in tier 2capital has been properly calculated anddisclosed, and verify that the supportingcomputations of that amount have beenadequately documented.

For the calculation of risk-weighted assets(the ratio’s denominator):

10. Determine whether the bank consolidates,in accordance with the Financial Account-ing Standards Board’s FIN 46-R, the assetsof any asset-backed commercial paper(ABCP) program that it sponsors.a. Determine whether the bank’s ABCP

program meets the definition of a spon-sored ABCP program under the FederalReserve’s risk-based capital guidelines.If the bank does consolidate the assets ofan ABCP program, review the documen-tation of its risk-based capital ratio cal-culations, and determine whether theassociated ABCP program’s assets andminority interests were excluded fromthe bank’s risk-weighted asset base (andalso if they were excluded from tier 1capital—the ratio’s numerator). See sec-tion III.B.6. of the risk-based capitalguidelines (12 CFR 208, appendix A).

b. Determine whether any of the bank’sliquidity facilities meet the definition andrequirements of an eligible ABCP liquid-ity facility under the Federal Reserve’srisk-based capital guidelines. See sectionIII.B.3.a.iv. of the risk-based capitalguidelines (12 CFR 208, appendix A).

c. Determine from the bank’s supportingdocumentation of its risk-based capitalratios whether the bank held risk-basedcapital against its eligible ABCP liquid-ity facilities.

d. Determine whether the bank applied thecorrect conversion factors to the eligibleABCP liquidity facilities when it deter-mined the amount of risk-weighted assetsfor its risk-based capital ratios. See sec-tion III.D. of the risk-based capital guide-lines (12 CFR 208, appendix A).• For those eligible ABCP liquidity

facilities having an original maturity ofone year or less, determine if a 10 per-cent credit-conversion factor was used.

• For those eligible ABCP liquidityfacilities having an original maturity

3020.3 Assessment of Capital Adequacy: Examination Procedures


exceeding one year, determine if a50 percent credit-conversion factorshould have been used.

e. Determine if ineligible ABCP liquidityfacilities were treated as direct-creditsubstitutes or as recourse obligations, asrequired by the risk-based capital guide-lines.

11. Verify that each on- and off-balance-sheetitem has been assigned to the appropriaterisk category in accordance with the risk-based capital guidelines. Close attentionshould be paid to the underlying obligor,collateral, and guarantees, and to assign-ment to a risk category based on the termsof a claim. The claim should be assigned tothe risk category appropriate to the highestrisk option available under the terms of thetransaction. Verify that the bank’s documen-tation supports the assignment of preferen-tial risk weights. If necessary, recalculatethe value of risk-weighted assets.

12. Verify that all off-balance-sheet items havebeen converted properly to credit-equivalentamounts based on the risk-based capitalguidelines. Close attention should be paid tothe proper reporting of assets sold withrecourse, financial and performance standbyletters of credit, participations of off-balance-sheet transactions, and commitments.

VERIFICATION OF THE TIER 1LEVERAGE RATIO

1. Verify that the bank has correctly calculatedtier 1 capital in accordance with the defini-tion of tier 1 capital, as set forth in therisk-based capital guidelines.

2. Verify that the bank has properly calculatedaverage total consolidated assets, which aredefined as the quarterly average total assetsas reported on the Call Report, less good-will and any other intangible assets and anyinvestments in subsidiaries that the FederalReserve determines should be deducted fromtier 1 capital.

OVERALL ASSESSMENT OFCAPITAL ADEQUACY

1. For banks that do not meet the minimumrisk-based tier 1 leverage capital standards

or that are otherwise considered to lacksufficient capital to support their activities,examine the bank’s capital plans for achiev-ing adequate levels of capital. In conjunc-tion with management of the appropriateReserve Bank, determine whether the plansare acceptable to the Federal Reserve.Review and comment on these plans andany progress achieved in meeting therequirements.

2. The review processes discussed in ‘‘ OverallConclusions Regarding Condition of theBank,’’ section 5020.1, require an evalua-tion of the propriety and consistency of thebank’s present and planned level of capitali-zation in light of existing conditions andfuture plans. In this regard, the examinerassigned to assessing capital adequacyshould do the following:a. Using the latest Uniform Bank Perfor-

mance Report (UBPR), analyze applica-ble ratios involving capital funds, com-paring these ratios with those of thebank’ s peer group and investigatingtrends or significant variations from peer-group averages.

b. Determine, with regard to the bank’soverall financial condition, that the bank’scapital is sufficient to compensate forany instabilities or deficiencies in theasset and liability mix and in quality, asdescribed in the ‘‘ Funds Management’’paragraph (‘‘ Financial Considerations’’subsection of section 3020.1).

c. Determine if the bank’s earnings perfor-mance enables it to fund its expansionadequately, to remain competitive in themarket, and to replenish or increase itscapital funds as needed.

d. Analyze trends in the bank’s deposit andborrowed funds structure to determinewhether capital is maintained at a levelsufficient to sustain depositor and lenderconfidence.

e. If the allowance for loan and lease lossesis determined to be inadequate, analyzethe impact of current and potential losseson the bank’s capital structure. See ‘‘Ana-lytical Review and Income and Expense,’’section 4010.1.

f. Consider the impact of any managementdeficiencies on present and projectedcapital.

g. Determine if there are any assets orcontingent accounts whose quality rep-

Assessment of Capital Adequacy: Examination Procedures 3020.3


resents an actual or potential seriousweakening of capital.

h. Consider the potential impact of anyproposed changes in controlling owner-ship (if approved) on the projected capi-tal position.

i. Analyze assets that are consideredundervalued on the balance sheet andcarried at below-market values. Theexcess of fair value over cost may rep-resent an additional cushion to the bank.

j. Consider the cushion for absorbing lossesthat may be provided by any subordi-nated debt or intermediate-term pre-ferred stock not included in tier 2 capitalbecause of the 50 percent of tier 2 capitallimitation, or that is not included incapital for tier 1 leverage ratio purposes.

k. Analyze any collateral and guaranteessupporting assets that may not be takeninto account for risk-based or tier 1leverage capital purposes, and considerthese collateral and guarantees in theoverall assessment of capital adequacy.

l. Evaluate the bank’s overall asset quality,and determine whether the bank needs tostrengthen its capital position based onthe following:• the severity of problem and classified

assets• investment or loan- portfolio con-

centrations• the adequacy of loan-loss reserves

m. Analyze the bank’s interest-rate risk anduse of hedging instruments. Determine ifthe bank should strengthen its capitalposition because of undue levels of risk.Review hedging instruments for the useof interest-only strips (IOs) and principal-only strips (POs) (which raise concerns),and review management’s expertise inusing hedging instruments.

n. Determine whether the sponsoring bankis able to assess and manage the retainedrisk in its credit portfolio after the issu-ance of synthetic collateralized loanobligations (CLOs).

o. If the bank has used the special risk-based regulatory capital treatment forsynthetic CLOs, verify that the stringent

minimum conditions have been met forthat treatment.

3. Review capital adjustments such as good-will and intangible assets by performing thefollowing procedures:a. Verify the existence of adequate docu-

mentation concerning book and fairvalues and the amortization method.

b. Verify that intangibles are being reducedin accordance with the amortizationmethod. If the book carrying amountexceeds the fair value, the intangibleshould be written down or off.

c. Determine if the bank is performing aquarterly review of the book and fairvalues and the quality of all intangibles.

d. Verify that goodwill and other nonquali-fying identifiable intangibles are deductedfrom tier 1 capital.

e. Determine the proper inclusion of otheridentifiable intangibles included in tier 1capital by verifying that the criteria andlimitations outlined in the risk-based capi-tal guidelines are met.

4. In light of the analysis conducted in step 2(under ‘‘ Overall Assessment of CapitalAdequacy’’ ), and in accordance with theFederal Reserve’s capital adequacy guide-lines, determine any appropriate supervi-sory action with regard to the bank’s capitaladequacy.

5. Review the following items with theexaminer-in-charge in preparation for dis-cussion with appropriate management:a. all deficiencies noted with respect to the

capital accountsb. the adequacy of present and projected

capital6. Ascertain through minutes, reports, etc., or

through discussions with management, howthe future plans of the bank (for example,growth through commercial lending, retailoperations, etc.) will affect the bank’s assetquality, capital position, and other areas ofits balance sheet.

7. Prepare comments for the examination reporton the bank’s capital position, including anydeficiencies noted.

8. Update the workpapers with any informa-tion that will facilitate future examinations.

3020.3 Assessment of Capital Adequacy: Examination Procedures


Assessment of Capital AdequacyInternal Control QuestionnaireEffective date November 1993 Section 3020.4

Review the bank’s internal controls, policies,practices, and procedures concerning capital.The bank’s system should be documented in acomplete and concise manner and should include,where appropriate, narrative descriptions, flow-charts, copies of forms used, and other pertinentinformation. Items marked with an asteriskrequire substantiation by observation or testing.

GENERAL

1. Has the bank established procedures toensure that—a. all components of capital are accurately

categorized and reported for purposesof the risk-based and leverage capitalmeasures?

b. all on-and off-balance-sheet items areaccurately risk-weighted and reportedfor purposes of the risk-based capitalmeasures?

c. categorization of on- and off-balance-sheet items and capital for purposes ofthe risk-based capital measures is ade-quately documented?

d. the bank is in compliance with theterms of any contractual agreementsunderlying capital instruments?

e. management and the board of directorsconsider the requirements of the risk-based capital guidelines for inclusionin capital of stock or debt prior toissuance?

2. Does the bank prepare a periodic analysisof its risk-based and leverage capital posi-tions to assess capital adequacy for bothcurrent and anticipated needs?

*3. Has the board of directors authorized spe-cific bank officers to—a. sign stock certificates?b. maintain custody of unissued stock

certificates?c. maintain stock journals and records?

*4. Are capital transactions verified by morethan one person before stock certificatesare issued?

*5. Are stock certificates and debentures han-dled by persons who do not also recordthose transactions?

*6. Does the bank maintain a stock certificatebook with certificates serially numberedby the printer?

*7. Is the stock certificate book maintainedunder dual control?

*8. Does the bank’s policy prohibit the sign-ing of blank stock certificates?

*9. Does the bank maintain a shareholders’ledger that shows the total number ofshares owned by each stockholder?

*10. Does the bank maintain a stock transferjournal disclosing names, dates, andamounts of transactions?

*11. Does the bank cancel surrendered stockcertificates?

*12. Are inventories of unissued notes ordebentures—a. maintained under dual control?b. counted periodically by someone other

than the person responsible for theircustody?

*13. When transfers are made—a. are notes or debentures surrendered and

promptly cancelled?b. are surrendered notes or debentures

inspected to determine that properassignment has been made and that newnotes or debentures agree in amount?

CONCLUSION

14. Indicate additional procedures used inarriving at conclusions.

15. Are internal controls of capital adequatebased on a composite evaluation, asevidenced by answers to the foregoingquestions?

Commercial Bank Examination Manual March 1994Page 1

Assessing Risk-Based Capital—Direct-Credit SubstitutesExtended to ABCP ProgramsEffective date October 2007 Section 3030.1

The Federal Reserve Board and the other federalbanking agencies (the agencies)1 amended theirrisk-based capital standards on November 29,2001, to adopt a new capital framework forbanking organizations (includes bank holdingcompanies) engaged in securitization activities(the securitization capital rule).2 In March 2005,the agencies issued interagency guidance thatclarifies how banking organizations are to useinternal ratings that they assign to asset poolspurchased by their asset-backed commercialpaper (ABCP) programs in order to appropri-ately risk-weight any direct-credit substitutes(for example, guarantees) extended to such pro-grams. For state member bank examinationpurposes, the interagency guidance has beenreformatted for examiner use as examinationobjectives, examination procedures, and an inter-nal control questionnaire. The guidance uses theterm ‘‘banking organization.’’ In this section, theguidance should be interpreted to mean theapplication of the risk-based capital guidelinesto all state member banks on a consolidatedbasis.

The guidance sets forth an analytical frame-work for assessing the broad risk characteristicsof direct-credit substitutes3 that a banking orga-nization provides to an ABCP program it spon-sors. The guidance provides specific informa-tion on evaluating direct-credit substitutes issuedin the form of program-wide credit enhance-ments, as well as an approach to determine therisk-based capital charge for these enhance-ments. (See SR-05-6 and its attachment. Also,see sections 3020.1, ‘‘Assessment of CapitalAdequacy,’’ and 4030.1, ‘‘Asset Securitization.’’)

The securitization capital rule permits bank-ing organizations with qualifying internal risk-rating systems to use those systems to apply the

internal-ratings approach to their unrated direct-credit substitutes extended to ABCP programs4

that they sponsor by mapping internal riskratings to external rating equivalents. Theseexternal credit rating equivalents are organizedinto three ratings categories: investment-grade(BBB and above) credit risk, high non-investment-grade (BB+ through BB-) credit risk,and low non-investment-grade (below BB-)credit risk. These rating categories can then beused to determine whether a direct-credit sub-stitute provided to an ABCP program should be(1) assigned to a risk weight of 100 percent or200 percent or (2) subject to the ‘‘gross-up’’treatment, as summarized in the table on thenext page.5 (See appendix A for a more detaileddescription of ABCP programs.)

As the table indicates, the minimum riskweight available under the internal risk-ratingsapproach is 100 percent, regardless of the inter-nal rating.6 Conversely, positions rated belowBB- receive the gross-up treatment. That is, thebanking organization holding the position mustmaintain capital against the amount of the posi-tion plus all more senior positions.7 Applicationof gross-up treatment, in many cases, will resultin a full dollar-for-dollar capital charge (theequivalent of a 1,250 percent risk weight) ondirect-credit substitutes that fall into the lownon-investment-grade category. In addition, therisk-based capital requirement applied to a direct-credit substitute is subject to the low-level-exposure rule. Under the rule, the amount ofrequired risk-based capital would be limited tothe lower of a full dollar-for-dollar capital chargeagainst the direct-credit substitute or the effec-tive risk-based capital charge (for example,8 percent) for the entire amount of assets in the

1. The Office of the Comptroller of the Currency, theFederal Deposit Insurance Corporation, and the Office ofThrift Supervision.

2. See 66 Fed. Reg. 59614 (November 29, 2001). See also12 C.F.R. 208, appendix A, section III.B.3.

3. Direct-credit substitute means an arrangement in whicha banking organization assumes, in form or in substance,credit risk associated with an on- or off-balance-sheet creditexposure that it did not previously own (that is, a third-partyasset) and the risk it assumes exceeds the pro rata share of itsinterest in the third-party asset. If the banking organization hasno claim on the third-party asset, then the organization’sassumption of any credit risk with respect to the third-partyasset is a direct-credit substitute.

4. ABCP programs include multiseller ABCP conduits,credit arbitrage ABCP conduits, and structured investmentvehicles.

5. The rating designations (for example, ‘‘BBB-’’ and‘‘BB+’’) used in the table are illustrative only and do notindicate any preference for, or endorsement of, any particularrating designation system.

6. Exposures externally rated by a nationally recognizedstatistical rating organization (NRSRO) above BBB+ areeligible for lower risk weights (that is, 20 percent for AAAand AA, 50 percent for A).

7. Gross-up treatment means that a position is combinedwith all more senior positions in the transaction. The resultingamount is then risk-weighted based on the obligor or, ifrelevant, the guarantor or the nature of the collateral.


ABCP program.8The use of internal risk rattings under the

securitization capital rule is limited to determin-ing the risk-based capital charge for unrateddirect-credit substitutes that banking organiza-tions provide to ABCP programs. Thus, bankingorganizations may not use the internal-ratingsapproach to derive the risk-based capital require-ment for unrated direct-credit substitutes ex-tended to other transactions. Approved use ofthe internal rating-based approach for ABCPprograms under the securitization capital rulewill have no bearing on the overall appropriate-ness of a banking organization’s internal risk-rating system for other purposes.

Most rated commercial paper issued out of anABCP program is supported by program-widecredit enhancement, which is a direct-creditsubstitute. Often the sponsoring banking orga-nization provides, in whole or in part, program-wide credit enhancement to the ABCP program.Program-wide credit enhancement may take anumber of different forms, including an irrevo-cable loan facility, a standby letter of credit, afinancial guarantee, or a subordinated debt.

The interagency guidance also discusses theweakest-link approach. This approach is usedfor calculating the risk-based capital require-ment and assumes that the risk of the program-wide credit enhancement is directly dependenton the quality (that is, internal rating) of theriskiest transaction(s) within the ABCPprogram. (See step 9 of the examinationprocedures, section 3030.3.) More specifically,the weakest-link concept presupposes the prob-ability that the program-wide credit enhance-ment that will be drawn is equal to the prob-ability of default of the transaction(s) with theweakest transaction risk rating.

A process is provided that is designed to aidin determining the regulatory capital treatmentfor program-wide credit enhancements, pro-vided to an ABCP program. The key underlyingprinciples are as follows:

1. The determination of the credit quality of theprogram-wide credit enhancement shall bebased on the risk of draw and subsequentloss, which depends directly on the quality ofthe credit-enhanced assets funded throughthe ABCP program.

2. An estimate of the risk of draw for theprogram-wide credit enhancement is derivedfrom the quality (rating) of the riskiest cred-it(s) within the ABCP program, which isoften indicated by the internal rating a bank-ing organization assigns to a transaction’spool-specific liquidity facility. Other creditrisks (for example, seller/servicer risk) to theprogram-wide credit enhancement may alsobe considered.

3. The weakest-link approach assigns risk-based capital against the program-wide creditenhancement in rank order of the internalratings starting with the lowest-rated posi-tions supported by the program-wide creditenhancement. Therefore, if all of the posi-tions supported by the program-wide creditenhancement are internally rated investmentgrade, the banking organization would risk-weight the notional amount of the program-wide credit enhancement at 100 percent andthere would be no need to proceed further.However, for positions supported by theprogram-wide credit enhancement that arenon-investment grade, banking organizationscan use the formula-driven weakest-linkapproach illustrated in step 9 of the exami-nation procedures to generate the appropriateamount of risk-based capital to be assessedagainst an unrated position.8. The low-level-exposure rule provides that the dollar

amount of risk-based capital required for a recourse obligationor direct-credit substitute should not exceed the maximumdollar amount for which a banking organization is contractu-ally liable. (See 12 C.F.R 208, appendix A, section III.B.3.g.i.)

Internal risk-ratingequivalent Ratings category Risk weighting

BBB- or better Investment grade 100%BB+ to BB- High non-investment

grade200%

Below BB- Low non-investmentgrade

Gross-up treatment

3030.1 Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs


ASSESSMENT OF INTERNALRATING SYSTEMS

The guidance is organized in the form of adecision tree that (1) provides an outline of thekey decisions that examiners and sponsoringbanking organizations should consider whenreviewing internal risk-rating systems for ABCPprograms and (2) provides supervisors withmore-specific information on how to assess theadequacy of these systems. Many of the quali-tative and quantitative factors used to evaluaterisk in this guidance are comparable with ratingagency criteria (for example, criteria from S&P,Moody’s, and Fitch) because the ABCP pro-gram sponsors generally use the rating method-ologies of nationally recognized statistical ratingorganizations (NRSROs) when assessing thecredit quality of their risk exposures to ABCPprograms. The guidance has two primary goals:

• provide information to banking organizationsto ensure the accuracy and consistency of theratings assigned to transactions in an ABCPprogram

• assist supervisors in assessing the adequacy ofa banking organization’s internal risk-ratingsystem based on the nine key criteria set forthin the securitization capital rule9

APPENDIX A—OVERVIEW OFABCP PROGRAMS

ABCP programs provide a means for corpora-tions to obtain relatively low-cost funding byselling or securitizing pools of homogenousassets (for example, trade receivables) tospecial-purpose entities (SPEs/ABCPprograms). The ABCP program raises funds forpurchase of these assets by issuing commercialpaper into the marketplace. The commercialpaper investors are protected by structuralenhancements provided by the seller (forexample, overcollateralization, spread ac-counts, early-amortization triggers, etc.) and bycredit enhancements (for example, subordinatedloans or guarantees) provided by bankingorganization sponsors of the ABCP programand by other third parties. In addition, liquid-ity facilities are also present to ensure the rapidand orderly repayment of commercial papershould cash-flow difficulties emerge. ABCPprograms are nominally capitalized SPEs thatissue commercial paper. A sponsoring bankingorganization establishes the ABCP program butusually does not own the conduit’s equity,which is often held by unaffiliated third-partymanagement companies that specialize in own-ing such entities, and are structured to bebankruptcy remote.

9. 12 C.F.R. 208, appendix A, III.B.3.f.i.

Pool-Specific CreditEnhancement

Asset Pools

CommercialPaper Investors

ABCP Conduit

Program-WideCredit Enhancement

Pool-SpecificLiquidity Facility

Program Manager/Sponsor

Program-WideLiquidity Facility

Risk-Based Capital—Direct-Credit Substitutes Extended to ABCP Programs 3030.1


Typical Structure

ABCP programs are funding vehicles that bank-ing organizations and other intermediaries estab-lish to provide an alternative source of fundingto themselves or their customers. In contrast toterm securitizations, which tend to be amortiz-ing, ABCP programs are ongoing entities thatusually issue new commercial paper to repaymaturing commercial paper. The majority ofABCP programs in the capital markets areestablished and managed by major internationalcommercial banking organizations. As with tra-ditional commercial paper, which has a maxi-mum maturity of 270 days, ABCP is short-termdebt that may either pay interest or be issued ata discount.

Types of ABCP Programs

Multiseller programs generally provide workingcapital financing by purchasing or advancingagainst receivables generated by multiple cor-porate clients of the sponsoring banking organi-zations. These programs are generally well diver-sified across both sellers and asset types.

Single-seller programs are generally establishedto fund one or more types of assets originated bya single seller. The lack of diversification isgenerally compensated for by increased program-wide credit enhancement.

Loan-backed programs fund direct loans tocorporate customers of the ABCP program’ssponsoring banking organization. These loansare generally closely managed by the bankingorganization and have a variety of covenantsdesigned to reduce credit risk.

Securities-arbitrage programs invest in securi-ties that generally are rated AA- or higher. Theygenerally have no additional credit enhancementat the seller/transaction level because the secu-rities are highly rated. These programs aretypically well diversified across security types.The arbitrage is mainly due to the differencebetween the yield on the securities and thefunding cost of the commercial paper.

Structured investment vehicles (SIVs) are a formof a securities-arbitrage program. These ABCPprograms invest in securities typically rated AA-

or higher. SIVs operate on a market-value basissimilar to market value CDOs in that they mustmaintain a dynamic overcollateralization ratiodetermined by analysis of the potential pricevolatility on securities held in the portfolio.SIVs are monitored daily and must meet strictliquidity, capitalization, leverage, and concentra-tion guidelines established by the rating agencies.

Key Parties and Roles

Key parties for an ABCP program include thefollowing:

• program management/administrators• credit-enhancement providers• liquidity-facility providers• seller/servicers• commercial paper investors

Program Management

The sponsor of an ABCP program initiates thecreation of the program but typically does notown the equity of the ABCP program, which isprovided by unaffiliated third-party investors.Despite not owning the equity of the ABCPprogram, sponsors usually retain a financialstake in the program by providing creditenhancement, liquidity support, or both, andthey play an active role in managing the pro-gram. Sponsors typically earn fees—such ascredit-enhancement, liquidity-facility, andprogram-management fees—for services pro-vided to their ABCP programs.

Typically, an ABCP program makes arrange-ments with various agents/servicers to conductthe administration and daily operation of theABCP program. This includes such activities aspurchasing and selling assets, maintaining oper-ating accounts, and monitoring the ongoingperformance of each transaction. The sponsor isalso actively engaged in the management of theABCP program, including underwriting theassets purchased by the ABCP program and thetype/level of credit enhancements provided tothe ABCP program.

Credit-Enhancement Providers

The sponsoring banking organization typicallyprovides pool-specific and program-wide backup



liquidity facilities, and program-wide creditenhancements, all of which are usually unrated(pool-specific credit enhancement, such as over-collateralization, is provided by the seller of theassets). These enhancements are fundamentalfor obtaining high investment-grade ratings onthe commercial paper issued to the market bythe ABCP program. Seller-provided creditenhancement may exist in various forms and isgenerally sized based on the type and creditquality of the underlying assets as well as thequality and financial strength of seller/servicers.Higher-quality assets may only need partialsupport to achieve a satisfactory rating for thecommercial paper. Lower-quality assets mayneed full support.

Liquidity-Facility Providers

The sponsoring banking organization and insome cases, unaffiliated third parties, providepool-specific or program-wide liquidity facili-ties. These backup liquidity facilities ensure thetimely repayment of commercial paper undercertain conditions, such as financial marketdisruptions or if cash-flow timing mismatchesoccur, but generally not under conditions associ-ated with the credit deterioration of the underly-ing assets or the seller/servicer to the extent thatsuch deterioration is beyond what is permittedunder the related asset-quality test.

Commercial Paper Investors

Commercial paper investors are typicallyinstitutional investors, such as pension funds,money market mutual funds, bank trust depart-ments, foreign banks, and investmentcompanies. Commercial paper maturities rangefrom 1 day to 270 days, but most frequently areissued for 30 days or less. There is a limitedsecondary market for commercial paper sinceissuers can closely match the maturity of thepaper to the investors’ needs. Commercial paperinvestors are generally repaid from the reissu-ance of new commercial paper or from cashflows stemming from the underlying asset poolspurchased by the program. In addition, to ensuretimely repayment in the event that new com-mercial paper cannot be issued or if anticipatedcash flows from the underlying assets do not oc-cur, ABCP programs utilize backup liquidityfacilities. In addition, the banking organization

can purchase the ABCP from the conduit if thecommercial paper cannot be issued. Pool-specific and program-wide credit enhance-ments also protect commercial paper investorsfrom deterioration of the underlying asset pools.

The Loss Waterfall

The loss waterfall diagram (on the next page)for the exposures of a typical ABCP programgenerally has four legally distinct layers.However, most legal documents do not specifywhich form of credit or liquidity enhancement isin a priority position after pool-specific creditenhancement is exhausted due to defaults. Forexample, after becoming aware of weakness inthe seller/servicer or in asset performance, anABCP program sponsor may purchase assetsout of the conduit using pool-specific liquidity.Liquidity agreements must be subject to a validasset-quality test that prevents the purchase ofdefaulted or highly delinquent assets. Liquidityfacilities that are not limited by such an asset-quality test are to be viewed as credit enhance-ment and are subject to the risk-based capitalrequirements applicable to direct-creditsubstitutes.

Pool-Specific Credit Enhancement

The form and size of credit enhancement foreach particular asset pool is dependent upon thenature and quality of the asset pool and theseller/servicer’s risk profile. In determining thelevel of credit enhancement, consideration isgiven to the seller/servicer’s financial strength,quality as a servicer, obligor concentrations, andobligor credit quality, as well as the historicperformance of the asset pool. Credit enhance-ment is generally sized to cover a multiple levelof historical losses and dilution for the particularasset pool. Pool-specific credit enhancement cantake several forms, including overcollateraliza-tion, cash reserves, seller/servicer guarantees(for only highly rated seller/servicers), and sub-ordination. Credit enhancement can either bedynamic (that is, increases as the asset pool’sperformance deteriorates) or static (that is, fixedpercentage). Pool-specific credit enhancement isgenerally provided by the seller/servicer (orcarved out of the asset pool in the case ofovercollateralization) but may be provided byother third parties.



The ABCP program sponsor or administratorwill generally set strict eligibility requirementsfor the receivables to be included in the pur-chased asset pool. For example, receivable eli-gibility requirements will establish minimumcredit ratings or credit scores for the obligorsand the maximum number of days the receivablecan be past due.

Usually the purchased asset pools are struc-tured (credit-enhanced) to achieve a credit-quality equivalent of investment grade (that is,BBB or higher). The sponsoring banking orga-nization will typically utilize established ratingagency criteria and structuring methodologies toachieve the desired internal rating level. Incertain instances, such as when ABCP programspurchase ABS, the pool-specific credit enhance-ment is already built into the purchased ABSand is reflected in the security’s credit rating.The internal rating on the pool-specific liquidityfacility provided to support the purchased assetpool will reflect the inclusion of the pool-

specific credit enhancement and other structur-ing protections.

Program-Wide Credit Enhancement

The second level of contractual credit protectionis the program-wide credit enhancement, whichmay take the form of an irrevocable loan facility,a standby letter of credit, a surety bond from amonoline insurer, or an issuance of subordinateddebt. Program-wide credit enhancement protectscommercial paper investors if one or more of theunderlying transactions exhaust the pool-specificcredit enhancement and other structural protec-tions. The sponsoring banking organization orthird-party guarantors are providers of this typeof credit protection. The program-wide creditenhancement is generally sized by the ratingagencies to cover the potential of multipledefaults in the underlying portfolio of transac-tions within ABCP conduits and takes into

Program-Wide

Liquidity

Pool-SpecificLiquidity

Program-Wide CreditEnhancement

Pool-Specific CreditEnhancement

Last Loss

First Loss

The Loss Waterfall



account concentration risk among seller/servicersand industry sectors.

Pool-Specific Liquidity

Pool-specific liquidity facilities are an importantstructural feature in ABCP programs becausethey ensure investors of timely payments on theissued commercial paper by smoothing timingdifferences in the payment of interest and prin-cipal on the pooled assets and ensuring pay-ments in the event of market disruptions. Thetypes of liquidity facilities may differ amongvarious ABCP programs and may even differamong asset pools purchased by a single ABCPprogram. For instance, liquidity facilities maybe structured either in the form of (1) anasset-purchase agreement, which provides liquid-ity to the ABCP program by purchasing nonde-faulted assets from a specific asset pool, or (2) aloan to the ABCP program, which is repaidsolely by the cash flows from the underlyingassets.10 Some older ABCP programs may haveboth pool-specific liquidity and program-wideliquidity coverage, while more-recent ABCPprograms tend to utilize only pool-specific facili-ties. Typically, the seller-provided credit enhance-ment continues to provide credit protection onan asset pool that is purchased by a liquiditybanking organization so that the institution isprotected against credit losses that may arise dueto subsequent deterioration of the pool.

Pool-specific liquidity, when drawn prior tothe ABCP program’s credit enhancements, issubject to the credit risk of the underlying assetpool. However, the liquidity facility does notprovide direct-credit enhancement to the com-mercial paper holders. Thus, the pool-specificliquidity facility generally is in an economicsecond-loss position after the seller-providedcredit enhancements and prior to the program-wide credit enhancement even when the legaldocuments state that the program-wide creditenhancement would absorb losses prior to thepool-specific liquidity facilities. This is becausethe sponsor of the ABCP program would mostlikely manage the asset pools in such a way thatdeteriorating portfolios or assets would be put tothe liquidity banking organizations prior to any

defaults that would require a draw against theprogram-wide credit enhancement.11 While theliquidity banking organization is exposed to thecredit risk of the underlying asset pool, the riskis mitigated by the seller-provided credit en-hancement and the asset-quality test.12 At thetime that the asset pool is put to the liquiditybanking organization, the facility is usually fullydrawn because the entire amount of the pool thatqualifies under the asset-quality test is pur-chased by the banking organization. However,with respect to revolving transactions (such ascredit card securitizations) it is possible toaverage less than 100 percent of the commitment.

Program-Wide Liquidity

The senior-most position in the waterfall,program-wide liquidity, is provided in an amountsufficient to support that portion of the faceamount of all the commercial paper that isissued by the ABCP program that is necessary toachieve the desired external rating on the issuedpaper. Progam-wide liquidity also providesliquidity in the event of a short-term disruptionin the commercial paper market. In some cases,a liquidity banking organization that extends adirect liquidity loan to an ABCP program maybe able to access the program-wide creditenhancement to cover losses while funding theunderlying asset pool.

APPENDIX B—CREDIT-APPROVAL MEMORANDUM

The credit-approval memorandum typicallyshould include a description of the following:

1. Transaction structure. In the beginning of thecredit-approval memorandum, the sponsor-ing banking organization will outline thestructure of the transaction, which includes a

10. Direct-liquidity loans to an ABCP program may betermed a commissioning agreement (most likely in a foreignbank program) and may share in the security interest in theunderlying assets when commercial paper ceases to be issueddue to deterioration of the asset pool.

11. In fact, according to the contractual provisions of someconduits, a certain level of draws on the program-wide creditenhancement is a condition for unwinding the conduit pro-gram, which means that this enhancement is never meant to beused.

12. An asset-quality test or liquidity-funding formula deter-mines how much funding the liquidity banking organizationwill extend to the conduit based on the quality of theunderlying asset pool at the time of the draw. Typically,liquidity banking organizations will fund against the conduit’spurchase price of the asset pool less the amount of defaultedassets in the pool.



discussion of the asset type that would bepurchased by the ABCP program and theliquidity facilities (and possibly creditenhancements) that the sponsoring bankingorganization is providing to the transaction.Generally, the sponsoring banking organiza-tion indicates the type and dollar volume ofthe liquidity facility that the institution isseeking to extend to the transaction, such asa $250 million short-term pool-specific liquid-ity facility, as well as the type of first-losscredit enhancement that is provided by theseller, such as overcollateralization. The assetpurchase by the ABCP conduit from theseller may be described as a two-step salethat first involves the sale of the assets (forexample, trade receivables) to an SPV on atrue-sale basis and then involves the sale ofthe assets by the SPV to the ABCP program.Other features of the structure should bedescribed, such as if the transaction is arevolving transaction with a one-year revolv-ing period.

In addition, the sponsoring banking orga-nization typically obtains true-sale and non-consolidation opinions from the seller’sexternal legal counsel. The opinions shouldidentify the various participants in thetransaction—including the seller, servicer,and trustee—as appropriate. For instance, theseller of the assets is identified as the partythat would act as the servicer of the assets andwho is responsible for all the representa-tions and warranties associated with the soldassets.

2. Asset seller’s risk profile. The assessment ofthe asset seller’s risk profile should considerits past and expected future financial perfor-mance, its current market position andexpected competitiveness going forward, aswell as its current debt ratings. For example,the sponsor may review the seller’s leverage,generation of cash flow, and interest cover-age ratios, and whether the seller is at leastinvestment grade. Also, the sponsoring bank-ing organization may attempt to anticipatethe seller’s ability to continue to performunder more-adverse economic conditions. Inaddition, some sponsors may take other infor-mation into account, such as KMV ratings, toconfirm their internal view of the seller’sfinancial strength.

3. Underwriting standards. A discussion of theseller’s current and historical underwritingstandards should be included in the transac-

tion summary. For certain types of assets,such as auto loans, the sponsoring bankingorganization should consider the seller’s useof credit scoring and the minimum accept-able loan score that may be included in theasset pool. In addition, the credit-approvalmemorandum may include an indication ofwhether the underwriting standards haveremained relatively constant over time orwhether there has been a recent tightening orloosening.

4. Asset-eligibility criteria. In order to reducethe ABCP program’s exposure to higher-risk assets, an ABCP program generallyspecifies minimum asset-eligibility criteria.This is particularly true for revolvingtransactions since the seller’s underwritingstandards may change so that the credit qual-ity of the assets purchased by the ABCPprogram can be adversely affected. Whileeligibility criteria may be designed forspecific transactions, there is a common setof criteria that are generally applicable,including those that exclude the purchase ofdefaulted assets or assets past due more thana specified number of days appropriate forthe specific transaction; limiting excessconcentration to an individual obligor;excluding the purchase of assets of obligorsthat are affiliates of the seller; or limiting thetenor of the assets to be purchased. Othercriteria also may require that the obligor be aresident of a certain country and that theasset is payable in a particular currency. Allof these criteria are intended to reduce thecredit risk inherent in the asset pool to bepurchased by the ABCP program. A strongset of eligibility criteria may reduce thenecessary credit enhancement provided bythe selling organization.

5. Collection process. Often, if the seller/servicer has a senior unsecured debt rating ofat least BBB-, cash collections may be com-mingled with the seller/servicer’s cash untilsuch time as periodic payments are requiredto be made to the ABCP program. Documen-tation should provide an ABCP program withthe ability to take steps to control the cashflows when necessary and include covenantsto redirect cash flows or cause the segrega-tion of funds into a bankruptcy-remote SPEupon the occurrence of certain triggers. Adescription of how checks, cash, and debitpayments are to be handled may be dis-cussed. For instance, documentation may



state that payments by check must be pro-cessed on the same day they are received bythe lockbox and that after the checks clear,the cash is deposited in a segregated collec-tion account at the sponsoring banking orga-nization. Also, the documents may describethe types of eligible investments in which thecash may be invested, which are usuallyhighly rated, liquid investments such as gov-ernment securities and A1/P1+ commercialpaper.

6. Assets’ characteristics. Usually, a transactionsummary will provide a description of theassets that will be sold into the program andoutline relevant pool statistics. For instance,there likely will be a discussion of theweighted average loan balance, weightedaverage credit score (if appropriate), weightedaverage original term, and weighted averagecoupon, as well as the ranges of each char-acteristic. In addition, the portfolio may besegmented by the sponsoring banking orga-nization’s internal-rating grades to give anindication of each segment’s average creditquality (as evidenced by an average creditscore) and share of the portfolio’s balances.Many times, the sponsor will identify con-centrations to individual obligors or geo-graphic areas, such as states.

7. Dilution. Certain asset types (for example,trade receivables) purchased by ABCP pro-grams may be subject to dilution, which isthe evaporation of the asset due to customerreturns of sold goods, warranty claims, dis-putes between the seller and its customers, aswell as other factors. For instance, the sellerof the assets to the ABCP program maypermit its customers to return goods, atwhich point the receivables cease to exist.The likelihood of this risk varies by assettype and is typically addressed in the trans-action summary. For instance, in sales ofcredit card receivables to an ABCP program,the risk of dilution is small due to theunderlying diversity of the obligors and mer-chants. While the pool-specific liquidityfacilities often absorb dilution initially, theseller generally is required to establish areserve to cover a multiple of expected dilu-tion, which is based on historical informa-tion. The adequacy of the dilution reserve isreviewed at the inception of the transactionand may or may not be incorporated in theseller-provided credit enhancement that isprovided on the pool of assets sold to the

ABCP program.8. Historical performance. As a prelude to siz-

ing the pool-specific credit enhancement pro-vided by the seller, the sponsoring bankingorganization will review the historical per-formance of the seller’s portfolio, includingconsideration of losses (that is, loss rate andloss severity), delinquencies, dilutions, andthe turnover rate.13 An indication of thedirection of losses and delinquencies, and thereasons behind any increase or decrease areoften articulated. For instance, an increase inlosses may reflect losses due to specificindustry-related problems and general eco-nomic downturns. Typically, the rating agen-cies prefer at least three years’ worth ofhistorical information on the performance ofthe seller’s asset pools, although the ratingagencies periodically permit transactions tohave less information. As a result, a sponsor-ing banking organization likely will requirethe same degree of information as a ratingagency whether this is a full three-year his-tory or a lesser amount, as appropriate, whenassessing the credit quality of its liquidityand credit-enhancement exposures.

9. Termination events. ABCP programs usuallyincorporate commercial paper stop-issuanceor wind-down triggers to mitigate losses thatmay result from a deteriorating asset pool orsome event that may hinder the ABCP pro-grams’ ability to repay maturing commercialpaper. Such triggers may be established ateither the pool level or program-wide level,and may, if hit, require the ABCP program toimmediately stop issuing commercial paperto fund (1) new purchases from a particularseller or (2) any new purchases regardless ofthe seller. In addition, such triggers mayrequire the ABCP program to begin liquidat-ing specific asset pools or its entire portfolio.

The rating agencies consider these struc-tural safeguards, which are designed to pro-tect the ABCP program from credit deterio-ration over time, in determining the rating onan ABCP program’s commercial paper. Inmany ABCP programs, there may be a pro-vision that requires the program to winddown if a certain percentage of the program-wide credit enhancement has been used to

13. The turnover rate of a receivables portfolio is ameasure of how fast the outstanding assets are paid off. Forexample, if a seller had sales of $4,000 in the prior year andan average portfolio balance of $1,000, then the turnover rateof the portfolio is four.



cover losses (for example, 25 percent).Examples of pool-specific triggers include

the insolvency or bankruptcy of the seller/servicer; downgrade of the seller’s creditrating below a specific rating grade; or dete-rioration of the asset pool to the point wherecharge-offs, delinquencies, or dilution rises

above predetermined levels. Program-widetriggers may include (1) the ABCP pro-gram’s failure to repay maturing commercialpaper or (2) when draws reduce the program-wide credit enhancement below a statedthreshold.



Assessing Risk-Based Capital (RBC)—Direct-CreditSubstitutes Extended to ABCP ProgramsExamination ObjectivesEffective date October 2007 Section 3030.2

Unless otherwise specified, examiners shouldweigh the importance and significance of theobjectives being assessed when he or she deter-mines a final conclusion.

INTERNAL RISK-RATINGSYSTEM

1. To determine if the banking organization hasa robust internal risk-rating system.

2. To determine if the banking organizationgenerally has sound risk-management prac-tices and principles.

INTERNAL RISK-RATINGSYSTEM FOR ABCPSECURITIZATION EXPOSURES

1. To determine the extent to which the bankingorganization integrates its ABCP internalrisk-rating process with its credit-risk man-agement framework.

2. To qualitatively assess the suitability of thebanking organization’s risk-rating processrelative to the transactions and type of assetssecuritized.

3. To assess the adequacy of the credit-approvalprocess.

INTERNALLY RATEDEXPOSURES

1. To determine whether the banking organiza-tion applies its internal risk-rating system toliquidity facilities and credit enhancementsextended to ABCP programs.

2. To determine whether the assigned internalratings incorporate all of the risks associatedwith rated exposures extended to ABCPprograms.

MONITORING OF ABCPPROGRAMS BY RATINGAGENCIES

1. To confirm that the commercial paper issued

by the ABCP programs is rated by one ormore nationally recognized statistical ratingorganizations (NRSROs).

2. To verify that NRSROs are monitoring theABCP programs in order to ensure the main-tenance of minimum standards for the respec-tive ABCP program’s rating.

UNDERWRITING STANDARDSAND MANAGEMENT OVERSIGHT

1. To assess the quality and robustness of theunderwriting process.

INTERNAL-RATINGCONSISTENCY WITHRATINGS ISSUED BY THERATING AGENCIES

1. To confirm that whenever ABCP programtransactions are externally rated, internal rat-ings are consistent with, or more conserva-tive than, those issued by NRSROs.

FIRST-LOSS POSITION FORPROGRAM-WIDE CREDITENHANCEMENT

1. To assertain the rank order, if possible, of therisk assumed by the various direct-creditsubstitutes and liquidity facilities in the ABCPprogram—determining the order in whichvarious exposures would absorb losses.

2. To determine if third-party investors provideprogram-wide credit enhancement to theABCP conduit.

3. To determine if the spread that third-partyinvestors or the banking organization chargesfor taking program-wide credit-enhancementrisk is generally within the market’sinvestment-grade pricing range.


CONCENTRATIONS OFNON-INVESTMENT GRADESELLER/SERVICERS

1. To determine if the sponsoring banking orga-nization is exposed to an inordinate amountof seller/servicer risk.

UNDERLYING ASSETS OF THEABCP PROGRAM STRUCTUREDTO INVESTMENT-GRADE RISK

1. To obtain the internal rating for the program-wide credit enhancement in order to deter-

mine the banking organization’s assessmentof the credit quality of the risk exposure.

2. To rank-order the underlying transactions inthe ABCP program on the basis of internalrisk ratings in order to determine the notionalamount of transactions falling in each of thethree ratings categories: investment grade(BBB- or better), high non-investment grade(BB+ to BB-), and low non-investment grade(below BB-).

3. To determine a risk-based capital require-ment for the program-wide creditenhancement.

3030.2 RBC—Direct-Credit Substitutions Extended to ABCP Programs: Examination Objectives


Assessing Risk-Based Capital (RBC)—Direct-CreditSubstitutes Extended to ABCP ProgramsExamination ProceduresEffective date October 2007 Section 3030.3

DECISION TREE

The decision tree is intended to assist examinersin determining the adequacy of the internalrating systems used for rating direct-credit sub-stitutes extended to asset-backed commercialpaper (ABCP) programs. If examiners considera banking organization’s internal rating systemadequate, then the institution may use the inter-nal ratings assigned to calculate the risk-basedcapital charge for unrated direct-credit substi-tutes, including program-wide credit enhance-ments. The determination process can essen-tially be broken down into individual steps thatstart by answering broad fundamental risk ques-tions and end with examining more-detailedABCP program-specific characteristics.

The first six steps (1–6) of the process focuson evaluating the banking organization’s risk-rating system, while the final three steps (7–9)are used to determine the amount of risk-basedcapital to be assessed against program-widecredit enhancements.

PERFORMING THEEXAMINATION PROCEDURES

Examiners should be mindful that evaluating theadequacy of internal risk-rating systems gener-ally depends on both subjective judgments andobjective information generated in each step ofthe process. When performing the examinationprocedures, the examiner may determine thatcertain observed weaknesses in meeting specificsupervisory expectations may not necessarily besevere enough to conclude that the internalrisk-rating system is inadequate. In some cases,compensating strengths in components of therisk-rating system may offset observed weak-nesses. However, examiners should take suchweaknesses into consideration in formulatingtheir overall conclusion and consider them whendeveloping recommendations to improve theinternal risk-rating process. Failure to meet theregulatory requirements and follow the supervi-sory guidance typically is an indication of unsafeand unsound banking practices in the risk man-agement of ABCP programs. Where failures areobserved, examiners should conclude that use of

the internal-ratings approach for exposures toABCP programs is inappropriate for purposes ofthe respective provisions of the risk-based capi-tal rule.

While this guidance has been designed toaddress common industry underwriting and risk-management practices, it may not sufficientlyaddress all circumstances. For unique cases notadequately addressed by the guidance, examin-ers should review the specific facts and circum-stances with the responsible Reserve Bank man-agement in conjunction with the Board’s BankingSupervision and Regulation staff before render-ing a final conclusion.

Organizing the Examination Process

When organizing the examination, examinersshould note if the banking organization operatesmultiple ABCP conduits. In some cases, a bank-ing organization may manage individual ABCPconduits out of different legal entities or lines ofbusiness, and each conduit may focus on differ-ent business strategies.

1. Before initiating the examination process,determine—a. the number of ABCP conduits sponsored

by the banking organization,b. which ABCP conduits have direct-credit

substitutes provided by the banking orga-nization, and

c. from what areas within the organizationthese activities are conducted.

2. When multiple ABCP conduits exist, assesswhether the banking organization applies theinternal risk-rating system consistently toeach program with identical policies, proce-dures, and controls.

3. If the banking organization operates ABCPprogram activities out of different legal enti-ties or lines of business, or if the applicationof an internal rating system varies fromprogram to program, evaluate the adequacyof each unique application.

4. Consider limiting any Federal Reserveapproval of the use of internal ratings tothose programs that have been examined anddetermined to meet the requirements outlinedin this guidance.


Assessment of Internal Risk-Rating System Assessment of Program-wide Credit Enhancement

Begin

AcceptableRisk-Rating

System?

EstablishedRating System

for ABCPExposure?

RelevantExposuresInternallyRated?

ExposuresMonitored by

RatingAgencies?

SufficientUnderwritingStandards &Oversight?

Internal &External

Ratings areConsistent?

Use of Internal Risk-Rating System is

Approved

Use of InternalRisk-Rating

System ShouldNot be Approved

Exposure Isin the First

LossPosition?

Is Seller/Service

Risk High?

Are AllUnderlyingExposuresInvestment

Grade?

DetermineRisk-Based CapitalRequirement Using

Weakest-LinkFormula

Risk-weightProgram-wide

CreditEnhancement

at 100%

Program-wideCredit

May RequireGross-UpTreatment

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Step 7

Step 8

Step 9

Yes

Yes

Yes

Yes

Yes

Yes

No

No

No

No

No

No

No

No

No

Yes

Yes

Yes

3030.3 RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures


Banking organizations may have estab-lished ABCP lines of business from whichthey coordinate client relationships,transaction-origination activities, fundingactivities, and ABCP conduit management.An inspection of such ‘‘front-office’’ opera-tions can provide important insight into theunique characteristics of the banking organi-zation’s ABCP program. Examiners shouldfocus the examination’s review on the areasof the organization where credit decisionsand credit-risk management are housed andwhere oversight of the internal risk-ratingsystem is maintained.

5. Consider the factors listed below while con-ducting the banking organization’s examina-tion. When any of these factors are observed,perform a more thorough review of its inter-nal controls, risk management, and potentialweaknesses before approving the bankingorganization’s internal risk-rating system.

Although observation of a single factormay not be compelling enough for withhold-ing approval, the examiner’s observation ofone or more of these factors should result inthe adoption of a more conservative bias asthe examination procedures are performed.

If a combination of the risk factors identifiedbelow is observed during the examinationprocess, the examiner may determine that theinternal risk-rating system should not berelied upon for assessing the risk-based capi-tal treatment for direct-credit substitutes pro-vided to ABCP programs.

The following factors should be considered:

1. The sponsoring banking organization has ashort track record and is inexperienced inthe management of an ABCP program.

2. The transaction-specific credit enhancementis solely in the form of excess spread.

3. Significantly higher ABCP program costsexist for program-wide credit enhancementas compared with the internal and externalbenchmarks for investment-grade risk.

4. The sponsoring banking organization failsto maintain historical ratings-migration dataor the migration data of required credit-enhancement levels.

5. There is an excessive number of transaction-rating migrations (both internal and exter-nal), or excessive collateral calls are neces-sary to enhance transaction-level credit

enhancement to maintain an internal riskrating.

6. The transactional due-diligence, approval,or execution documentation is poorlyprepared.

7. A significant number of problem transac-tions are taken out of the ABCP programthrough liquidity draws.

8. There is no independent review or oversightof the internal rating system or the assignedtransaction ratings. A review conducted byinternal parties within the sponsoring/administrating banking organization maystill be considered independent so long asthe business unit conducting the reviewdoes not report to the unit that is responsiblefor the ABCP program’s transactions.

9. The transaction-underwriting and risk-management functions of an ABCP pro-gram sponsor/administrator, other than rou-tine outside audit reviews, are delegated tounaffiliated third parties.

10. The ABCP conduit commercial paper is notrated lower than A-2/P2 on an ongoingbasis by the rating agencies.

If examiners observe either of the followingtwo factors, the banking organization shouldnot receive Federal Reserve approval to usethe internal-ratings approach. (See theexamination procedures for more detail.)

11. The banking organization does not have, inthe examiner’s view, an established oracceptable internal risk-rating system toassess the credit quality of its exposures toits ABCP programs.

12. Relevant direct-credit substitutes or liquid-ity facilities are not internally risk rated.

Step 1—Acceptable InternalRisk-Rating Systems

1. Determine if the banking organization is ableto satisfactorily demonstrate how its internalrisk-rating system corresponds to the ratingagencies’ standards used as the frameworkfor complying with the securitization require-ments in the risk-based capital rule. Ascer-tain whether the credit ratings map to therisk-weight categories in the ratings-basedapproach so they can be applied to internalratings.

RBC—Direct-Credit Substitutes Extended to ABCP Programs: Examination Procedures 3030.3


2. If a separate supervisory team has conducteda detailed evaluation of the robustness andeffectiveness of the banking organization’soverall internal ratings system, use the inspec-tion work to assess the application of internalratings specific to the banking organization’sABCP programs. Consider reducing the pro-cedures to a quick review of the previousexamination’s findings.

3. If there was no previous evaluation of thebanking organization’s risk-rating system orif documentation of the evaluation findings isunavailable, perform a full review of theorganization’s risk-rating system.

4. Ascertain whether the banking organiza-tion’s overall risk-rating process is generallyconsistent with the fundamental elements ofsound risk management and with the ratingassumptions and methodologies of the ratingagencies.a. Determine if the internal ratings are incor-

porated into the credit-approval processand are considered in the pricing of credit.

b. Find out if the internal lending and expo-sure limits are linked to internal ratings.

5. Verify that the internal risk-rating system forABCP programs contains the following ninecriteria:a. The internal credit-risk system is an inte-

gral part of the banking organization’srisk-management system, which explicitlyincorporates the full range of risks arisingfrom its participation in securitizationactivities.

b. Internal credit ratings are linked to mea-surable outcomes, such as the probabilitythat the position will experience any loss,the position’s expected loss given default,and the degree of variance in losses givendefault on that position.

c. The banking organization’s internal credit-risk system separately considers (1) therisk associated with the underlying loansor borrowers and (2) the risk associatedwith the structure of a particular securiti-zation transaction.

d. The banking organization’s internal credit-risk system identifies gradations of riskamong ‘‘pass’’ assets and other riskpositions.

e. The banking organization has clear, explicitcriteria, including subjective factors, thatare used to classify assets into each inter-nal risk grade.

f. The banking organization has independent

credit-risk management or loan-reviewpersonnel assigning or reviewing thecredit-risk ratings.

g. The banking organization has an internalaudit procedure that periodically verifiesthat internal risk ratings are assigned inaccordance with the organization’s estab-lished criteria.

h. The banking organization (1) monitors theperformance of the internal credit-riskratings assigned to nonrated, nontradeddirect-credit substitutes over time to deter-mine the appropriateness of the initialcredit-risk rating assignment and (2) adjustsindividual credit-risk ratings, or the over-all internal credit-risk ratings system, asneeded.

i. The internal credit-risk system makescredit-risk rating assumptions that are con-sistent with, or more conservative than,the credit-risk rating assumptions andmethodologies of the nationally recog-nized statistical rating organizations(NRSROs).

If all of the above supervisory guidance isnot adhered to, the use of internal ratingsunder the risk-based capital rule should notbe approved.

Step 2—Use of an EstablishedInternal Risk-Rating System Tailoredto ABCP Securitization Exposures

1. Determine if an internal rating system existsthat assesses exposures (for example, liquid-ity facilities) provided to ABCP programs.

2. Ascertain whether there is evidence that theABCP internal risk-rating process is an inte-grated component of the enterprise-widecredit-risk management process. Thisincludes—a. risk ratings that are a fundamental portfo-

lio management tool andb. internal ratings that are considered in

credit and pricing decisions.3. Evaluate whether the management team and

staff are experienced with the types of assetsand facilities internally rated for the ABCPprogram.

4. Determine if there is meaningful differentia-tion of risk. Verify that—a. separate ratings are applied to borrowers

and facilities that separately consider the



risk associated with the underlying loansand borrowers, as well as the risk associ-ated with the specific positions in a secu-ritization transaction, and

b. a distinct set of rating criteria exists foreach grade. The banking organizationshould have classified its assets into eachrisk grade using clear, explicit criteria,even for subjective factors.

5. Verify that the risk-ratings criteria for ABCPtransactions are documented with specificmethodologies detailed for different assettypes.

6. Find out if the banking organization includesa transaction summary1 as part of its credit-approval process. The transaction summaryshould include a description of the following:transaction structure, seller/servicer’s risk pro-file,2 relevant underwriting criteria, asset-eligibility criteria, collection process, assetcharacteristics, dilution and historical lossrates, and trigger and termination events.(See appendix B of section 3030.1 for a moredetailed description of the above transaction-summary categories.)

7. Before reaching a final assessment, consultwith the other examiners who have con-ducted reviews of the banking organization’sother risk-rating systems, including the cor-porate risk-rating system.

Step 3—Relevant Internally RatedExposures

1. Verify that the banking organization inter-nally rates all relevant exposures to ABCPprograms, such as pool-specific liquidityfacilities.

2. Ascertain if the banking organization mapsits internal ratings to the full scale of externalratings provided by the NRSROs.

Step 4—ABCP Program Monitoredby Rating Agencies

1. Verify that the commercial paper issued by

the ABCP program has been rated in thesecond-highest short-term rating category(A2, P2, or F2) or higher.

2. Confirm that there is evidence that ratingagencies are actively monitoring the structur-ing methodologies and credit quality of thetransactions purchased by the ABCP conduit.a. Prescreened programs. Confirm that

NRSROs are prescreening each new trans-action placed in the ABCP program.

b. Post-review programs. Find out if ABCPprogram transactions are monitored by theNRSROs via monthly or quarterly reports.Determine if the banking organization ispromptly forwarding information on newtransactions and transactions experiencingdeterioration to the NRSROs (for example,through monthly reports).

Step 5—Sufficient UnderwritingStandards and Management Oversight

1. Determine if the banking organization hasinternal policies addressing underwritingstandards that are applicable to ABCPprograms.

2. For each ABCP transaction, ascertainwhether the institution applies the followingfactors in its underwriting process:

a. General Portfolio Characteristics:

• an understanding of the operations ofthe businesses that originates theassets being securitized

• a review of the general terms offeredto the customer

• a determination of the quality of assetsand from which legal entity assets areoriginated

• a determination of customer, indus-try, and geographic concentrations

• an understanding of the recent trendsin the business that may affect anyhistorical information about the assets

b. Legal Structure of theTransaction:

• A general structuring of transactionsas ‘‘bankruptcy-remote’’ via a legal‘‘true sale’’ of assets rather than as

1. The transaction summary may not be specifically iden-tified, but its elements would be part of the credit-approvalprocess.

2. The seller/servicer’s risk profile may be developed by agroup within the banking organization other than the ABCPprogram group and incorporated into the transaction summaryby reference.



secured loans. (This reduces the like-lihood that a creditor of the seller cansuccessfully challenge the securityinterest in the asset pool in the eventof seller insolvency.) Determine if thebanking organization maintains cop-ies of true-sale opinions in the facilityfile or as a part of the facility’s legaldocuments.

• An appropriate management level inthe credit-approval hierarchy that isresponsible for reviewing transac-tions that do not have a bankruptcy-remote ‘‘true-sale’’ structure.

• Uniform commercial code (UCC) fil-ings and searches on securitizedassets. (UCC filings are often neededto ensure that asset transfers resistthird-party attack [that is, are ‘‘per-fected’’]). UCC searches often ensurethat asset transfers are not subject to ahigher-priority security interest (thatis, that the banking organization’sinterests are ‘‘first priority’’). If suchfilings and searches have not beenperformed, examiners should makefurther inquiry. There may be a satis-factory reason for not using the UCCfiling system.

• Transactions that include a contrac-tual representation or a legal opinionensuring that there are no provisions,such as negative pledges or limita-tions on the sale of assets, that wouldprohibit the securitization transaction.

c. Transaction-Specific CreditEnhancements

Transaction-specific credit enhance-ment takes a variety of forms depend-ing upon the asset type. For instance,credit enhancement relating to tradereceivables may consist of the follow-ing types of reserves:• loss reserve—reserves related to obli-

gor default risk• dilution reserve—reserves related to

non-cash reductions of balances• servicing reserve—reserves related to

fees for servicing and trustees

The loss and dilution reserves typicallyaccount for most of the reserves.

Reserves may take a number of differ-ent forms, including recourse to theseller (if the seller is of high creditquality), funded cash reserves, and over-collateralization.(1) Determine if the credit-approval

chain carefully scrutinizes transac-tions in which reserves are in theform of recourse to a seller withweak credit quality.

(2) Ascertain if the banking organiza-tion’s criteria for structuring theappropriate reserve levels are gen-erally consistent with rating agencycriteria for a particular asset class.

(3) Review and consider the relevantrating agency methodology whenevaluating reserves for any particu-lar transaction.

d. Eligibility Criteria

Eligibility criteria are structured intosecuritization transactions to restrict (orlimit) the inclusion of certain categoriesof receivables as appropriate to theparticular transaction. Examples of suchrestricted categories may include:• delinquent receivables (based on a

stated aging policy, such as 30 dayspast due)

• receivables of bankrupt obligors• foreign receivables• affiliate receivables• receivables of obligors with delin-

quent balances above a certain amount• bill and hold receivables• unearned receivables• non-U.S.-dollar-denominated receiv-

ables• receivables subject to offset• disputed receivables• receivables with a payment date

beyond a specified time horizon• post-petition receivables

The above list is illustrative and shouldnot be considered comprehensive.

(1) Conduct further analysis when thereis a lack of any specific eligibilitycriteria (for example, those listedabove) that warrants a further deter-mination as to whether the banking



organization has taken appropriatemeasures to alleviate any particularrisk arising from the lack of aspecific feature.

e. Concentrations

(1) Analyze obligor, industry, and geo-graphic concentrations.

(2) Ascertain if the appropriate concen-tration limits have been establishedwithin transaction documents, oftenwithin the eligibility criteria.

f. Trigger Events and TerminationEvents

The inclusion of trigger and terminationevents plays a critical role in securiti-zation structures. It is standard practiceto have trigger or termination eventsrelated to the performance of the assetsand, depending upon the asset type, tothe seller/servicer. Trigger events arecomparable to performance covenantsin corporate debt and provide a lenderwith the ability to accelerate a transac-tion, when appropriate. In addition, suchtriggers create incentives that allow theseller and the banking organization tonegotiate higher levels of credit enhance-ment or add further restrictions to eli-gibility criteria when the receivables’performance metrics indicate deteriora-tion beyond an established trigger level.In a similar way, termination events areestablished to begin the early termina-tion of the transaction when the receiv-able performance deteriorates. Typicaltrigger events are based on one or moreof the following performance metrics:• asset coverage ratio• delinquencies• losses• dilution

Termination events may include thesesame metrics but may also include thebankruptcy, insolvency, change of con-trol of the seller/servicer, or the failureof the servicer to perform its responsi-bilities in full.

g. Due-Diligence Reviews

(1) Ascertain if the banking organiza-tion conducts due-diligence reviewsprior to closing its ABCP transac-tions. Determine if such reviewswere tailored to the asset type beingsecuritized and the availability ofaudit information. A frequent pub-lic asset-backed securities (ABS)issuer that accesses conduit fundingor a seller that has strong creditquality may be eligible for a post-closing review, provided recentaudit results are obtained. If not, itshould be subject to pre-closingreview. For example, a review tai-lored to trade receivables shouldfocus on most of the following:• Confirming the receivable infor-

mation (balances, sales, dilution,write-offs, etc.) previously pro-vided by the seller, with the sell-er’s books and records over atleast two reporting periods. Sucha review might be performed by athird-party auditor.

• Sampling invoices against theseller’s aged trial balance to testthe accuracy of agings.

• Sampling past invoices to deter-mine ultimate resolution (paid,credited, written-off, etc.)

• Sampling credits against theirrespective invoices to test thedilution horizon.

• Sampling write-offs to determinetiming and reasons for write-offs.

• Reviewing significant customerconcentrations, including delin-quent balances.

• Determining systems capabilitywith respect to transaction report-ing and compliance.

• Reviewing credit files for com-pleteness and conformity withcredit policies.

• Reviewing collection systems anddetermining the portion of cashgoing into segregated lockboxesor bank accounts.

• Reviewing internal and externalauditor reports to the extent thatsuch documents are available forreview.



• Noting any unusual items thatmay complicate the receivabletransaction.

(2) Determine if ABCP transactions arereviewed at least annually.• Confirm that the banking organi-

zation verifies the accuracy of themonthly servicer’s transactionreports, including compliancewith sale and servicing require-ments.

• Determine if an increased reviewfrequency is needed for any issuesraised in prior reviews, transac-tions with higher-risk sellers, andtransactions serviced out of mul-tiple locations.

h. Cash Management

(1) Assess a seller’s cash-managementpractices. Commingling of cash col-lections can cause a loss in theperfected security interest of cashflows, particularly in the event ofseller insolvency.• Determine if, preferably, the bank-

ing organization requires that allpayment collections flow into asingle, segregated lockboxaccount to minimize cash-commingling risk.

• For trade receivables, find out ifthe banking organization requiresthat the cash collections be rein-vested in new receivables toeliminate cash-commingling risk.

(2) For higher-risk sellers, determine ifthe banking organization—• establishes an account in the name

of the trust or special-purposevehicle (SPV) into which collec-tions could be swept on a dailybasis or

• requires that settlement be doneweekly, or daily, ensuring thatthere are always sufficient receiv-ables to cover investments andreserves.

i. Reporting

When underwriting a portfolio, it isimportant to decide what information

should be required in the monthly report.

(1) Determine if quarterly, or more fre-quent, reports for a trade receivabletransaction include the following:• beginning balances• sales• cash collections• dilution or credits• write-offs• ending balances• delinquencies by aging bucket• ineligible assets• total eligible receivables• excess concentrations• net receivable balance• conduit investment• conduit’s purchased interest• calculation of receivable perfor-

mance termination events• top 10 obligor concentrations

(2) Ascertain if the banking organiza-tion has established other specialreporting requirements based on theparticular pool of receivables beingsecuritized.

j. Receivable Systems

(1) Because of the significant reportingrequirements in a securitizationtransaction, verify that the bankingorganization assesses—• the seller’s receivable systems to

determine if they will be suffi-cient to provide the requiredinformation and

• the seller’s data backup and disas-ter recovery systems.

k. Quality of Seller/Servicer

(1) Verify that the banking organiza-tion performs an assessment of thecreditworthiness of the seller that isconducted from the relationshipside.

(2) Determine if the banking organiza-tion conducts a more focused as-sessment on the seller/servicer’smanagement team that is involvedin the day-to-day receivables opera-tion (that is, credit, accounting,sales, servicing, etc.).



l. Performance Monitoring

(1) Find out whether the banking orga-nization has developed and uses aperformance-monitoring plan thatperiodically monitors the portfolio.• Determine if there is appropriate

monitoring that allows the desig-nated administrator to review rel-evant pool performance to evalu-ate the level of available fundingunder the asset-quality tests inthe related liquidity facility.

• Determine if the banking organi-zation tests these conditions whenthe seller reports performancedata relating to an underlyingtransaction (usually monthly orquarterly).

Typically, a liquidity facility has a fund-ing condition based on asset qualitywhereby the liquidity provider will notadvance against any receivable that isconsidered defaulted. A performance-monitoring plan may entail monitoring therun rate of defaulted assets so that thepotential losses do not exceed the lossprotection.

m. Post-Closing Monitoring

(1) Determine if the banking organiza-tion’s underwriting team assists theportfolio management team indeveloping all of the items thatshould be tracked on the transac-tion, including the development ofa spreadsheet that ensures the cap-ture and calculation of the appro-priate information.

n. Underwriting Exceptions

(1) If a banking organization approvesa transaction after it has agreed toan exception from standard under-writing procedures, find out if thebanking organization closely moni-tors and periodically evaluates thepolicy exception.

Banking organizations may utilize variations ofthe above-listed underwriting standards.

(2) Evaluate the robustness of theunderwriting process and deter-mine if it is comparable to statedrating agency criteria. If weak-nesses in the underwriting processare found, determine if there areany existing compensating strengthsand any other relevant factors to beconsidered when determining itsoverall assessment.

(3) If the examiner determines that thesupervisory expectations generallyare not met, he or she should notrecommend to the appropriateReserve Bank supervisory officialthat the use of internal ratings,under the securitization capital rule,be approved.

Step 6—Consistency of InternalRatings of ABCP Program’sExposures with Ratings Issuedby the Rating Agencies

1. Find out if any underlying transactions fundedthrough ABCP programs are externally ratedby one or more rating agencies.

2. Confirm if the mapping of the internal ratingsassigned to these transactions is consistentwith, or more conservative than, those issuedby NRSROs.

3. When the underlying transactions are split-rated by two or more rating agencies, deter-mine if the internal ratings are consistentwith the most conservative (lowest) externalrating.

4. Ascertain that the above exceptions do notrepresent more than a small fraction of thetotal number of transactions that are exter-nally rated. If such exceptions exist, deter-mine if there are generally an equal or largerpercentage of externally rated transactionswhere internal ratings are more conservativethan the external rating.

If supervisory expectations are not met, thenthe internal risk-rating system may not beappropriately mapped to the external ratingsof an NRSRO. In such cases, further reviewof the adequacy of the banking organiza-tion’s risk-rating system must be undertakenbefore the use of internal ratings under thesecuritization capital rule can be approved.



Determine Adequacy of Internal RatingsSystems

If, through the examination process, the internalrisk-rating system utilized for ABCP exposuresis found to be inadequate, then the bankingorganization may not apply the internal risk-ratings approach to ABCP exposures for risk-based capital purposes until the organization hasremedied the deficiencies. Banking organiza-tions that have adequate risk-rating systems thatare well integrated into risk-management pro-cesses applied to ABCP programs may beapproved for use of the internal risk-ratingsapproach.

Once a banking organization’s internal ratingsystem is deemed adequate, the organizationmay use its internal ratings to slot ABCP expo-sures, including pool-specific liquidity facilities,into the appropriate rating category (investmentgrade, high non-investment grade, and low non-investment grade), and apply the correspondingrisk weights. However, due to the unique natureof program-wide credit enhancements, furtherguidance is provided in steps 7 through 9 to helpestablish the appropriate capital requirement.

Step 7—Determination of WhetherProgram-Wide Credit EnhancementsAre in the First-Loss Position

1. Determine if the ABCP program documenta-tion confirms that the program-wide creditenhancement is not the first-loss creditenhancement for any transaction in the ABCPprogram and is, at worst, in the second-economic-loss position, usually aftertransaction-specific credit enhancements.

2. Verify if the spread charged for the program-wide credit enhancement is the spread rangeof investment-grade exposures of a termsecuritization. Consider other factors thatmay influence pricing, such as availability ofthe credit enhancement.

3. Find out if the financial guarantee providers,such as AMBAC, FSA, and FGIC, partici-pate in a program-wide credit-enhancementtranche either on a senior position or on apari-passu position with other providers. Therisk taken by these institutions is usuallyinvestment grade.a. Compare the price of the guarantee

charged by these institutions to the pricing

ranges of non-investment-grade andinvestment-grade exposures of the spon-soring banking organization, the loan syn-dication market, and the bond market.This may be a gauge as to whether a thirdparty considers the risk as investmentgrade or non-investment grade.

b. Reference such sources for reviewing mar-ket pricing as Loan Pricing Corporation’sGold Sheets and Bloomberg (for bondspreads). A range or average pricing forboth investment-grade and non-investment-grade syndicated loans can be found in theGold Sheets.

c. Similarly, review also the price the sponsor/banking organization is charging for itsrespective portion of the program-widecredit enhancement.

Step 8—Risk LevelsPosed by Concentrations ofNon-Investment-GradeSeller/Servicers

1. Confirm that the banking organization’s inter-nal risk-rating systems properly account forthe existence of seller/servicer risk.

An asset originator (that is, the entityselling the assets to the ABCP program)typically is the servicer and essentially actsas the portfolio manager for the ABCP pro-gram’s investment. The servicer identifiesreceivables eligible for the ABCP programand manages to preserve the investment onbehalf of the banking organization sponsor-ing the ABCP program. As previously dis-cussed, servicer risk can be partially miti-gated through seller allocation and structuringpayments to protect against commingling ofcash.

2. Determine if the banking organization hasspecific transaction structures, such as abackup servicer, in place to mitigate servicerrisk.

3. Ascertain if exposure to an excessive numberof non-investment-grade servicers adverselyaffects the overall credit quality of the ABCPprogram, exposing the conduit to the higherbankruptcy risk that inherently exists withnon-investment-grade obligors.

4. Use the benchmarks below to assess thebanking organization’s potential exposuresto non-investment-grade seller/servicer con-



centrations in its ABCP program. Dependingon the circumstances, concentrations exceed-ing these benchmarks may be considered asunsafe and unsound banking practices.a. Determine, based on the grid below, the

percentage of securitized assets from non-investment-grade servicers to the totaloutstandings of an ABCP program thathas a lower weighted average rating of allthe transactions in the program. Forexample, if the ABCP program transac-tions have a weighted average ratingequivalent to ‘‘BBB,’’ no more than 30 per-cent of the total outstandings of the ABCPprogram should be represented by non-investment-grade seller/servicers. How-ever, an ABCP program that has transac-tions structured to a higher weightedaverage rating, such as a single ‘‘A’’equivalent, could have up to 60 percent ofthe outstandings originated by non-investment-grade seller/servicers withoutcausing undue concerns.

Weightedaverage rating

equivalentof transactions

Servicerpercentage

belowinvestment grade

AA 90%AA– 80%A+ 70%A 60%

A– 50%BBB+ 40%BBB 30%

BBB– 20%BB+ 10%

Step 9—The Portion of UnderlyingAssets of the ABCP ProgramStructured to Investment-Grade Risk

1. Determine the appropriate amount of risk-based capital that should be assessed againstthe program-wide credit enhancement basedon the internal risk ratings of the underlyingtransactions in the ABCP program.a. If all underlying transactions are rated

investment grade, risk-weight the notionalamount of the program-wide creditenhancement at 100 percent.

b. If one or more of the underlying transac-

tions are internally rated below invest-ment grade, then consider using the fol-lowing weakest-link approach to calculatean appropriate risk-based capital chargefor the program-wide credit enhancement.

The approach takes into account theinternal ratings assigned to each underly-ing transaction in an ABCP program.These transaction-level ratings are typi-cally based on the internal assessment of atransaction’s pool-specific liquidity facil-ity and the likelihood of its being drawn.The transactions are rank-ordered by theirinternal rating and then bucketed into thethree ratings categories: investment grade,high non-investment grade, and low non-investment grade. The program-wide creditenhancement is then assigned an appropri-ate risk weight based upon the notionalamount of transactions in each ratingsbucket.

Under the weakest-link approach, therisk of loss corresponds first to the weak-est transactions to which the program-wide credit enhancement is exposed. Bank-ing organizations should begin with thelowest bucket (low non-investment grade)and then move to the next-highest ratingbucket until the entire amount of theprogram-wide credit enhancement hasbeen assigned. The assigned risk weightsand their associated capital charges arethen aggregated. However, if the risk-based capital charge for the non-investment-grade asset pools equals orexceeds the 8 percent charge against theentire amount of assets in the ABCPprogram, then the risk-based capital chargeis limited to the 8 percent against theprogram’s assets.

Banking organizations that sponsorABCP programs may have other method-ologies to quantify risk across multipleexposures. For example, collateralized debtobligation (CDO) ratings methodologytakes into account both the probability ofloss on each underlying transaction andcorrelations between the underlying trans-actions. This and other methods may gen-erate capital requirements equal to ormore conservative than those arrived atvia the weakest-link method. Regardlessof the approach used, well-managed insti-tutions should be able to support theirrisk-based capital calculations.



Example 1

ABCP program size (PROG) = $1,000 MM

Program-wide credit enhancement (PWC) =$100 MM

Total amount of investment grade (IG) =$995 MM

Total amount of high non-investment grade(NI1) = $4 MM

Total amount of low non-investment grade(NI2) = $1 MM

Weakest Link

RBC = IF [(0.16 * 4) + 1] ≥ (0.08 * 1,000), thenRBC = (0.08 * 1,000)

= $1.64 MM < $80 MM

Else

RBC = [(0.08 * (100 Ø (4 + 1))] + (0.16 * 4) +(1)

RBC = (7.60) + (0.64) + (1)= $ 9.24 MM

Example 2

ABCP program size (PROG) = $1,000 MM

Program-wide credit enhancement (PWC) =$150 MM

Total amount of investment grade (IG) =$940 MM

Total amount of high non-investment grade(NI1) = $50 MM

Total amount of low non-investment grade(NI2) = $10 MM

Weakest Link

RBC = IF [(0.16 * 50) + 10] ≥ (0.08 * 1,000),then RBC = (0.08 * 1,000) = $18 MM< $80 MM

Else

RBC = [(0.08 * (150 Ø (50+10))] + (0.16 * 50)+ (10)

RBC = (7.20) + (8.00) + (10)= $25.2MM

Weakest-Link Formula

IF [(0.16 * NI1) + NI2**] ≥ (0.08 * PROG), THEN RBC = (0.08 x PROG)Else

Capital = [0.08 * (PWC Ø (NI1 + NI2))] + 0.16 * NI1] + [NI2**]

**Although the term NI2 should reflect a gross-up charge under the securitization capital rule(that is, an effective 1,250 percent risk weight), for the sake of simplicity a dollar-for-dollarcharge is used here. The reason for using dollar-for-dollar is based on the assumption that theNI2 portion of an ABCP pool is typically smaller than the gross-up charge would be on theentire pool. Thus, instead of grossing-up the NI2 portion and then applying the low-level-exposure rule (which, if NI2 is less than the gross-up charge, will yield a dollar-for-dollarcapital charge), the term just assumes the dollar-for-dollar amount.

In any event, the risk-based capital charge on the program-wide credit enhancement willnever exceed the maximum contractual amount of that program-wide credit enhancement(that is, the low-level-exposure rule).

RBC = Risk-based capitalPROG = Notional amount of all underlying exposures in the programPWC = Notional amount of program-wide credit enhancementIG = Notional amount of exposures rated BBB- or betterNI1 = Notional amount of exposures rated between BB+ and BB-NI2 = Notional amount of exposures rated below BB-



Example 3

ABCP program size (PROG) = $1,000 MMProgram-wide credit enhancement (PWC) =

$150 MMTotal amount of investment grade (IG) =

$0 MMTotal amount of high non-investment grade

(NI1) = $500 MMTotal amount of low non-investment grade

(NI2) = $500 MM

Weakest Link

RBC = IF [(0.16 * 500) + 500] ≥ (0.08 * 1,000),THEN RBC = (0.08 * 1,000) = $580 MM >$80 MM

Therefore,

RBC = (0.08 * 1,000) = $80 MM

Because $580 MM is greater than the $80 MMcapital charge that would apply if all of theassets supported by the PWC were on-balance-sheet, the maximum risk-based capital charge is$80 MM.

When the sum of all non-investment-gradeasset pools (that is, NI1 + NI2) exceeds theamount of the program-wide credit enhance-ment, the weakest-link formula would result in

too much risk-based capital being assessed. Ifthis situation arises, banking organizationsshould first apply the gross-up treatment to theNI2 asset pools and then assess 16 percentrisk-based capital against an amount of the NI1asset pools that, when added with the NI2 assetpools, would equal the amount of the program-wide credit enhancement. For example, if theprogram-wide credit enhancement is $100 onunderlying transactions totaling $1,000, and theunderlying exposures are $10 low non-investment grade, $100 high non-investmentgrade, and $890 investment grade, then riskweighting will be based on the gross-up approachfor $10 and assigning the remaining $90 to the200 percent risk-weight category, as shownbelow:

$10 * 1,250% * 8% = $10.00$90 * 200% * 8% = $14.40

Total $24.40

Finally, the aggregate capital charge, $24.40in this case, is then compared to the capitalcharge imposed on the underlying transactions ifall the program assets were on the bankingorganization’s balance sheet (that is, 0.08 *$1,000 = $80); the lower amount prevails. Thisestablishes the capital charge for the program-wide credit enhancement.



Assessing Risk-Based Capital—Direct-Credit SubstitutesExtended to ABCP ProgramsInternal Control QuestionnaireEffective date October 2007 Section 3030.4

1. Does the banking organization have anacceptable risk-rating system?

2. Does the banking organization use an estab-lished internal risk-rating system tailored toABCP securitization exposures?

3. Are the relevant exposures internally rated?4. Are the ABCP programs monitored by rating

agencies?5. Are there sufficient underwriting standards

and management oversight?6. Are internal ratings of ABCP program expo-

sures consistent with ratings issued by therating agencies?

7. Is program-wide credit enhancement in thefirst-loss position?

8. Do concentrations of non-investment-gradeseller/services pose an excessive level ofrisk?

9. What portion of the underlying assets of theABCP programs is structured to investment-grade risk?


Dodd-Frank Act Company-Run Stress Testingfor Banking Organizations with Total ConsolidatedAssets $10−50 BillionEffective date April 2015 Section 3050.1

The federal banking agencies1 issued Supervi-sory Guidance on Implementing Dodd-FrankAct2 Company-Run Stress Tests for BankingOrganizations with Total Consolidated Assets ofMore Than $10 Billion but Less than $50 Billion(see 79 Fed. Reg. 14153, March 13, 2014)($10–50 billion companies). The guidance offersadditional details about methodologies thatshould be employed by these companies. Theterm “company” refers to state member banks,bank holding companies, and savings and loanholding companies. This guidance builds uponthe interagency stress testing guidance that wasissued in May 2012 for companies with morethan $10 billion in total consolidated assets thatset forth general principles for a satisfactorystress testing framework.3 The guidance dis-cusses supervisory expectations for the Dodd-Frank Wall Street Reform and Consumer Pro-tection Act (Dodd-Frank Act) stress test practicesfor companies. The agencies determined thatproviding the supervisory guidance would behelpful to the $10–50 billion companies incarrying out their tests that are appropriate fortheir risk profile, size, complexity, business mix,and market footprint.4

The Dodd-Frank Act stress tests may notnecessarily capture a company’s full range ofrisks, exposures, activities, and vulnerabilitiesthat have a potential effect on capital adequacy.Additionally, the Dodd-Frank Act stress testsassess the impact of stressful outcomes oncapital adequacy and are not intended to mea-sure the adequacy of a company’s liquidity inthe stress scenarios. Companies to which thisguidance applies are not subject to the FederalReserve’s capital plan rule, the Federal Reserve’s

annual Comprehensive Capital Analysis andReview (CCAR), supervisory stress tests forcapital adequacy, or the related data collectionssupporting the supervisory stress test. Refer toSR-14-3 and its attachments 1 and 2.

EXPECTATIONS FORDODD-FRANK ACT STRESSTESTS

The supervisory expectations contained in theguidance follow the specific rule requirementscontained in the final Dodd-Frank Act stress testrules for $10–50 billion companies and areorganized in a similar manner. The guidancecovers several categories, outlined below.

Dodd-Frank Act Stress Test Timelines

Under the Dodd-Frank Act stress test rules,stress test projections are based on exposureswith the as-of date of September 30 and extendover a nine-quarter planning horizon that beginsin the quarter ending December 31 of the sameyear and ends December 31 two years later.

Scenarios for Dodd-Frank Act StressTests

Under the stress test rules implementing theDodd-Frank Act requirements, $10–50 billioncompanies must assess the potential impact oncapital of a minimum of three macroeconomicscenarios (that is, baseline, adverse, and severelyadverse scenarios) provided by their primarysupervisor on their consolidated losses, rev-enues, balance sheet (including risk-weightedassets), and capital. A company is not requiredto use all of the variables provided in thescenario, if those variables are not relevant orappropriate to the company’s line of business. Inaddition, a company may, but is not required to,use additional variables beyond those providedby the agencies. When using additional vari-ables, companies should ensure that the paths ofsuch variables (including their timing) are con-sistent with the general economic environmentassumed in the supervisory scenarios.

1. The Federal Reserve Board, the Office of the Comptrol-ler of the Currency, and Federal Deposit Insurance Corpora-tion (the agencies).

2. Pub. L. 111–203, 124 Stat. 1376 (2010).3. See 77 Fed. Reg. 29458, “Supervisory Guidance on

Stress Testing for Banking Organizations With More Than$10 Billion in Total Consolidated Assets,” (May 17, 2012).The Federal Reserve’s rule for “Annual Company-Run StressTest Requirements for Banking Organizations with TotalConsolidated Assets over $10 Billion Other than CoveredCompanies” was issued by the Board on October 12, 2012 (77Fed. Reg. 62396).

4. The Dodd-Frank Act stress tests produce projections ofhypothetical results and are not intended to be forecasts ofexpected or most likely outcomes.


Dodd-Frank Act Stress TestMethodologies and Practices

The agencies expect that the specific method-ological practices used by companies to producethe estimates of the impact on capital and thatother measures may vary across organizations.5

In addition, Dodd-Frank Act stress testing prac-tices for $10–50 billon companies should becommensurate with each company’s size, com-plexity, and sophistication. This means that,generally, larger or more sophisticated compa-nies should consider employing not just theminimum expectations, but the more advancedpractices described in the supervisory guidance.In addition, $10–50 billion companies shouldconsider using more than just the minimumexpectations for the exposures and activities ofhighest impact and that present the highest risk.

• Data sources. Companies are expected tohave appropriate management information sys-tems and data processes that enable them tocollect, sort, aggregate, and update data andother information efficiently and reliablywithin business lines and across the companyfor use in Dodd-Frank Act stress tests. Insome cases, proxy data may be used. Compa-nies should challenge conventional assump-tions to ensure that a company’s stress test isnot constrained by its own past experience.

• Data segmentation. To account for differencesin risk profiles across various exposures andactivities, companies should segment theirportfolios and business activities into catego-ries based on common or related risk charac-teristics. The company should select the appro-priate level of segmentation based on the size,materiality, and risk of a given portfolio,provided there are sufficiently granular histori-cal data available to allow for the desiredsegmentation. The minimum expectation isthat companies will segment their portfoliosand business activities using the categorieslisted in the $10–50 billion reporting form.6

• Model risk management. Companies shouldhave in place effective model risk-managementpractices, including validation, for all modelsused in Dodd-Frank Act stress tests, consis-tent with existing supervisory guidance.7 Com-panies should ensure an effective challengeprocess by unbiased, competent, and qualifiedparties is in place for all models. There shouldalso be sufficient documentation of all models,including model assumptions, limitations, anduncertainties. Companies should ensure thattheir model risk-management policies andpractices generally apply to the use of vendorand third-party products as well. Qualitativeelements of models should also be subject tomodel risk management.

• Loss estimation. For their Dodd-Frank Actstress tests, companies are expected to havecredible loss estimation practices that capturethe risks associated with their portfolios, busi-ness lines, and activities. Credit losses associ-ated with loan portfolios and securities hold-ings should be estimated directly and separately,whereas other types of losses should be incor-porated into estimated pre-provision net rev-enue (PPNR).8 Each company’s loss estima-tion practices should be commensurate withthe materiality of the risks measured and wellsupported by sound, empirical analysis. Lossestimates should include projections of other-than-temporary impairments (OTTI) for secu-rities both held for sale and held to maturity.

• Pre-provision net revenue estimation. For theDodd-Frank Act stress test, companies arerequired to project PPNR over the planninghorizon for each supervisory scenario. Com-panies should estimate PPNR at a level at leastas granular as the components outlined in the$10–50 billion reporting form. Companiesshould ensure that PPNR projections are gen-erally consistent with projections of losses,the balance sheet, and risk-weighted assets. Acompany may estimate the stressed compo-nents of PPNR based on its own or industry-

5. In making projections, companies should make conser-vative assumptions about management responses in the stresstests and should include only those responses for which thereis substantial support. For example, companies may accountfor hedges that are already in place as potential mitigatingfactors against losses but should be conservative in makingassumptions about potential future hedging activities and notnecessarily anticipate that actions taken in the past could betaken under the supervisory scenarios.

6. For purposes of the supervisory guidance, the term

“$10–50 billion reporting form” generally refers to the AnnualCompany-Run Stress Test Report (FR Y-16). However, forsubsidiary banks and thrifts of $10–50 billion holding com-panies, it could be the relevant reporting form the subsidiarywill use to report the results of its Dodd-Frank Act stress teststo its primary federal financial regulatory agency.

7. Refer to SR-11-7, “Guidance on Model RiskManagement.”

8. The Dodd-Frank Act stress test rules define PPNR as netinterest income plus non-interest income less non-interestexpense. Non-operational or non-recurring income and expenseitems should be excluded.

3050.1 Dodd-Frank Act Company-Run Stress Testing


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wide historical income and expense experi-ence. Other types of losses that could ariseunder the supervisory scenarios should beincluded in projections of PPNR to the extentthey would arise under the specified scenarioconditions.

• Balance sheet and risk-weighted asset projec-tions. A company is expected to project itsbalance sheet and risk-weighted assets foreach of the supervisory scenarios. In doing so,these projections should be consistent withscenario conditions and the company’s priorhistory of managing through the differentbusiness environments, especially stressfulones. The projections of the balance sheet andrisk-weighted assets should be consistent withother aspects of stress test projections, such aslosses and PPNR.

• Projections for quarterly provisions and allow-ance for loan and lease losses (ALLL). TheDodd-Frank Act stress test rules require com-panies to project quarterly provisions for loanand lease losses (PLLL). Companies areexpected to project PLLL for each scenariobased on projections of quarterly loan andlease losses and while maintaining an appro-priate ALLL balance at the end of eachquarter of the planning horizon, including thelast quarter.

• Projections for quarterly net income. Underthe Dodd-Frank Act stress test rules, compa-nies must estimate projected quarterly netincome for each scenario. Net income projec-tions should be based on loss, revenue, andexpense projections.

Estimating the Potential Impact onRegulatory Capital Levels and CapitalRatios

Companies must estimate projected quarterlyregulatory capital levels and regulatory capitalratios for each scenario. Any rare cases in whichratios are higher under the adverse and severelyadverse scenarios should be very well supportedby analysis and documentation. Projected capi-tal levels and ratios should reflect applicableregulations and accounting standards for eachquarter of the planning horizon. In their Dodd-Frank Act stress tests, bank holding companiesand savings and loan holding companies arerequired to calculate pro forma capital ratiosusing a set of capital action assumptions basedon historical distributions, contracted payments,

and a general assumption of no redemptions,repurchases, or issuances of capital instruments.There are no specified capital actions for statemember banks.

Controls, Oversight, andDocumentation

A company must establish and maintain a sys-tem of controls, oversight, and documentation,including policies and procedures that apply toall of its Dodd-Frank Act stress test compo-nents. Senior management and the board ofdirectors have specific responsibilities relatingto Dodd-Frank Act stress testing. The board ofdirectors should ensure it remains informedabout critical reviews of elements of the Dodd-Frank Act stress tests, especially regarding keyassumptions, uncertainties, and limitations. Inaddition, the board of directors and senior man-agement of a $10–50 billion company mustconsider the role of stress testing results innormal business, including the company’s capi-tal planning, assessment of capital adequacy,and risk-management practices. A companyshould appropriately document the manner inwhich Dodd-Frank Act stress tests are used forkey decisions about capital adequacy, includingcapital actions and capital contingency plans.The company should indicate the extent towhich Dodd-Frank Act stress tests are used inconjunction with other capital assessment tools.

Report to Supervisors

A $10–50 billion company must report theresults of its Dodd-Frank Act company-runstress tests on the $10–50 billion annual report-ing form (FR Y-16). This report will include acompany’s quantitative projections of losses,PPNR, balance sheet, risk-weighted assets,ALLL, and capital on a quarterly basis over theduration of the scenario and planning horizon. Inaddition to the quantitative projections, compa-nies are required to submit qualitative informa-tion supporting their projections.9

9. These companies should look to the $10–50 billionconsolidated assets reporting instructions for the supervisoryexpectations as to what information should be included in thereport on the company’s Dodd-Frank Act stress test. See theFR Y-16 instructions:http://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+5BzDbzK2O0R3zNJw==

Dodd-Frank Act Company-Run Stress Testing 3050.1


Public Disclosure of Dodd-Frank ActTest Results

Under the Dodd-Frank Act stress test rules, a$10–50 billion company must publicly discloseDodd-Frank Act stress test results between June15 and June 30, with the first disclosure in 2015.

The summary of the results of the stress test,including both quantitative and qualitative infor-mation, should be included in a single release ona company’s website or in any other forum thatis reasonably accessible to the public. A com-pany is required to publish results for the severelyadverse scenario only.

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deposit accounts section 3000.1

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