international banking activities section 2100 - the fed banking activities section 2100.0 what’s...

International Banking ActivitiesSection 2100.0

WHAT’S NEW IN THIS REVISEDSECTION

Effective July 2010 this section was revised todiscuss the Federal Reserve’s supervision andregulation of the international operations ofbanking organizations headquartered in theUnited States as well as the domestic activitiesof foreign banking organizations (FBOs). Thisincludes the number of member banks, Edge Actcorporations and agreement corporations oper-ating in foreign countries and overseas areas ofthe United States and the number of entitiesrepresenting FBOs operating in the UnitedStates at the end of 2009.

The Federal Reserve has supervisory and regu-latory responsibility for the international opera-tions of member banks (national and state mem-ber banks) and bank holding companies (BHCs).These responsibilities include

• authorizing the establishment of foreignbranches of national banks and state memberbanks and regulating the scope of theiractivities;

• chartering and regulating the activities ofEdge and agreement corporations, which arespecialized institutions used for internationaland foreign business;

• authorizing foreign investments of memberbanks, Edge and agreement corporations, andBHCs and regulating the activities of foreignfirms acquired by such investors; and

• establishing supervisory policy and practicesregarding foreign lending by state memberbanks.

In addition, the Federal Reserve supervisesthe activities that foreign banking organizations(FBOs) conduct through entities in the UnitedStates, including branches, agencies, representa-tive offices, and subsidiaries.

2100.0.1 FOREIGN OPERATIONS OFU.S. BANKING ORGANIZATIONS

In supervising the international operations ofstate member banks, Edge Act and agreementcorporations, and BHCs, the Federal Reservegenerally conducts its examinations or inspec-tions at the U.S. head offices of these organiza-tions, where the ultimate responsibility for theforeign offices lies. When appropriate, examin-ers also visit the overseas offices of U.S. bank-

ing organizations to obtain financial and operat-ing information and, in some instances, toevaluate the organization’s efforts to implementcorrective measures or to test their adherence tosafe and sound banking practices. Examinationsabroad are conducted with the cooperation ofthe supervisory authorities of the countries inwhich they take place.

At the end of 2009, 53 member banks wereoperating 557 branches in foreign countries andoverseas areas of the United States; 32 nationalbanks were operating 503 of these branches, and21 state member banks were operating the other54.

2100.0.2 EDGE ACT ANDAGREEMENT CORPORATIONS

Edge Act corporations are international bankingorganizations chartered by the Federal Reserveto provide all segments of the U.S. economywith a means of financing international busi-ness, especially exports. Agreement corpora-tions are similar organizations, state charteredor federally chartered, that enter into agree-ments with the Federal Reserve to refrain fromexercising any power that is not permissible foran Edge Act corporation.

Sections 25 and 25A of the Federal ReserveAct grant Edge Act and agreement corporationspermission to engage in international bankingand foreign financial transactions. These corpo-rations, most of which are subsidiaries of mem-ber banks, may (1) make foreign investmentsthat are broader than those permissible for mem-ber banks, and (2) conduct a deposit and loanbusiness in states other than that of the parent,provided that the business is strictly related tointernational transactions. Foreign banks mayalso own Edge Act and agreement corporations.At year-end 2009, 38 U.S. banking organiza-tions owned Edge Act or agreement corpora-tions; foreign banks directly owned an addi-tional 14; and two were standalone companies.These corporations are examined annually.

2100.0.3 SUPERVISION OF FOREIGNBANKING ORGANIZATIONS

The Federal Reserve has broad authority for thesupervision and regulation of FBOs that engage

BHC Supervision Manual July 2010

in banking in the United States throughbranches, agencies, representative offices, com-mercial lending companies, Edge Act and agree-ment corporations, commercial bank subsidi-aries, BHCs, and certain nonbank companies.Under the International Banking Act of 1978, asamended by the Federal Deposit Insurance Cor-poration Improvement Act of 1991, the FederalReserve is required to approve the establishmentof foreign bank branches, agencies, commerciallending subsidiaries, and representative officesin the United States and may also terminate, orrecommend termination of, the operations offoreign banks in the United States under certainconditions. The Federal Reserve is primarilyresponsible for supervising the U.S. nonbankingoperations of FBOs.

The Federal Reserve may coordinate theexaminations of foreign bank operations withother state and federal regulators. In most cases,on-site examinations of branches and agenciesare required to be conducted once during each12-month period, although the period may beextended to 18 months if the branch or agencyof the foreign bank meets certain criteria. Formore information on the Federal Reserve’ ssupervision of FBOs, see SR-08-9, ‘‘ Consoli-

dated Supervision of Bank Holding Companiesand the Combined U.S. Operations of ForeignBanking Organizations.’’ In particular, seeattachments B1, ‘‘ Guidance for the Supervisionof the Combined U.S. Operations of ForeignBanking Organizations that are Large ComplexBanking Organizations’’ and B2, ‘‘ Guidance forthe Supervision of the Combined U.S. Opera-tions of Multi-office Foreign BankingOrganizations.’’

As of December 31, 2009, 176 foreign banksfrom 53 countries were operating 204 state-licensed branches and agencies (six of whichwere insured by the FDIC) and 50 branches andagencies licensed by the Office of the Comptrol-ler of the Currency (four of which were insuredby the FDIC). These foreign banks also directlyowned three commercial lending companies. Inaddition, the foreign banks held a controllinginterest in 58 U.S. commercial banks. Alto-gether, these foreign banks controlled approxi-mately 17 percent of U.S. commercial bankingassets. These foreign banks also operated 78representative offices; an additional 58 foreignbanks operated in the United States through arepresentative office. FBOs are significant par-ticipants in the U.S. banking system.

International Banking Activities 2100.0

BHC Supervision Manual July 2010

Formal Corrective ActionsSection 2110.0

WHAT’S NEW IN THIS REVISEDSECTION

This section has been updated for the varioustypes of formal supervisory actions—correctiveactions (i.e., cease and desist orders (includingplacing limits on the activities or functions of aBHC or institution-affiliated party), writtenagreements, suspensions (also removals andprohibitions), nonbank activity termination, vio-lations of orders and written agreements, civil-money penalties (revised penalty amounts), etc.

In addition, the cease-and-desist order dis-cussion has been expanded to include what anorder may require from a BHC or person, and itprovides a discussion of the nature of affirma-tive actions by a BHC or person that may needto be taken to restore the BHC to a safe andsound condition. The prohibition and removaldiscussion has been expanded to detail whatentities or individuals that the Board may takeaction against. It also discusses the prohibitionagainst any individual who has been convictedof a crime involving dishonesty, breach of trust,or money laundering, from serving, participat-ing in, or owning or controlling a BHC, bank ornonbank subsidiary, or any affiliate thereof with-out the prior approval of the FDIC or in certaincases, the Federal Reserve Board. The discus-sion on indemnifications and payments includesa detailed discussion of the provisions of section18(k) of the FDI Act and the FDIC’s regulationon indemnification agreements and payments.The definition of a prohibited indemnificationpayment is included.

2110.0.1 STATUTORY TOOLS FORFORMAL SUPERVISORY ACTION

Statutory tools are available to the FederalReserve Board if formal supervisory action iswarranted against a bank holding company(BHC) or nonbank subsidiaries, or against cer-tain individuals associated with them. Theobjective of formal actions is to correct prac-tices that the regulators believe to be unlawful,unsafe, or unsound. The initial considerationand determination of whether formal action isrequired usually results from an inspection. Thissection discusses the following topics:

1. Board jurisdiction under the law2. actions or practices that may trigger the

statutory remedies3. Board staff procedures

4. the elements of a corrective order5. temporary orders6. written agreements7. suspensions and removals8. enforcement of orders9. civil money penalties

10. termination of certain nonbank subsidiaryactivities or ownership

2110.0.2 TYPES OF CORRECTIVEACTIONS

Generally, under section 8 of the FederalDeposit Insurance Act (FDI Act), 12 U.S.C.1818(b), the Board may use its cease and desistauthority and other enforcement tools against(1) a BHC1, (2) a nonbank subsidiary of a BHC,and (3) any institution-affiliated party. The term‘‘institution-affiliated party’’ includes any direc-tor, officer, employee, controlling shareholder(other than a BHC), or agent, and any otherperson who has filed or is required to file achange in control notice. It also includes anyshareholder, consultant, joint venture partner, orany other person who participates in the conductof the affairs of a BHC or nonbank subsidiary,as well as any independent contractor, includingattorneys, appraisers, and accountants whoknowingly or recklessly participates in any vio-lation of law or regulation, breach of fiduciaryduty, or unsafe or unsound practice that causes(or is likely to cause) more than a minimalfinancial loss to, or a significant adverse effecton, an institution.2 The Board’s jurisdiction overan institution-affiliated party extends for up tosix years after the party’s resignation, termina-tion of employment, or separation caused by theclosing of a financial institution, provided thatany notice (such as a notice of intent to removefrom office and of prohibition) is served on theparty before the end of a six-year period.

1. The Board’s authority under 12 U.S.C. 1818 also extendsto savings and loan holding companies, their nonbank subsid-iaries, and their institution-affiliated parties.

2. The Board is authorized to issue regulations furtherdefining which individuals should be considered institution-affiliated parties. Similarly, the Board may determine whetheran individual is an institution-affiliated party on a case-by-case basis (see 12 U.S.C. 1813(u)).

BHC Supervision Manual January 2013Page 1

2110.0.2.1 Cease and Desist Orders

Generally, under 12 U.S.C. 1818(b), the Boardmay use its cease and desist authority against aBHC and any institution-affiliated party when itfinds that the entity or party is engaging, hasengaged, or is about to engage in (1) a violationof law, rule, or regulation; (2) a violation of acondition imposed in writing by the Board inconnection with the granting of any applicationor any written agreement; or (3) an unsafe orunsound practice in conducting the business ofthe institution. Section 12 U.S.C. 1818(b)(3)makes clear that the cease and desist authorityapplies to BHCs and Edge and agreement corpo-rations, as well as to all institution-affiliatedparties associated with them.

A cease and desist order may require theBHC or person subject to the order to (1) ceaseand desist from the practices or violations or(2) take affirmative action to correct the viola-tions or practices. Affirmative actions includeactions necessary to restore the BHC to a safeand sound condition, such as measures toimprove the BHC’s consolidated capital,restricting dividends and new debt to conservethe BHC’s assets so it can serve as a source ofstrength to the bank; employ qualified officersor employees; and any other action the Boarddetermines to be appropriate. An individual maybe required to reimburse the company for unau-thorized or improper payments received, orboth.

Most cease and desist orders are issued byconsent. When Board staff, in conjunction withthe appropriate Reserve Bank, determines that acease and desist action is necessary, the BHC orparty is permitted an opportunity to consent tothe issuance of the order without the need forthe issuance of a notice of charges and a con-tested administrative hearing. Board staff draftsthe proposed cease and desist order and, withReserve Bank staff, presents it to the BHC orindividual for consent. BHCs and individualsare advised that they may have legal counselpresent at all meetings with Board or ReserveBank staff concerning formal supervisoryactions. If the parties voluntarily agree to settlethe case by the issuance of a consent cease anddesist order, the proposed consent order will bepresented to senior Board officials for approval,at which time the order will be final and bind-ing.

When a BHC or person fails to consent to acease and desist order, the Board may issue a

notice of charges and of hearing to the entity orparty. The notice of charges contains a detailedstatement describing the facts constituting thealleged violations or unsafe or unsound prac-tices. The issuance of the notice of charges andof hearing3 starts a formal process that includesthe convening of a public administrative hearingto be conducted before an administrative lawjudge, appointed by the Board. After the hear-ing, the judge makes a recommended decisionto the Board. A hearing must be held within 30to 60 days of service of the notice of charges,unless a later date is set by the administrativelaw judge. After the Board considers the recordof the proceeding, including the administrativelaw judge’s recommended decision, it deter-mines whether to issue a final cease and desistorder. BHCs and individuals who are subject tocease and desist orders that were issued as aresult of contested proceedings may appeal theBoard’s issuance of the order to the appropriatefederal court of appeals.

2110.0.2.2 Temporary Cease and DesistOrders

If a violation or threatened violation of law,rule, or regulation, or if engaging in an unsafe orunsound practice that is specified in the noticeof charges is likely to cause the insolvency of aBHC or its subsidiary bank, weaken the condi-tion of the BHC, cause a significant dissipationin earnings, or otherwise seriously prejudice theinterests of subsidiary bank’s depositors beforethe completion of the proceedings (initiated bythe issuance of the notice of charges), the Boardmay, in conjunction with issuing a notice ofcharges, issue a temporary cease and desistorder against the BHC or an institution-affiliatedparty to effect immediate correction (pursuant to12 U.S.C. 1818(c)).

The Board may also issue a temporary orderif it determines that a BHC’s or nonbank subsid-iary’s books and records are so incomplete orinaccurate that the Board is unable to determine,through the normal supervisory process, theBHC’s or nonbank subsidiary’s financial condi-tion or the details or purpose of any transactionthat may have a material effect on the BHC’scondition. The temporary order may require theBHC or nonbank subsidiary to take the samecorrective actions as a cease and desist order.The advantage of issuing a temporary cease and

3. A private hearing may be held if the Board determinesthat holding a public hearing would be contrary to the publicinterest.

Formal Corrective Actions 2110.0


desist order is that it is effective immediatelyafter it is served on the BHC or individual.Within 10 days after being served with a tempo-rary order, however, the BHC or individual mayappeal to a U.S. district court for relief from theorder. Unless set aside by the district court, thetemporary order stays in effect until the Boardissues a final cease and desist order or dismissesthe action.

2110.0.2.3 Written Agreements

When circumstances warrant, a written agree-ment may be used. The provisions of a writtenagreement may relate to any of the problemsfound at the institution or involving institution-affiliated parties. Written agreements are draftedby Board staff, in consultation with ReserveBank staff, and must be approved by the Board’sDirector of the Division of Banking Supervisionand Regulation. After approval by the GeneralCounsel before issuance, the Reserve Bank mayenter into the Written Agreement under del-egated authority (12 C.F.R. 265.11(a)(15)).

2110.0.2.4 Prohibition and RemovalAuthority

The Board is authorized by 12 U.S.C. 1818(e) toremove any current institution-affiliated party ofa BHC and its nonbank subsidiaries for certainviolations and misconduct and to prohibit per-manently from the banking industry any currentor former institution-affiliated party from futureinvolvement with any insured depository institu-tion, bank or thrift holding company, and non-bank subsidiary. The Board is authorized toinitiate removal or prohibition actions when

1. the institution-affiliated party has directly orindirectly—a. violated any law, regulation, cease and

desist order, condition imposed in writing,or any written agreement;

b. engaged in any unsafe or unsound prac-tice; or

c. breached a fiduciary duty; and2. the Board determines that, because of the

violation, unsafe or unsound practice, orbreach—a. the institution has suffered or will suffer

financial loss or other damage;b. the interests of depositors have been or

could be prejudiced; orc. the institution-affiliated party has received

financial gain or other benefit from the

violation or practice; and3. such violation, practice, or breach—

a. involves personal dishonesty; orb. demonstrates a willful or continuing disre-

gard for the safety or soundness of theinstitution.

The statute also authorizes the Board to initi-ate removal or prohibition actions against(1) any institution-affiliated party who has com-mitted a violation of any provision of the BankSecrecy Act that was not inadvertent or uninten-tional, (2) any officer or director who has knowl-edge that an institution-affiliated party has vio-lated the money-laundering statutes and did nottake appropriate action to stop or prevent thereoccurrence of such a violation, or (3) anyofficer or director who violates the prohibitionson management interlocks. The removal or pro-hibition actions for these violations do notrequire a finding of gain to the individual, lossto the institution, personal dishonesty, or willfulor continuing disregard for the safety or sound-ness of the institution.4

Like a cease and desist order, a removal orprohibition order may be issued either by con-sent or after an administrative process initiatedby the issuance of a notice of intent to removeand prohibit. If an institution-affiliated party’sactions warrant immediate removal from theBHC, the Board is authorized to suspend theperson temporarily from the BHC pending theoutcome of the complete administrative process.An institution-affiliated party currently associ-ated with a BHC may also be suspended orremoved for cause based on actions taken whileformerly associated with a different insureddepository institution, BHC, or business institu-tion. ‘‘Business institution’’ is not specificallydefined in the statute so that it may be inter-preted to include any other business interests ofthe institution-affiliated party.

Under 12 U.S.C. 1818(g), the Board is autho-rized to suspend from office or prohibit fromfurther participation any institution-affiliatedparty charged or indicted for the commission ofa crime involving personal dishonesty or breachof trust that is punishable by imprisonment for aterm exceeding one year under state or federallaw, if the continued participation mightthreaten either the interests of depositors or pub-lic confidence in the institution. The Board mayalso suspend or prohibit any individual charged

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



with a violation of the money-laundering stat-utes. The suspension can remain in effect untilthe criminal action is disposed of or until thesuspension is terminated by the Board. TheBoard may also initiate a removal or prohibitionaction against an institution-affiliated party whohas been convicted of, or pleaded to, a crimeinvolving personal dishonesty or breach of trustif his or her continued service would threatenthe interests of the depositor or impair publicconfidence in the institution. The Board isrequired to issue such an order against anyinstitution-affiliated party who has been con-victed of, or pleaded to, a violation of themoney-laundering statutes.

Furthermore, 12 U.S.C. 1829 prohibits anyindividual who has been convicted of a crimeinvolving dishonesty, breach of trust, or moneylaundering from (1) serving as an institution-affiliated party of, (2) directly or indirectly par-ticipating in the affairs of, and (3) owning orcontrolling, directly or indirectly, an insureddepository institution without the FDIC’s priorapproval. The statute also prohibits a convictedperson from holding a position at a BHC ornonbank affiliate without the Board of Gover-nors of the Federal Reserve System’s priorapproval. The penalty for violation of this law isa potential fine for a knowing violation of up to$1 million per day, imprisonment for up to fiveyears, or both. The criminal penalty applies toboth the individual and the employing institu-tion.

2110.0.2.5 Termination of NonbankActivity

The Board is authorized by 12 U.S.C. 1844(e) toorder a BHC to terminate certain activities of itsnonbank subsidiary (other than a nonbank sub-sidiary of a bank) or to sell its shares of thenonbank subsidiary. When the Board has rea-sonable cause to believe that the BHC’s continu-ation of any activity or ownership or control ofany of its nonbank subsidiaries constitutes aserious risk to the financial safety, soundness, orstability of the BHC, and if the activity, owner-ship, or control is inconsistent with sound bank-ing principles or inconsistent with the purposesof the Bank Holding Company Act (BHC Act)or the Financial Institutions Supervisory Act of1966, the Board may order the BHC to termi-nate the activity or sell control of the nonbanksubsidiary.

2110.0.2.6 Violations of Final Orders andWritten Agreements

When any final order or temporary cease anddesist order has been violated, the Board mayapply to a U.S. district court for enforcement ofthe action. Violations of final orders and writtenagreements may also give rise to the assessmentof civil money penalties against the offendingBHC or institution-affiliated parties, as circum-stances warrant. The civil money penalty isassessed in the same manner as described in the‘‘Civil Money Penalties’’ section below. Anyinstitution-affiliated party who violates a suspen-sion or removal order is subject to a criminalfine of up to $1 million, imprisonment for up tofive years, or both.

2110.0.2.7 Civil Money Penalties

The Board may assess civil money penalties ofup to $7,500 per day against any institution orinstitution-affiliated party for a violation of(1) law or regulation; (2) a final cease-and-desist, temporary cease and desist, suspension,removal, or prohibition order; (3) a conditionimposed in writing by the Board in connectionwith the granting of an application or otherrequest; and (4) a written agreement.

A fine of up to $37,500 per day can beassessed for a violation, an unsafe or unsoundpractice recklessly engaged in, or a breach offiduciary duty when the violation, practice, orbreach is part of a pattern of misconduct, causesor is likely to cause more than a minimal loss, orresults in pecuniary gain or other benefit for theoffender. A civil money penalty of up to $1.375million per day can be assessed for any knowingviolation, unsafe or unsound practice, or breachof any fiduciary duty when the offender know-ingly or recklessly caused a substantial loss tothe financial institution or received substantialpecuniary gain or other benefit. Civil moneypenalties may also be assessed, under the three-tier penalty framework described above, for anyviolation of the Change in Bank Control Actand for violations of the anti-tying provisions offederal banking law, among other provisions(12 U.S.C. 1972).

The Board may also assess civil money penal-ties for the submission of any late, false, ormisleading reports required by the BHC Act andRegulation Y of the Board. If a BHC maintainsprocedures that are reasonably adapted to avoidinadvertent errors and unintentionally fails topublish any report, submits any false or mislead-ing report or information, or is minimally late



with the report, it can be assessed a fine of up to$2,200 per day. The financial institution has theburden of proving that the error was inadvertentunder these circumstances. If the error was notinadvertent, a penalty of up to $32,000 per daycan be assessed for all false or misleadingreports or information submitted to the Board. Ifthe submission was done in a knowing manneror with reckless disregard for the law, a fine ofup to $1.375 million or 1 percent of the BHC’sassets can be assessed for each day of the viola-tion. Notwithstanding the above, violations ofthe BHC Act (with the exception of late, false,or inaccurate report violations as describedabove) may be addressed by the assessment ofcivil money penalties of not more than $25,000per day.

2110.0.2.8 Administration of FormalActions

2110.0.2.8.1 Publication of Final Orders

Under 12 U.S.C. 1818(u), the Board is requiredto publish and make publicly available any finalorder issued for any administrative enforcementproceeding it initiates. These orders includecease and desist, removal, prohibition, and civilmoney penalty assessments. The Board is alsorequired to publish and make publicly availableany written agreement or other written state-ment that it may enforce, unless the Board deter-mines that publication of the order or agreementwould be contrary to the public interest.

2110.0.2.8.2 Public Hearings

Under 12 U.S.C. 1818(u), all formal hearings,including contested cease and desist, removal,and civil money penalty proceedings, are opento the public unless the Board determines that apublic hearing would be contrary to the publicinterest. Transcripts of all testimony; copies ofall documents submitted as evidence in the hear-ing, which could include examination andinspection reports and supporting documents(except those filed under seal); and all otherdocuments, such as the notice and the adminis-trative law judge’s recommended decision, areavailable to the public. These documents couldinclude examiner’s workpapers, file memoran-dums, reports of examination and inspection,and correspondence between a problem institu-tion or wrongdoer and the Federal ReserveBank. Appropriate actions should always betaken to ensure that all written material prepared

in connection with any supervisory matter beaccurate and free of insupportable conclusionsor opinions.

2110.0.2.8.3 Subpoena Power

Under 12 U.S.C. 1818(n), which is made appli-cable to BHCs by 12 U.S.C. 1818(b)(3) and1844(f), the Board has the authority to issuesubpoenas directly or through its delegated rep-resentatives, and it has the authority to adminis-ter oaths or take depositions in connection withan examination or inspection.

2110.0.3 INDEMNIFICATIONPAYMENTS AND GOLDENPARACHUTE PAYMENTS

In general, an indemnification payment is a pay-ment that reimburses an insider for a specifiedliability or cost that the person incurred in con-nection with a Federal Reserve investigation orenforcement action. Golden parachute paymentsare severance payments or agreements to makeseverance payments that are paid or entered intoat a time when the BHC or its subsidiary bank isin a troubled condition. These payments requirethe prior written approval of the institution’sfederal primary regulator and the concurrence ofthe FDIC. Although both types of payments fallunder the same statute, section 18(k) of the FDIAct (12 U.S.C. 1828(k)) and the FDIC’s accom-panying regulations,5 the two types of paymentsare quite different and distinct. However, someof the restrictions on these payments are thesame or similar.

2110.0.3.1 Indemnification Agreementsand Payments

BHCs may seek to indemnify their officers,directors, and employees from any judgments,fines, claims, or settlements, whether civil,criminal, or administrative. The bylaws of someBHCs may have broadly worded indemnifica-tion provisions, or the BHC may have enteredinto separate indemnification agreements thatcover the ongoing activities of its owninstitution-affiliated parties. Such indemnifica-

5. See the FDIC’s golden parachute regulations in 12C.F.R. 359.



tion provisions may be inconsistent with federalbanking law and regulations, as well as withsafe and sound banking practices.

Supervisory and examiner staff should bealert to the limitations and prohibitions onindemnification imposed by section 18(k) of theFDI Act6 and the regulations issued thereunderby the FDIC. The law and regulations apply toindemnification agreements and payments madeby a BHC to any institution-affiliated party,regardless of the condition of the BHC. Thepurpose of the law and regulations is to preservethe deterrent effects of administrative enforce-ment actions (by ensuring that individuals sub-ject to final enforcement actions bear the costsof any judgments, fines, and associated legalexpenses) and to safeguard the assets of finan-cial institutions.

A prohibited indemnification paymentincludes any payment (or agreement to make apayment) by a BHC to an institution-affiliatedparty to pay or reimburse such person for anyliability or legal expense incurred in any Boardadministrative proceeding that results in a finalorder or settlement in which the institution-affiliated party is assessed a civil money penalty,is removed or prohibited from banking, or isrequired to cease an action or take any affirma-tive action, including making restitution, withrespect to the BHC.7

The FDIC’s regulations provide criteria formaking permissible indemnification payments.A BHC may make or agree to make a reason-able indemnification payment if all of the fol-lowing conditions are met: (i) the institution’sboard of directors determines in writing that theinstitution-affiliated party acted in good faithand the best interests of the institution; (ii) theboard of directors determines that the paymentwill not materially affect the institution’s safetyand soundness; (iii) the payment does not fallwithin the definition of a prohibited indemnifi-cation payment; and (iv) the institution-affiliatedparty agrees in writing to reimburse the institu-tion, to the extent not covered by permissibleinsurance, for payments made in the event thatthe institution-affiliated party does not prevail.

The law and the FDIC’s regulations reinforcethe Federal Reserve’s long-standing policy thatan institution-affiliated party who engages inmisconduct should not be insulated from theconsequences of his or her misconduct. From a

safety-and-soundness perspective, a BHCshould not divert its assets to pay a fine or otherfinal judgment issued against an institution-affiliated party for misconduct that presumablyviolates the BHC’s policy of compliance withapplicable law, especially when the individual’smisconduct has already harmed the BHC.

BHCs should review their bylaws and anyoutstanding indemnification agreements, as wellas insurance policies, to ensure that they con-form with the requirements of federal law andregulations. If a BHC fails to take appropriateaction to bring its indemnification provisionsinto compliance with federal laws and regula-tions, appropriate follow-up supervisory actionmay be taken. As part of the supervisory pro-cess, which will include merger and acquisitionapplications, the Federal Reserve’s supervisoryand examiner staff will review identified agree-ments having indemnification-related issues forcompliance with federal laws and regulations.(See SR-02-17.)

2110.0.3.2 Golden Parachute Payments

The FDIC’s golden parachute regulations applyto a BHC or its insured depository institutionsubsidiary that is in a troubled condition asdefined in Regulation Y. The purposes of thelaw and regulations are to safeguard the assetsof financial institutions and limit rewards toinstitution-affiliated parties who contributed tothe institution’s troubled condition.

In general, the FDIC’s regulations prohibitBHCs and their insured depository institutionsubsidiaries from making golden parachute pay-ments except in certain circumstances. A goldenparachute payment means any payment in thenature of compensation (or agreement to makesuch payment) for the benefit of any current orformer institution-affiliated party of a BHC orits insured depository institution subsidiary thatmeets three criteria. First, the payment or agree-ment must be contingent on the termination ofthe institution-affiliated party’s employment orassociation. Second, the agreement is made orthe payment received on or after, or made incontemplation of, among other things, a deter-mination that the BHC or its insured depositoryinstitution subsidiary is in a troubled conditionunder the regulations of the applicable bankingagency.8 Third, the agreement is made or the

6. See 12 U.S.C. 1828(k).7. See 12 C.F.R. 359.

8. See section 225.71 of Regulation Y (12 C.F.R. 225.71),which defines a ‘‘troubled condition’’ for a state member bankor BHC as an institution that (1) has a composite rating of 4 or5; (2) is subject to a cease and desist order or formal written



payment is payable to an institution-affiliatedparty when a BHC or its insured depositoryinstitution subsidiary meets certain specific con-ditions, including being subject to a determina-tion that it is in a troubled condition.

The definition of a golden parachute paymentalso covers a payment made by a BHC that isnot in a troubled condition to an institution-affiliated party of an insured depository institu-tion subsidiary that is in a troubled condition, ifthe other criteria in the definition are met. Thiscircumstance may arise when a BHC, as part ofan agreement to acquire a troubled bank orsavings association, proposes to make paymentsto the troubled institution’s institution-affiliatedparties that are conditioned on their terminationof employment.9

A BHC or state member bank may make orenter into an agreement to make a golden para-chute payment only (1) if the Federal Reserve,with the written concurrence of the FDIC, deter-mines that the payment or agreement is permis-sible; (2) as part of an agreement to hire compe-tent management in certain conditions, with theconsent of the Federal Reserve and the FDIC asto the amount and terms of the proposed pay-ment; or (3) pursuant to an agreement to providea reasonable severance not to exceed 12 months’salary in the event of an unassisted change incontrol of the depository institution, with theconsent of the Federal Reserve. In determiningthe permissibility of the payment, the FederalReserve may consider a variety of factors,including the individual’s degree of managerialresponsibilities and length of service, the rea-sonableness of the payment, and any other fac-tors or circumstances that would indicate thatthe proposed payment would be contrary to thepurposes of the statute or regulations.

A BHC or state member bank requestingapproval to make a golden parachute paymentor enter into an agreement to make such apayment should submit its request simultane-ously to the appropriate FDIC regional officeand the Reserve Bank. The request must detail

the proposed payments and demonstrate that theBHC or state member bank does not possessand is not aware of any evidence that there isreasonable basis to believe, at the time the pay-ment is proposed to be made, that (1) theinstitution-affiliated party receiving such a pay-ment has committed any fraud, breach of fidu-ciary duty, or insider abuse or has materiallyviolated any applicable banking law or regula-tion that had or is likely to have a materialadverse effect on the BHC or state memberbank; (2) the individual is substantially respon-sible for the institution’s insolvency or troubledcondition; and (3) the individual has violatedspecified banking or criminal laws.

Requests regarding golden parachute pay-ments or agreements should be forwarded bythe Reserve Bank to appropriate Board staff fora final determination on the permissibility of thepayment. Golden parachute payments or agree-ments must be approved by the Board’s Direc-tor of the Division of Banking Supervision andRegulation and the General Counsel. Denialsare not delegated by the Board of Governors toBoard or Reserve Bank staffs.

If a state member bank or BHC makes orenters into an agreement to make a golden para-chute payment without prior regulatory approvalwhen such approval is required, appropriatefollow-up supervisory action should be taken.This follow-up could include an enforcementaction requiring the offending institution-affiliated party to reimburse the institution forthe amount of the prohibited payment. When aBHC or state member bank is identified as hav-ing golden parachute-related issues in the super-visory process, those issues should be carefullyreviewed for compliance with the law and theFDIC’s regulations. The appropriate ReserveBank supervisory staff and the appropriate staffof the Board’s Division of Banking Supervisionand Regulation and Legal Division should benotified and consulted on the golden parachute-related issues.

2110.0.4 DISCIPLINARY ACTIONSAGAINST ACCOUNTANTS ANDACCOUNTING FIRMS PERFORMINGCERTAIN AUDIT SERVICES

Section 36 of the FDI Act authorizes the federalbank regulatory agencies to take disciplinaryactions against independent public accountantsand accounting firms that perform audit services

agreement that requires action to improve the institution’sfinancial condition, unless otherwise informed in writing bythe Federal Reserve; or (3) is informed in writing by theFederal Reserve that it is in a troubled condition.

9. The FDIC’s regulations exclude from the definition of agolden parachute payment several types of payments, such aspayments made pursuant to a qualified pension or retirementplan; a benefit plan or bona fide deferred compensation plan(which are further defined in the FDIC’s regulations); or aseverance plan that provides benefits to all eligible employ-ees, does not exceed the base compensation paid over thepreceding 12 months, and otherwise meets the regulatorydefinition of nondiscriminatory and other conditions in theFDIC’s regulations.



covered by the act’s provisions. Section 36, asimplemented by part 363 of the FDIC’s rules(12 C.F.R. 363), requires that each federallyinsured depository institution with total assetsof $500 million or more obtain an audit of itsfinancial statements and an attestation on man-agement’s assertions concerning internal con-trols over financial reporting performed by anindependent public accountant (the accountant).The insured depository institution must includethe accountant’s audit and attestation reports inits annual report.

The audit requirement can be fulfilled by anindependent audit of a BHC where the insuredsubsidiary bank (1) has total assets of less than$5 billion or (2) has total assets of $5 billion ormore and has a composite CAMELS rating of 1or 2.

Section 36 and the rules enacted pursuantthereto set forth the practices and procedures toremove, suspend, or debar, for good cause,10 anaccountant or firm from performing audit andattestation services for an insured state memberbank, or BHC that obtains audit services for aninsured subsidiary bank. Immediate suspensionsare permitted in limited circumstances. Also, anaccountant or accounting firm is prohibited fromperforming audit services for the covered insti-tution if an authorized agency has taken such adisciplinary action against the accountant orfirm, or if the U.S. Securities and ExchangeCommission or the Public Company Account-ing Oversight Board has taken certain disciplin-ary action against the accountant or firm.

2110.0.5 APPOINTMENT OFDIRECTORS AND SENIOREXECUTIVE OFFICERS

Under section 32 of the FDI Act (12 U.S.C.1831i) and subpart H of Regulation Y (12 C.F.R.225.71 et seq.), any BHC or state member bankthat is in troubled condition, or does not meetminimum capital standards, must provide 30days’ written notice to the Board before appoint-ing any new director or senior executive offi-cer,11 or changing the responsibilities of anysenior executive officer so that the officer wouldassume a different senior officer position. Sub-part H of Regulation Y sets forth the proceduresfor filing and the content of the notice. If a BHCor state member bank that is in a troubled condi-tion appoints a director or senior officer withoutthe required 30 days’ prior written notice, appro-priate follow-up supervisory action should betaken.

The Board may disapprove a notice if it findsthat the competence, experience, character, orintegrity of the proposed individual indicatesthat his or her service would not be in the bestinterest of the institution’s depositors or thepublic. A disapproved individual or the institu-tion that filed the notice may appeal the FederalReserve’s notice of disapproval under the proce-dures set forth in Regulation Y. While the appealis pending, the individual may not serve as adirector or senior executive officer of a BHC ora state member bank.

10. The rules provide that certain violations of law, negli-gent conduct, reckless violations of professional standards, orlack of qualifications to perform auditing services may beconsidered good cause.

11. The Board or Reserve Bank, under extraordinary cir-cumstances, may permit an individual to serve as a director orsenior executive officer before a notice is provided; however,this permission does not affect the Federal Reserve’s authorityto disapprove a notice within 30 days of its filing.



Foreign Corrupt Practices Act andFederal Election Campaign Act Section 2120.0

2120.0.1 INTRODUCTION

On January 17, 1978, the three federal banksupervisory agencies issued a joint policy state-ment to address their concern with regard to thepotential for improper payments by banks andbank holding companies in violation of the For-eign Corrupt Practices Act and the Federal Elec-tion Campaign Act.While not widespread, the federal bank super-

visory agencies were concerned that such prac-tices could reflect adversely on the banking sys-tem and constitute unsafe and unsound bankingpractices in addition to their possible illegality.The potential devices for making political

payments in violation of the law could includecompensatory bonuses to employees, designatedexpense accounts, fees or salaries paid to offi-cers, and preferential interest rate loans. In addi-tion, political contributions could be made byproviding equipment and services withoutcharge to candidates for office. Refer to F.R.R.S.at 3–447.1 and 4–875.

2120.0.2 SUMMARY OF THEFEDERAL ELECTION CAMPAIGNACT

The Federal Election Campaign Act (FECA),enacted in 1971, was designed to curb potentialabuses in the area of federal election financing.In general, FECA regulates the making of cam-paign contributions and expenditures in connec-tion with primary and general elections to fed-eral offices. Since 1907, federal law hasprohibited national banks from making contribu-tions in connection with political elections.FECA does not specifically address the makingof contributions and expenditures by banks orother corporations to advocate positions onissues that are the subjects of public referenda.As originally enacted, FECA required disclo-sure of contributions received or expendituresmade; however, amendments to the law in 1974and 1976 imposed additional limitations on con-tributions and expenditures as well. The 1974amendments also established the Federal Elec-tion Commission (Commission) to administerFECA’s provisions. The Commission is respon-sible for adopting rules to carry out FECA, forrendering advisory opinions, and for enforcingthe Act. The Commission was reorganized as aresult of the FECA Amendments of 1976, and ithas issued regulations interpreting the statute(11 C.F.R.).

2120.0.3 BANKS AND THE FECA

National banks and other federally charteredcorporations are specifically prohibited frommaking contributions or expenditures in connec-tion with any election; other corporations, in-cluding banks and bank holding companies, maynot make contributions or expenditures in con-nection withfederalelections. However, corpo-rations may establish and solicit contributionsto ‘‘separate segregated funds’’ to be used forpolitical purposes; these are discussed in greaterdetail below.State member banks and bank holding com-

panies may make contributions or expendituresthat are consistent with state and local law inconnection with state or local elections. Becausemany states have laws that prohibit or limitpolitical contributions or expenditures by banks,familiarization with applicable state and locallaws is a necessity. According to the joint policystatement of the three banking agencies, a polit-ical contribution must meet not only the require-ment of legality but also the standards of safetyand soundness. Thus, a contribution or expendi-ture, among other things, must be recordedproperly on the bank’s books, may not be exces-sive relative to the bank’s size and condition,and may not involve self-dealing.Banks may make loans to political candidates

provided the loans satisfy the requirements setout below.

2120.0.4 CONTRIBUTIONS ANDEXPENDITURES

The words ‘‘contribution’’ and ‘‘expenditure’’are defined broadly by FECA and the Commis-sion’s regulations to include any loan, advance,deposit, purchase, payment, distribution, sub-scription or gift of money or anything of valuewhich is made for the purpose of influencing thenomination or election of any person to federaloffice. The payment by a third party of compen-sation for personal services rendered withoutcharge to a candidate or political committee isalso treated as a contribution by FECA, al-though the term doesnot include the value ofpersonal services provided by an individualwithout compensation on a volunteer basis.Although loans are included in the definitions

of contribution and expenditure under FECA, a

BHC Supervision Manual December 1992Page 1

specific exemption is provided for bank loansmade in the ordinary course of business and inaccordance with applicable banking laws andregulations. The Commission’s regulations pro-vide, further, that in order for extensions ofcredit to a candidate, political committee orother person in connection with a federal elec-tion to be treated as a loan and not a contribu-tion, they must be on terms substantially similarto those made to non-political debtors and besimilar in risk and amount. The regulations alsoprovide that a debt may be forgiven only if thecreditor has treated it in a commercially reason-able manner, including making efforts to collectthe debt which are similar to the efforts it wouldmake with a non-political debtor. In consideringwhether a particular transaction is a contributionor a loan, it is expected that a factor would bethe extent to which the creditor may have de-parted from its customary credit risk analysis.FECA and the implementing regulation per-

mit certain limited payments to candidates ortheir political committees. For example, pay-ment of compensation to a regular employeewho is providing a candidate or political com-mittee with legal or accounting services whichare solely for the purpose of compliance withthe provisions of the FECA is exempt from thedefinitions of contribution and expenditure. TheCommission’s regulations also permit occa-sional use of a corporation’s facilities by itsshareholders and employees for volunteer polit-ical activity; however, reimbursement to the cor-poration is required for the normal rental chargefor anything more than occasional or incidentaluse.

2120.0.5 SEPARATE SEGREGATEDFUNDS AND POLITICALCOMMITTEES

FECA allows the establishment and administra-tion by corporations of ‘‘separate segregatedfunds’’ to be utilized for political purposes.While corporate monies may not be used tomake political contributions or expenditures,corporations may bear the costs of establishingand administering these separate segregatedfunds, including payment of rent for officespace, utilities, supplies and salaries. Thesecosts need not be disclosed under FECA. Com-mission regulations also permit a corporation toexercise control over its separate segregatedfund.

In practice, most corporate segregated fundsare administered by a group of corporate person-nel, which, if the fund receives any contribu-tions or makes any expenditures during a calen-dar year, constitutes a ‘‘political committee,’’ asdefined by FECA. As such, it is required to file astatement of organization with the Commission,to keep detailed records of contributions andexpenditures, and to file with the Commissionreports identifying contributions in excess of$200 and candidates who are recipients of con-tributions from the fund.Solicitation of contributions to corporate seg-

regated funds by political committees must beaccomplished within the precise limits estab-lished by FECA. All solicitations directed tocorporate employees must satisfy the followingrequirements: (1) the contribution must be en-tirely voluntary; (2) the employee must be in-formed of the political purposes of the fund atthe time of the solicitation; and (3) the em-ployee must be informed of his right to refuse tocontribute without reprisal. Beyond those basicrequirements, FECA distinguishes between ‘‘ex-ecutive and administrative’’ personnel and otheremployees. The former and their families maybe solicited any number of times, while thelatter and their families may only be solicitedthrough a maximum of two written solicitationsper year, and these solicitations must be ad-dressed to the employees at their homes. Solici-tations may also be directed to corporate stock-holders and their families in the same manner asto executive and administrative personnel.Although a corporation, or a corporation and

its subsidiaries, may form several political com-mittees, for purposes of determining the statu-tory limitations on contributions and expendi-tures, all committees established by acorporation and its subsidiaries are treated asone. Thus, the total amount which all politicalcommittees of a corporation and its subsidiariesmay make to a single candidate is $5,000 in anyfederal election (provided that the committeesare qualified multicandidate committees underFECA).

2120.0.6 INSPECTION OBJECTIVES

1. To determine if the company has madeimproper or illegal payments in violation ofeither of these statutes, and regardless of legal-ity, and whether they constitute an unsafe andunsound banking practice.2. To determine if controls have been estab-

lished to prevent unproper payments in viola-tion of these statutes.

Foreign Corrupt Practices Act and Federal Election Campaign Act 2120.0


2120.0.7 INSPECTION PROCEDURES

1. Determine whether the company and itsnonbank subsidiaries have a policy prohibitingimproper or illegal payments, bribes, kickbacks,or loans covered by either the Foreign CorruptPractices Act or the Federal Election CampaignAct.2. Determine how the policy, if any, has been

communicated to officers, employees, or agentsof the organization.3. Review any investigation or study per-

formed by, or on behalf of, the board of direc-tors that evaluates policy or operations associ-ated with the advancement of funds in possibleviolation of the statutes mentioned above. Inaddition, ascertain whether the organization hasbeen investigated by any other governmentagency in connection with possible violations ofthe statutes and, if this is the case, review avail-able materials associated with the investigation.4. Review and analyze any internal or exter-

nal audit program employed by the organizationto determine whether the internal and externalauditors have established appropriate routines toidentify improper or illegal payments under thestatutes. In connection with the evaluation of theadequacy of any audit program, the examinershould:

a. Determine whether the auditor is awareof the provisions of the Foreign Corrupt Prac-tices Act and the Federal Election CampaignAct and whether audit programs are in placewhich check for compliance with these laws;

b. Review such programs and the resultsof any audits; and

c. Determine whether the program directsthe auditor to be alert to unusual entries orcharges which might indicate that improper orillegal payments have been made to persons ororganizations covered by the statutes.5. Analyze the general level of internal con-

trol to determine whether there is sufficient pro-tection against improper or illegal payments be-ing irregularly recorded on the organization’sbooks.6. Both the examiner and assistants should

be alert in the course of their usual inspectionprocedures for any transactions, or the use oforganization services or equipment, whichmight indicate a violation of the statutes. Exam-ination personnel should pay particular attentionto:

a. Commercial and other loans (includingparticipations), which may have been made inconnection with a political campaign, to assurethat any such loans were made in the ordinary

course of business in accordance with applica-ble laws.

b. Income and expense ledger accounts forunusual entries including unusual debit entries(reductions) in income accounts or unusualcredit entries (reductions) in expense accounts,significant deviations from the normal amountof recurring entries, and significant entries froman unusual source, such as a journal entry.Procedure 7, following here, should only be

undertaken in cases in which the examiner be-lieves that there is some sufficient evidence indi-cating that improper or illegal payments haveoccurred. Such evidence would justify the imple-mentation of these additional procedures.7. Verification of audit programs and internal

controls.a. Randomly select charged-off loan files

and determine whether any charged-off loanswere made to (i) foreign government officials orother persons or organizations covered by theForeign Corrupt Practices Act, or (ii) persons ororganizations covered under the Federal Elec-tion Campaign Act.

b. For those significant income and ex-pense accounts on which verification procedureshave not been performed: (i) prepare an analysisof the account for the period since the lastexamination, preferably by month, and note anyunusual fluctuations for which explanationsshould be obtained, and (ii) obtain an explana-tion for significant fluctuations or any unusualitems through discussions with organization per-sonnel and review of supporting documents.

2120.0.8 APPARENT VIOLATIONS OFTHE STATUTES

Where violations of law or unsafe and unsoundbanking practices result from improper pay-ments, the Federal Reserve System should exer-cise its full legal authority, including cease-and-desist proceedings and referral to the appropriatelaw enforcement agency for further action, toensure that such practices are terminated. Inappropriate circumstances, the fact that suchpayments have been made may reflect so ad-versely on an organization’s management as tobe a relevant factor in connection with the con-sideration of applications submitted by the orga-nization.In addition, the Reserve Bank should forward

any information on apparent violations of theFederal Election Campaign Act to the Federal



Election Commission. The Federal ElectionCommission is authorized to enforce FECA.The Commission may be prompted to investi-gate possible illegal payments by either a swornstatement submitted by an individual alleging aviolation of the law, or on its own initiativebased on information it has obtained in thecourse of carrying out its supervisory responsi-bilities. When the Commission determines thatthere is probable cause to believe a violation hasoccurred or is about to occur, it endeavors toenter into a conciliation agreement with theviolator. If, however, it finds probable cause tobelieve that a willful violation has occurred or isabout to occur, it may refer the matter directly tothe Department of Justice for possible criminalprosecution, without having first attempted con-ciliation.If informal means of conciliation fail, the

Commission may begin civil proceedings to ob-tain relief. Should the Commission prevail, amaximum penalty of a fine equal to the greater

of $10,000 or 200 percent of the amount of theillegal payment may be imposed. Knowing andwillful violations involving over $1,000 maysubject the violator to a fine, up to the greater of$25,000 or 300 percent of the illegal payment,and imprisonment for up to one year.

2120.0.9 ADVISORY OPINIONS

Any person, including a bank or a corporation,may request an advisory opinion concerning theapplication of FECA or of the Commission’sregulations to a specific transaction or activityin which that person wishes to engage. TheCommission must render such advisory opinionwithin 60 days from receipt of a complete re-quest. Banks or bank employees wishing toengage in activity which may be regulated byFECA are encouraged to request advisory opin-ions from the Commission.



Internal Credit-Risk Ratings at Large BankingOrganizations Section 2122.0

Techniques, practices, and tools for credit-riskmanagement are evolving rapidly, as are thechallenges that banking organizations face intheir business-lending activities. For larger insti-tutions, the number and geographic dispersionof their borrowers make it increasingly difficultfor such institutions to manage their loan port-folios simply by remaining closely attuned tothe performance of each borrower. As a result,one increasingly important component of thesystems for controlling credit risk at larger insti-tutions is the identification of gradations incredit risk among their business loans, and theassignment of internal credit-risk ratings toloans that correspond to these gradations.1 Theuse of such an internal rating process is appro-priate and necessary for sound risk managementat large institutions. See SR-98-25.

Certain elements of internal rating systemsare necessary to support sophisticated credit-risk management. Supervisors and examiners,both in their on-site inspections and other con-tacts with banking organizations, need toemphasize the importance of development andimplementation of effective internal credit-rating systems and the critical role such systemsshould play in the credit-risk-management pro-cess at sound large institutions. See SR-98-18with regard to lending standards for commercialloans.

Internal rating systems are currently beingused at large institutions for a range of purposes.At one end of this range, they are primarily usedto determine approval requirements and identifyproblem loans. At the other end, they are anintegral element of credit-portfolio monitoringand management, capital allocation, the pricingof credit, profitability analysis, and the detailedanalysis to support loan-loss reserving. Internalrating systems being used for these latter pur-poses should be significantly richer and morerobust than systems used for the purposes suchas approval requirements and identifying prob-lem loans.

As with all material financial institutionalactivities, a sound risk-management processshould adequately illuminate the risks beingtaken. It should also cause management to ini-tiate and apply appropriate controls that willallow the institution to balance risks againstreturns. Furthermore, the process should pro-

vide information as to the institution’s overallappetite for risk, giving due consideration to theuncertainties faced by lenders and the long-termviability of the institution. Accordingly, largebanking organizations should have strong risk-rating systems which should take proper accountof gradations in risk. They should also consider(1) the overall composition of portfolios inoriginating new loans, (2) assessing overall port-folio risks and concentrations, and (3) reportingon risk profiles to directors and management.Moreover, such rating systems should also playan important role in (1) establishing an appropri-ate level for the allowance for loan and leaselosses, (2) conducting internal analyses of loanand relationship profitability, (3) assessing capi-tal adequacy, and possibly (4) administeringperformance-based compensation.

Examiners should evaluate the adequacy ofinternal credit-risk-rating systems, includingongoing development efforts, when assessingboth asset quality and the overall strength ofrisk management at large institutions. Recogniz-ing that a strong risk-rating system is an impor-tant element of sound credit-risk managementfor such institutions, examiners should specifi-cally evaluate the adequacy of internal risk-rating systems at large institutions as one factorin determining the strength of credit-risk man-agement. In doing so, examiners should be cog-nizant that an internal risk-identification and-monitoring system should be consistent withthe nature, size, and complexity of the bankingorganization’s activities.

2122.0.1 APPLICATION TO LARGEBANK HOLDING COMPANIES

The guidance provided in this section should beapplied to all ‘‘large’’ bank holding companies.For this purpose, examiners should treat an insti-tution as being ‘‘large’’ if its lending activitiesare sufficient in scope and diversity such thatinformal processes that rely on keeping track ofthe condition of individual borrowers are inad-equate to manage its loan portfolio. In this con-text, those institutions with significant involve-ment in relevant secondary-market creditactivities, such as securitization of businessloans or credit derivatives, should have moreelaborate and formal approaches for managing

1. For information on current practices in risk rating amonglarge banking organizations, see ‘‘Credit Risk Rating at LargeU.S. Banks,’’ Federal Reserve Bulletin,November 1998,pp. 897–921.


the risks associated with these activities.2

Whether or not they are active in suchsecondary-market credit activities, however,larger and complex institutions typically wouldrequire a more structured and sophisticated setof arrangements for managing credit risk thansmaller regional or community institutions. Inperforming their evaluation, examiners shouldalso consider whether other elements of therisk-management process might compensate forany specific weaknesses attributable to an inad-equate rating system.

In addition, examiners should review internalmanagement information system reports todetermine whether the portion of loans in lower-quality pass grades has grown significantly overtime, and whether any such change might havenegative implications for the adequacy of riskmanagement or capital at the institution. Exam-iners should also consider whether a significantshift toward higher-risk pass grades, or an over-all large proportion of loans in a higher-riskpass grade, should have negative implicationsfor the institution’s asset-quality rating, includ-ing the adequacy of the loan-loss reserve. Tosome extent, such reviews are already an infor-mal part of the current inspection process.Examiners should also continue the long-standing practice of evaluating trends in catego-ries associated with problem assets.

Examiners should discuss these issues,including plans to enhance existing credit-ratingsystems, with bank management and directors.Inspection comments on the adequacy of risk-rating systems and the credit quality of the passportfolio should be incorporated within theinspection report, noting deficiencies whereappropriate.

2122.0.2 SOUND PRACTICES INFUNCTION AND DESIGN OFINTERNAL RATING SYSTEMS

A consistent and meaningful internal risk-ratingsystem is a useful means of differentiating thedegree of credit risk in loans and other sourcesof credit exposure. This consistency and mean-ing is rooted in the design of the risk-grading

system itself. Although assigning such riskratings—as with ratings issued by public ratingagencies—necessarily involves subjective judg-ment and experience, a properly designed ratingsystem will allow this judgment to be applied ina structured, more or less formal manner.

Credit-risk ratings are designed to reflect thequality of a loan or other credit exposure, andthus, explicitly or implicitly, the loss characteris-tics of that loan or exposure. Increasingly, largeinstitutions link definitions to one or more mea-surable outcomes such as the probability of aborrower’s default or expected loss (whichcouples the probability of default with someestimate of the amount of loss to be incurred inthe event a default occurs). In addition, credit-risk ratings may reflect not only the likelihoodor severity of loss but also the variability of lossover time, particularly as this relates to theeffect of the business cycle. Linkage to thesemeasurable outcomes gives greater clarity torisk-rating analysis and allows for more consis-tent evaluation of performance against relevantbenchmarks. The degree of linkage variesamong institutions, however.

Although the degree of formality may vary,most institutions distinguish the risks associatedwith the borrowing entity (essentially defaultrisk) from the risks stemming from a particulartransaction or structure (more oriented to loss inevent of default). In documenting their credit-administration procedures, institutions shouldclearly identify whether risk ratings reflect therisk of the borrower or the risk of the specifictransaction. In this regard, many large institu-tions currently assign both a borrower and facil-ity rating, requiring explicit analysis of both theloan’s obligor and how the structure and termsof the particular loan being evaluated (that is,collateral or guarantees) might strengthen orweaken the quality of the loan.

The rating scale chosen should meaningfullydistinguish gradations of risk within the institu-tion’s portfolio so that there is clear linkage toloan quality (and/or loss characteristics), ratherthan just to levels of administrative attention.3

2. Secondary-market credit activities generally includeloan syndications, loan sales and participations, credit deriva-tives, and asset securitizations, as well as the provision ofcredit enhancements and liquidity facilities to such transac-tions. Such activities are described further in section 2129.05and in SR-97-21.

3. See the December 1993 Interagency Policy Statementon the Allowance for Loan and Lease Losses in section2010.7. The policy does not apply to bank holding companiesdirectly. As they supervise their respective FDIC-insuredfinancial institution subsidiaries, bank holding companies areadvised to apply this supervisory guidance. Internal risk-rating systems and/or supporting documentation should besufficient to enable examiners to reconcile the totals for thevarious internal risk ratings under the institution’s systemto the federal banking agencies’ categories for those loansgraded below ‘‘pass’’ (that is, loans classified as specialmention, substandard, doubtful, or loss).

Internal Credit-Risk Ratings at Large Banking Organizations 2122.0


To do so, the rating system should be designedto address the range of risks typically encoun-tered in the underlying businesses involving theinstitution’s loan portfolio. One reflection ofthis degree of meaning is that there should be afairly wide distribution of portfolio outstandingsor exposure across grades, unless the portfolio isgenuinely homogeneous. Many current ratingsystems include grades intended solely to cap-ture credits needing heightened administrativeattention, such as so-called ‘‘watch’’ grades.Prompt and systematic tracking of credits inneed of such attention is an essential element ofmanaging credit risk. However, to the extentthat loans in need of attention vary in the riskthey pose, isolating them in a single grade maydetract from that system’s ability to indicaterisk. One alternative is the use of separate orauxiliary indicators for those loans needing suchadministrative attention.

Institutions whose risk-rating systems areleast effective in distinguishing risk use themprimarily to identify loans that are classified forsupervisory purposes or that bank managementotherwise believes should be given increasedattention (that is, ‘‘watch’’ loans). Such systemscontribute little or nothing to evaluating thebulk of loans in the portfolio—that is, loans forwhich no specific difficulties are present or fore-seen. In some cases these institutions might alsoestablish one or two risk grades for loans havingvery little perceived risk, such as those collater-alized by cash or liquid securities or those to‘‘blue-chip’’ private firms. Although the forego-ing gradations are well-defined in terms of therelative credit risk they represent, the conse-quence for these least effective systems is thatthe bulk of the loan portfolio falls into one ortwo remaining broad risk grades—representing‘‘pass’’ loans that are neither extremely low risknor current or emerging problem credits—eventhough such grades may encompass many dif-ferent levels of underlying credit risk.

2122.0.3 SOUND PRACTICES INASSIGNING AND VALIDATINGINTERNAL RISK RATINGS

Experience and judgment, as well as moreobjective elements, are critical both in makingthe credit decision and in assigning internal riskgrades. Institutions should provide clear andexplicit criteria for each risk grade in their creditpolicies, as well as other guidance to promoteconsistency in assigning and reviewing grades.Criteria should be specified, even when address-ing subjective or qualitative considerations, that

allow for consistent assignment of risk grades tosimilarly risky transactions. Such criteria shouldinclude guidance both on the factors that shouldbe considered in assigning a grade and howthese factors should be weighed in arriving at afinal grade.

Such criteria can promote consistency inassessing the financial condition of the borrowerand other objective indicators of the risk of thetransaction. One vehicle for enhancing thedegree of consistency and accuracy is the use of‘‘guidance’’ or ‘‘target’’ financial ratios or otherobjective indicators of the borrower’s financialperformance as a point of comparison whenassigning grades. Banking organizations mayalso provide explicit linkages between internalgrades and credit ratings issued by external par-ties as a reference point, for example, seniorpublic debt ratings issued by one or more majorratings agencies. The use of default probabilitymodels, bankruptcy scoring, or other analyticaltools can also be useful as supporting analysis.However, the use of such techniques requiresinstitutions to identify the probability of defaultthat is ‘‘typical’’ of each grade. The borrower’sprimary industry may also be considered, bothin terms of establishing the broad characteristicsof borrowers in an industry (for example, degreeof vulnerability to economic cycles or long-termfavorable or unfavorable trends in the industry)and of a borrower’s position within the industry.

In addition to quantitative indications andtools, credit policies and ratings definitionsshould also cite qualitative considerations thatshould affect ratings. These might include fac-tors such as (1) the strength and experience ofthe borrower’s management, (2) the quality offinancial information provided, and (3) theaccess of the borrower to alternative sources offunding. Addressing qualitative considerationsin a structured and consistent manner whenassigning a risk rating can be difficult. It requiresexperience and business judgment. Nonetheless,adequate consideration of these factors is impor-tant to assessing the risk of a transaction appro-priately. In this regard, institutions may chooseto cite significant and specific points of compari-son for qualitative factors in describing howsuch considerations can affect the rating (forexample, whether a borrower’s financial state-ments have been audited or merely compiled byits accountants, or whether collateral has beenindependently valued).

Although the rating process requires the exer-cise of good business judgment and does not



lend itself to formulaic solutions, some formal-ization of the process can be helpful in promot-ing accuracy and consistency. For example, theuse of a ‘‘risk-ratings analysis form’’ can beimportant (1) in providing a clearstructureforidentifying and addressing the relevant qualita-tive and quantitative elements to be consideredin determining internal risk grades, and (2) fordocumentinghow those grades were set byrequiring analysis or discussion of key quantita-tive and qualitative elements of a transaction.

Risk ratings should be reviewed, if notassigned, by independent credit-risk manage-ment or loan-review personnel both at the incep-tion of a transaction and periodically over thelife of the loan.4 Such independent reviewersshould reflect a level of experience and businessjudgment that is comparable to that of the linestaff responsible for assigning and reviewinginitial risk grades. Among the elements of suchindependent review should be whether risk-rating changes (and particularly downgrades)have been timely and appropriate. Such inde-pendent reviews of individual ratings supportthe discipline of the rating assignments byallowing management to evaluate the perfor-mance of those individuals assigning andreviewing risk ratings. If an institution relies onoutside consultants, auditors, or other third par-ties to perform all or part of this review role,such individuals should have a clear understand-ing of the institution’s ‘‘credit culture’’ and itsrisk-rating process, in addition to commensurateexperience and competence in making creditjudgments.

Finally, institutions should track performanceof grades over time to gauge migration, consis-tency, and default/loss characteristics to allowfor evaluation of how well risk grades are beingassigned. Such tracking also allows forex postanalysis of the loss characteristics of loans ineach risk grade.

Because ratings are typically applied to differ-ent types of loans—for example, to both com-mercial real estate and commercial loans—it isimportant that each grade retains the samemeaning to the institution (in terms of overallrisk) across the exposure types. Such compara-bility allows management to treat loans in high-risk grades as a potential concentration of creditrisk and to manage them accordingly. It alsoallows management and supervisors to monitorthe overall degree of risk, and changes in the

risk makeup, of the portfolio. Such consistencyfurther permits risk grades to become a reliableinput into portfolio credit-risk models.5

2122.0.4 APPLICATION OFINTERNAL RISK RATINGS TOINTERNAL MANAGEMENT ANDANALYSIS

As noted earlier, robust internal credit-ratingsystems are an important element in several keyareas of the risk-management process. Althoughnearly all large institutions currently use riskratings, many of the institutions need to furtherdevelop these systems so that they provide accu-rate and consistent indications of risk and suffi-cient granularity—finer distinctions amongrisks, especially for riskier assets. Describedbelow are approaches to risk management andanalysis that are based on robust internal risk-rating systems and that are currently being usedat some banking organizations. These tech-niques appear to be emerging as sound practicesin the use of risk ratings.

2122.0.4.1 Limits and ApprovalRequirements

Many large institutions have different approvalrequirements and thresholds for different inter-nal grades, allowing less scrutiny and greaterlatitude in decision making for loans with lesserrisk.6 While this appears reasonable, institutionsshould also consider whether the degree ofeased approval requirements (or the degree towhich limits are higher) is supported by thedegree of reduced risk and uncertainty associ-ated with these lower-risk loans. If not, lesserrequirements may provide incentives to rateloans too favorably, particularly in the currentbenign economic environment, with resultingunderassessment of transaction risks.

2122.0.4.2 Reporting to Management onCredit-Risk Profile of the Portfolio

As part of reports that analyze the overall creditrisk in the institution’s portfolio, management

4. See section 2010.10 regarding internal loan review.

5. For a discussion of these models and the role played byinternal credit-risk ratings, see the May 1998 Federal ReserveSystem report, ‘‘Credit Risk Models at Major U.S. BankingInstitutions: Current State of the Art and Implications forAssessments of Capital Adequacy,’’ prepared by the FederalReserve System Task Force on Internal Credit-Risk Models.

6. See section 2160.0 for more general guidance involvingrisk evaluation and control.



and directors should receive information on theprofile of actual outstanding balances, expo-sures, or both by internal risk grade.7 Suchinformation can thus be one considerationamong others, such as concentrations in particu-lar industries or borrower types, in evaluating aninstitution’s appetite for originating varioustypes of new loans. Portfolio analysis may rangefrom simple tallies of aggregates by risk gradeto a formal model of portfolio behavior thatincorporates diversification and other elementsof the interaction among individual loan types.In this more complex analysis, gradations ofrisk reflect only one among many dimensions ofportfolio risk, along with potential industry con-centrations, exposure to an unfavorable turn inthe business cycle, geographical concentrations,and other factors.

2122.0.4.3 Allowance for Loan andLease Losses

The makeup of the loan portfolio and the losscharacteristics of each grade—including indi-vidual pass grades—should be considered, alongwith other factors, in determining the adequacyof an institution’s allowance for loan and leaselosses.8

2122.0.4.4 Pricing and Profitability

In competitive marketplaces, it is properly therole of bankers rather than supervisors to judgethe appropriateness of pricing, particularly withregard to any single transaction or group oftransactions. One way that some institutionschoose to discipline their overall pricing prac-tices across their portfolio is by incorporatingrisk-rating-specific loss factors in the determina-tion of the minimum profitability requirements(that is, ‘‘hurdle rates’’). Following this practicemay render such institutions less likely to priceloans well below the level indicated by thelong-term risk of the transaction. Given thatbank lending, particularly pricing, can be highlycompetitive, the application of appropriate disci-plines to pricing, in conjunction with a clear and

meaningful assessment of the risks inherent ineach transaction and in the portfolio as a whole,can be important tools in avoiding competitivefuture excessive practices.

2122.0.4.5 Internal Allocation of Capital

Those institutions that choose to allocate capitalmay use their internal risk grades as importantinputs in identifying appropriate internal capitalallocations. Use of appropriately allocated capi-tal in evaluating profitability offers many advan-tages, including the incentive to consider bothrisk and return in making lending decisionsrather than merely rewarding loan volume andshort-term fee revenue. Under appropriatecircumstances—that is, where internal capitalallocations are sufficiently consistent, rigorous,and well-documented—such allocations mayalso be considered as a source of input forsupervisory evaluations of capital adequacy.9

2122.0.5 INSPECTION OBJECTIVES

1. To evaluate whether the internal risk-identification and -monitoring systems areconsistent with—a. sound practices in the function and design

of internal rating systems;b. sound practices in assigning and review-

ing internal risk ratings; andc. the nature, size, and complexity of activi-

ties within the banking organization.2. To determine whether the level and volume

of lower-quality pass grades of loans havegrown significantly over time and whetherany such trends should—a. have adverse implications for determining

the adequacy of risk management andcapital, and

b. materially alter the institution’s asset-quality ratings and valuations, and theexaminer’s evaluation of the adequacy ofthe allowance for loan and lease losses.

3. To determine whether improvements areneeded in the credit-risk-management pro-cess and to discuss them with the board ofdirectors and senior management.

4. To document the extent to which the institu-tion has adopted current and emerging sound

7. See section 2010.2 regarding a bank holding company’ssupervision of its subsidiaries and loan administration. Seealso the more general financial analysis sections 4020.2 and4060.1 with regard to evaluating the asset quality of subsidi-ary financial institutions and evaluating the asset quality ofthe holding company on a consolidated basis.

8. See footnote 3. Section 2010.7 emphasizes the bankholding company’s responsibility as it supervises its subsidi-aries with respect to each entity maintaining an adequateallowance for loan and lease losses.

9. See sections 4060.3 and 4060.4 regarding the evaluationof capital adequacy of bank holding companies.



practices in the use of internal ratings infor-mation in internal risk management andanalysis.

5. To incorporate the examiner’s evaluation ofsound credit-risk-rating practices into theassessment of management and capitaladequacy.

2122.0.6 INSPECTION PROCEDURES

1. Determine whether the institution is consid-ered ‘‘large’’ for purposes of applying thissection’s guidance and procedures.

2. Evaluate the adequacy of internal credit-risk-rating systems, including ongoing devel-opment efforts, when assessing the qualityand overall strength of risk management.Give particular attention to the followingpractices:a. Function and design of internal rating

systems.• Ascertain whether the rating scale

meaningfully distinguishes gradationsof risk within the institution’s portfolioevidencing clear linkage to loan qualityand/or loss characteristics.— Determine if the design of the rat-

ing system has an adequate numberof internal ratings to distinguishamong levels of risks in its port-folio, and whether the grades usedaddress the range of risks typicallyencountered in the underlying busi-nesses of the institution.

— Determine whether loans or expo-sures are broadly distributed acrossthe internal grades.

— Establish if there are ‘‘watchgrades’’ that are intended to captureloans needing heightened adminis-trative attention, or whether sepa-rate or auxiliary indicators are usedfor such loans.

• Determine whether credit-risk-ratingdefinitions are linked to one or moremeasurable outcomes (for example, theprobability of a borrower’s default orexpected loss).

b. Sound practices in assigning internal riskratings.• Determine whether loan policies pro-

vide clear and explicit criteria for eachrisk grade as to the risk factors that areto be considered in assigning a grade

with respect to—— financial analysis, including

whether reference financial ratios orother objective indicators are usedto indicate the borrower’s financialperformance;

— explicit linkages between the inter-nal grades assigned and credit rat-ings issued by external parties (forexample, senior public debt ratingsby major rating agencies);

— default probability models, bank-ruptcy scoring, or other analyticaltools used;

— analysis of a borrower’s primaryindustry, considering both thebroad characteristics of borrowerswithin that industry and the borrow-er’s position within that industry;and

— qualitative factors (for example, thequality of the financial informationthat is provided, the borrower’saccess to alternative sources offunding, whether the financial state-ments were audited or merely com-piled, or whether collateral wasindependently valued).

• Determine whether loan policies pro-vide clear and explicit guidance as tohow these risk factors should beweighed in arriving at a final grade.

• Determine whether the ratings assign-ment is well documented, possiblyincluding the use of a risk-rating formto provide formalization and standard-ization of the quantitative and qualita-tive criteria elements used in rating bor-rowers and/or transactions.

• Establish whether risk ratings are inde-pendently reviewed at the inception of aloan and periodically over the life of aloan, and whether risk-rating changeshave been timely and appropriate (par-ticularly downgrades).

• Ascertain whether the performance ofrating grades is tracked over time toevaluate migration, consistency, anddefault/loss characteristics and trends.

c. Application of internal risk ratings tointernal management and analysis.• Determine whether loan-approval

requirements for each grade appear tobe supported by the degree of risk anduncertainty associated with the respec-tive loans.

• Review internal management informa-tion system reports and determine



whether such reporting is adequate forthe institution.

• Ascertain if the risk-rating-specific lossfactors are used to determine risk pric-ing, minimum profitability require-ments, and capital adequacy needs, anddocument the institution’s progress inthis regard.

3. Determine whether other risk elements maycompensate for any specific weaknessesattributable to an inadequate rating system.

4. Review internal management informationsystem reports to determine whether the por-tion of loans in lower-quality pass grades hasgrown significantly over time, and whetherany such change might have negative impli-cations for the adequacy of risk managementor capital at the institution.

5. Determine whether a significant shift towardhigher-risk pass grades, or an overall largeproportion of loans in a higher-risk passgrade, should have negative implications forthe institution’s asset-quality rating, includ-ing the adequacy of the loan-loss reserve.

6. Evaluate trends in risk-rating categories asso-ciated with problem assets.

7. Discuss the results of the evaluations withmanagement, including whether there areany plans to enhance existing credit-ratingsystems.

8. Prepare written comments for the inspectionreport on the adequacy of risk-rating systemsand the credit quality of the pass portfolio,noting any deficiencies.



international banking activities section 2100 - the fed banking activities section 2100.0 what’s...

Documents