futures, forward, and option contracts section 2130 · futures, forward, and option contracts...

Futures, Forward, and Option ContractsSection 2130.0

2130.0.1 INTRODUCTION

Effective March 1, 1983, the Board issued anamended bank holding company policy state-ment entitled ‘‘Futures, Forward and Options onU.S. Government and Agency Securities andMoney Market Instruments.’’ Bank holdingcompanies are now required to furnish writtennotification to their District Federal ReserveBanks within 10 days after financial contractactivities are begun by the parent or a nonbanksubsidiary. The policy is consistent with thejoint policy statement previously issued by thethree federal bank regulators with regard tobanks participating in financial contracts, andreflects the Board’s judgment that bank holdingcompanies, as sources of strength for their sub-sidiary banks, should not take speculative posi-tions in such activities.If a bank holding company or nonbank sub-

sidiary is taking or intends to take positions infinancial contracts, that company’s board ofdirectors should approve written policies andestablish appropriate limitations to ensure thatthe activity is conducted in a safe and soundmanner. Also, appropriate internal control andaudit procedures should be in place to monitorthe activity. The following discussion andinspection procedures apply to futures contractactivity generally, but are intended to focus spe-cifically on financial futures contracts. For adiscussion of currency futures and options andthe examination procedures for those instru-ments, see sections F and G in the Merchant andInvestment Bank Examination Manual.Information, instructions, and inspection pro-

cedures have been provided for verifying com-pliance with the Board’s policy statement. It isintended that the policy statement will ensurethat contract activities are conducted in accor-dance with safe and sound banking practices.The task of evaluating BHC contract activitiesis the responsibility of System examiners. Thefollowing information and inspection proce-dures are intended to serve as a guide for Fed-eral Reserve Bank staff in that effort.

2130.0.2 DEFINITIONS

Basis—Basis is defined as the differencebetween the futures contract price and the cashmarket price of the same underlying security,money market instrument, or commodity.Call Option—A contract that gives the buyer

(holder) the right, but not the obligation to buy

(call), a specified quantity of an underlyingsecurity, money market instrument or commod-ity at or before the stated expiration of thecontract. At expiration, if the value of the optionincreases, the holder will exercise the option orclose it at a profit. If the value of the option doesnot increase, the holder would probably let theoption expire (or close it out at a profit) and,consequently, will lose the cost (premium paid)of (for) the option. Alternatively, the option maybe sold prior to expiration.Clearing Corporation—A corporation orga-

nized to function as the clearing house for anexchange. The clearing house registers, moni-tors, matches and guarantees trades on a futuresmarket, and carries out financial settlement offutures transactions. The clearing house acts asthe central counterparty to all trades executedon the exchange. It substitutes as a seller to allbuyers and as a buyer to all sellers. In addition,the clearing corporation serves to insure that allcontracts will be honored in the event of acounterparty default.Clearing Member—A member firm of the

clearing house or corporation. Membership inclearing associations or corporations is restrictedto members of the respective commodity ex-changes, but not all exchange members areclearing house members. All trades of a non-clearing member must be registered with, andeventually settled through, a clearing member.Commodities Futures Trading Commission—

The CFTC is a federal regulatory agencycharged with regulation of futures trading in allcommodities. It has broad regulatory authorityover futures trading. It must approve all futurecontracts traded on U.S. commodity exchanges,ensure that the exchanges enforce their ownrules (which it must review and approve), anddirect an exchange to take any action needed tomaintain orderly markets whenever it believesthat an ‘‘emergency’’ exists.Contract Activities—This term is used in this

manual to refer to banking organization partici-pation in the futures, forward, standby contract,or options markets to purchase and sell U.S.government and agency securities or moneymarket instruments, foreign currencies and otherfinancial instruments.Convergence—The process by which the fu-

tures market price and the cash market price of afinancial instrument or commodity converge asthe futures contract approaches expiration.

BHC Supervision Manual December 1992

Covered Call Options—This term refers tothe issuance or sale of a call option where theoption seller owns the underlying deliverablesecurity or financial instrument.Cross Hedging—The process of hedging a

‘‘cash’’ or derivative instrument position withanother cash or derivative instrument that hassignificantly different characteristics. For exam-ple, an investor who wants to hedge the salesprice of long-term corporate bonds might hedgeby establishing a short position in a treasurybond or treasury bond futures contract, but sincethe corporate bonds cannot be delivered to sat-isfy the contract, the hedge would be a crosshedge. To be successful, the price movements ofthe hedged instrument must be highly correlatedto that of the position being hedged.Difference Check—A difference check is sent

by the party which recognizes a loss when aforward contract is closed out by the executionof an offsetting forward contract pursuant to apair-off clause. In essence, the difference checkrepresents a net cash settlement on offsettingtransactions between the same two parties andreplaces a physical delivery and redelivery ofthe underlying securities pursuant to offsettingcontracts.Financial Contract—This term is used in the

manual to refer to financial futures, forward,standby contracts, and options to purchase andsell U.S. government and agency securities,money market instruments, foreign currencyfutures and other financial instruments.Firm Forward Contract—This term is used

to describe a forward contract under which de-livery of a security is mandatory. See ‘‘StandbyContract’’ for a discussion of optional deliveryforward contracts.Forward Contracts—Over-the-counter con-

tracts for forward placement or delayed deliveryof securities in which one party agrees to pur-chase and another to sell a specified security at aspecified price for future delivery. Contractsspecifying settlement in excess of 30 days fol-lowing trade date shall be deemed to be forwardcontracts. Forward contracts are usually non-standardized and are not traded on organizedexchanges, generally have no required marginpayments, and can only be terminated by agree-ment of both parties to the transaction. The termalso applies to derivative contracts such asswaps, caps, and collars.Futures Contracts—Standardized contracts

traded on organized commodity exchanges topurchase or sell a specified financial instrument

or commodity on a future date at a specifiedprice. While futures contracts traditionally spec-ified a deliverable instrument, newer contractshave been developed that are based on variousindexes. Futures contracts based on indexes set-tle in cash and never result in delivery of anunderlying instrument; some traditional con-tracts that formerly specified delivery of anunderlying instrument have been redesigned tospecify cash settlement. New financial futurescontracts are continually being proposed andadopted for trading on various exchanges.Futures Commission Merchant (FCM)—An

FCM functions like a broker in securities. AnFCM must register with the CommoditiesFutures Trading Commission (CFTC) in orderto be eligible to solicit or accept orders to buy orsell futures contracts. The services provided byan FCM include a communications system fortransmittal of orders, and may include researchservices, trading strategy suggestions, trade exe-cution, and recordkeeping services.Financial Futures Contracts—Standardized

contracts traded on organized exchanges to pur-chase or sell a specified security, money marketinstrument, or foreign currency on a future dateat a specified price on a specified date. Futurescontracts on GNMA mortgage-backed securitiesand Treasury bills were the first interest ratefutures contracts. Other financial futures con-tracts have been developed, including contractson Eurodollars, currencies, and Euro-Rate dif-ferentials. It is anticipated that new and similarfinancial futures contracts will continue to beproposed and adopted for trading on variousexchanges.Futures Exchange—Under the Commodities

Exchange Act (CEA), a ‘‘board of trade’’ desig-nated by the Commodity Futures Trading Com-mission as a contract market. Trading occurs onthe floor of the exchange and is conducted byopen auction in designated trading areas.GNMA or GINNIE MAE—Either term is used

to refer to the Government National MortgageAssociation. Ginnie Mae is a government corpo-ration within the U.S. Department of Housingand Urban Development. In creating GNMA,Congress authorized it to grant a full faith andcredit guaranty of the U.S. government tomortgage-backed securities issued by privatesector organizations.Hedge—The process of entering transactions

that will protect against loss through compensa-tory price movement. A hedge transaction is onewhich reduces the organization’s overall levelof risk.Initial Futures Margin—In the futures mar-

ket, a deposit held by an FCM on behalf of a

Futures, Forward, and Option Contracts 2130.0


client against which daily gains and losses onfutures positions are added or subtracted. Afutures margin represents a good-faith depositor performance bond to guarantee a partici-pant’s performance of contractual obligations.Interest Rate Cap—A multi-period interest

rate option for which the buyer pays the seller afee to receive, at predetermined future times, theexcess, if any, of a specified floating interest rateindex above a specified fixed per annum rate(cap or strike rate). Caps can be sold separatelyor may be packaged with an interest rate swap.Interest Rate Collar—the combination, in sin-

gle contract, of a simultaneous sale of a cap andthe purchase of a floor, or, a purchase of a capand sale of a floor. The buyer of the collar is abuyer of a cap and the seller of a floor. Byselling the floor, the collar buyer gives up thepossibility of benefiting from a decline in inter-est rates below the strike rate in the floor compo-nent. On the other hand, the fee earned in sellingthe floor lowers the cost of protection againstinterest rate reversal.Interest Rate Floor—is the reverse of an

interest rate cap. The buyer pays a premium toobtain protection against a decline in interestrates below a specified level.Long Contract—A financial contract to buy

securities or money market instruments at aspecified price on a specific future date.Long Hedge—The long hedge, also called the

anticipatory hedgeis the process by which amarket participant protects a cash or risk posi-tion by buying a futures or forward contract, i.e.taking a long financial contract position.Maintenance Margin—Maintenance margin

is the minimum level to which an equity posi-tion can decline as a result of a price declinebefore additional margin is required. In otherwords, it is the minimum margin which a cus-tomer must keep on deposit with a member atall times. Each futures contract has specifiedmaintenance margin levels. A margin call isissued when a customer’s initial margin balancefalls below the maintenance margin level speci-fied by the exchange. Maintenance margin mustbe satisfied by the deposit of cash or agreedupon cash equivalents. The amount of cash re-quired is that amount which is sufficient torestore the account balance to the initial marginlevel.Mandatory Delivery—See ‘‘Firm Forward

Contract.’’Mark-to-market—The process by which the

carrying value (market value or fair value) of afinancial instrument is revalued, and which isrecognized as the generally accepted accountingprinciple for determining profit or loss on secu-

rities positions in proprietary trading and invest-ment accounts. Futures positions are typicallymarked-to-market at the end of each tradingsession.Naked Call Option—Refers to the issuance or

sale of a call option where the option seller doesnot own the underlying deliverable security orinstrument.Open Interest—Refers to the number of

futures contracts outstanding for a given deliv-ery month in an individual futures contracts.The mechanics of futures trading require thatfor every open long futures contract there is anopen short futures contract. For example, anopen interest of 10,000 futures contracts meansthat there are 10,000 long contract holders and10,000 short contract holders.Options Contracts—Option contracts require

that the buyer of the option pay the seller (orwriter) of the option a premium for the right, butnot the obligation, to exercise an option to buy(call option) or sell (put option) the instrumentunderlying the option at a stated price (strike orexercise price) on a stated date (European styleoption) or at any time before or on the statedexpiration date (American style option). Thereare also exchange traded options contracts:(1) put and call options on futures contracts thatare traded on commodities exchanges; and(2) put and call options that specify delivery ofsecurities or money market instruments (or thatare cash settled) that are traded on securitiesexchanges. The key economic distinctionbetween options on futures and options on secu-rities, is that the party who exercises an optionon a futures contract receives a long or shortfutures position rather than accepting or makingdelivery of the underlying security or financialinstrument.Pair-Off Clause—A pair-off clause specifies

that if the same two parties to a forward contracttrade should subsequently execute an offsettingtrade (e.g. a long contract against an outstandingshort contract), settlement can be effected byone party sending the other party a differencecheck rather than having physical delivery andredelivery of securities.Par Cap—This term refers to a provision in

the contract of sale for Ginnie Mae mortgage-backed securities which restricts delivery onlyto pools which bear an interest rate sufficientlyhigh so that the securities would trade at orbelow par when computed based on the agreedto yield.Put Option—An option contract which gives



the holder the right, but not the obligation, tosell (put) a specified quantity of a financialinstrument (money market) or commodity at aspecified price on or before the stated expirationdate of the contract. If price of the underlyinginstrument occurs, the purchaser will exercise orsell the option. If a decline in price of theunderlying instrument does not occur, the optionpurchaser will let it expire and will lose only thecost (premium paid) of (for) the option.Round Turn—Commissions for executing

futures transactions are charged on a round turnbasis. A round turn constitutes opening a futuresposition and closing it out with an offsettingcontract, i.e. executing a short contract and clos-ing out the position with a long contract orvice-versa.Short Contract—A financial contract to sell

securities or money market instruments at aspecified price on a specified future date.Short Hedge—The process by which a cus-

tomer protects a cash or risk position by sellinga futures or forward contract, i.e. taking a shortfinancial contract position. The purpose of theshort hedge is to lock in a selling price.Standby Contract—Optional delivery forward

contracts on U.S. government and agency secu-rities arranged between securities dealers andcustomers that do not involve trading on orga-nized exchanges. The buyer of a standby con-tract (put option) acquires, upon paying a fee,the right to sell securities to the other party at astated price at a future time. The seller of astandby (the issuer) receives the fee, and muststand ready to buy the securities at the otherparty’s option. See the fuller discussion ofStandby Contracts under 2130.0.3.1.2)TBA (To Be Announced) Trading—TBA is

the abbreviation used in trading Ginnie Maesecurities for forward delivery when the poolnumber of securities bought or sold is ‘‘to beannounced’’ at a later date.Variation Margin—is when, in very volatile

markets, additional funds are required to bedeposited to bring the account back to its initialmargin level, while trading is in progress. Varia-tion margin requires that the needed funds bedeposited within the hour, or when reasonablypossible. If the customer does not satisfy thevariation or maintenance margin call(s), thefutures position is closed. Unlike initial margin,variation margin must be in cash. Also refer to‘‘Maintenance Margin’’.Weighted Hedge—a hedge that is used to

compensate for a greater decline in the dollar

value of a cash bond as compared to a pricedecline of an accessible T-bond futures contract.Yield Maintenance Contract—This is a for-

ward contract written with terms which main-tain the yield at a fixed rate until the deliverydate. Such a contract permits the holder of ashort forward contract to deliver a different cou-pon security at a comparable yield.

2130.0.3 FINANCIAL CONTRACTTRANSACTIONS

Futures, forward and options contracts aremerely other tools for use in asset–liability man-agement. These contracts are neither inherentlya panacea nor a speculative vehicle for use bybanks and bank holding companies. Rather, thebenefit or harm resulting from engaging infinancial contract activities results from themanner in which contracts are used. Proper utili-zation of financial contracts can reduce the risksof interest or exchange rate fluctuations. On theother hand, financial contracts can serve asleverage vehicles for speculation on ratemovements.

2130.0.3.1 Markets and Contract Trading

Forward contract (OTC) trading of GovernmentNational Mortgage Association (‘‘GNMA’’) or‘‘Ginnie Mae’’ Mortgage-Backed Securities pre-ceded exchange trading of GNMA futures con-tracts in 1975.

2130.0.3.1.1 Forward Contracts

Forward contracts are executed solely in anover-the-counter market. The party executing acontract to acquire securities on a specifiedfuture date is deemed to have a ‘‘long’’ forwardcontract; and the party agreeing to deliver secu-rities on a future date is described as a partyholding a ‘‘short’’ forward contract. Each con-tract is unique in that its terms are arrived atafter negotiation between the parties.For purposes of illustrating a forward con-

tract, assume that SMC Corporation is an origi-nator of government guaranteed mortgages andissuer of GNMA securities. SMC Corporationhas a proven ability to manage and predict thevolume of its loan originations over a timehorizon of three to four months. To assure aprofit or prevent a loss on current loan origina-tions, SMC Corporation may enter binding over-the-counter commitments to deliver 75% of its



mortgage production which will be convertedinto GNMA securities three months in thefuture. If SMC agrees to sell $3 million ofGNMA securities (11% coupon) to the WPSecurities Firm at par in three months, SMCCorporation is considered to have entered a‘‘short’’ (commitment to sell) forward contract.Conversely, WP has entered a ‘‘long’’ (commit-ment to buy) forward contract. The two partiesto the transaction are both now obligated tohonor the terms of the contract in three months,unless the contract is terminated by mutualagreement.It should be noted that executing a ‘‘short’’

forward contract is not the same as executingthe short sale of a security. Generally, a shortsale of a security is understood to represent thespeculative sale of a security which is not ownedby the seller. The short seller either purchasesthe security prior to settlement date or borrowsthe security to make delivery; however, a‘‘short’’ forward contract merely connotes theside of the contract required to make delivery ona future date. Short forward contracts should notbe considered inherently speculative, but mustbe considered in light of the facts surroundingthe contract.Forward trading can be done on a mandatory

delivery (sometimes referred to as ‘‘firm for-ward’’ contracts) basis or on an optional deliv-ery basis (‘‘standby’’ contract). With respect toa ‘‘mandatory’’ trade, the contract can also bewritten with a ‘‘pair-off’’ clause. A pair-offclause specifies that if the same two parties to atrade should subsequently execute an off-settingtrade (e.g., the banking organization executes along contract against an outstanding short con-tract), settlement can be effected by one partysending the other party a ‘‘difference check’’rather than having a physical delivery and rede-livery of securities.When a forward contract is executed by a

dealer, a confirmation letter or contract is sent tothe other party to the transaction. The contractwill disclose pertinent data about the trade, suchas the size of the trade, coupon rate, the dateupon which final delivery instructions will beissued, and the yield at which the trade waseffected. In addition, the contract letter willspecify whether it is permissible for the ‘‘short’’side of the trade to deliver a different couponsecurity at a comparable yield (‘‘yield mainte-nance contract’’) if the coupon specified in thecontract is not available for delivery. Contractswhich prohibit the delivery of securities requir-ing a premium over par are considered to have a‘‘par cap.’’ The initial contract letter generallydoes not specify which specific securities (e.g.,

GNMA mortgage-backed securities identifiedby a pool number) will be delivered. Instead,such contracts generally identify the deliverablesecurities as having been traded on a ‘‘TBA’’basis (‘‘to be announced’’). Prior to settlement,the dealer holding the short contract will send afinal confirmation to the other party specifyingthe actual securities to be delivered, accruedinterest, dollar price, settlement date, couponrate, and the method of payment.Forward contracts are not typically marked-

to-market. Both parties in a forward contract areexposed to credit risk, since either party candefault on its obligation.

2130.0.3.1.2 Standby Contracts

Standby contracts are ‘‘put options’’ that tradeover-the-counter, with initial and final confirma-tion procedures that are quite similar to those onforward transactions. Standby contracts weredeveloped to allow GNMA issuers to hedgetheir production of securities, especially ininstances where mortgage bankers haveextended loan commitments in connection withthe construction of new subdivisions. When amortgage banker agrees to finance a subdivisionwith conventional and government guaranteedmortgages it is difficult to predict the actualnumber of FHA and VA guaranteed loans whichwill be originated. Hence, it is risky for aGNMA issuer to enter mandatory forward con-tracts to deliver the entire estimated amount ofloans eligible to be pooled as GNMA securities.By entering an option contract and paying a feefor the option to ‘‘put’’ securities to anotherparty, a GNMA issuer or securities dealer ob-tains downside market protection, but remainsfree to obtain the benefits of market apprecia-tion since it can ‘‘walk away’’ from the optioncontract. In addition to the flexibility of walkingaway and selling securities at the prevailingmarket price when GNMA prices are rising, aGNMA issuer avoids the potential risk of pur-chasing mortgages or GNMA securities to covershort forward contracts in the event that produc-tion of GNMA securities falls below anticipatedlevels.When a securities dealer sells a standby con-

tract granting a GNMA issuer the right ‘‘to put’’securities to it, the dealer, in turn, will attempt topurchase a matching standby contract from aninvestor because the dealer does not want toshoulder all of the downside market risk. There



is also potential for securities firms to deal instandby contracts having no relationship to theissuance of GNMA securities.Some illustrations of standby contracts fol-

low. They are intended to illustrate the mechan-ics of a standby contract when a banking organi-zation has sold or issued a standby contractgranting the contra party the option to ‘‘put’’GNMA securities to the banking organization.

Assumptions

1. Fee paid to banking organization = 1% ofcontract value

2. Contract delivery price = 983. Coupon = 12%

Situation 1

On contract exercise date: Market Price = 100.Therefore, the dealer would sell securities atmarket rather than put them to the bank.

Dealer Banking organization

Sale price 100Fee paid (1)

99

Result:Dealer sacrificed 1% to insuresale price.

Purchase price N/AFee Received 1

1

Result: Banking organization earned1% fee for ‘‘standing by.’’

Situation 2

On contract exercise date: Market price = 95.

Therefore, dealer would deliver securities pursu-ant to the standby contract.

Dealer Banking organization

Sale price 98Market price 95Contract gain 3Fee paid (1)Actual gain 2

Result:Dealer paid 1% fee to avoid3 point market loss.

Purchase price 98Market price 95Contract loss (3)Fee received 1Actual loss (2)

Result:Banking organization received1% fee to compensate for purchasingsecurities 3 points above market.

2130.0.3.1.3 Futures Contracts

Futures Contract transactions involve threetypes of participants: customers—the buyers orsellers of contracts, brokers, and a futures ex-change. As in the forward markets, a buyer(party committed to take delivery of securitiesspecified in the futures contract) of a futurescontract has a ‘‘long’’ contract and the seller(party committed to deliver the underlying secu-

rities) has a ‘‘short’’ contract. If a customerdesires to purchase (sell) a futures contract, thebroker—possibly a member of a clearing houseof an exchange—will take the order to the ex-change floor and purchase (sell) a contract sold(bought) by another customer (through anotherbroker).1 All futures transactions are made

1. Brokers in commodities are required to register asfutures commission merchants (‘‘FCMs’’) with the Commod-ities Futures Trading Commission (‘‘CFTC’’) in order to beeligible to solicit or accept orders to buy or sell futurescontracts.



through and carried on the books of clearinghouse member brokers, who are treated by theexchange as their own customers. Hence, thereare always an equal number of long and shortcontracts outstanding, referred to as the ‘‘openinterest,’’ since the auction process requires abuyer and seller for every contract.All futures contracts are obligations of an

exchange’s clearing association or corporation,i.e. the clearing association is on the oppositeside of each long and short contract; and alltransactions are guaranteed within the resourcesof the exchange’s clearing association (on mostfutures exchanges a small fee is collected oneach transaction and placed into an insurancefund). Should an FCM default on a futurescontract, the association pays the costs of com-pleting the contract.

2130.0.4 MARGIN REQUIREMENTS

In order to insure the integrity of futures mar-kets, the clearing house requires that memberbrokers (clearing house members) deposit initialmargin in connection with new futures positionscarried for the firm, other brokers or FCMs forwhom the clearing house member clears trans-actions, and public customers. The clearinghouse members in turn require their customers—whether they are other FCMs or public custom-ers—to deposit margin.2 The FCMs generallyrequire that public customers meet initial mar-gin requirements by depositing cash, pledginggovernment securities, or obtaining irrevocablestandby letters of credit from substantial com-mercial banking organizations. Daily mainte-nance margin or variation margin calls (depositsof cash required to keep a certain minimumbalance in the margin account) based upon eachday’s closing futures prices are calculated pursu-ant to rules of the various futures exchanges,and clearing house members are required tomeet daily variation margin calls on positionscarried for customers and the firm. In turn, the

FCMs require customers to reimburse them forposting additional margin.Once a customer has executed a futures con-

tract to make or accept delivery of securities inthe future it is obligated to fulfill the terms ofthe contract. A futures contract cannot be resoldover-the-counter because futures contracts arenot transferable. However, a customer may ter-minate its obligation under a futures contracteither by making or accepting delivery of thesecurities as specified by the contract, or byexecuting an offsetting futures contract (longcontract to cancel a short contract or vice-versa)with the same broker to cancel the originalcontract on the same exchange. The overwhelm-ing majority of futures contracts are closed outby the execution of an offsetting contract priorto expiration.The key to understanding futures transactions

is the fact that futures contract prices on U.S.government and agency securities move in thesame manner as bond prices; e.g. rising interestrates result in falling futures prices and fallinginterest rates result in rising futures prices.Hence, the purchase of a futures contract(‘‘long’’ futures contract) at a price of 98 willresult in a loss if future market participantsperceive rising interest rates in the month ofcontract expiration and act accordingly; then theoffsetting of a futures contract (executing a‘‘short’’ futures contract) would have to be at alower price; e.g. 96. As in the case of anycommercial transaction, the participant has aloss if the sale price is lower than the purchaseprice, or a gain if the sale price is higher than thepurchase price.

2130.0.4.1 Variation Margin Calls

Variation margin calls for each contract andexpiration month are based upon the closingfutures exchange price. If there is a change fromthe previous day’s closing prices, the long con-tract holders will be required to post additionalmargin which will be passed through via theclearing house process to short contract holdersor vice-versa. Subsequent to the computation ofvariation margin calls, the clearing house mem-ber brokers are required to post variation marginon behalf of the clearing firm and its customeraccounts prior to commencement of the nextday’s trading. Then, the clearing brokers calltheir FCM and public customers requestingmore margin to bring the accounts up to the

2. In general, the futures exchanges set different initialmargin requirements based upon the types of activity engagedin by the customer. Margin requirements are higher for cus-tomer contracts characterized as ‘‘speculative’’ than for thosecontracts deemed to be ‘‘hedge’’ positions. The commoditiesindustry traditionally defines someone with a business needfor using the futures market as a hedger; others are defined asspeculators. Therefore, in instances where there are differentinitial hedge and speculative margin requirements, it is as-sumed that banking organizations will only be required tomeet margin required for hedgers.



required maintenance margin level.3 Of course,if a futures position has a gain at the end of theday, the clearing firm receives a deposit in itsmargin account. The firm, in turn, increases themargin account balances of customers holdingcontracts with gains.For illustrative purposes, we will again as-

sume that a customer purchased a futures con-tract (long contract, face value $100,000) at aprice of 98. If the next closing futures price is97, the customer will have suffered a one pointmargin loss (if the customer chose to offset thelong contract with a short contract, the transac-tion would be closed out at a one point loss).Conversely, the party with a short contract exe-cuted at 98 would receive a one point marginpayment to his account.Assuming that the initial margin requirement

is $1,500 and the variation margin requirementis $1,000, the following summarizes the stepsfollowed in administering a customer’s (longposition) margin account in connection with thepreviously described transaction.

Transaction

MarginAccountBalance

1. Deposit initial margin $1,5002. Purchase $100,000

contract @ 98 5003. Day 1—Closing futures price 97

(Reduction of $1,000 inmargin account to reimbursebroker for posting margin withclearing corporation).

4. FCM calls customer to request$1,000 to bring account up torequired initial margin level.

5. Reimbursement to FCMof $1,000 1,500

It is important to note that once the marginaccount balance falls below the variation marginlevel, the customer is required to deposit addi-tional funds to replenish the account balance to

the initial margin level. If there is a drop in thevalue of the contract which places the marginaccount balance below the initial margin levelbut above the variation margin level, the cus-tomer is not required to deposit additional mar-gin monies. Alternatively, if there is a positiveflow of margin monies the customer is free towithdraw any amount which exceeds the initialmargin requirement.The entire marking-to-the-market process is

repeated at the close of the next business dayusing a comparison of the previous day’s clos-ing price (97) to the current closing price. (Thepreceding example is simplified because itimplies that the customer deposits promptly therequired margin. In reality, margin is not alwaysdeposited so quickly.)In summary, futures trading is a ‘‘zero sum

game’’ because of the equal number of long andshort contracts outstanding, and the variationmargin payments reflect this fact, i.e. for everylong contract holder posting variation margin,there is a short contract holder receiving margin.

2130.0.5 THE DELIVERY PROCESS

Futures contracts are defined as ‘‘standardizedcontracts traded on organized exchanges to pur-chase or sell a specified financial instrument orphysical commodity on a future date at a speci-fied price.’’ Even when a participant keeps acontract open for delivery, the ‘‘specified price’’(which corresponds to a specified yield) is actu-ally obtained through a combination of pastfutures market gains or losses (incurred throughthe daily mark to market process) and the cur-rent futures market price. For invoicing pur-poses, the actual delivery price is based upon aclosing futures market ‘‘settlement price’’ on adate designated by the exchange. In addition,the final calculation of a delivery price on abond contract will typically involve an adjust-ment reflecting the fact that the coupon issue tobe delivered against the contract grade (8 per-cent) futures contract is not an 8 percent bond.For example, when current U.S. treasury bondcoupons are 12 percent it is highly unlikely thata party with a short futures position woulddeliver a bond with an 8 percent coupon.

2130.0.6 MECHANICS ANDOPERATION OF FUTURESEXCHANGES

Certain technical factors should be noted with

3. It should be noted that public customers generally havemore time to meet maintenance margin calls than do FCMs.However, if a customer fails to meet a variation margin callwithin three days, the FCM must take a charge against its netcapital if it fails to close out the customer’s contract (17C.F.R. 1.17(c)5(viii)).



respect to futures markets. First, futures marketsare not totally free markets. Rules of theexchanges put artificial constraints—daily pricemovement limits—upon the amount of dailymarket movement allowed in given types offutures contracts. For example, governmentsecurities prices in the cash market will move asfar as the market participants deem necessary toreflect the ‘‘market’’ for those securities, whilethe futures market specifying delivery of theunderlying security will be constrained fromhaving the same potential unlimited marketmovement. There have been instances wherepersons desiring to close out a futures contractby executing an offsetting contract have beenunable to do so for one or more days until theexchange’s daily trading limits allowed futuresprices to ‘‘ratchet’’ up or down to the level thatreflected the true ‘‘market’’ price as perceivedby hedgers, speculators, and arbitragers.Although the preceding illustrates the basic

nature of futures price movements, do notassume that futures and cash market pricesalways move in the same direction at the samevelocity. Futures prices by definition predictfuture events, e.g., a market participant can buya futures contract to take delivery of a threemonth Treasury bill two years in the future.4

In such an instance, the holder of a long T-billfutures contract agrees to the future purchase ofa government security which has not yet beenissued. There is no reason to assume that acontract with a distant maturity will move in thesame manner as the cash market for a threemonth Treasury bill. In addition, there is a rela-tionship between the cash market price of anexisting security and the price of that security inthe futures market which is called the basis. Thebasis can vary significantly over the life of agiven futures contract. In the contract deliverymonth, the futures market price will convergetowards the cash market price (the basis ap-proaches zero), adjusted for technical factorsthat reflect the costs of processing and deliver-ing securities. If the futures market price did notconverge towards the cash market price in thedelivery month, the arbitragers would take off-setting futures and cash market positions to arbi-trage away any profitable discrepancies betweenthe two markets.

2130.0.7 COMPARISON OF FUTURES,FORWARD, AND STANDBYCONTRACTS

Excluding the fact that futures contracts aretraded on organized exchanges, there are manysimilarities between contracts. Conceptually, thecontracts are interchangeable; each type of con-tract can be utilized for hedging, speculating, orarbitrage strategies, but none of the contracts aretransferable to third parties. While engaging incontract activities allows the participants toeither assume or shift the risks of interest ratechanges associated with the security deliverableunder the contract, such contracts fail to providethe other benefits of owning the underlyingsecurity. Specifically, financial contracts do notpay interest, do not have a U.S. governmentguaranty of payment of principal at maturity,and cannot be pledged to secure public depositsor be used as collateral for repurchase agree-ments. The forward markets are perceived to bedelivery markets wherein there is a high per-centage of delivery of the underlying security.As in the case of other futures markets, the

financial futures markets were not designed tobe delivery markets. Nevertheless, there havebeen a number of instances when a relativelyhigh percentage of financial futures contractshave resulted in delivery. Some persons suggesttax reasons and the deliverable supply of securi-ties as two factors that have contributed to themuch higher delivery of securities than deliveryof physical commodities. It is, of course, alsoeasier and cheaper to make delivery of securi-ties rather than railroad carloads of grain.Trading units on futures exchanges are stan-

dardized. The standardized trading unit in aphysical commodity which may be a railroadcar of grain; the typical trading unit in a govern-ment or agency security futures contract may be$100,000 or $1 million par principal at a couponrate (on coupon issues) fixed by the exchange.On the other hand, forward and standby con-tracts are not traded in standardized unitswith given contract maturity months. Instead,forward and standby contracts are custom madeto suit the needs of the two parties to thetransaction.While all contract holders are involved with

market risks, the holders of forward and standbycontracts are especially prone to credit risk.Unlike futures contracts where the mechanics ofexchange trading provide for the futures ex-change clearing association to guaranty perfor-

4. All financial futures contracts have a number of contractexpiration months extending into the future. As the near termcontract expires, a contract with a more distant expiration dateis added.



mance of each contract, forward and standbycontracts are only as good as the entity on theother side of the contract. Anyone who reads thefinancial press should be aware that prior to thepassage of the Government Securities Act of1986, there were a number of defaults involvingforward and standby contracts. In an effort tobring increased integrity into the unregulatedforward contract markets, there has been a trendby some of the major securities dealers torequire the posting of margin in connection withforward contract trading. There are no uniformmargin requirements governing all aspects offorward contract trading, nor is there a uniformapplication of margin requirements by dealersrequiring ‘‘house’’ margin (or internal marginrequirements established and enforced by indi-vidual securities dealers). GNMA has estab-lished limited margin requirements (24 C.F.R.390.52), as described below.

2130.0.8 OPTION CONTRACTS

Subsequent to the Board’s initial adoption of apolicy statement governing futures, forward, andstandby contracts, trading of interest rate optionsbegan on organized futures and securities ex-changes. Proponents of exchange traded optionsargue that such instruments are attractive tousers because they permit the user to obtaindown side price risk protection, yet benefitfrom favorable price movement. In contrast,futures and forward contracts allow the user tolock in a specific price, but the user must forgofuture participation if the market should experi-ence an upward price movement. Furthermore,the purchaser of an option pays a one timepremium for this protection and is spared thecontingent liabilities associated with futuresmargin calls.An option is a contract that gives the buyer,

or holder, the right, but not the obligation, tobuy or sell a specified financial instrument at afixed price, called the exercise or strike price,before or at a certain future date. Some options,however do not provide for the delivery of theunderlying financial instrument and, instead, arecash settled. Moreover, in some cases, theunderlying financial instrument is an index.Options that can be exercised before or at theexpiration date are referred to as Americanoptions; if an option can be exercised only onthe expiration date, it is termed a Europeanoption.

There are two basic types of options: callsand puts. Thecall option is any option whichobligates the writer to deliver to the buyer at aset price (exercise or strike price) within a spec-ified time limit the underlying financial instru-ment. When the market price of the underlyinginstrument is above the exercise (strike) price ofthe call, the call option is ‘‘in-the-money.’’ Con-versely, when the market price of the underlyingfinancial instrument is below the exercise(strike) price of the call option, the call is ‘‘out-of-the-money.’’ When the market price of theunderlying instrument is equal to the strikeprice, the option is ‘‘at-the-money.’’ At expira-tion, the buyer will exercise the option if it is‘‘in-the-money’’ or let it expire unexercised if itis out-of-the-money. An out-of-the-money calloption has no value at expiration, since buyerswill not purchase the underlying instrument at aprice above the current market price. Prior toexpiration, the value of an ‘‘in-the-money’’ calloption is at least equal to the market value of theunderlying instrument minus the strike price.The ownership of a call provides significantleverage, but raises the breakeven price relativeto ownership of the underlying instrument.Holding the call limits the amount of potentialloss and offers unlimited potential for gains.A put optiongives the buyer the right, but not

the obligation, tosell the underlying instrumentat a specified price (exercise or strike price),before or at expiration. When the market priceof the underlying instrument is below the strikeprice of the put option, the put is ‘‘in-the-money,’’ and a put option is out-of-the-moneywhen the market price of the underlying finan-cial instrument is above the strike price of theput option. Ownership of a put option offersleveraged profitability if the market value of theunderlying instrument declines.Some portfolio managers commonly employ

‘‘covered’’ call writing strategies to gain feeincome from options written on securities heldin the portfolio. If an option position is covered,the seller owns the underlying financial instru-ment or commodity or has a futures position.For example, an option position would be ‘‘cov-ered’’ if a seller owns cash market U.S. Treasurybonds or holds a long position on a Treasurybond futures contract. Writing ‘‘covered calls’’has only limited potential for gain. Writing‘‘covered calls’’ is not a proper strategy for amarket that could rise or fall by substantialamounts. It is generally used in a flat marketenvironment.Referring to the above example, if a seller

holds neither the cash market U.S. TreasuryBonds or was not long on the Treasury bond



futures contract, the writer would have anuncovered or ‘‘naked’’ position. In suchinstances, margin would be required (by theexchange, if an exchange traded option—not thecase for an OTC option) since the seller wouldbe obligated to satisfy the terms of the optioncontract if the option buyer exercises the con-tract. The risk potential for loss in writing‘‘naked calls’’ (calls against which there are nosecurities held in portfolio) is great since theparty required to deliver must purchase the re-quired securities at current market prices. Naked‘‘covered call’’ writing is generally viewed to bespeculative since the risks are theoreticallyunlimited, particularly if it is done solely togenerate fee income.Options are purchased and traded either on

organized exchanges or in the over-the-counter(OTC) market. Option contracts follow three-month expiration cycles (example: March/June/September/December). The option contractsexpire on the Saturday following the third Fri-day in the expiration month. Thus, options areconsidered as ‘‘wasting assets’’ because theyhave a limited life since they expire on a certainday, even though it may be weeks, months, oryears from now. The expiration date is the lastday the option can be exercised. After that datethe option is worthless.Option premium valuation.The price (value)

of an option premium is determined competi-tively by open outcry auction on the tradingfloor of the exchange. The premium value isaffected by the inflow of buy and sell ordersreaching the exchange floor. The buyer of theoption pays the premium in cash to the seller ofthe option which is credited to the seller’saccount. Several factors affect the value of anoption premium, as discussed below. The optionpremium consists of two parts, ‘‘intrinsic value’’and ‘‘time value.’’ The intrinsic valueis thegross profit that would be realized upon immedi-ate exercise of the option. Stated another way, itis the amount by which the option is in-the-money. It is the higher of: the value of an optionif it is exercised today; or zero. For ‘‘in-the-money’’ call options, it is the difference betweenthe price of the underlying financial instrument,and the exercise (strike) price of the option. For‘‘in-the-money’’ put options, it is the differenceof the exercise (strike) price of the put optionand the price of the underlying financial instru-ment. The intrinsic value is zero for ‘‘at-the-money’’ or ‘‘out-of-the-money’’ options. Thetime value derives from the chance that anoption will gain intrinsic value in the future orthat its intrinsic value will increase before matu-rity of the contract. Time value is determined by

subtracting intrinsic value from the option pre-mium. For example,

Time value = Option premium− Intrinsic values

Time value = 5–10/64 − 4.00

Time value = 1.15384

The option premium is affected by severalother factors. One factor involves the compari-son of the underlying futures price versus thestrike price of the option. An option’s price isincreased the more that it is in-the-money. Asecond factor is volatility. Volatile prices of theunderlying financial instrument can help stimu-late demand for the options, thus increasing thepremium. A third factor that affects the pre-mium of an option is the time until expiration.Option premiums are subject to greater pricefluctuations because the underlying value of thefutures contract changes more with a longertime period. Other factors that affect the optionpremium are the strike rate(s) and the domesticand foreign (if applicable) interest rates.An exchange-traded option is often referred

to as a ‘‘standardized’’ option, reflecting the factthat the terms of the contract are uniform withrespect to the underlying instrument, amounts,exercise prices, and expiration dates. OTCoptions are characterized by terms and condi-tions which are unique to each transaction.Large financial institutions are often dealers incustomized interest rate or foreign exchangeoptions. For example, a banking organizationmight write a ‘‘cap,’’ or series of put option onpounds sterling to protect the dollar value of asterling denominated receivable due in one year.In this case, an option can be tailored to fit theexact needs of the buyer.Like futures contracts, contract performance

on exchange-traded options is guaranteed by theclearing corporation which interposes itself as acentral counterparty to all transactions. It substi-tutes itself as a seller to all buyers and as a buyerto all sellers. Standardization combined with theclearing corporation’s guarantee facilitates trad-ing and helps to insure liquidity in the market.The buyer or seller of an exchange-traded optionmay always close out an open position by enter-ing into an offsetting transaction, with the samestrike price and expiration date, and for thesame amount. Indeed, most exchange-tradedoptions are liquidated prior to maturity with anoffsetting transaction, rather than by exercising



the option in order to buy or sell the underlyinginstrument.Buyers of exchange-traded options are not

required to post funds to a margin accountbecause their risk is limited to the premium paidfor the option. However, writers (sellers) ofoptions are required to maintain marginaccounts because they face substantial amountsof risk. The amount of the margin variesdepending upon the volatility in the price of theoption. As the option moves closer and closer tobeing in-the-money, the writer is required todeposit more and more into his margin account,in order to guarantee his performance should theoption eventually be exercised.Options on futures contracts provide the

holder with the right to purchase (call) or sell(put) a specified futures contract at the option’sstrike price. The difference between the strikeprice on the option and the quote on the futurescontract represents the intrinsic value of theoption. Options on futures contracts differ fromtraditional options in one key way: the partywho exercises an option on a futures contractreceives a long or short futures position (de-pending on whether he is exercising a call or putoption) rather than accepting or making deliveryof the underlying security or financial instru-ment. When the holder of a call option on afutures contract exercises the option and thefutures contract is delivered, the option writermust pay the option holder the differencebetween the futures contract’s current value andthe strike price of the exercised call. The buyertakes on a long position, and the writer a shortposition in the futures contract. When a futuresput option is exercised, the holder takes on ashort futures position, and the writer a longposition. The writer of the put pays the holderthe difference between the current price of thefutures contract and the strike price of the putoption. The resultant futures position, like anyother futures position, is subject to a dailymarked-to-market valuation. In order to liqui-date the futures position, both the buyer andthe seller must undertake offsetting futurestransactions.

2130.0.8.1 Other Option Contracts

2130.0.8.1.1 Stock Index Options

A stock index option is a call or a put that isbased on a stock market index such as the S & P

500. As opposed to a regular call or put optionon equity securities where there must be a saleand delivery of shares of stock, there is nodelivery of the underlying instrument when anindex option is exercised. Rather, settlement isin cash.

2130.0.8.1.2 Foreign Currency Options

The right to buy (call) or sell (put) a quantity ofa foreign currency for a specified amount of thedomestic currency is a foreign currency option.The size of the contract is standard for eachcurrency. The contracts are quoted in cents perunit of foreign currency. As an example, onecall option for the British pound is 12,500pounds.

2130.0.8.2 Caps, Floors, and Collars

Caps, floors, and collars provide risk protectionagainst floating interest rates. The market forthese products is an outgrowth of the OTC mar-ket in fixed income (bond) options.An interest rate cap contract pays the buyer

cash if the short term interest index risesabove the strike rate in the contract in exchangefor a fee. In combination with a floating rateobligation, it effectively sets a maximum levelon interest rate payments. If market rates arebelow the cap rate, no payments are madeunder the cap agreement. Thus, the buyer of acap is able to place a ceiling on his floatingrate borrowing costs without having to foregopotential gains from any decline in marketrates.Cap agreements typically range in maturity

from 6 months to as long as 12 years, with resetdates or frequencies that are usually monthly,quarterly, or semiannual. The London InterbankOffered Rate (LIBOR) is the most widely usedreference rate for caps, floors, and collars. Otherindexes used as reference rates are commercialpaper rates, the prime interest rate, Treasury billrates, and certain tax-exempt rates. Cap feesdepend upon the cap level, the maturity of theagreement, the volatility of the index used as thereference rate, and market conditions. Thehigher the cap rate, the lower the premium.The fee is usually paid up front, but can beamortized.An interest rate floor agreement is used to

protect the overall desired rate of return associ-ated with a floating-rate asset. In accordancewith the agreement, the seller receives a fee for



the floor agreement from the holder of theunderlying asset. When interest rates fall, theholder of the floor contract is protected by theagreement, which specifies the fixed per annumrate (floor rate) that will be retained on thoseassets, at specified times during the life of theagreement, even though floating interest ratesmay decline further.An interest rate collar is a variation of a

cap-only agreement. Under this arrangement theseller of the collar, for a fee, agrees to limit thebuyer’s floating rate of interest within oneagreement by a simultaneous sale of a capand purchase of a floor, or purchase of a capand sale of a floor. When the reference rate isabove the cap rate the seller makes payments tothe buyer sufficient to return the buyer’s floatingrate interest cost to the cap rate. Conversely, thebuyer makes payments to the collar provider tobring its rate back to the floor whenever thereference rate falls below the floor rate. In effect,under a collar agreement the buyer is selling astring of call options (the floor) back to theprovider of the cap. The premium received fromselling the floor reduces the overall cost of thecap to the buyer of the collar. Thus, the pre-mium for a floor/ceiling, or collar, agreement, islower than for a cap-only agreement with thecap at the same level. This is because the floorsold to the provider of the collar has a certainvalue, which is passed along to the buyer in theform of a lower premium.The disadvantage to collars, of course, is that

they limit the buyer’s ability to profit fromdeclines in market rates below the specifiedfloor. Clearly, one’s interest rate expectationsplay an important role in determining whetheror not to use a collar agreement. It should alsobe noted that collar agreements involve creditrisk on both sides of the agreement, similar tothe credit risk considerations found in interestrate swap agreements. The buyer of the collar isexposed to the risk that the provider may defaulton payments due under the cap agreement; andthe provider of the collar is exposed to the riskthat the buyer may default on payments dueunder the floor agreement.

2130.0.9 REGULATORYFRAMEWORK

GNMA has adopted limited margin require-ments. Specifically, the GNMA margin require-ments (12 C.F.R. 390.52) require marking-to-market and the posting of maintenance

margin.5 However, the GNMA margin require-ments exclude the majority of GNMA forwardcontracts and only pertain to contracts involvingGNMA issuers with other parties.6

The Commodities Futures Trading Commis-sion (‘‘CFTC’’) is the agency authorized byCongress to supervise the trading of ‘‘commodi-ties,’’ including financial futures. Exchangeswhich trade commodities must register withthe CFTC. In addition, the various futuresexchanges must receive CFTC approval beforethey can begin trading a new futures instrument.Brokers and dealers who execute futures con-tracts for customers must register as FuturesCommission Merchants (‘‘FCM’’) with theCFTC. There are also CFTC registrationrequirements pertaining to firms engaging incommodities activities similar to an investmentadvisor or mutual fund in the securities markets.Finally, the surveillance activities of the variousfutures exchange examiners are subject to over-sight by the CFTC.With the exception of reporting requirements

concerning persons or entities with large futurespositions, the CFTC’s jurisdiction generallydoes not extend to financial institutions. Rather,the federal and state banking agencies, stateinsurance commissions, and the Office of ThriftSupervision are responsible for supervisingregulated entities’ future activities, if permitted,under statute or regulation.

2130.0.10 EXAMPLES OF CONTRACTSTRATEGIES

For purposes of reporting large positions to theCFTC a market participant defines its futureactivities as ‘‘speculative’’ or as ‘‘hedging.’’Basically, CFTC rules consider a participant tobe a hedger if certain facets of such person’sbusiness can be hedged in the futures markets;persons who do not have a business need forparticipating are deemed to be speculators. It isanticipated that bank holding companies charac-terize their contract activities as ‘‘hedging’’, orpossibly as arbitrage between various markets.

5. Initial margin requirements necessitate the pledging ofsomething of value prior to initiation of a transaction. Depos-iting maintenance margin refers to pledging something ofvalue in reaction to market movements; e.g. depositing cashrepresenting the difference between a forward contract priceand its current market value.6. See SR-625 dated July 23, 1980.



Examiners must scrutinize contract positions forpurposes of evaluating risk.The Board policy statement concerning bank

holding companies7 states:‘‘. . . the Board believes that any positions

that bank holding companies or their nonbanksubsidiaries take in financial contracts shouldreduce risk exposure, that is, not be specula-tive.’’ It should be noted, however, that a moreliberal interpretation of the policy statement hasbeen permitted for dealer subsidiaries. For ex-ample, in a government securities dealer subsid-iary, it is permissible to use related financialcontracts as a substitute trading instrument forcash market instruments. Thus, the use of finan-cial contracts is not limited solely to reducingthe risk of dealing activities.Some examples of contract strategies are pro-

vided which reduce risk when viewed in isola-tion. A definition of a financial hedge is:

‘‘to enter transactions that will protectagainst loss through a compensatory pricemovement.’’In looking at a hedge transaction in isolation,

there should be certain elements present to makea hedge workable:1. The interest rate futures or forward con-

tract utilized should have a high positive corre-lation (prices that tend to move in the samedirection with similar magnitude) with the cashposition being hedged. In other words, thefutures or forward position taken should bestructured so that an upward price movement inthe contract offsets a downward price move-ment in the cash or risk position being hedged,and vice versa.2. The type (e.g. T-bill, T-bond, etc.) and size

of the contract position8 taken should have aproportionate relationship to the cash or riskposition being hedged, so that futures gains

(losses) will approximately offset any losses(gains) on the hedged position.3. The contract position taken should have a

life which is equal to or greater than the end ofthe period during which the hedge will be out-standing. For example, if interest rate protectionwas deemed necessary for a six-month timespan, it would not ordinarily be wise to enter acontract expiring in three months.

2130.0.10.1 The Mortgage Banking PriceHedge

Assume that a mortgage banking subsidiaryagrees in June to originate mortgages at a fixedyield in the following October. Unless the loanoriginator has a forward commitment to sell theloans to a permanent investor(s), it is exposed toa decline in the principal value of mortgagesdue to a rise in interest rates between the com-mitment date and ultimate sale of the loans. Anexample of a traditional ‘‘short hedge’’ wouldbe the sale of futures contracts in an attempt toreduce the risk of price fluctuation and insure aprofitable sale of the loans. However, in follow-ing this strategy the mortgage originator alsochooses to forfeit its ability to reap a profit ifinterest rates should fall.If interest rates increased, the loss on the sale

of mortgages or a pool of mortgage-backed se-curities will probably be largely offset by a gainon the futures transaction; see example below. Ifinterest rates fall, the mortgage originator wouldgain on the resale of mortgages but lose on thefutures market transaction. Hence, in a truehedge, the hedger’s earnings are relatively unaf-fected by a change in market interest rates ineither direction.Generally accepted accounting principles

applicable to mortgage activity require thatmortgages held for resale be periodically reval-ued to the lower of cost or market (FinancialAccounting Standards Board Statement No. 65,‘‘Accounting for Certain Mortgage BankingActivities’’). Unrealized gains and losses on out-standing futures contracts are matched againstrelated mortgages or mortgage commitmentswhen the inventory is revalued to the lower ofcost or market; i.e. the lower of cost or marketvaluation is based upon a net figure includingunrealized related futures gains and losses.

2130.0.10.2 Basis

Basis is the difference between the cash (spot)price of a security (or commodity) and itsfutures price. In other words:

7. The Board’s policy statement on engaging in futures,forwards, and option contracts.8. Futures market participants engage in a practice, some-

times known as ‘‘factorweighting’’ or ‘‘overhedging,’’ to de-termine the appropriate number of futures contracts necessaryto have the proper amount of compensatory price movementagainst a hedged cash or risk position. For example, it wouldrequire 10 mortgaged-backed futures contracts (8% coupon,$100,000 face value) to hedge an inventory of $1,000,000mortgage-backed (8% coupon) securities. Alternatively, 14mortgage-backed futures contracts would be required to hedgea $1 million inventory of mortgage-backed securities with a131⁄2% coupon. Overhedging or factor weighting is necessaryin hedging securities with higher coupons than those specifiedin futures contracts (currently 8% on bond futures) becausehigher coupon securities move more in price for a givenchange in yield than lower coupons.



Basis = Spot price− Future price

For short-term and intermediate futures con-tracts, the futures price is the quoted futuresprice times an appropriate conversion factor.For short-term futures contracts the quotedfutures price is 100 less the annualized futuresinterest rate. The invoice price must be deter-mined using yield-to-price conventions for thefinancial instrument involved.Basis may be expressed in terms of prices.

Due to the complexities involved in determiningthe futures price, it is thus better to redefineprice basis using actual futures delivery pricesrather than quoted futures prices. Thus, the pricebasis for fixed income securities should be rede-fined as:

Price Basis = Spot price− Futures delivery price.

Basis may also be expressed in terms of inter-est rates. Therate basisis defined as:

Rate basis = Spot rate− Futures rate

The spot rate refers to the current rate on theinstrument that can be held and delivered on thecontract. The futures rate represents the interestrate that corresponds to the futures deliveryprice of the deliverable instrument.

The rate basis is useful in analyzing hedges ofshort-term instruments since it nets out alleffects resulting from aging. For example, if aone year T-bill has a rate of 9 percent with aprice of 85, and a 3-month T-bill has a rate of9 percent and a price of 94, the price basiswould be−9. If a cash security ages, it does notnecessarily mean that a change in the rate basishas taken place.

2130.0.10.3 Trading Account ShortHedge

Another example of a short hedge pertains tosecurities dealers that maintain bond tradingaccounts. While bonds are held ‘‘long’’ (actual-ly owned by the dealer) in trading accounts,dealers are subject to two risks. First, there isthe risk that the cost can change regardless ofwhether the funds are generated through repur-chase agreement financing or the dealer’s otherfunding sources. When there is an inverted yieldcurve (short-term interest rates are higher thanlong-term rates), trading portfolio bonds ininventory yield less than the cost of fundsrequired to carry them. Second, there is the riskthat bond market interest rates will rise, thusforcing the dollar price of bonds down.

2130.0.10.3.1 Example 1: A Perfect Short Hedge1

Month Cash Market Futures Market

June Mortgage department makes commitment to abuilder to originate $1 million of mortgages(based on current GNMA 8’s cash price) at98-28⁄32 for $988,750

Sells 10 December mortgage-backed futures at 96-8⁄32for $962,500 to yield8.59 percent

October Mortgage department originates thensells $1million of pooled mortgages to investors at aprice of 95-20⁄32, for $956,250

Loss: $32,500

Buys 10 December mortgage-backed futures at 93,for $930,000 to yield8.95 percent

Gain: $32,500

1. The effects of margin and brokerage costs on the trans-action are not considered. It should be noted that ‘‘perfecthedges’’ generally do not occur.

The following example pertains to a bond trad-ing account. Assume that the dealer purchasesTreasury bonds on October 4 and simulta-neously sells a similar amount of Treasury bondfutures contracts. The illustration ignores com-

mission charges and uses futures contractsmaturing in March 19x9 because the dealer’s



technical analysis discovered an advantage inusing the March 19x9, rather than the previousDecember contract as a hedge. (At that time the

previous December contract was the next avail-able contract still trading.)

Cash Market Futures Market

10/04/1998 Purchase $5MM T-bonds maturing Aug.2005, 8% coupon at 87-10⁄32:Principal = $4,365,625

Sell $5MM T-bonds futures contractsexpiring Mar. 1999 at 86-21⁄32:Contract value = $4,332,813

10/23/1998 Sell $5MM T-bonds at 79.0:

Principal = 3,950,000

Cash loss = ($415,625)

Buy $5MM T-bond futuresMar. 1999 at 79-1⁄32Contract value = 3,951,563

Futures gain = $381,250

Although the hedge did not prevent the dealer’strading account from losing money, it limitedthe loss to $34,375 instead of $415,625.It is worth noting that the preceding example

also illustrates some of the dangers of usinginterest rate futures contracts. Although thefutures market proved useful to the trading de-partment, a futures contract could have seriousconsequences for a dealer using an alleged‘‘long hedge to lock-in an attractive yield.’’

2130.0.10.4 Long Hedge

In certain areas of the country, financial institu-tions desiring to hold public deposits are re-quired to bid competitively for deposits. Thecase discussed below pertains to a situationwhere the competitive bids must be tenderedone calendar quarter in advance of receiving thedeposit. In this example, the asset side of thebalance sheet is not discussed since it is as-sumed that a banking organization paying theprevailing one-year C.D. interest rate can utilizethe funds at a profitable spread.In this type of situation the bidding institu-

tions are generally vulnerable to falling interestrates; one can safely assume that an institutionselected to hold public deposits would not bedismayed to learn subsequently that interestrates had risen and it had locked-in a fundingsource at or below market rates. However, thefunds will not be received for another 3 months.Thus, there is the possibility that interest ratescould drop in the interim, leaving a reduced orpossibly negative net interest margin when thefunds are deployed.

There are a number of approaches availableto attempt to ensure that future time depositscan be obtained without paying higher than mar-ket interest rates. One method is forecasting theappropriate interest rate to be paid on a giventime deposit three months in the future. How-ever, forecasting has become increasingly diffi-cult to do with accuracy in the recent periods offluctuating interest rates. An alternative ap-proach would be to quote the current C.D. rate(adjusted slightly for competitive factors) withan intent to hedge in the futures market if thebanking organization’s interest rate bid isaccepted. Upon receiving notification that itsdeposit bid has been accepted, the institutioncan then purchase an appropriate number offutures contracts to insure a profitable invest-ment spread three months hence when it actu-ally receives the deposit.The following example on June 1, 19x0; the

facts are as follows:

Size of public depositsoffered $10 million

Date of deposit September 2, 19x0Term 1 yearCurrent C.D. rate 81⁄4%

For purposes of this illustration, assume that abid was submitted to pay 81⁄4% for one year on$10 million. The bids were due June 1 andnotification was given June 2 of the intention toprovide the funds on September 2; and the bank-ing organization decided to purchase futurescontracts on June 2.A Treasury bill futures contract, expiring in

3 months, is selected as the hedging vehiclebecause it reflects price movement of an instru-ment with a comparable maturity to one-year



C.D., and there was no C.D. futures contracttrading. For purposes of this illustration, it isassumed that the contract offers sufficient liquid-ity to enable the banking organization to readilyoffset its open futures position when necessary.Using the bill contract is an example of ‘‘crosshedging’’ which is defined as the buying orselling of an interest rate futures contract toprotect the value of a cash position of a similar,

but not identical, instrument. This type of hedg-ing is a measured risk since the outcome of sucha transaction is a function of the price correla-tion of the instruments being hedged. At anygiven moment it is conceivable that a negativecorrelation could exist between two unlikeinstruments despite the presence of a strongcorrelation over an extended time period.

Date C.D. Rate Transactions T-bill Futures1

June 2, 19x0 8.25% Purchase 40 Contracts 91.84 8.16%Sept. 2, 19x0 11.00% Sell 40 Contracts 90.05 9.95%

1. The size of the trading unit is based upon U.S. T-billshaving a face value at maturity of $250,000 (402 250M =10MM). Prices are quoted in terms of an index representing

the difference between the actual T-bill yield and 100.00.Every one basis point movement on a contract is equal to$25.00 per contract.

2130.0.10.4.1 Evaluation of the Hedge

Total interest (not compounded)to be paid (81⁄4%) $ 825,000

Alternative C.D. interest(not compounded)at current rate (11%) 1,100,000

Difference 275,000Futures trading loss* (179,000)Net difference $ 96,000

*Computation—Purchase price 91.84Sale price 90.05

1.79 or 179 basis points(1792 $25.002 40 contracts = $179,000)

In retrospect, it would have been better if thebanking organization would not have hedged.By agreeing to an interest rate on June 2, itobtained deposits on September 2 and will payapproximately $275,000 less in interest pay-ments to the municipality than is required on anordinary C.D.(s) issued on September 2. The$179,000 futures trading loss, of course, re-duced the windfall interest income due the bank-ing organization. A net interest income spreadof approximately $96,000, instead of a$275,000, demonstrates two principles: 1) crosshedging can cause unexpected results; and 2) itis quite difficult to find perfect hedges in the realworld. The hedge was structured so that a cashgain was offset by a futures loss—incorporatingthe offsetting principles of a hedge transaction.If the general level of interest rates had fallen, afutures gain should have occurred to offset thehigher (relative to prevailing market rates) costof funds obtained on September 2.

2130.0.10.5 Using Options to Create anInterest Rate Floor

Assume that on September 28th it is decided torollover a $1,000,000 investment in 13-weekTreasury bills on November 28, which also hap-pens to be the expiration date for call options onthe December Treasury bill futures contract.The banking organization, concerned that inter-est rates will fall between September 28 and therollover date, wishes to hedge the rollover of itsinvestment. The portfolio manager can set aminimum yield on the rollover investment byeither buying a Treasury bill future call option,or by buying a Treasury bill futures contract.Further assume that the December Treasury billfutures contract can be bought for a price of93.70 which implies a discount yield of6.30 percent. Treasury bill futures call optionswith a strike price of 93.75, implying a discountyield of 6.25 percent, sell for a premium of20 basis points, or $600 (20 basis points2

$25/basis point = $500).If the banking organization could actually

buy a Treasury bill futures contract that expiredon exactly November 28, then there would be aperfect hedge since the rate of return on the billswould be explicitly fixed by the futures hedgingstrategy. However, the closest maturing Trea-sury bill futures contract expires in December,several weeks after the rollover date for thebanking organization’s investment. Uncertaintyover the actual discount yield of the Treasurybills on the rollover date and the yield produced



by the hedge is known as ‘‘basis risk,’’ the riskthat the yield on the hedge may differ from theexpected yield on the hedged item. For purposesof this example, assume that the yield on thefutures contract equals the actual discount yieldon the 13-week Treasury bills at the rolloverdate. Thus, the futures hedge in this examplewill provide an effective discount yield of6.30 percent on the rollover of the 13-weekTreasury bill investment.Assume that rates fall after September 28 and

that the discount yield on Treasury bill futurescontracts declines from 6.30 percent to 6.00 per-cent at the November 28 expiration date of theDecember Treasury bill futures options con-tract. The option to buy the Treasury bill futureswill be exercised since the strike price of 93.75is below the market price of 94.00 for theunderlying futures contract, yielding a profit of25 basis points or $625 (25 basis points2

$25/basis point). The profit must be offset by the20 basis point cost of the option, which reducesthe net profit to 5 basis points. The effectivehedged discount yield is 6.05 percent (6.00 per-cent on the 13-week Treasury bills—assumingno basis risk—plus the 5 basis point profit fromthe hedge). The option hedge produces a yieldthat is 5 basis points higher than the unhedgedyield, but 25 basis points lower than the6.30 percent yield that would have resulted fromhedging with futures.Although the option hedge resulted in a lower

effective yield than the futures hedge, it set anabsolute floor on the investment. This is becauseany decline in the discount yield of the Treasurybills below 6.05 percent would be offset dollarfor dollar by the additional profits from thehedge. The real advantage of the option hedge isthat, although it establishes a floor that is lowerthan the rate fixed by the futures hedge, it allowsthe hedger to participate in any increase in inter-est rates above the cost of the call premium. Forexample, if interest rates increased such that theprice on the December Treasury bill futurescontract on November 28 falls to 93.00, imply-ing a discount yield of 7.00 percent, the optionwould expire unexercised since the strike priceis above the price of the underlying futurescontract. Again, assuming that the spot price forthe 13-week Treasury bills is equal to the futuresprice, the effective discount yield is 6.80 percent(7.00 percent minus the 20 basis point calloption premium), 50 basis points higher than theyield that would have been provided by thefutures hedge.

2130.0.10.6 Hedging a Borrowing withan Interest Rate Cap

In order to limit a borrower’s interest rate risk,sophisticated banking institutions may offer capagreements as part of a loan package to theirclients. While such an arrangement providessome comfort that the borrower’s ability to re-pay will not be jeopardized by a sharp increasein interest rates, it obviously transfers that inter-est rate risk back to the lender. Nevertheless,many banking institutions feel they are betterable to manage that risk than are some of theirclients. Cap agreements have also been utilizedto cap the rate on issued liabilities. For example,an institution might be able to issue medium-term floating rate notes at 3-month LIBOR plusan eighth of a percent. Alternatively, that institu-tion could issue a capped floating rate note at3-month LIBOR plus three-eights of a percent.By subsequently selling the cap separately backinto the market the institution could, achievesub-LIBOR funding, depending on the proceedsfrom the sale of the cap.A cap agreement is typically specified by

following terms: notional principal amount;maturity; underlying index, frequency of reset,strike level. As an illustration, a cap agreementmight have the following terms:

Notional PrincipalAmount $10,000,000

Maturity 2 Years

Underlying Index 3-month LIBOR

Rate Fixing quarterly

Payment quarterly, in arrears, onan actual/360-day basis

Cap Level 9%

Up Front Fee 1.11% of par($111,000)

Under the terms of this agreement, if at anyof the quarterly rate fixing dates 3-monthLIBOR exceeds the cap level then the seller ofthe cap would pay the buyer an amount equal tothe difference between the two rates. For exam-ple, if at a reset date LIBOR was set at 10 per-cent, the payment would be:



10%(90/3602 $10,000,000)

−

9%(90/3602 $10,000,000)

=

$25,000

Thus, the writer of the cap would pay the buyer$25,000. If 3-month LIBOR for the quarter wereset at or below the cap level of 9 percent, nopayment would be made.

2130.0.11 ASSET-LIABILITYMANAGEMENT

Financial contracts can be used as a tool in anoverall asset-liability management strategy. Inorder to use financial contracts in this context, aBHC or nonbank subsidiary must first identifywhere interest-rate exposure lies as indicated bymismatches between asset and liability struc-tures. In those instances where the BHC ornonbank subsidiary has variable-rate assets andvariable-rate liabilities with comparable maturi-ties, there is, in theory, no need to hedge withfinancial contracts since that portion of theasset-liability structure is already hedged. Thesame holds true for fixed-rate assets and liabili-ties (yielding a positive interest-rate margin) ofcomparable maturities. Once a BHC or nonbanksubsidiary has identified the undesired mis-matches in assets and liabilities, financial con-tracts can be used to hedge against the identifi-able mismatch—for example, long positions incontracts can be used as a hedge against fundinginterest-sensitive assets with fixed-rate sourcesof funds, and short positions in contracts can beused as a hedge against funding fixed-rate assetswith interest-sensitive liabilities.

BHCs or nonbank subsidiaries that choose toemploy financial contracts as a tool in theirgeneral asset-liability management program andproperly use financial contracts are strivingtowards worthwhile goals. The discipline ofidentifying mismatches between assets andliabilities tends to focus the practitioner’s atten-tion on the entire balance sheet. Examinersshould be aware that marketing efforts on behalfof the futures exchanges have attempted to focusupon just one side of the balance sheet by ‘‘pair-ing’’ a futures contract with an asset or a liabil-ity. In considering financial-contract activities,examiners need to remember that financial-contract activities must be evaluated in light ofboth sides of a balance sheet.

One final point should be made with respectto ‘‘hedging’’ based upon pairing a futures con-tract against a portfolio security. Since this typeof ‘‘hedging’’ can be done while consideringonly the asset side of the balance sheet, it ispossible that such a strategy could increaseinterest-rate risk rather than reduce it. For exam-ple, assume (unrealistically) that there is a per-fect balance between variable-rate assets andliabilities, and the firm is evaluating fixed-rateassets and liabilities. Management determinesthat there is a perfect balance between fixed-rateassets and liabilities and then isolates the lastfixed-rate asset and liability. Make the furtherassumption that the organization holds a six-month note yielding 12 percent which isfinanced by funds maturing in six months whichcosts the organization 10.5 percent. By execut-ing a short futures contract ‘‘paired’’ against thesix-month note, the organization would movefrom an overall ‘‘hedged’’ position to an‘‘unhedged’’ position. In other words, thefutures contract would move the organizationfrom an overall neutral position and expose theorganization to interest-rate risk.

It should be evident why it is more productiveto consider the ‘‘big picture’’ in inspectionsrather than focusing upon individual or‘‘paired’’ (futures against each position) transac-tions. The most meaningful approach is toevaluate hedging strategies and open financialcontract positions in light of its business needs,operations, and asset-liability mix.

2130.0.12 INSPECTION OBJECTIVES

1. To determine the purpose of financial-contract positions. Any positions that bankholding companies or their nonbank subsidi-aries (except certain authorized dealersubsidiaries) take in financial contractsshould reduce risk exposure, that is, not bespeculative.

2. To determine whether prudent written poli-cies, appropriate limitations, and internalcontrols and audit programs have been estab-lished and whether management informationsystems are sufficiently adequate to monitorrisks associated with contracts involvingfutures, forwards, and options (includingcaps, floors, and collars).

3. To determine whether policy objectives con-cerning the relationship of subsidiary bank-ing organizations and the parent bank hold-



ing company specify that each bankingorganization in a holding company systemmust be treated as a separate entity.

4. To determine reporting compliance inaccordance with the Board’s bank holdingcompany policy statements. See section2130.0.17 for the appropriate cites.

2130.0.13 INSPECTION PROCEDURES

The term ‘‘banking organization’’ is used gener-ally to refer to a bank holding company, theparent company, or nonbank subsidiary.

1. Determine if the banking organization’sfinancial-contract activities are related to thebasic business of banking.

Consider whether the financial-contractactivities are closely related to the basic busi-ness of banking; that is, taking deposits, mak-ing and funding loans, providing services tocustomers, and operating at a profit for share-holders without taking undue risks. Takingfinancial-contract positions solely to profitupon interest-rate forecasts is considered tobe an unsafe and unsound practice. Profit-ability of contract activities is not the crite-rion for evaluating such activities. It is quiteprobable that a bona fide hedge strategycould result in a contract loss which wouldbe offset by increased interest earnings or ahigher price for an asset sold, for example, apool of mortgages. Criticize contracts placedsolely to profit upon interest-rate movements.Verify that contract activities are conductedin accordance with the Board’s policy state-ment. Where contract positions are of exces-sive size and could jeopardize the financialhealth of the entity under examination, thegains or losses realized because of financial-contract activities should be criticized.

2. Ascertain whether policy objectives high-light the circumstances under which financialcontracts should be used.

Determine whether management and oper-ating personnel have received sufficient guid-ance. Carefully constructed policy objectivesshould be formulated with the knowledgethat although proper utilization of financialcontracts limits loss potential, such utiliza-tion also limits potentials for gains. Policyobjectives should be formulated to limitrequired resources (margin monies, commis-

sions, and personnel to execute, monitor, andaudit contract activities). A well-constructedpolicy should be designed to preclude vari-ous operating areas of a banking orga-nization from taking offsetting financial con-tract positions. Finally, there should beestablished benchmarks for determiningwhether financial contracts are meetingdesired objectives.

3. Determine if policy objectives concerningthe relationship of subsidiary banking organi-zations and the parent bank holding companycomply with the Board’s directives.

Each banking organization in a holdingcompany system must be treated as a sepa-rate entity. The policy statement accommo-dates centralized holding companies in thatthe holding companies are free to provideguidance to subsidiary banking organizationsand execute contracts as agent on behalf ofthe banking organization, provided that eachbanking organization maintains responsibil-ity for financial contract transactionsexecuted on its behalf. Accordingly, a hold-ing company that has centralized manage-ment could, and perhaps should, consider theinterest-rate exposure of its subsidiary bankson a consolidated basis in determiningwhether future contracts can usefully beemployed to reduce that exposure, but anyfuture contracts that are executed must berecorded on the books and records of a sub-sidiary bank that will directly benefit fromsuch contracts.

The question concerning the relationshipof a subsidiary bank to its holding companymay also lead one to consider the relation-ship of a subsidiary bank with its correspon-dent bank or broker. One might also query towhat extent may less sophisticated institu-tions rely upon brokers and/or correspondentbanking organizations for advice in this area?

Less sophisticated institutions can placeonly limited reliance on others for advice inthis area. The bank holding company policystatement9 emphasizes that responsibility forfinancial-contract activities rests solely withmanagement. Additional information onsecurities transactions and the selections ofsecurities dealers can be found in sec-tion 2126.1.

4. Ascertain whether policy objectives and/orposition limits require prudence on the partof authorized personnel entering into thesenew activities. If discretion is left to senior

9. The Board’s policy statement on engaging in futures,forwards, and option contracts.



managers, determine whether managementhas issued instructions to ensure that thelevel of financial-contract activity is prudentrelative to the capabilities of persons autho-rized to execute and monitor contracts.

A new activity such as financial contractsshould, as a general rule, be entered slowly.In developing expertise, management shouldmandate a low level of activity until personsauthorized to execute contracts gain suffi-cient expertise or until new personnel areemployed that have sufficient training andexperience to engage in financial-contractactivities on a larger scale. Senior manage-ment must develop the expertise to under-stand and evaluate techniques and strategiesemployed to ensure that an experienced pro-fessional does not engage in improper orimprudent activities.

5. If a banking organization uses financial con-tracts as part of its overall asset-liability man-agement strategy, determine whether theorganization developed an adequate systemfor evaluating its interest-rate risk.

Without a system for identifying and mea-suring interest-rate risk, it is impossible toengage in hedging activity in an informedand meaningful manner. Failure to identifythe mismatches in the organization’s asset-liability mix would make it difficult to selectthe proper number and types of financialcontracts—for example, bond or bill finan-cial contracts—to provide an appropriateamount of interest-rate-risk protection.Evaluate whether the organization’s interest-rate-risk measurement techniques appear rea-sonable to determine whether the financialcontracts employed were successful in pro-viding the proper amount of futures gains(losses) to cover the hedged risk position.

6. Determine if the recordkeeping system issufficiently detailed to permit personnel todocument and describe in detail howfinancial-contract positions taken have con-tributed to the attainment of the bankingorganization’s stated objectives.

There is no universal, adequate record-keeping system for this purpose. Examinersmust evaluate each individual system rela-tive to the organization’s stated objectivesand activities. If the recordkeeping systemcannot be used to illustrate how financialcontracts contributed to the attainment of thebanking organization’s stated objectives, therecordkeeping system is inadequate. BHCswith inadequate recordkeeping systemsshould be instructed to make appropriatemodifications.

7. Ascertain whether the banking organization’sboard of directors has established writtenlimitations with respect to financial-contractpositions.

NOTE: The bank holding company pol-icy statement requires that the board ofdirectors establish written policies and posi-tion limitations in connection withfinancial-contract activities. If a committeehas been delegated similar responsibilitieswithin the organization, and a committeemakes the decision, its recommendationshould be ratified by the board of directors.

8. If there is the potential to exceed the abovelimitations in certain instances, determinewhether there are firm, written proceduresin place concerning the authorizations nec-essary to exceed limits.

9. Determine whether the board of directors, aduly authorized committee thereof, or inter-nal auditors review at least monthlyfinancial-contract positions to ascertain con-formance with limitations. (See item (b) ofthe bank holding company policystatement.)

10. Determine if the banking organizationmaintains general-ledger memorandumaccounts or commitment registers toadequately identify and control allfinancial-contract commitments to make ortake delivery of securities or money marketinstruments.

11. Determine if the banking organizationissues or writes option contracts expiring inexcess of 150 days which give the otherparty to the contract the option to deliversecurities to it.

Examiners should review the facts sur-rounding standby contracts issued by hold-ing companies. Examiners should alsoreview accounting entries connected withbank holding company standby contracts todetermine whether standbys were issued toearn fee income ‘‘up front’’ and exploit thelack of generally accepted accountingprinciples.

12. Determine whether financial-contract posi-tions are properly disclosed in notes to thestatements of financial condition andincome and that the contract positions havebeen properly reported on FR Y-9C, Sched-ule HC-F, ‘‘Off-Balance-Sheet Items.’’

13. Determine whether the banking organiza-tion has implemented a system for monitor-ing credit-risk exposure associated with



various customers and dealers with whomoperating personnel are authorized to trans-act business.

All financial-contract trading involvesmarket risks. However, forward and OTCoptions trading, as well as swap activities,also involve credit risk. The key concern iswhether the contra party to a transactionwill be ready, willing, and able to performon contract settlement and payment dates.While maintaining control over credit-riskexposure should ensure that a financialorganization will not enter excessive (rela-tive to the financial condition of the contraparty) forward or standby contracts, moni-toring such exposure may not preventdefault in all instances.

14. Ascertain whether the banking organizationhas implemented internal controls and inter-nal audit programs to ensure adherence towritten policies and prevent unauthorizedtrading and other abuses.

15. Determine if the Reserve Bank was notifiedat the inception of bank holding companyfutures, forward, and option activities asrequired by paragraph (f) of the holdingcompany policy statement (Federal ReserveRegulatory Service4–830).

16. Determine if the personnel engaged infinancial-contract activities have sufficientknowledge and understanding of the mar-kets to perform those functions.

2130.0.13.1 Evaluating the Risks ofContract Activities

Evaluating the organization’s stated objectivesand their effects on overall risk is a difficult taskinvolving legitimate cause for concern becauseof the high degree of leverage involved in con-tract activities. Although there is an emergingtrend towards dealers requiring margin on for-ward trades, forward contract transactions gen-erally have not required margin deposits, andthus, grant users unlimited leverage. Althoughthe amount of margin required for futures tradesis extremely small (for example, $1,500 initialmargin to take a $1 million futures position), therules of the exchanges do require a daily markto market and a requirement that members ofthe futures exchanges meet maintenance margincalls on behalf of their customers. Customers, ofcourse, are generally required to promptly reim-burse brokers for margin posted on their behalf.Nevertheless, engaging in contract activities

requires market participants to assume the mar-ket risks of either owning securities or ‘‘short-ing’’ securities. Issuing (or selling) standby con-tracts granting the other party to the contract theoption to deliver securities is a practice whichresults in the issuer functioning as an insureragainst downside market risk for the other party;in essence, the party receiving the standby feeassumes all of the interest-rate risks of securityownership, but receives none of the benefits.

2130.0.13.2 ReviewingFinancial-Contract Positions

The preceding questions were designed to focusthe examiner’s attention on a bank holding com-pany’s stated objectives for engaging in finan-cial contract activities and the manner in whichsuch activities are conducted. It is also vital toreview position records with respect to financialcontracts or, if necessary, prepare a schedulegrouping similar contracts by maturity. Oncethe various positions have been scheduled itwill be possible to evaluate the risk of contractpositions relative to the organization underinspection.

2130.0.13.3 Factors to Consider inEvaluating Overall Risk

To determine whether contract positions are rea-sonable, an examiner must evaluate positions inlight of certain key factors: the size of the orga-nization, its capital structure, its business needs,and its capacity to fulfill its obligations. Forexample, open contracts to purchase $7 millionof GNMA securities would be viewed differ-ently in a BHC with $24 million of assets thanin a BHC with $1 billion of assets.

There is no guaranty that financial contractprices and cash market prices will move in thesame direction at the same velocity; however,contract prices and cash market prices ulti-mately move towards price convergence in thedelivery month. Keeping this fact in mind, therisk evaluating process can be simplified bythinking of the securities underlying the variouscontracts as a frame of reference. For example,if a BHC holds ‘‘long’’ futures contracts on$10 million (par value) of Treasury bonds theexaminer should first evaluate the effect(excluding tangible benefits of ownership, e.g.,interest income, pledging, etc.) on the organiza-tion of holding $10 million of bonds in itsportfolio and the resultant appreciation or depre-ciation if interest rates rise or fall by a givenamount. A ‘‘short’’ contract of $10 million Trea-sury bonds would be evaluated as if the banking



organization had executed a short sale for$10 million. In addition, the examiner wouldhave to consider the positive or negative flow offunds received or disbursed as margin to reflectdaily contract gains and losses. While commis-sions on futures contracts are not a major factorin hedging transactions, they also should beconsidered in this evaluation. Typically, com-missions are charged on a ‘‘round turn’’ basis—meaning that commissions are charged basedupon an assumption that each futures contractwill be offset prior to maturity. Since each con-tract will have to be offset, or securities boughtor delivered, it should be determined whetherfunds will be available to offset contracts orfund delivery. In the case of certain shortcontracts, a determination must be made asto whether deliverable securities are heldor committed for purchase by the bankingorganization.

2130.0.13.4 Contract Liquidity

In addition to looking at the ‘‘big picture,’’examiners should consider a position in a givencontract maturity month relative to the volumeof contracts outstanding. For example, in futurestrading there is generally a greater open interestin the next contract maturity month and perhapsthe following one or two contract maturitymonths. As one moves away from the near termcontracts, there is generally less trading and less‘‘open interest’’ in the more distant contracts.‘‘Open interest’’ or the amount of contracts out-standing is reported in financial newspapers andother publications. Generally, the contracts withthe largest open interest and daily trading vol-ume are considered to be the most liquid.

To illustrate the concept discussed above, oneshould consider the following example. A ‘‘redflag’’ should be apparent if a contract reviewdiscloses that the organization has taken a size-able position in a contract expiring in two years.When the examiner checks financial newspapersand other publications, he or she may discoverthat the BHC’s position represents 20 percent ofthe open interest in that contract. Such a situa-tion would clearly be unsafe and unsoundbecause the relatively huge position coupledwith the typically less liquid conditions in dis-tant contracts makes it highly unlikely that theBHC could quickly close out its position ifnecessary. In addition, one should also questionwhy the distant maturity was chosen since thereis no immediate reason to expect a close correla-tion to the cash market for the underlyingsecurity.

With respect to forward contracts, there is anactive forward market for GNMA securitiesspecifying delivery of the underlying securitiesup to four or five months in the future. If abanking organization is executing contracts formore distant maturities, management should bequeried as to why it is necessary to trade outsidethe normal trading cycle.

2130.0.13.5 Relationship to BankingActivities

In evaluating contract activities, examinersshould verify that contract strategies are carriedto fruition in connection with their relationshipto overall objectives. Examiners may find ituseful to recommend additional recordkeepingin borderline cases when they encounter situa-tions where financial-contract positions areclosed out frequently during the hedge period,but not frequently enough to be considered trad-ing rather than hedging activities. Examinersshould suggest proper documentation withregard to financial contracts executed and anyadditional recordkeeping as needed. Specifi-cally, users could be requested to establish writ-ten criteria specifying what circumstances willtrigger the closing of such contracts. Then userswould be judged by how well they adhered tothe criteria as well as whether the plan reducedrisk. Hopefully, such recordkeeping would giveusers the latitude to close out a financial-contract position working against them (asdetermined by some prearranged benchmark),yet still require sufficient discipline to preventusers from selectively executing financial con-tracts merely to profit upon interest-rateforecasts.

The preceding discussion should reinforce thefact that the actual utilization of financial con-tracts is not a clear-cut issue in terms of hedgingverses speculation. However, certain key con-cepts should be kept in mind. First, a decision tohedge with futures or forward contracts involvesmaking a decision that one is content to lock inan effective cost of funds, a sale price of aspecific asset, etc. However, the decision tohedge which gives downside protection alsomeans forfeiting the benefits which would resultfrom a favorable market movement. Thus, inevaluating hedge strategies, the organizationshould be judged as to whether it maintainedhedge positions long enough to accomplish itsobjectives.



Caution should be employed in performingthe analysis of financial contracts used to obtaintargeted effective interest rates. Examinersshould not evaluate transactions solely on a‘‘paired’’ basis, that is, looking at paired cashmarket and financial-contract positions and for-getting about financial-contract positions rela-tive to the organization’s entire balance sheet,nor should examiners fail to review the overallnature of financial-contract activities. For exam-ple, individual opening and closing of financialcontracts could appear reasonable, but theaggregate activities may be indicative of anorganization that is in reality operating a futurestrading account solely to profit on interest-rateexpectations.

2130.0.13.6 Parties Executing or Takingthe Contra Side of a Financial Contract

In addition to monitoring contra-party creditrisk, serious efforts should be made to ensurethat the banking organization carefully scruti-nizes the selection of brokers and dealers. In thecase of futures contracts, the CommodityExchange Act requires that an entity functioningas a futures commission merchant be registeredwith the CFTC. However, not every FCM maybe a member of a commodities exchange. Mem-bers of an exchange are given additional super-vision by the exchange, while nonmembers aresubject to audit by the National Futures Associa-tion. In selecting any broker or dealer, an organi-zation should give careful consideration to itsreputation, financial viability, and length of timein business. If an organization intends to dealwith a newly established FCM or broker-dealer,special efforts should be made to verify thereputation and integrity of its principals. (Foradditional discussion, seeFederal ReserveRegulatory Service3–1562). Although suchmeasures cannot ensure that problems will notsubsequently develop with an FCM or broker-dealer, some careful forethought can tend toensure that relationships will not be developedwith persons or firms who had serious problemsin the past.

2130.0.14 ACCOUNTING FORFUTURES CONTRACTS

All futures contracts, except for foreign-currency futures contracts, shall be reported in

the Consolidated Financial Statements for BankHolding Companies in accordance with Finan-cial Accounting Standards Board (FASB) State-ment No. 80, ‘‘Accounting for Futures Con-tracts.’’ Foreign-currency futures contracts shallbe reported in accordance with the guidance inFASB Statement No. 52, ‘‘Foreign CurrencyTranslation.’’

2130.0.14.1 Performance Bonds underFutures Contracts

When the reporting banking organization, aseither buyer or seller of futures contracts, hasposted a performance bond in the form of amargin account deposited with a broker orexchange, the current balance (as of the reportdate) of that margin account shall be reported inOther Assets. The balance in the margin accountincludes the following:

1. the original margin deposit, plus (less)2. any additions (deductions) as a result of daily

fluctuations in the market value of the relatedcontracts (i.e., ‘‘variation margin’’), plus

3. any additional deposits made to the accountto meet margin calls or otherwise (i.e.,‘‘maintenance margin’’), less

4. any withdrawals of excess balances from theaccount

When the performance bond takes the formof a pledge of assets with a broker rather than amargin account, the pledged assets shall bemaintained on the books of the pledging bank-ing organization and no other balance-sheetentry is made for the performance bond. In thiscase, gains and losses resulting from daily fluc-tuations in the market value of the related con-tracts are generally settled with the broker incash. However, if the pledging banking organi-zation also maintains a working balance withthe broker against which recognized daily mar-ket gains and losses are posted, the workingbalance should be reported in Other Assets, andtreated in the same manner as a margin account.

2130.0.14.2 Valuation of Open Positions

All open positions in futures contracts must bereviewed at least monthly (or more often, ifmaterial) and their current market values deter-mined. The market value of a futures contract isto be based on published price quotations. Thesefutures positions must be revalued at their cur-



rent market values on these valuation dates andany changes in these values reported in accor-dance with the guidance presented below forhedge or nonhedge contracts, as appropriate.

2130.0.14.3 Criteria forHedge-Accounting Treatment

A futures contract shall be accounted for as ahedge when the following conditions are met:

1. The banking organization must have deter-mined that the item or group of items to behedged (that is, the identifiable assets, liabili-ties, firm commitments, or anticipated trans-actions) will expose it to price or interest-raterisk.

2. The futures contract must reduce the expo-sure to risk. This will be demonstrated if, atthe inception of the hedge andthroughoutthe hedge period, high correlationisexpected to exist between the changes in theprices of both the contract and the hedgeditem or group of items.10 In other words, thebanking organization must monitor the pricemovements of both the hedge contract andthe hedged items to determine that it is prob-able that changes in the market value of thefutures contract will offset the effects of pricechanges on the hedged items.

3. The futures contract must be designated inwriting as a hedge by management at theinception of the hedge.

In order for a futures contract to qualify asa hedge of an anticipated transaction, thefollowing two additional criteria must bemet:a. The significant characteristics and

expected terms of the anticipated transac-tion must be identified.

b. The occurrence of the anticipated transac-tion must be probable.11

2130.0.14.4 Gains and Losses fromMonthly Contract Valuations of FuturesContracts That Qualify as Hedges

If the hedge criteria are met, the accounting for

the futures contract shall be related to theaccounting for the hedged item so that changesin the market value of the futures contract arerecognized in income when the effects of relatedchanges in the price or interest rate of thehedged item are recognized. If a banking organi-zation must include unrealized changes in thefair value of a hedged item in income, a changein the market value of the related futures con-tract shall be recognized in income when thechange occurs. Otherwise, a change in the mar-ket value of a futures contract that qualifies as ahedge of an existing asset or liability shall berecognized as an adjustment of the carryingamount of the hedged item. A change in themarket value of a futures contract that is a hedgeof a firm commitment shall be included in themeasurement of the transaction that satisfies thecommitment. A change in the market value of afutures contract that is a hedge of an anticipatedtransaction shall be included in the measure-ment of the subsequent transaction.

Once the carrying amount of an asset or lia-bility has been adjusted for the change in themarket value of a futures contract, the adjust-ment must be recognized in income in the samemanner as other components of the carryingamount of that asset or liability (for example,using the interest method). If the item beinghedged is an interest-bearing financial instru-ment otherwise reported at amortized historicalcost, then the changes in the market value of thehedge contract that have been reflected asadjustments in the carrying amount of the finan-cial instrument shall be amortized as an adjust-ment of interest income or expense over theexpected remaining life of the hedged item.

If a futures contract that has been accountedfor as a hedge of an anticipated transaction isclosed before the date of the related transaction,the accumulated change in value of the contractshall be carried forward (assuming high correla-tion continues to exist) and included in themeasurement of the related transaction. When itbecomes probable that the quantity of the antici-pated transaction will be less than that originallyhedged, a pro rata portion of the futures resultsthat would have been included in the measure-ment of the transaction shall be recognized as again or loss.

When futures contracts that are hedges areterminated, the gain or loss on the terminatedcontracts must be deferred and amortized overthe remaining life of the hedged item.

10. Generally, banking practice maintains that correlationin the changes in the market values of the futures contract andthe hedged item must be at least 80 percent for the ‘‘highcorrelation’’ criteria in FASB Statement No. 80 to be met.

11. It will be particularly difficult to meet this criteria whenan anticipated transaction is not expected to take place in thenear future.



2130.0.14.5 Gains and Losses fromMonthly Contract Valuations of FuturesContracts That Do Not Qualify as Hedges

For futures contracts that are not accounted foras hedges, the change that has occurred in themarket value of open positions since the last callreport date shall be reflected in current income,either as ‘‘other noninterest income’’ for netgains or ‘‘other noninterest expense’’ for netlosses.

If high correlation ceases to exist, the bankingorganization should discontinue accounting fora futures contract as a hedge. When this occurs,the portion of the change in the market value ofthe contract that has not offset the market valuechanges of the hedged item, since the inceptionof the hedge, must be reflected in the Report ofIncome as ‘‘other noninterest income’’ or ‘‘othernoninterest expense,’’ as appropriate. The con-tract should thereafter be accounted for as anonhedge contract with subsequent changes inthe contract’s market value reflected in currentperiod income.

When futures contracts that are not hedgesare terminated, the gain or loss on the termi-nated contract must be recognized currently inthe Report of Income as ‘‘other noninterestincome’’ or ‘‘other noninterest expense,’’ asappropriate.

There is the potential for holding companiesand nonbank subsidiaries to follow the refer-enced accounting applications and break‘‘hedges’’ with unrealized futures gains to rec-ognize income, and maintain hedges withfutures losses and adjust the carrying basis ofthe paired, that is, ‘‘hedged’’ asset. Examinersshould look for patterns of taking gains andlosses with a view to determining whether theopening and closing of contracts is consistentwith the organization’s risk-reducing strategies.

2130.0.15 PREPARING INSPECTIONREPORTS

Unsatisfactory comments pertaining to a bankholding company’s financial-contract activitiesshould be noted on the ‘‘Examiner’s Com-ments,’’ ‘‘Policies and Supervision,’’ and‘‘Analysis of Financial Factors’’ or other appro-priate page depending on the severity of thecomments within the bank holding companyinspection report.

2130.0.16 INTERNAL CONTROLSAND INTERNAL AUDIT

The following is designed to illustrate desirableinternal controls and internal audit proceduresapplicable to the organization’s activities infinancial contracts. This illustration is notintended to serve as an absolute standard relat-ing to contract activities, but is designed tosupplement examiners’ knowledge relating tointernal controls and internal audits in this con-text. In evaluating internal controls and audits,the examiner will need to evaluate the scope offutures, forward, and options activities to deter-mine whether internal controls and audit proce-dures are adequate in relation to the volume andnature of the activities.

2130.0.16.1 Internal Controls

It is a management’s responsibility to minimizethe risks inherent in financial-contract activitiesthrough the establishment of policies and proce-dures covering organizational structure, segre-gation of duties, operating and accounting sys-tem controls, and comprehensive managementreporting. Formal written procedures should bein place in connection with purchases and sales,processing, accounting, clearance and safekeep-ing activities relating to these transactions. Ingeneral, these procedures should be designed toensure that all financial contracts are properlyrecorded and that senior management is awareof the exposure and gains or losses resultingfrom these activities. Some examples of desir-able controls follow:

1. Written documentation indicating what typesof contracts are eligible for purchase by theorganization, which individual persons areeligible to purchase and sell contracts, whichindividual persons are eligible to sign con-tracts or confirmations, and the names offirms or institutions with whom employeesare authorized to conduct business.

2. Written position limitations for each type ofcontract established by the banking organiza-tion’s board of directors and written proce-dures for authorizing trades, if any, in excessof those limits.

3. A system to monitor the organization’s expo-sure with customers and those broker-dealers and institutions eligible to do busi-ness with it. To implement this, managementmust determine the amount of credit riskpermissible with various parties and theninstitute surveillance procedures to ensure



that such limits are not exceeded with-out written authorization from seniormanagement.

4. Separation of duties and supervision toensure that persons executing transactionsare not involved in approving the accountingmedia and/or making accounting entries.Further, persons executing transactionsshould not have authority to sign incomingor outgoing confirmations or contracts, rec-oncile records, clear transactions, or controlthe disbursement of margin payments.

5. A clearly defined flow of order tickets andconfirmations. Confirmations generatedshould, preferably, be prenumbered. In addi-tion to promptly recording all commitmentsin a daily written commitment ledger, therelated documentation should be filed sepa-rately for purposes of audit and examination.The flow of confirmations and order ticketsshould be designed to verify accuracy andenable reconciliations throughout the system,for example, to ensure that a person couldnot execute unauthorized transactions andbypass part of the accounting system, and toenable the reconcilement of traders’ positionreports to those positions maintained by anoperating unit.

6. Procedures to route incoming confirmationsto an operations unit separate from the trad-ing unit. Confirmations received from bro-kers, dealers, or others should be comparedto confirmations (or other control records)prepared by the banking organization toensure that it will not accept or make deliv-ery of securities, or remit margin payments,pursuant to contracts unless there is properauthorization and documentation.

7. Procedures for promptly resolving fails toreceive or fails to deliver securities on thedate securities are due to be received or sentpursuant to contracts.

8. Procedures for resolving customer com-plaints by someone other than the personwho executed the contract.

9. Procedures for verifying brokers’ reports ofmargin deposits and contract positions (usean outside pricing source), and reconcilingsuch reports to the records.

10. Procedures for daily review of outstandingcontracts and supervision of traders. Inaddition, there should be periodic reports tomanagement reflecting the margin depositsand contract positions.

11. Selecting and training competent person-nel to follow the written policies andguidelines.

2130.0.16.2 Internal Audit

The scope and frequency of the internal auditprogram should be designed to review the inter-nal control procedures and verify that the inter-nal controls purported to be in effect are beingfollowed. Further, the internal auditor shouldverify that there are no material inadequacies inthe internal control procedures that would per-mit a person acting individually to perpetrateerrors or irregularities involving the records ofthe organization or assets that would not bedetected by the internal control procedures intime to prevent material loss or misstatement ofthe banking organization’s financial statementsor serious violation of applicable banking, bankholding company, or securities rules or regula-tions. Any weaknesses in internal control proce-dures should be reported to management, alongwith recommendations for corrective action. Ifinternal auditors do not report to an audit com-mittee, the person to whom they report shouldnot be in a position to misappropriate assets.In addition, auditors should occasionally spot-check contract prices and mark-to-marketadjustments.



2130.0.17 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws1 Regulations2 Interpretations3 Orders

Statement of policy concerning bankholding companies engaging infutures, forward, and optionscontracts on U.S. government andagency securities and money marketinstruments

225.142 4–830

Policy Statement on FinancialContracts

3–1535

Supervisory Policy Statement onInvestment Securities andEnd-User Derivatives Activities

3–1562

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.

3. Federal Reserve Regulatory Servicereference.



Securities LendingSection 2140.0

Financial institutions, including bank holdingcompany subsidiaries, are lending securitieswith increasing frequency, and, in someinstances, a financial institution may lend itsown investment or trading-account securities.Financial institutions lend customers’ securitiesheld in custody, safekeeping, trust, or pensionaccounts. Because the securities available forlending often greatly exceed the demand forthem, inexperienced lenders may be tempted toignore commonly recognized safeguards. Bank-ruptcies of broker-dealers have heightened regu-latory sensitivity to the potential for problems inthis area.

2140.0.1 SECURITIES-LENDINGMARKET

Securities brokers and commercial banks are theprimary borrowers of securities. They borrowsecurities to cover securities fails (securities soldbut not available for delivery), short sales, andoption and arbitrage positions. Securities lend-ing, which used to involve principally corporateequities and debt obligations, increasinglyinvolves loans of large blocks of U.S. govern-ment and federal-agency securities.

Securities lending is conducted through open-ended ‘‘loan’’ agreements, which may be termi-nated on short notice by the lender or borrower.Repurchase agreements are generally used byowners of securities as financing vehicles and,in certain respects, are closely analogous tosecurities lending. The objective of securitieslending, however, is to receive a safe return inaddition to the normal interest or dividends.Securities loans in industry practice are gener-ally collateralized by U.S. government orfederal-agency securities, cash, or letters ofcredit.1 At the outset, each loan is collateralizedat a predetermined margin. If the market valueof the collateral falls below an acceptable levelduring the time a loan is outstanding, a margincall is made by the lender institution. If a loanbecomes over-collateralized because of appreci-ation of collateral or market depreciation of aloaned security, the borrower usually has theopportunity to request the return of any exces-sive margin.

When a securities loan is terminated, thesecurities are returned to the lender and thecollateral to the borrower. Fees received on

securities loans are divided between the lenderand the customer account that owns the securi-ties. In situations involving cash collateral, partof the interest earned on the temporary invest-ment of cash is returned to the borrower, and theremainder is divided between the lender and thecustomer account that owns the securities.

2140.0.2 DEFINITIONS OF CAPACITY

Securities lending may be done in variouscapacities and with differing associated liabili-ties. It is important that all parties involvedunderstand in what capacity the lender is acting.For the purposes of these guidelines, the rel-evant capacities are as follows:

1. Principal. A lender offering securities fromits own account is acting as principal. Alender institution offering customers’ securi-ties on an undisclosed basis is also consid-ered to be acting as principal.

2. Agent.A lender offering securities on behalfof a customer-owner is acting as an agent.For the lender to be considered a bona fide or‘‘fully disclosed’’ agent, it must disclose thenames of the borrowers to the customer-own-ers (or give notice that names are availableupon request), and must disclose the namesof the customer-owner to borrowers (or givenotice that names are available uponrequest). In all cases, the agent’s compensa-tion for handling the transaction should bedisclosed to the customer-owner. Undis-closed agency transactions, that is, ‘‘blindbrokerage’’ transactions in which partici-pants cannot determine the identity of thecontra party, are treated as if the lender wasthe principal.

3. Directed agent.A lender which lends securi-ties at the direction of the customer-owner isacting as a directed agent. The customerdirects the lender in all aspects of the transac-tion, including to whom the securities areloaned, the terms of the transaction (rebaterate and maturity/call provisions on the loan),acceptable collateral, investment of any cashcollateral, and collateral delivery.

4. Fiduciary. A lender which exercisesdiscre-tion in offering securities on behalf of and forthe benefit of customer-owners is acting as afiduciary. For purposes of these guidelines,

1. Broker-dealers borrowing securities are subject to therestrictions of the Federal Reserve’s Regulation T (12 C.F.R.220.10), which specifies acceptable borrowing purposes.

BHC Supervision Manual December 1998Page 1

the underlying relationship may be as agent,trustee, or custodian.

5. Finder. A finder brings together a borrowerand a lender of securities for a fee. Findersdo not take possession of the securities orcollateral. Delivery of securities and collat-eral is direct between the borrower and thelender, and the finder does not becomeinvolved. The finder is simply a fully dis-closed intermediary.

2140.0.3 GUIDELINES

All bank holding companies or their subsidi-aries that participate in securities lending shouldestablish written policies and procedures gov-erning these activities. Other than commercialbanks with trust departments, the bank holdingcompany subsidiaries most likely to be engagedin securities lending are non-deposit-taking trustcompanies and certain discount brokers whichprovide custody services and make marginloans. At a minimum, policies and proce-dures should cover each of the topics in theseguidelines.

2140.0.3.1 Recordkeeping

Before establishing a securities-lending pro-gram, a financial firm or institution must estab-lish an adequate recordkeeping system. At aminimum, the system should produce dailyreports showing which securities are availablefor lending, and which are currently lent, out-standing loans by borrower, outstanding loansby account, new loans, returns of loaned securi-ties, and transactions by account. These recordsshould be updated as often as necessary toensure that the lender institution fully accountsfor all outstanding loans, that adequate collat-eral is required and maintained, and that policiesand concentration limits are being followed.

2140.0.3.2 Administrative Procedures

All securities lent and all securities standing ascollateral must be marked to market daily. Pro-cedures must ensure that any necessary calls foradditional margin are made on a timely basis.

In addition, written procedures should outlinehow to choose the customer account that will bethe source of lent securities when they are held

in more than one account. Possible methodsinclude loan volume analysis, automated queue,a lottery, or some combination of these. Securi-ties loans should be fairly allocated among allaccounts participating in a securities-lendingprogram.

Internal controls should include operatingprocedures designed to segregate duties andtimely management reporting systems. Periodicinternal audits should assess the accuracy ofaccounting records, the timeliness of manage-ment reports, and the lender’s overall compli-ance with established policies and the firm’sprocedures.

2140.0.3.3 Credit Analysis and Approvalof Borrowers

In spite of strict standards of collateralization,securities-lending activities involve risk of loss.Such risks may arise from malfeasance or fail-ure of the borrowing firm or institution. There-fore, a duly established management or super-visory committee of the lender should formallyapprove, in advance, transactions with anyborrower.

Credit and limit approvals should be basedupon a credit analysis of the borrower. A reviewshould be performed before establishing such arelationship and reviews should be conducted atregular intervals thereafter. Credit reviewsshould include an analysis of the borrower’sfinancial statement, and should consider capi-talization, management, earnings, business repu-tation, and any other factors that appear rel-evant. Analyses should be performed in anindependent department of the lender, by per-sons who routinely perform credit analyses.Analyses performed solely by the person(s)managing the securities-lending program are notsufficient.

2140.0.3.4 Credit and ConcentrationLimits

After the initial credit analysis, management ofthe lender should establish an individual creditlimit for the borrower. That limit should bebased on the market value of the securities to beborrowed, and should take into account possibletemporary (overnight) exposures resulting froma decline in collateral values or from occasionalinadvertent delays in transferring collateral.Credit and concentration limits should take intoaccount other extensions of credit by the lenderto the same borrower or related interests.

Securities Lending 2140.0


Procedures should be established to ensurethat credit and concentration limits are notexceeded without proper authorization frommanagement.

2140.0.3.5 Collateral Management

Securities borrowers generally pledge and main-tain collateral at a level equal to at least 100 per-cent of the value of the securities borrowed.2

The minimum amount of excess collateral, or‘‘margin,’’ acceptable to the lender should relateto price volatility of the loaned securities andthe collateral (if other than cash).3 Generally,the minimum initial collateral on securities loansis at least 102 percent of the market value of thelent securities plus, for debt securities, anyaccrued interest.

Collateral must be maintained at the agreedmargin. A daily ‘‘mark-to-market’’ or valuationprocedure must be in place to ensure that callsfor additional collateral are made on a timelybasis. The valuation procedures should take intoaccount the value of accrued interest on debtsecurities.

Securities should not be lent unless collateralhas been received or will be received simulta-neously with the loan. As a minimum steptoward perfecting the lender’s interest, collat-eral should be delivered directly to the lender oran independent third-party trustee.

2140.0.3.6 Cash as Collateral

When cash is used as collateral, the lender isresponsible for making it income productive.Lenders should establish written guidelines forselecting investments for cash collateral. Gener-ally, a lender will invest cash collateral in repur-chase agreements, master notes, a short-terminvestment fund (STIF), U.S. or Eurodollar cer-tificates of deposit, commercial paper, or someother type of money market instrument. If thelender is acting in any capacity other than asprincipal, the written agreement authorizing the

lending relationship should specify how cashcollateral is to be invested.

Using cash collateral to pay for liabilities ofthe lender or its holding company would be animproperconflict of interestunless that strategywas specifically authorized in writing by theowner of the lent securities.

2140.0.3.7 Letters of Credit as Collateral

If a lender plans to accept letters of credit ascollateral, it should establish guidelines for theiruse. Those guidelines should require a creditanalysis of the banks issuing the letter of creditbefore securities are lent against that collateral.Analyses must be periodically updated andreevaluated. The lender should also establishconcentration limits for the banks issuing lettersof credit, and procedures should ensure they arenot exceeded. In establishing concentration lim-its on letters of credit accepted as collateral, thelender’s total outstanding credit exposures fromthe issuing bank should be considered.

2140.0.3.8 Written Agreements

Securities should be lent only pursuant to awritten agreement between the lender and theowner of the securities, specifically authorizingthe institution to offer the securities for loan.The agreement should outline the lender’sauthority to reinvest cash collateral (if any) andresponsibilities with regard to custody and valu-ation of collateral. In addition, the agreementshould detail the fee or compensation that willgo to the owner of the securities in the form of afee schedule or other specific provision. Otheritems which should be covered in the agreementhave been discussed earlier in these guidelines.

A lender must also have written agreementswith the parties who wish to borrow securities.These agreements should specify the duties andresponsibilities of each party. A written agree-ment may detail acceptable types of collateral(including letters of credit); standards for collat-eral custody and control, collateral valuationand initial margin, accrued interest, marking tomarket, and margin calls; methods for transmit-ting coupon or dividend payments received if asecurity is on loan on a payment date; condi-tions which will trigger the termination of a loan(including events of default); and acceptable

2. Employee benefit plans subject to the Employee Retire-ment Income Security Act are specifically required to collater-alize securities loans at a minimum of 100 percent of themarket value of loaned securities (see section 2140.0.3.10below).

3. The level of margin should be dictated by level of riskbeing underwritten by the securities lender. Factors to beconsidered in determining whether to require margin abovethe recommended minimum include the type of collateral, thematurity of collateral and lent securities, the term of thesecurities loan, and the costs which may be incurred whenliquidating collateral and replacing loaned securities.



methods of delivery for loaned securities andcollateral.

2140.0.3.9 Use of Finders

Some lenders may use a finder to place securi-ties, and some financial institutions may act asfinders. A finder brings together a borrower anda lender for a fee. Finders should not take pos-session of securities or collateral. The deliveryof securities loaned and collateral should bedirect between the borrower and the lender. Afinder should not be involved in the deliveryprocess.

The finder should act only as a fully disclosedintermediary. The lender must always know thename and financial condition of the borrower ofany securities it lends. If the lender does nothave that information, it and its customers areexposed to unnecessary risks.

Written policies should be in place concern-ing the use of finders in a securities-lendingprogram. These policies should cover circum-stances in which a finder will be used, whichparty pays the fee (borrower or lender), andwhich finders the lender institution will use.

2140.0.3.10 Employee Benefit Plans

The Department of Labor has issued two classexemptions which deal with securities-lendingprograms for employee benefit plans covered bythe Employee Retirement Income Security Act(ERISA): Prohibited Transaction Exemption81-6 (46 FR 7527 (January 23, 1981) and cor-rection (46 FR 10570 (February 3, 1981))), andProhibited Transaction Exemption 82-63 (47 FR14804 (April 6, 1982)). The exemptions autho-rize transactions which might otherwise consti-tute unintended ‘‘prohibited transactions’’ underERISA. Any firm engaged in the lending of

securities for an employee benefit plan subjectto ERISA should take all steps necessary todesign and maintain its program to conformwith these exemptions.

Prohibited Transaction Exemption 81-6 per-mits the lending of securities owned byemployee benefit plans to persons who could be‘‘parties in interest’’ with respect to such plans,provided certain conditions specified in theexemption are met. Under those conditions,neither the borrower nor an affiliate of the bor-rower can have discretionary control over theinvestment of plan assets, or offer investmentadvice concerning the assets, and the loan mustbe made pursuant to a written agreement. Theexemption also establishes a minimum accept-able level for collateral based on the marketvalue of the loaned securities.

Prohibited Transaction Exemption 82-63 per-mits compensation of a fiduciary for servicesrendered in connection with loans of plan assetsthat are securities. The exemption details certainconditions which must be met.

2140.0.3.11 Indemnification

Certain lenders offer participating accountsindemnification against losses in connectionwith securities-lending programs. Such indem-nifications may cover a variety of occurencesincluding all financial loss, losses from a bor-rower default, or losses from collateral default.Lenders that offer such indemnification shouldobtain a legal opinion from counsel concerningthe legality of their specific form of indemnifi-cation under federal and/or state law.

A lender which offers an indemnity to itscustomers may, in light of other related factors,be assuming the benefits and, more importantly,the liabilities of a principal. Therefore, lendersoffering indemnification should also obtain writ-ten opinions from their accountants concerningthe proper financial statement disclosure of theiractual or contingent liabilities.





Securities Lending policystatement of the FederalFinancial InstitutionsExamination Council,adopted by the FederalReserve Board on May 6,1985

3–1579.5


3. Federal Reserve Regulatory Service reference.



Repurchase Transactions1

Section 2150.0

Depository institutions and others involved withthe purchase of United States Government andAgency obligations under agreements to resell(reverse repurchase agreements),2 have some-times incurred significant losses. The most im-portant factors causing these heavy losses havebeen inadequate credit risk management and thefailure to exercise effective control over securi-ties collateralizing the transactions.3

The following minimum guidelines addressthe need for managing credit risk exposure tocounterparties under securities repurchaseagreements and for controlling the securities inthose transactions, and should be followed whenentering into repurchase agreements with securi-ties dealers and others.Depository institutions and nonbank subsidi-

aries that actively engage in repurchase agree-ments are encouraged to have more comprehen-sive policies and controls to suit their particularcircumstances. The examining staffs of the Fed-eral Reserve should review written policies andprocedures of dealers to determine their ade-quacy in light of these minimum guidelines andthe scope of each subsidiary’s operations.

2150.0.1 CREDIT POLICYGUIDELINES

The apparent safety of short-term repurchaseagreements which are collateralized by highlyliquid, U.S. Government and Federal agencyobligations has contributed to an attitude ofcomplacency. Some portfolio managers haveunderestimated the credit risk associated withthe performance of the counterparty to the trans-actions, and have not taken adequate steps to

assure control of the securities covered by theagreement.All firms that engage in securities repurchase

agreement transactions should establish writtencredit policies and procedures governing theseactivities. At a minimum, those policies andprocedures should cover the following:Written policiesshould establish ‘‘know your

counterparty’’ principles. Engaging in repur-chase agreement transactions in volume and inlarge dollar amounts frequently requires the ser-vices of a counterparty who is a dealer in theunderlying securities. Some firms which deal inthe markets for U.S. Government and Federalagency securities are subsidiaries of, or relatedto, financially stronger and better known firms.However, these stronger firms may be indepen-dent of their U.S. Government securities subsid-iaries and affiliates and may not be legally obli-gated to stand behind the transactions of relatedcompanies. Without an express guarantee, thestronger firm’s financial position cannot berelied upon in assessing the creditworthiness ofa counterparty.It is important to know the legal entity that is

the actual counterparty to each repurchaseagreement transaction. Know about the actualcounterparty’s character, integrity of manage-ment, activities, and the financial markets inwhich it deals. Be particularly careful in con-ducting repurchase agreements with any firmthat offers terms that are significantly morefavorable than those currently prevailing in themarket.In certain situations firms may use, or serve

as, brokers or finders in order to locate repur-chase agreement counterparties or particularsecurities. When using or acting as this type ofagent the names of each counterparty should befully disclosed. Do not enter into undisclosedagency or ‘‘blind brokerage’’ repurchase trans-actions in which the counterparty’s name is notdisclosed.

2150.0.1.1 Dealings with UnregulatedSecurities Dealers

A dealer in U.S. Government and Federalagency obligations is not necessarily a Federallyinsured bank or thrift, or a broker/dealer regis-tered with the Securities and Exchange Com-mission. Therefore, the dealer firm may not

1. A repurchase agreement is a transaction involving thesaleof assets by one party to another, subject to an agreementby the seller to repurchase the assets at a specified date or inspecified circumstances.2. In order to avoid confusion among market participants

who sometimes use the same term to describe different sidesof the same transaction, the term ‘‘repurchase agreement’’will be used in the balance of this statement to refer to bothrepurchase and reverse repurchase agreements. A repurchaseagreement is one in which a party that owns securities ac-quires funds by transferring the securities to another partyunder an agreement to repurchase the securities at an agreedupon future date. A reverse repurchase (resale) agreement isone in which a party provides funds by acquiring securitiespursuant to an agreement to resell them at an agreed uponfuture date.3. Throughout this document repurchase agreements are

generally discussed in terms of secured credit transactions.This usage should not be deemed to be based upon a legaldetermination.


be subject to any Federal regulatory oversight.A firm doing business with an unregulated

securities dealer should be certain that the dealervoluntarily complies with the Federal ReserveBank of New York’s minimum capital guide-line, which currently calls for liquid capital toexceed measured risk by 20 percent (that is, theratio of a dealer’s liquid capital to risk of 1.2:1).This ratio can be calculated by a dealer usingeither the Securities and Exchange Commis-sion’s Net Capital Rule for Brokers and Dealers(Rule 15c31) or the Federal Reserve Bank ofNew York’s Capital Adequacy Guidelines forUnited States Government Securities Deal-ers. To ensure that an unregulated dealer com-plies with either of those capital standards, itshould certify its compliance with the capitalstandard and provide the following three formsof certification:1. A letter of certification from the dealer

that the dealer will adhere on a continuous basisto the capital adequacy standard;2. Audited financial statements which dem-

onstrate that as of the audit date the dealer wasin compliance with the standard and the amountof liquid capital; and3. A copy of a letter from the firm’s certified

public accountant stating that it found no mate-rial weaknesses in the dealer’s internal sys-tems and controls incident to adherence to thestandard.4Periodic evaluationsof counterparty credit-

worthiness should be conducted by individualswho routinely make credit decisions and whoare not involved in the execution of repurchaseagreement transactions.Prior to engaging in initial transactions with a

new counterparty, obtain audited financial state-ments and regulatory filings (if any) from coun-terparties, and insist that similar information beprovided on a periodic and timely basis in thefuture. Recent failures of government securitiesdealers have typically been foreshadowed bydelays in producing these statements. Manyfirms are registered with the Securities and Ex-change Commission as broker/dealers and haveto file financial statements and should be willingto provide a copy of these filings.The counterparty credit analysis should con-

sider the financial statements of the entity that isto be the counterparty as well as those of any

related companies that could have an impact onthe financial condition of the counterparty.When transacting business with a subsidiary,consolidated financial statements of a parent arenot adequate. Repurchase agreements should notbe entered into with any counterparty that isunwilling to provide complete and timely dis-closure of its financial condition. As part of thisanalysis, the firm should make inquiry about thecounterparty’s general reputation and whetherthere have been any formal enforcement actionsagainst the counterparty or its affiliates by Stateor Federal securities regulators.Maximum positionand temporary exposure

limits for each approved counterparty should beestablished based upon credit analysis per-formed. Periodic reviews and updates of thoselimits are necessary.Individual repurchase agreement counterparty

limits should consider overall exposure to thesame or related counterparty. Repurchase agree-ment counterparty limitations should include theoverall permissible dollar positions in repur-chase agreements, maximum repurchase agree-ment maturities and limits on temporary expo-sure that may result from decreases in collateralvalues or delays in receiving collateral.

2150.0.2 GUIDELINES FORCONTROLLING REPURCHASEAGREEMENT COLLATERAL

Repurchase agreements can be a useful assetand liability management tool, but repurchaseagreements can expose a firm to serious risks ifthey are not managed appropriately. It is possi-ble to reduce repurchase agreement risk bynegotiating written agreements with all repur-chase agreement counterparties and custodianbanks. Compliance with the terms of these writ-ten agreements should be monitored on a dailybasis. If prudent management control require-ments of repurchase agreements are too burden-some, other asset/liability management toolsshould be used.The marketplace perceives repurchase agree-

ment transactions as similar to lending transac-tions collateralized by highly liquid Govern-ment securities. However, experience has shownthat the collateral securities will probablynotserve as protection if the counterparty becomesinsolvent or fails, and the purchasing firm doesnot have control over the securities. Ultimateresponsibility for establishing adequate controlprocedures rests with management of the firm.Management should obtain a written legal opin-

4. This letter should be similar to that which must be givento the SEC by registered broker/dealers.

Repurchase Transactions 2150.0


ion as to the adequacy of the procedures utilizedto establish and protect the firm’s interest in theunderlying collateral.A written agreementspecific to a repurchase

agreement transaction or master agreement gov-erning all repurchase agreement transactionsshould be entered into with each counterparty.The written agreement should specify all theterms of the transaction and the duties of boththe buyer and seller. Senior managers shouldconsult legal counsel regarding the content ofthe repurchase and custodial agreements. Therepurchase and custodial agreements shouldspecify, but should not be limited to, thefollowing:

• Acceptable types and maturities of collateralsecurities;

• Initial acceptable margin for collateral securi-ties of various types and maturities

• Margin maintenance, call, default and selloutprovisions;

• Rights to interest and principal payments;• Rights to substitute collateral; and• The persons authorized to transact businesson behalf of the firm and its counterparty.

2150.0.2.1 Confirmations

Some repurchase agreement confirmations maycontain terms that attempt to change the firm’srights in the transaction. The firm should obtainand compare written confirmations for each re-purchase agreement transaction to be certainthat the information on the confirmation is con-sistent with the terms of the agreement. Theconfirmation should identify specific collateralsecurities.

2150.0.2.2 Control of Securities

As a general rule, a firm should obtain posses-sion or control of the underlying securities andtake necessary steps to protect its interest in thesecurities. The legal steps necessary to protectits interest may vary with applicable facts andlaw and accordingly should be undertaken withthe advice of counsel. Additional prudentialmanagement controls may include:

• delivery of either physical securities to, or inthe case of book entry securities, making ap-propriate entries in the books of a third partycustodian designated under a written custodialagreement which explicitly recognizes the

firm’s interest in the securities as superior tothat of any other person; or

• appropriate entries on the books of a thirdparty custodian acting pursuant to a tripartiteagreement with the firm and the counterparty,ensuring adequate segregation and identi-fication of either physical or book-entrysecurities.

Where control of the underlying securities isnot established, the firm may be regarded onlyas an unsecured general creditor of the insolventcounterparty. In such instance,substantial lossesare likely to be incurred.Accordingly, a firmshould not enter into a repurchase agreementwithout obtaining control of the securities un-less all of the following minimum proceduresare observed: (1) it is completely satisfied as tothe creditworthiness of the counterparty; (2) thetransaction is within credit limitations that havebeen pre-approved by the board of directors, ora committee of the board, for unsecured transac-tions with the counterparty; (3) periodic creditevaluations of the counterparty are conducted;and (4) the firm has ascertained that collateralsegregation procedures of the counterparty areadequate. Unless prudential internal proceduresof these types are instituted and observed, thefirm may be cited for engaging in unsafe orunsound practices.All receipts and deliveries of either physical

or book-entry securities should be made accord-ing to written procedures, and third party deliv-eries should be confirmed in writing directly bythe custodian. It is not acceptable to receiveconfirmation from the counterparty that thesecurities are segregated in a firm’s name with acustodian; the firm should, however, obtain acopy of the advice of the counterparty to thecustodian requesting transfer of the securities tothe firm. Where securities are to be delivered,payment for securities should not be made untilthe securities are actually delivered to the firmor its agent. The custodial contract should pro-vide that the custodian takes delivery of thesecurities subject to the exclusive direction ofthe firm.Substitution of securities should not be

allowed without the prior consent of the firm.The firm should give its consent before thedelivery of the substitute securities to it or athird party custodian. Any substitution of securi-ties should take into consideration the followingdiscussion of ‘‘margin requirements.’’



2150.0.2.3 Margin Requirements

The amount paid under the repurchase agree-ment should be less than the market value of thesecurities, including the amount of any accruedinterest, with the difference representing a pre-determined margin. Factors to be considered inestablishing an appropriate margin include thesize and maturity of the repurchase transaction,the type and maturity of the underlying securi-ties, and the creditworthiness of the counter-party. Margin requirements on U.S. Governmentand Federal agency obligations underlying re-purchase agreements should allow for the antic-ipated price volatility of the security until thematurity of the repurchase agreement. Less mar-ketable securities may require additional marginto compensate for less liquid market conditions.Written repurchase agreement policies and pro-cedures should require daily mark-to-market ofrepurchase agreement securities to the bid sideof the market. Repurchase agreements shouldprovide for additional securities or cash to beplaced with the firm or its custodian bank tomaintain the margin within the predeterminedlevel.Margin calculations should also consider

accrued interest on underlying securities and theanticipated amount of accrued interest over theterm of the repurchase agreement, the date ofinterest payment and which party is entitled toreceive the payment. In the case of pass-throughsecurities, anticipated principal reductionsshould also be considered when determiningmargin adequacy.Prudent managementprocedures should be

followed in the administration of any repurchaseagreement. Longer term repurchase agreementsrequire management’s daily attention to theeffects of securities substitutions, margin main-tenance requirements (including considerationof any coupon interest or principal payments)and possible changes in the financial conditionof the counterparty. Engaging in open repur-chase agreement transactions without maturitydates may be regarded as an unsafe and unsoundpractice unless the firm has retained rights toterminate the transaction quickly to protect itselfagainst changed circumstances. Similarly, auto-matic renewal of short-term repurchase agree-ment transactions without reviewing collateralvalues and adjusting collateral margin maybe regarded as an unsafe and unsound practice.If additional margin is not deposited when

required, the firm’s rights to sell securities orotherwise liquidate the repurchase agreementshould be exercised without hesitation.

2150.0.2.4 Overcollateralization

A firm should use current market values, includ-ing the amount of any accrued interest, to deter-mine the price of securities that are sold underrepurchase agreements. Counterparties shouldnot be provided with excessive margin. Thus,the written repurchase agreement contractshould provide that the counterparty must makeadditional payment or return securities if themargin exceeds agreed upon levels. When ac-quiring funds under repurchase agreements it isprudent business practice to keep at a reason-able margin the difference between the marketvalue of the securities delivered to the counter-party and the amount borrowed. The excessmarket value of securities sold may be viewedas an unsecured loan to the counterparty subjectto the unsecured lending limitations for the firmand should be treated accordingly for creditpolicy and control purposes.

2150.0.3 OPERATIONS

A firm’s operational functions should be de-signed to regulate the custody and movement ofsecurities and to adequately account for tradingtransactions. Because of the dollar volume andspeed of trading activities, operational ineffi-ciencies can quickly result in major problems.In some cases, a firm may not receive or

deliver a security by settlement date. When afirm fails to receive a security by the settlementdate, a liability exists until the transaction isconsummated or cancelled. When the security isnot delivered to the contra-party by settlementdate, a receivable exists until that ‘‘fail’’ is re-solved. ‘‘Fails’’ to deliver for an extended time,or a substantial number of cancellations, aresometimes characteristic of poor operationalcontrol or questionable trading activities.Fails should be controlled by prompt report-

ing and follow-up procedures. The use of multi-copy confirmation forms enables operationalpersonnel to retain and file a copy by settlementdate and should allow for prompt fail reportingand resolution.





Federal FinancialInstitutions ExaminationCouncil policy statement,adopted by the FederalReserve Board onNovember 12, 1985, onrepurchase agreements

3–1579





Recognition and Control of Exposure to RiskSection 2160.0

Risk management is an important responsibilityof any bank holding company. The objective ofthis responsibility is to determine and limit theextent of the holding company organization’svulnerability to uncontrollable variables. Whileall companies perform risk evaluation in someform and exercise some degree of control overits magnitude, the precise processes used differconsiderably across organizations in terms offormality, extensiveness, and effectiveness. Itshould be recognized that many organizationshave only an implicit risk evaluation process,and that it may be appropriate to recommendthat this process be formalized. Ultimately, theboard of directors of the parent company shouldbe held accountable for the consolidated riskevaluation and control.Risk management at any level involves two

basic elements: evaluation and control. Riskevaluation involves three steps: determinationof exposures; specification of uncontrollablevariables that have an impact on each exposure;and quantification of the expected effect of eachvariable on exposure. After the extent of exist-ing or potential risk is determined, decisions tolimit or control risk are made. This procedure isever present, since most transactions create ex-posure, and every exposure has some element ofrisk. The following two sections discuss the riskevaluation and the risk control processes in verybroad terms in an attempt to provide a frame-work that can be applied to most organizations.

2160.0.1 RISK EVALUATION

The risk identification process begins with adetermination of exposures that an institutionhas to the environment.Exposure conceptually occurs in every trans-

action undertaken by a banking organization.Because of the magnitude of the list of potentialexposures, institutions generally limit theirefforts to extremely large exposures, to areaswhere losses appear likely, and to activitieswhere the market is changing and new expo-sures are created. The size of an exposure gener-ally is dependent on the size of a transaction.This is true both for transactions recorded onaccounting balance sheets and for those whichoccur off balance sheet. Exposure is not neces-sarily determined by the likelihood of loss. Forexample, many holding company organizationshave a large ‘‘exposure’’ in Treasury bills, butdo not consider these transactions to be risky.

The list of exposures that banks commonlyidentify has increased dramatically in the pastdecade. Historically, the primary focus has beenon the exposure of the loan portfolio centeringon the financial security of each individual loan;recently industry and geographical exposure ofloans has increased in importance. The exposureof fixed assets, such as buildings, to fires, floodsand other problems also has been recognized. Inmore recent years, exposure of mismatchedmaturities of assets and liabilities to interest ratemovements has increased in importance asinterest-rate movements have sharply fluctu-ated. While this exposure had always existed, ithad not been recognized as particularly danger-ous until recently. Another example of an expo-sure that historically was considered safe isrepurchase agreements backed by governmentsecurities. When Drysdale Government Securi-ties, Inc. failed, several risks were brought tolight—whether the instrument is a loan (thatwould be tied up in case of bankruptcy) or a saleand potential liability when serving as an agentof a government securities firm that fails. Aparticularly difficult area to evaluate is exposureto legal action. For example, a suit against abank over lending terms and representations isdifficult to anticipate and the exposure could besignificant.Numerous exposures exist that many holding

company organizations may not recognize. Forexample, the Federal Reserve System encour-ages evaluation of wire transfer exposure. Thisexposure is very large and theoretically a break-down on the framework or compromise of inter-nal systems could result in major failures. Expo-sure from foreign exchange contracts also canbe large, and may not always be recognized.Fraud and exposure of management to kidnap-ping continue to increase in importance. Andfinally, some major holding company organiza-tions have found that dependence on short-termmarket funds creates a risky exposure. Whenaccess to a funding market may be suddenlywithdrawn, the exposure of the entire fundingprocess is an issue.The second step of the risk identification pro-

cess is specification of the variables that couldaffect an exposure and determination of whatthe impact would be.This process is difficult, since any number of

variables may influence an exposure. Further-more, as the environment changes new variables


may appear relevant and the effects of variablesmay change. For example, the recent problemsof public sector lending to foreign countrieswith loans denominated in dollars having float-ing interest rates during inflationary periods maynot have been fully evaluated at the time of thelending process.Determining influential variables is particu-

larly difficult with new products. A historicalexamination cannot be made of these new prod-ucts and questions may go unanswered regard-ing the stability of the new markets. For exam-ple, problems have occurred in hedgingoperations as underlying instruments did notmove as expected, thus negating the hedgingcontract. Consequently, the hedge created anexposure rather than reducing an exposure.The final step of the risk identification pro-

cess is risk quantification.Conceptually, this involves calculation of an

expected loss of value related to variance of aparticular environmental factor. This has twoparts: (1) estimation of the probability that agiven variance will occur; and (2) determinationof the cost impact of each potential variance.Probabilities are often drawn up in generalterms. In some cases historical records facilitateestimation of probabilities. Measurement ofcredit risk in an organization that specializes byindustry or geography may be an example ofthis. In the most recent recession, however,many past records have proven not to be accu-rate predictors. In other situations, the holdingcompany organization may evaluate the effectof a change but be unwilling to estimate proba-bilities of the change occurring. An exampleof this is managing asset and liability maturi-ties. The effect of a change in interest rates onprofits may be determined; but, in many cases,institutions will not derive probabilities on thedirection and/or magnitude of interest ratemovements.The difficulty of quantifying costs and proba-

bilities is exacerbated by emergence of newproducts and by environmental changes. With anew product, it is particularly difficult to deter-mine the cost of a variance. For example, atten-tion to interest rate risk has induced organiza-tions to resort to hedging to reduce exposure.Innovative instruments are difficult to hedge,however, since the issuer may inaccuratelygauge price movements. In this case, the expo-sure results not from price movements, but frominability to predict the relationship betweenmarket and price fluctuations. Furthermore, as

the environment changes, the effect of a variableon an exposure changes as does the cost andprobability of the occurrence. For example, inthe 1970’s the impact of inflation on the bank-ing system would have been very different with-out the concurrent economic downturn and thetechnological advances.

2160.0.2 RISK CONTROL

After management has identified and evaluatedrisk, they may decide the risk or cost of anaction is sufficiently low (and management isconfident all possible variables have been identi-fied) that the holding company can take on therisk as it is; if not there are a number of optionsthat can be used to control the risk. Attempts tocontrol risk can be accomplished through a com-bination of three general techniques: purchaseof insurance, limitation of exposure size, andreduction of the expected cost associated with avariance. The use of insurance to decrease theeffect of a loss on the corporation is common forexposure to fire, theft, kidnapping, and internalfraud. Various types of loans are underwrittenby third parties. The innovative use of insurancemay prove to have various applications to riskcontrol in the banking industry. As with othercontracts, the financial strength and reputationof the counterparty (the insurer) are important,and the organization’s method of selecting andmonitoring underwriters should be evaluated.Management generally limits the level of

exposure in relationship to the size of assets,capital or earnings. In most situations, relatingthe level of exposure to capital would appearappropriate. Reduction of exposure will auto-matically reduce risk, assuming other variablesremain constant. Constraints should be deter-mined by line management at a seniority levelcommensurate with the degree of perceived risk.Depending on the degree of risk, there may be aneed for the board of directors to approve theconstraints.The third method of reducing the potential

loss to the corporation involves decreasing theprobability of a variance occurring or decreas-ing the probable effect when a variance occurs.This is exemplified by the exposure to fire.Installation of fire alarms and other precautionscould reduce the expected loss substantially.Similarly, hedging with financial futures is amethod used to reduce the effect of interest ratemovement on the profits of the holding com-pany organization when the maturities of assetsand liabilities are not equal.The final option management has, after risk

Recognition and Control of Exposure to Risk 2160.0


has been evaluated, is simply not to participatein the activity if the risk is determined to be toohigh for the expected return.The inspection procedures should include a

broad-based evaluation of parent level risk man-agement. Management’s effectiveness in identi-fying risk, its willingness to accept risk, and itsability to control risk should be regularly evalu-ated. In an environment of rapid change andemerging financial instruments, there needs tobe sufficient expertise to recognize the existenceof ‘‘new’’ sources of risk concentration to eval-uate the company’s command of those sources.


1. To review the risk evaluation and controlprocess.2. To determine if management’s system of

identifying risks is effective, and if the parentcompany is adequately informed of risksthroughout the organization.3. To determine management’s recognition

of new risks that may arise from the changingenvironment.4. To determine the reasonableness of the

holding company’s exposure-risk figures.5. To assess the effect on the holding compa-

ny’s financial condition if the risk figures arerealized.

6. To determine what actions are necessaryto rebalance transactions of a holding companyorganization to a prudent level.


1. Review the financial condition and theoperations of the holding company organizationto detect substantive exposure-risk situations.2. Review management’s policies, proce-

dures, and practices in recognizing exposure-risk factors.3. Determine awareness that all management

levels need to be cognizant of exposures relatedto transactions of their respective operations.4. Review the holding company’s exposure-

risk figures, or constraints placed on types oftransactions.5. Discuss with management the significance

of exposure-risks facing the holding companyand whether or not those risks are set at seem-ingly prudent levels.6. Recommend that the organization address

any areas where the holding company is per-ceived to have assumed an imprudent level ofrisk.

Recognition and Control of Exposure to Risk 2160.0


Purchase and Sale of Loans Guaranteed by theU.S. Government Section 2170.0


On April 10, 1985, the Board approved a super-visory policy, via the Federal Financial Institu-tions Examination Council, for supervisingbanking organizations that participate in the pur-chase and sale of loans guaranteed by the U.S.government. The policy reminds those organiza-tions that premiums received in lieu of servicingfees, with respect to the selling and servicingentity, are to be amortized over the life of theloan; and that, with respect to the purchaser, thepremiums paid over the face value of the noteare not guaranteed and are not paid by theguaranteeing federal agency when the loans areprepaid or in default. The statement thus cau-tions against paying inappropriate or excessivepremiums.

2170.0.2 RECOMMENDATIONS FORORIGINATING AND SELLINGINSTITUTIONS

Examiners should review the extent and natureof activities in connection with the sale of gov-ernment guaranteed loans. Lax or impropermanagement of the selling institution’s servic-ing responsibilities should be criticized. Out-of-trade area lending for the purpose of resale ofany portion of U.S. government guaranteedloans should be carefully reviewed to ensurethat the practice is conducted in a safe andsound manner.All income, including servicing fees and pre-

miums charged in lieu of servicing fees, associ-ated with the sale of U.S. government guaran-teed loans, should be recognized only as earnedand amortized to appropriate income accountsover the life of the loan.

2170.0.3 RECOMMENDATIONS FORPURCHASING INSTITUTIONS

Purchasers of U.S. government guaranteed loansshould be aware that the purchase premiums arenot guaranteed and are not paid by the guaran-teeing Federal agency when the loans are pre-paid. Because payment of premiums which donot reasonably relate to the yield on the loan candistort published financial reports by overstatingthe value of a banking organization’s assets, itwill generally be viewed as an unsafe and un-sound practice to pay purchase premiums whichresult in a significant overstatement in the valueof bank assets.Many government guaranteed loans currently

being originated and sold are variable rate.These variable rate loans normally should nottrade at anything more than a modest premiumor discount from par. Examiners will carefullyreview any loans being sold or purchased atsignificant premiums and will criticize anyinvolvement with excessive premiums as anunsafe and unsound business practice. Exces-sive purchase premiums will be classified loss.The loans will be required to be revalued to themarket value at the time of the acquisition andthe excessive premiums will be charged againstcurrent earnings.In addition, any unamortized loan premium

on a government guaranteed loan must be im-mediately charged against income if the loan isprepaid, regardless of whether payment isreceived from the borrower or the guaranteeingagency.


Sale of Uninsured AnnuitiesSection 2175.0


Banking organizations have become increas-ingly involved in marketing third-party unin-sured annuities to their retail customers eitherdirectly or through third-party companies. Asannuity sales have grown, so have concerns thatsome methods used to sell these instrumentscould give purchasers the impression that theannuities are federally insured deposits or thatthey are obligations of a bank. In the event ofdefault by an annuities underwriter, this impres-sion could cause a loss of public confidence in adepository institution, leading to unexpectedwithdrawals and liquidity pressures. Moreover,a bank or bank holding company that advertisesor markets annuities in a way viewed as mis-leading could potentially be held liable forlosses sustained by annuity holders.This manual section provides guidelines to

examiners for reviewing the sale of uninsuredannuities by bank holding companies and banksthat have legal authority to act as agent in thesale of annuities. State member banks and bankholding companies should not market, sell, orissue uninsured annuities or allow third partiesto market, sell, or issue uninsured annuities ondepository-institution premises in a manner thatconveys the impression or suggestion that suchinstruments are either (1) federally insureddeposits or (2) obligations of or guaranteed byan insured depository institution. Consequently,state member banks should not sell these instru-ments at teller windows or other areas whereretail deposits are routinely accepted.

2175.0.2 PERMISSIBILITY OFUNINSURED ANNUITY SALES

The legal status of annuities under the BankHolding Company Act is somewhat uncertain atthe present time. The Office of the Comptrollerof the Currency has authorized national banks toact as agent in the sale of annuities on the basisthat variable-rate annuities are securities andfixed-rate annuities are financial investmentinstruments.1 These determinations, however,

have been challenged by insurance associationson the basis that annuities are insurance prod-ucts and, therefore, may be sold by nationalbanks only in a town of less than 5,000.2

State member banks generally have been per-mitted to engage in the brokerage of bothvariable- and fixed-rate annuities consistent withtheir general corporate powers. In order toengage in this activity without filing a formalapplication, staff has advised interested banksthat the brokerage of annuities must beexpressly authorized under state law (or by thestate banking regulatory agency on a case-by-case basis) and constitute an activity incidentalto the bank’s banking activities.The authority of state member banks to con-

tinue to engage in this activity, in the samemanner and subject to the conditions discussedabove, does not appear to depend on a resolu-tion of the issues.3 State member banks havebeen permitted to engage in general insuranceagency activities since 1937,4 and to engage inbrokerage activities under the same limitationsapplicable to bank holding companies. In addi-tion, the Board has determined that the nonbank-ing restrictions in the Bank Holding CompanyAct do not apply to the direct activities of banksowned by a bank holding company.5

The authority of bank holding companies toengage directly or through a nonbanking subsid-iary in the sale of annuities has not yet beendetermined. InNorwest Corporation,6 the Boardconsidered a proposal by a nonbanking affiliateto engage in the sale of variable- and fixed-rateannuities. The Board concluded that, under thespecific facts of that case, it was unnecessary toreach the question of whether the sale of annu-ities is an insurance agency activity becauseNorwest is one of a small number of bankholding companies entitled to act as agent in the

1. Interpretive Letter No. 331, April 4, 1985,reprinted in[1985–1987 Transfer Binder] Fed. Banking L. Rep. (CCH)¶85,501; OCC Interpretive Letter No. 499 (February 12,1990),reprinted in[1989–1990] Fed. Banking L. Rep. (CCH)¶83,090. National banks are authorized to buy and sell securi-ties for the account of customers and broker financial invest-ment instruments.

2. The Variable Annuity Life Insurance Company v. Clarke,No. H-91-1016 (S.D. Tex. filed Apr. 16, 1991) (‘‘NCNBlitigation’’).3. NCNB litigation.4. Prior to 1937, the Board imposed as a condition of

membership in the Federal Reserve System that a bank dis-continue all insurance activities other than insurance activitiesin a town of less than 5,000. The purpose of this restrictionwas to conform insurance activities allowed for state memberbanks to those allowed for national banks.5. Merchants National Corp., 75 Federal Reserve Bulletin

388 (1989),aff’d, 890 F.2d 1275 (2d Cir. 1989),cert. denied,111 S. Ct. 44 (1990).6. 76 Federal Reserve Bulletin 873 (1990).

BHC Supervision Manual June 1996Page 1

sale of any type of insurance pursuant to Ex-emption G of the Garn Act.7

2175.0.3 CHARACTERISTICS OFANNUITY INSTRUMENTS

An annuity is an investment from which a per-son receives periodic payments based on earlierpayments made to the obligor. Annuities arecommonly underwritten by insurance compa-nies, then marketed and sold either directly orthrough third parties, such as banks. Insurancecompanies retain the actuarial and underwritingrisks on these annuities.Annuities may be either variable or fixed-

rate. An investor in a variable annuity contractpurchases a share in an investment portfolio andthen receives payments that vary according tothe performance of the portfolio. A purchaserof a fixed-rate annuity contract, in contrast,receives a fixed-rate payment or minimum levelof payments. Annuity payments can usually bereceived monthly, quarterly, semi-annually, orannually.Variable- and fixed-rate annuities may be pur-

chased in a single lump sum (‘‘single pre-mium’’) or in periodic contributions (‘‘flexiblepremium’’). Minimum and maximum contribu-tions to annuities vary among vendors. Somesingle-premium annuities have ‘‘bail-out’’ fea-tures which allow holders to withdraw all fundsif the rate of return on the annuity contract fallsbelow a specified rate.The ability to take money out of an annuity

prior to maturity varies by product, as does theimposition of a surrender penalty by the insurerwhen withdrawal occurs prior to maturity. Whena penalty is imposed, the insurer generally cal-culates the penalty as a percentage of the annu-ity product’s accumulated value. The penaltyfor withdrawal generally declines with the annu-

ity’s age. Normally, funds may not be with-drawn prior to the first anniversary date of theannuity.8Annuities sold at depository institutions often

include rate guarantees over the life of theinstrument. They also frequently mature in one,three, or five years, similar to maturity rangeson certificates of deposit.Insurance companies arrange for the sale of

annuities on the premises of depository institu-tions in different ways. Some insurance compa-nies approach banks directly. At other times,wholesalers (who market the products of anumber of different insurance companies) mayapproach a bank. Depending on state restric-tions on insurance activities, sales might beconducted by bank employees, employees ofbank subsidiary insurance agencies, or by third-party insurance agents leasing space on thebank’s premises.Sales commissions on annuities vary by the

type of annuity. Commissions earned on single-premium products generally vary from 4 percentto 6 percent, but they decline sharply when theproduct sold includes a ‘‘bail-out’’ provision.Wholesalers may also give retailers a commis-sion when the annuity is renewed, based on theaccumulated value of the annuity. Commissionsin some instances are paid on a variable basis,rising as the volume of sales increases.

2175.0.4 IMPROPER MARKETINGPRACTICES

Banks have become involved in the sale ofuninsured annuities through marketing programsdesigned to appeal specifically to their retailcustomers. It is important that these programsnot employ marketing practices that could mis-lead the bank’s customers. For example, the usein annuities advertisements of terms such as‘‘CD,’’ ‘‘deposit,’’ and ‘‘interest plan’’ to implythat the instruments are insured deposits wouldbe inappropriate. Also, advertisements thatprominently display the bank’s name and logoin a way that suggests the product is an obliga-tion of the bank are similarly inappropriate.Disclosure that the annuities are not federallyinsured and are not obligations of the bankshould be displayed prominently in annuity con-tracts and related documentation, on printed

7. The Garn Act amended section 4(c)(8) of the BankHolding Company Act to prohibit generally bank holdingcompanies from engaging in insurance activities as a princi-pal, agent, or broker with certain exceptions. Under the ex-press language of the Garn Act, the sale of insurance is not‘‘closely related to banking’’ and is not permissible for a bankholding company unless it qualifies under one of the sevenspecified exceptions (Exemptions A–G) in the Garn Act.Exemption G applies to a limited number of bank holdingcompanies that received approval from the Board prior toJanuary 1, 1971, to conduct insurance agency activities. Inorder to utilize Exemption G or any other Garn Act exemp-tions that may be applicable, the bank holding company mustfile an application and would be subject to the proposedrestrictions through the application process.

8. If an investor withdraws tax-deferred income from anannuity before the investor is 591⁄2 years old, the IRS levies atax penalty on the person equal to 10 percent of the amount oftax-deferred income withdrawn. This penalty may be avoidedonly if the person reinvests annuity proceeds in another tax-deferred investment within 60 days of the withdrawal.

Sale of Uninsured Annuities 2175.0


advices, and verbally emphasized in telemarket-ing contacts. Finally, personnel selling unin-sured annuities should be distinguishable frombank employees conducting normal retaildeposit-taking operations.


1. To review the marketing and sale of unin-sured annuities sold by the bank holding com-pany and its member banks, or those soldthrough a third party.2. To determine whether the bank holding

company and its banks have adequate policiesand procedures in place and if they are moni-tored by the parent company.3. To determine if, prior to agreeing to sell

annuities, a comprehensive financial analysis ismade of the financial condition of the annuitiesunderwriter and whether products of only finan-cially secure underwriters are sold.4. To determine whether the contract and

advertising and related documents discloseprominently that the annuities do not representdeposits or obligations of an insured depositoryinstitution and that they are not insured by theFederal Deposit Insurance Corporation.5. To ascertain that annuities are not sold at

teller windows or other areas where deposits areroutinely accepted.


1. Determine whether the bank holding com-pany and its banks have adequate policies andprocedures in place:

a. to assess the financial condition of theannuities underwriter;

Banking organizations engaged in thesale of annuities are expected to sell only prod-ucts of financially secure underwriters. Priorto agreeing to sell annuities, a comprehensivefinancial analysis of the obligor should be per-formed and reviewed with the banking organiza-tion’s directors. The policies should also includea program to evaluate the underwriter’s finan-cial condition at least annually and to review thecredit ratings assigned to the underwriter bythe independent agencies evaluating annuityunderwriters.

b. to ensure that the marketing and sale ofuninsured annuities is not misleading and isseparated and distinguished from routine retaildeposit-taking activities.

(1) With regard to the sale of annuities,determine whether the contract, advertising, and

all related documents disclose prominently inbold print that the annuities:

(a) are not deposits or obligations ofan insured depository institution; and

(b) are not insured by the FederalDeposit Insurance Corporation.

(2) State member banks should not sellannuity instruments at teller windows or otherareas where retail deposits are routinely ac-cepted. In assessing the adequacy of disclosuresand the separation of the marketing and sale ofuninsured annuities from the retail deposit-taking function, examiners should take intoaccount whether:

(a) advertisementsdo not containwords, such as ‘‘deposit’’, ‘‘CD’’, etc., or a logothat could lead an investor to believe an annuityis an insured deposit instrument;

(b) the obligor of the annuity contractis prominently disclosed, and names or logos ofthe insured depository institution are not used ina way that might suggest the insured depositoryinstitution is the obligor;

(c) adequate verbal disclosures aremade during telemarketing contacts and at thetime of sale;

(d) retail deposit-taking employees ofthe insured depository institutionare not en-gaged in the promotion or sale of uninsuredannuities;

(e) information on uninsured annu-ities is notcontained in retail deposit statementsof customers or in the immediate retail deposit-taking area;

(f) account information on annuitiesowned by customersis not included on insureddeposit statements; and

(g) officer or employee remunerationassociated with selling annuities is limited toreasonable levels in relation to the individual’ssalary.

(3) If a bank allows a third-party entityto market annuities on depository institutionpremises, examiners should take into accountwhether:

(a) the depository institution hasassured itself that the third-party company isproperly registered or licensed to conduct thisactivity;

(b) depository institution personnelare notinvolved in sales activities conducted bythe third party;

(c) desks or officesare not used tomarket or sell annuities, are separate and dis-



tinctly identified as being used by an outsideparty; and

(d) depository institution personneldo notnormally use desks or offices used by athird party for annuities sales.2. Determine that advertisements do not

prominently display the bank’s name and logothat suggests the product is an obligation of aBHC bank.

3. Determine whether the banks obtain asigned statement from the customer indicatingthat the customer understands that the annuity isnot a deposit or any other obligation of thedepository institution, that the depository insti-tution is only acting as an agent for the insur-ance company (underwriter), and that the annu-ity is not FDIC insured.



Support of Bank-Affiliated Investment Funds Section 2178.0

On January 5, 2004, the federal banking andthrift agencies1 (the agencies) issued an inter-agency policy to alert banking organizations,including their boards of directors and seniormanagement, of the safety-and-soundnessimplications of and the legal impediments to abank providing financial support to investmentfunds2 advised by the bank, its subsidiaries, oraffiliates (that is, affiliated investment funds). Abanking organization’s investment advisory ser-vices can pose material risks to the bank’sliquidity, earnings, capital, and reputation andcan harm investors, if the associated risks arenot effectively controlled. In addition, bank-affiliated investment advisers are encouraged toestablish alternative sources of financial supportto avoid seeking support from affiliated banks.(See SR-04-1 and SR-94-53.)

Banks are under no statutory requirement toprovide financial support to the funds theyadvise; however, circumstances may motivatebanks to do so for reasons of reputation risk andliability mitigation. This type of support bybanking organizations to funds they adviseincludes credit extensions, cash infusions, assetpurchases, and the acquisition of fund shares. Invery limited circumstances, certain arrange-ments between banks and the funds they advisehave been expressly determined to be legallypermissible and safe and sound when properlyconducted and managed. However, the agenciesare concerned about other occasions when emer-gency liquidity needs may prompt banks to sup-port their advised funds in ways that raise pru-dential and legal concerns. Federal laws andregulations place significant restrictions ontransactions between banks and their advisedfunds. In particular, sections 23A and 23B of theFederal Reserve Act and the Board’s RegulationW (12 C.F.R. 223) place quantitative limits andcollateral and market-terms requirements onmany transactions between a bank and certainof its advised funds.

2178.0.1 POLICY ON BANKSPROVIDING FINANCIAL SUPPORTTO ADVISED FUNDS

To avoid engaging in unsafe and unsound bank-ing practices, banks should adopt appropriatepolicies and procedures governing routine oremergency transactions with bank-advisedinvestment funds. Such policies and proceduresshould be designed to ensure that the bank willnot (1) inappropriately place its resources andreputation at risk for the benefit of the funds’investors and creditors; (2) violate the limits andrequirements contained in sections 23A and 23Bof the Federal Reserve Act and Regulation W,other applicable legal requirements, or any spe-cial supervisory condition imposed by the agen-cies; or (3) create an expectation that the bankwill prop up the advised fund. Further, the agen-cies expect banking organizations to maintainappropriate controls over investment advisoryactivities that include:

• Establishing alternative sources of emergencysupport from the parent holding company,nonbank affiliates, or external third partiesprior to seeking support from the bank.

• Instituting effective policies and proceduresfor identifying potential circumstances trig-gering the need for financial support and theprocess for obtaining such support. In thelimited instances that the bank provides finan-cial support, the bank’s procedures shouldinclude an oversight process that requires for-mal approval from the bank’s board of direc-tors, or an appropriate board-designated com-mittee, independent of the investmentadvisory function. The bank’s audit commit-tee also should review the transaction toensure that appropriate policies and proce-dures were followed.

• Implementing an effective risk-managementsystem for controlling and monitoring risksposed to the bank by the organization’s invest-ment advisory activities. Risk controls shouldinclude establishing appropriate risk limits,liquidity planning, performance measurementsystems, stress testing, compliance reviews,and management reporting to mitigate theneed for significant bank support.

• Implementing policies and procedures thatensure that the bank is in compliance withexisting disclosure and advertising require-

1. The Board of Governors of the Federal Reserve System(Board), the Office of the Comptroller of the Currency (OCC),the Federal Deposit Insurance Corporation (FDIC), and theOffice of Thrift Supervision (OTS).

2. Bank-advised investment funds include mutual funds,alternative strategy funds, collective investment funds, andother funds where the bank, its subsidiaries, or affiliates is theinvestment adviser and receives a fee for its investmentadvice.


ments to clearly differentiate the investmentsin advised funds from obligations of the bankor insured deposits.

• Ensuring proper regulatory reporting of con-tingent liabilities arising out of its investmentadvisory activities in the banking organiza-tion’s published financial statements in accor-dance with FAS 5, and fiduciary settlements,surcharges, and other losses arising out of itsinvestment advisory activities in accordancewith the instructions for completing call reportSchedule RC-T (Fiduciary and RelatedServices).

2178.0.2 NOTIFICATION ANDCONSULTATION WITH THEPRIMARY FEDERAL REGULATOR

Because of the potential risks posed by theprovision of financial support to advised funds,bank management should notify and consultwith its appropriate federal banking agency priorto (or immediately after, in the event of anemergency) the bank providing material finan-cial support to its advised funds. The appropri-ate federal banking agency will closely scruti-nize the circumstances surrounding thetransaction and will address situations that raisesupervisory concerns.


1. To determine if the BHC has adequate over-sight and control of its functionally regulatedinvestment adviser subsidiaries.

2. To review and assess the existence,adequacy, maintenance, and monitoring ofthe BHC’s policies, procedures, and prac-tices (includes those involving the parentcompany’s oversight and investment advisersubsidiaries). The BHC’s policies, proce-dures, and practices should be designed tolimit the exposures to financial, litigation, orreputational risk arising from its bank andnonbank subsidiaries.

3. To ensure that the BHC’s banking subsidi-aries that advise investment funds are incompliance with the Interagency Policy onBanks and Thrifts Providing Financial Sup-port to Funds Advised by the Banking Orga-nization or Its Affiliates.


1. Determine if the BHC has adequate over-sight policies, procedures, and practices toensure that its banking and nonbank subsidi-aries that advise investment funds do not—a. inappropriately place the resources and

reputation of the bank at risk for the bene-fit of affiliated investment funds’ investorsand creditors;

b. violate the limits and requirements in Fed-eral Reserve Act sections 23A and 23Band Regulation W, other applicable legalrequirements, or any special supervisorycondition imposed by the agencies; or

c. create an expectation that a bank will sup-port the advised fund (or funds).

2. Find out how the BHC ensures through itscommunications with subsidiaries that bank-affiliated investment advisers are encouragedto establish alternative sources of financialsupport from an unaffiliated bank or otheraffiliate.

3. Ascertain whether the BHC’s internal orexternal auditors verified that its oversightpolicies and procedures for bank-advisedfunds were adequately communicated to itsbanking subsidiaries to ensure compliancewith the January 5, 2004, Interagency Policyon Banks and Thrifts Providing FinancialSupport to Funds Advised by the BankingOrganization or Its Affiliates. Complianceincludes the BHC’s or subsidiary’s notifica-tion of and consultation with its appropriatefederal banking agency before (or, in anemergency, immediately after) providingmaterial financial support to an affiliatedinvestment fund.

4. Find out if the BHC’s internal audit functionmonitors any financial support given to bankor nonbank subsidiaries’ advised funds and ifthe internal auditors follow up on compli-ance with any policies, limits, or internalcontrols that are intended to restrict theactivities.

5. Determine if the BHC is able to assess at alltimes the extent of its subsidiary banks’ riskexposures that may arise from providing sup-port to affiliated investment funds.

Support of Bank-Affiliated Investment Funds 2178.0


Securities Activities in Overseas MarketsSection 2180.0

Existing regulations permit banks and bankholding companies to engage in a wide range ofsecurities activities in overseas markets. For anumber of years these activities were not con-sidered to be significant in the context of totalbank and bank holding company assets. Indige-nous rules and market practice served to con-strain to a degree securities activities of U.S.banking organizations overseas.Changes in local rules now make it possible

for members of the London stock exchange tobe wholly-owned by non-member companiesand by year-end 1986 will allow stockbrokers toact as principals or market makers in securities.These new rules are expected to change signifi-cantly the complexion of the London securitiesmarket. In this context, U.S. banking organiza-tions are making substantial investments in U.K.securities firms, and are also significantly ex-panding their securities business in other foreignand international markets.The Board has expressed its concerns, in con-

nection with an application by a banking organi-zation to expand its securities activities over-seas, that proper safeguards, limits, and controlswill be exercised to protect the organizationfrom undue risk. Applications generally statethe methods through which the banking organi-zation plans to control risk and establish over-sight over securities operations. While thesesafeguards are initially evaluated at the time theapplication is made, nevertheless, examinationsof bank holding companies and Edge corpora-tions should incorporate an assessment of alloverseas securities activities in order to deter-mine the degree to which these activities con-form to high standards of banking and financial

prudence. The affiliation of a securities com-pany, especially one engaged in corporate debtand equities transactions, with a banking organi-zation raises a potential for conflict of interestand in some cases could pose substantial addi-tional risk to the institution.In those U.S. banking organizations where

overseas securities trading and brokering aresignificant in scope or are prominent in the scaleof the local market, examination proceduresmust incorporate an assessment of the controls,limits, and safeguards implemented by the orga-nization to monitor and contain risk. Securitiesactivities should be subject to the same degreeof scrutiny and rigorous assessment of risk asbank lending activities. In addition, examinersshould monitor the substance and nature of alltransactions.In particular, the following kinds of activities

should be reviewed to determine whether theyraise considerations of safety and soundness orotherwise do not conform to standards of pru-dence required of U.S. banking organizations:

• The degree of lending by a bank holdingcompany to its securities affiliate, especiallywhen loans are extended to support or en-hance the obligations underwritten by thesecurities affiliate;

• The extent to which securities underwrittenby an affiliate are purchased by the bank hold-ing company as principal or trustee; and,

• The extent to which the parent is liable to anexchange for any losses incurred by the affil-iate due to failure to deliver securities or settlecontracts.


Violations of Federal Reserve Margin Regulations Resultingfrom ‘‘Free-Riding’’ Schemes Section 2187.0

Targeted examinations and investigations by theFederal Reserve and the Enforcement Divisionof the Securities Exchange Commission (SEC),as well as court actions, have found banks inviolation of Regulation U, Credit by Banks forthe Purpose of Purchasing or Carrying MarginStock, (12 C.F.R. 221) when their trust depart-ments, using bank or other fiduciary funds, haveextended credit to individuals involved in illegalday trading or free-riding schemes. These activi-ties also involved the aiding and abetting ofviolations of two other securities credit regula-tions: Regulation T, Credit by Brokers and Deal-ers (12 C.F.R. 220), and Regulation X, Borrow-ers of Securities Credit, (12 C.F.R. 224).

Day trading and free-riding schemes involvethe purchase and sale of stock on the same day(or within a very short period of time) and thefunding of the purchases with the proceeds ofthe sale. Banking organizations1 engaging insuch illegal activities may subject themselves todisciplinary proceedings, as well as to substan-tial credit risk.

Federal Reserve examiners should ensure thatbanks and bank holding companies (includingthe broker-dealer and trust activities of bankingand nonbanking subsidiaries of state memberbanks and bank holding companies) are notengaged in such illegal activities. Examinersmust make certain that these entities have takenall steps necessary to prevent their customersfrom involving them in free-riding. Promptenforcement action may be needed to eliminatefree-riding activities. (See SR-93-13.)

2187.0.1 TYPICAL DAY TRADING ORFREE-RIDING ACTIVITIES

The free-riding conduct in question typicallyinvolves trading large amounts of securitieswithout depositing the necessary money orappropriate collateral in their customeraccounts. The customer seeks to free-ride, thatis, purchase and sell the same securities and payfor the purchase with the proceeds of the sale.Often, free-riding schemes involve initial publicofferings because broker-dealers are prohibited

from financing these new issues. If the money topay for the securities is not in the account whenthe securities are delivered in a delivery-versus-payment (DVP) transaction, a bank that permitscompletion of the transaction creates a tempo-rary overdraft in the customer’s account. Thisoverdraft is an extension of credit that subjectsthe banks to Regulation U.

The typical free-riding scheme involves anew customer’s opening a custodial agencyaccount into which a number of broker-dealerswill deliver securities or funds in DVP transac-tions. Although a deposit may be made into thecustodial agency account, the amount of tradingis greatly in excess of the original deposit, caus-ing the financial institution to extend its owncredit to meet the payment and delivery obliga-tions of the account. Therefore, although thefinancial institution may be earning fees as aresult of the activity in these accounts, it issubjecting itself to substantial losses if the mar-ket prices for the purchased securities fall or thetransactions otherwise fail. In addition, otherliabilities under federal banking and securitieslaws may be involved.

2187.0.2 SECURITIES CREDITREGULATIONS

2187.0.2.1 Regulation U, Credit byBanks or Persons Other Than Brokers orDealers for the Purpose of Purchasing orCarrying Margin Stocks

Any extension of credit in the course of settlingcustomer securities transactions, including thoseoccuring in a trust department or trust subsidi-ary of a bank holding company, must complywith all of the provisions of Regulation U.2

Regulation U requires all extensions of creditfor the purpose of buying or carrying margin

1. The use of the term ‘‘banking organization’’ in thissection, with regard to Regulation U, means a bank, trustdepartment of a bank, or trust company of a bank holdingcompany that is subject to Regulation U. Regulation Uincludes any nondealer nonbank subsidiary of a bank holdingcompany that extends purpose credit by margin stock. Withregard to Regulation T, it refers to any nonbank company thatconducts broker-dealer activities.

2. For purposes of the regulation, the definition of ‘‘bank’’specifically includes institutions ‘‘exercising fiduciary pow-ers.’’ (See 12 C.F.R. 221.2, 15 U.S.C. 78(c)(a)(6), andFederalReserve Regulatory Serviceat 5–795 (1946).) When used indiscussing a bank’s trust department or any other type offinancial institution exercising fiduciary powers, the term‘‘extension of credit’’ includes overdrafts in settling custom-er’s accounts that may be covered by advances from thebanking organization, from other fiduciary customers, or froma combination of both.


stock that are secured by margin stock to bewithin the 50 percent limit. To avoid violationsof the Board’s securities credit regulations, onsettlement date, the customer’s account musthold sufficient funds, excluding the proceeds ofthe sale of the security, to pay for each securitypurchased. Although Regulation U applies onlyto transactions in margin stock, free-riding innonmargin stocks in custodial agency accountscould result in a banking organization’s aidingand abetting violations of Regulations T and Xand other securities laws, and could raise finan-cial safety-and-soundness issues.

2187.0.2.2 Regulation T, Credit byBrokers and Dealers, and Regulation X,Borrowers of Securities Credit

Because the custodial agency accounts are usedto settle transactions effected by the customer atbroker-dealers, a banking organization thatopens this type of account should have somegeneral understanding of how Regulation Trestricts the customer’s use of the account at theinstitution. Regulation T requires the use of acash account for customer purchases or sales ona DVP basis. Section 220.8(a) of Regulation Tspecifies that cash-account transactions arepredicated on the customer’s agreement that thecustomer will make full cash payment for secu-rities before selling them and does not intend tosell them before making such payment. There-fore, free-riding is prohibited in a cash account.A customer who instructs his or her agent finan-cial institution to pay for a security by relyingon the proceeds of the sale of that security in aDVP transaction is causing, or aiding or abet-ting, the broker-dealer to violate the creditrestrictions of Regulation T. Regulation X,which generally prohibits borrowers from will-fully causing credit to be extended in violationof Regulations T or U, also applies to the cus-tomer in such cases.

As described above, banking organizations3

involved in customer free-riding schemes maybe aiding and abetting violations of RegulationT by the broker-dealers who deliver securitiesor funds to the banking organization’s custom-ers’ accounts. As long as a financial institutionuses its funds to complete a customer’s transac-

tions, broker-dealers may not discover that theyare selling securities to the customer in violationof Regulation T. A similar aiding and abettingviolation of Regulation X could occur if a cus-tomer used the financial institution to induce abroker-dealer to violate Regulation T.

2187.0.3 NEW-CUSTOMER INQUIRIESAND WARNING SIGNALS

Examiners should make certain that all banksand other financial-institution subsidiaries of abank holding company are administering andfollowing appropriate written policies and pro-cedures concerning the establishment of custo-dial agency accounts or any new account involv-ing customer securities transactions. Suchpolicies and procedures should address, amongother things, ways an institution can protectitself against free-riding schemes. One way is toobtain adequate background and credit informa-tion from new clients, including whether thecustomer intends to obtain credit to use with theaccount. This type of activity requires moreextensive monitoring than the typical DVPaccount in which no credit is extended. It wouldbe prudent to inquire why a new customer is notusing the margin-account services of its broker-dealers. If the account is to be used as a marginaccount, a financial institution must obtain FormFR U-1 from the customer and must sign andconstantly update the form.

The financial institution should obtain fromthe customer a list of broker-dealers that will besending securities to or receiving funds from theaccount in DVP transactions. If a number ofbroker-dealers may be used, the institutionshould obtain from the customer a written state-ment that all transactions with the broker-dealerwill conform with Regulations T and X and thatthe customer is aware that a security purchasedin a cash account is not to be sold until it is paidfor. Similarly, when obtaining instructions forsettling DVP transactions for a customer, thefinancial institution should clarify that it will notrely upon the proceeds from the sale of thosesecurities to pay for the purchase of the samesecurities.

2187.0.4 SCOPE OF THE INSPECTIONFOR FREE-RIDING ACTIVITIES

Examiners, bank holding companies, state mem-ber banks, and financial-institution and trustsubsidiaries owned by bank holding companies(also U.S. branches and agencies of foreign

3. For a discussion of Regulation T as it applies to a bankholding company’s broker-dealer nonbank subsidiary, see sec-tion 3230.0.

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


banks exercising trust powers) should ensurethat their banking organizations monitoraccounts closely for an initial period to detectpatterns typical of free-riding, including intra-day overdrafts, and to ensure that sufficientfunds or margin collateral are on deposit at alltimes. Frequent transactions in securities beingoffered in an initial public offering may suggestan avoidance of Regulations T and X. If itappears that a customer is attempting to free-ride, the financial institution should immedi-ately alert the broker-dealers involved in trans-ferring securities and take steps to minimize itsown credit risk and legal liability.

At a minimum, examiners should also evalu-ate a trust institution’s ability to ensure that itdoes not extend to a customer more credit onbehalf of a bank or other financial institutionthan is permitted under Regulation U. If thereare any questions in this regard, examinersshould consult with their Reserve Bank’s trustexaminers. Any overdraft that is related to apurchase or sale of margin stock, and that issecured by margin stock, is an extension ofcredit subject to the regulation, including over-drafts that are outstanding for less than a day.Board staff have published a number of opin-ions discussing the application of Regulation Uto various transactions relating to free-riding.

Free-riding violations that could endanger thebanking organization (for example, fraudulentactivities that could subject the organization tolosses or lawsuits), as well as significant viola-tions that were previously noted but have notyet been corrected, should be noted in theinspection report. Violations of the Board’sRegulation T, U, or X, as applicable to theinspection, should be reported on the Examin-er’s Comments and Violations report pages. Thereport should discuss what action has or will betaken to correct those violations.

2187.0.5 SEC AND FEDERALRESERVE SANCTIONS ANDENFORCEMENT ACTIONS

The SEC, in exercising its broad authority toenforce the Board’s securities credit regulations,requires banks to (1) establish credit compliancecommittees to formulate written policies andprocedures concerning the extension of purposecredit in their securities-clearance business,(2) establish training programs for bank person-nel responsible for the conduct of theirsecurities-clearance business, and (3) submit tooutside audits to verify their compliance withthe conditions of injunctions. The Board may

also institute enforcement proceedings againstthe banking organizations it supervises andagainst any institution-affiliated parties involvedin these activities, including cease-and-desistorders, civil money penalty assessments, andremoval and permanent-prohibition actions.


1. To make certain that policies of the bankholding company’s board, and the supervi-sory operating procedures, internal controls,and audit procedures will ensure, in thecourse of settling customers’ securitiestransactions—a. that bank extensions of credit within the

holding company comply with the provi-sions of Regulation U (including therequirement that initial extensions ofcredit that are secured by margin stock arewithin the initial 50 percent margin limit)and

b. that customer accounts hold sufficientfunds on the settlement date for each secu-rity purchased.

2. To determine—a. whether the banking organizations of the

bank holding company can adequatelymonitor compliance with Regulation Uthrough systems of internal controls, train-ing, and compliance procedures (i.e., useof credit compliance committees) thataddress free-riding activities within the‘‘back-office function’’4 and

b. whether noncompliance is properlyreported.

3. To initiate corrective action when policies,practices, procedures, or internal controls arenot sufficient to prevent free-riding schemes,and when violations of the Board’s regula-tions have been noted by bank examiners orself-regulatory organizations.


1. Review the bank holding company’s boardof directors’ policies for its banking institu-tion subsidiaries regarding supervisoryoperational policies, procedures, and internalcontrols for loans extended for the purpose

4. Refers to the movement of cash and securities relating totrades and to the processing and recording of trades. Thisprocess is also called the ‘‘securities-clearance cycle.’’



of buying or carrying margin stock andsecured directly or indirectly by marginstock.a. Determine whether the policies require,

for each extension of credit not specifi-cally exempted under Regulation U, that aForm FR U-1 be executed and signed bythe customer and accepted and signed bya duly authorized officer of the bankingorganization acting in good faith.

b. Determine whether the policies limitextensions of credit to no more than themaximum allowed loan value of the col-lateral, as set by section 221.7 of Regula-tion U, and whether those policies requireadherence to margin requirements.

2. Review the bank holding company’s boardof directors’ credit policies and operatingpolicies, internal controls, and internal auditprocedures to determine if they provideadequate safeguards against customers’ free-riding practices. In so doing—a. determine if new-customer accounts are

required to be approved by appropriatepersonnel; and

b. establish whether the bank holding com-pany’s credit-system policies require—

• controlling securities positions andfinancial-instrument contracts that serveas collateral for loans;

• monitoring established restrictions andlimits placed on the amounts and typesof transactions to be executed with eachcustomer and the dollar amounts placedon unsettled trades;

• obtaining appropriate documentationconsisting of essential facts pertainingto each customer, and in particular,financial information evidencing thecustomer’s ability to pay for orderedsecurities, repay extensions of credit,and meet other financial commitments;

• monitoring the location of all collateral;• ensuring that there are no overdrawn

margin accounts; and• monitoring the status of failed transac-

tions for the purpose of detecting free-riding schemes.

3. Determine if the bank holding company’saudit committee or its internal or externalauditors are required to review a selectedrandom sample of individual or custodialagency accounts for customer free-ridingactivities.



Credit by brokersand dealers

220(Reg. T)

Regulation U, Credit by Banksor Persons Other ThanBrokers or Dealers forthe Purpose of Purchasingor Carrying Margin Stocks

221(Reg. U)

Purpose credit—delivery-versus-payment transactions

5–942.15,5–942.18,5–942.2,5–942.21,5–942.22

Borrowers ofsecurities credit

224(Reg. X)





Note Issuance and Revolving UnderwritingCredit Facilities Section 2220.3

2220.3.1 NOTE ISSUANCE FACILITY(NIF)

One type of off-balance-sheet activity is thenote issuance facility (NIF). The first publicfacility was arranged in 1981. A NIF is amedium-term arrangement under which a bor-rower can issue short-term paper. The paper isissued on a revolving basis, with maturitiesranging from as low as 7 days to up to one year.Underwriters are committed either to purchas-ing any unsold notes or to providing standbycredit. Bank borrowing usually involves com-mercial paper consisting of short-term certifi-cates of deposit and for nonbank borrowers itwould generally be promissory notes (Euro-notes). NIF is the most common term used forthis type of arrangement. Other terms includethe revolving underwriting facility (RUF), andthe standby note issuance facility (SNIF). NIFs,RUFs, and SNIFs are essentially the same creditproduct. The NIF is usually structured for 5 to7 years.Euronotes are denominated in US dollars and

are issued with high face values (often $500,000or more), being intended for the more sophisti-cated investor (professional or institutional in-vestors). Holders of the notes show them as anasset on their balance sheets. The underwritingcommitment represents an off-balance sheetitem. The NIF allows the various functions per-formed by a single institution in a syndicatedcredit to be separated and performed by differ-ent institutions.Instead of lending money, as in a syndicated

credit, the NIF arranger provides a mechanismfor placing notes with other investors whenfunds are needed. The underwriting commit-ment transforms the maturity, assuring the bor-rower access to short-term funds over themedium term, which remains off-balance sheet,unless drawn upon. The underwriters take theshort-term credit risk since they face the risk oflending to a borrower that has difficulty inobtaining full confidence from investors.NIFs can be arranged with an issuer-set mar-

gin whereby the issuer determines the marginover LIBOR (the London Interbank OfferedRate), or some other index at which notes willbe offered. The issuer thus benefits from anyimprovement in market conditions. The notesare placed by the placing agent, but seniorunderwriters have the option of purchasing a

prearranged share of any notes issued. Anynotes not taken up at the issuer-set margin aredistributed to underwriters at the pre- estab-lished maximum (cap) rate.

2220.3.2 REVOLVINGUNDERWRITING FACILITY (RUF)

Another type of facility, a revolving underwrit-ing facility (RUF), was introduced in 1982. Arevolving underwriting facility is a medium-term revolving commitment to guarantee theoverseas sale of short-term negotiable promis-sory notes (usually a fixed-spread over LIBOR)issued by the borrower at or below a predeter-mined interest rate. RUFs separate the roles ofthe medium-term risk-taker and the providers ofthe funding (the short-term investors). RUFsand NIFs allow access to capital sources atinterest rates considerably below conventionalfinancing rates. The savings in interest cost arederived because the borrower obtains the lowerinterest costs prevailing in the short-term mar-kets, while still retaining the security of longerterm financing commitments. The notes issuedunder RUFs are attractive for institutional inves-tors since they permit greater diversification ofrisk than the certificates of deposit of only onebank. Underwriters favor them because theircommitments do not appear on the statement offinancial condition. RUFs are usually structuredfor periods of four to seven years.A revolving underwriting facility (RUF) dif-

fers from a (NIF) in that it separates the func-tions of underwriting and distribution. With aRUF, the lead bank (manager or arranger) actsas the only placing agent. The arranger retainstotal control over the placing of the notes. Thelead bank provides assistance to a borrower whoforms a lending group of banks. The borrower,assisted by a lead bank (arranger), obtains amedium term revolving commitment that guar-antees the sale of short-term negotiable promis-sory notes at or below a pre-determined interestrate. The participating group of banks arrangethe funding, subject to certain lending condi-tions and rates, for the duration of the facility. Inreturn, the borrower pays a facility fee to therevolving credit banks.


When the borrower desires funds, a place-ment agent or tender panel1 places short-termnotes with other banks and institutional inves-tors (usually having maturities of 90 days, 180days or 12 months). The short term notes can beissued to these investors at significantly lowerinterest rates than would be available from arevolving credit facility that the same bankswould have been willing to provide. The notepurchasers generally have a rollover option atmaturity and new note purchasers are added asneeded. The note purchasers bear the risk of lossin the event of default by the borrower. Newnote purchasers are added as needed. In theevent the full line of credit is not placed with thenote purchasers on any rollover date, the revolv-ing credit banks must make funding availablefor the difference at the previously committedrevolving credit interest rates, subject to theterms and conditions within the agreement.With the RUF, and the use of a sole placing

agent, the underwriters are not assured of secur-ing any notes that they could place themselvesnor can they benefit from any improvement interms available in the market. The hindrance isremoved by the use of NIFs with an issuer-setmargin whereby the issuer determines the mar-gin over an index at which notes will be offered.Another form of a RUF is a transferable

revolving underwriting facility (TRUF). Withthis arrangement the underwriter is able, withthe borrower’s approval, to transfer all rightsand obligations under the underwriting commit-ment to another institution at any time duringthe life of the facility.

2220.3.3 RISK

The loan commitments involved in NIF andRUF transactions contain substantially the sameterms as other loan commitments extended tosimilar borrowers. The failure of the borrowerto satisfy the revolving standby agreement re-lieves the banks of any obligation to fund the

transaction. The major source of risk is thus theliquidity risk that is derived from the uncer-tainty of the timing or amount of required fund-ing. If the underlying notes cannot be marketedat or below the interest rate specified in theagreement, the bank would need to discount thenotes to whatever rate would be necessary tomake the notes attractive to investors, perhapstaking an up-front loss to avoid funding a lowmargin loan.NIFs and RUFs involve less credit risk than

extensions of credit because of the additionalstep that is required before funding takes place,a step that is not present with a revolving creditagreement. In other words, no funding isrequired until: (1) a decision is made by theborrower to issue notes; and (2) the placingagent becomes unable to place the short-termnotes with short-term investors. Further, the riskof loss rests with the note investors. The under-writer’s risk of nonpayment is not present untilthe rollover date. If there has been a significantdeterioration in the issuer/borrower’s financialcondition on that date, the issuer/borrower maybe prevented from drawing under the facility.This would be dependent on the funding condi-tions or the cancellation provisions stipulated inthe agreement.

2220.3.4 PRICING AND FEES

The forms of compensation involving a NIF andRUF are: the underwriting and commitment fee;the one-time arrangement fee, and the periodicplacement fees. An annual fixed underwritingfee is paid by the borrower on the amount ofunderlying commitment. This fee must be paidregardless of the frequency of usage of thefacility or whether or not the underwriters arerequired to make any purchases of the short-term paper. This compensation is for the com-mitment to underwrite the issuance of the notes.The arranger receives a one-time arrangementfee based on a percentage of the amount of thefacility. The issuer pays the borrowing costs onthe notes issued, usually at a spread above orbelow an index. A portion of this borrowing feeis retained by the placement agent or the tenderpanel members as compensation for placing thepaper.Competitive pricing on NIFs and RUFS

causes them to be very thinly margined. Com-mitment fees may be as low as 5 basis points forblue chip customers, while ‘‘BBB’’ credit-ratedor equivalent borrowers might be charged asmuch as 20 basis points. Because of the thinspread some banks may only be serving as an

1. The tender panel was introduced in 1983. It is usuallymade up of several commercial investment banks and otherinstitutional investors. The panel members bid for any notesissued, up to a predetermined maximum spread. The revolv-ing credit banks can bid as part of the tender panel, but theyare not required to do so. Any notes not bid for are purchasedby the revolving credit banks or they extend credit of an equalamount. The tender panel may be a continuous tender panelwhereby the underwriters are entitled to purchase notes fromthe lead manager up to their pro rata share at any time duringthe offer period, if available, at the market price.

Note Issuance and Revolving Underwriting Credit Facilities 2220.3


arranger, preferring to not participate in the mar-ket. Typical fees for this service may consist of:an up-front arrangement fee of 20 basis pointson the total principal amount of the facility, andan annual placement fee such as 12.5 basispoints on the short-term notes sold. Revolvingcredit banks usually receive facility fees andannual maintenance fees.If the underwriters have to purchase the notes,

the backup rate of interest may be the index plus10 to 15 basis points for blue chip companies toplus 37.5 basis points over the index for ‘‘BBB’’rated borrowers. The interest rates charged (iffunded) are usually lower because of market-pricing conventions (lower spreads) and theintense competition within the market.

2220.3.5 STANDBY RUFS

Some RUFS may provide for a utilization fee ormay provide for a higher yield on the notes inthe event that more than a nominal amount ofpaper is allocated to the underwriters. Such aprovision would more likely be found in astandby facility. Standby facilities are backupcommitments under which notes are notexpected to be issued. This provision essentiallyprotects the underwriter from having to bookloans that are earning an insufficient yield. Thestructure of the facility generally determines itspricing depending upon the requirements of theissuer/borrower.Standby RUFs substitute for committed bank

lines which may be used, for example, asbackup commitments for issuance of U.S. com-mercial paper. Commitment fees will be lowbecause of the low probability that funds willneed to be advanced. A standby facility willmake borrowing from the underwriter veryexpensive in relation to what the issuer mighthave to pay. Otherwise, the underlying notes areissued on a regular basis, the maximum yield on

the notes is set to approximate the normal mar-ket level for the issuer’s short term borrowing-s.This facility would have a higher underwritingfee than a standby facility, because the regularissuances of notes increase the likelihood thatthe underwriting bank will have to purchasenotes that cannot be placed.

2220.3.6 RUF DOCUMENTS

The revolving credit agreementis the primarydocument in a RUF. It includes the principalagreement of the transaction, executed by therevolving credit banks and the borrower. It con-tains the terms and conditions under which theborrower can draw on the facility. The docu-ment includes the financial covenants and eventsof default.An agency agreementbetween the borrower

and the placement agent designates the place-ment agent for the notes and sets forth theconditions of the agent’s obligations for arrang-ing the sale of the notes. Included are represen-tations and warranties of the borrower regardingthe authority to enter into the agreement and toissue the notes.A description of the terms and conditions of

the facility is contained within aninformationmemorandum. Detail is provided with regard tothe use of the proceeds, current and historicalfinancial information, a description of thecompany, its finances and operations. It is dis-tributed to prospective credit banks and notepurchasers.The note is the last document involving a

RUF. Usually the notes will be unsecured obli-gations of the borrower and will include rep-resentations and warranties of the companyregarding authorization and the absence ofmaterial litigation and bankruptcy proceedings.It will also contain a statement that a revolvingcredit facility is available to the borrower.

Note Issuance and Revolving Underwriting Credit Facilities 2220.3


Real Estate Appraisals and EvaluationsSection 2231.0

WHAT’S NEW IN THIS REVISEDSECTION

Effective July 2011, this section was revised toinclude the December 2010 InteragencyAppraisal and Evaluation Guidelines (Inter-agency Guidelines). The Interagency Guidelinespertain to all real estate–related financial trans-actions originated or purchased by a regulatedinstutution (including a bank holding company)or its subsidiaries for its own portfolio or asassets held for sale, including activities of com-mercial and residential real estate mortgageoperations, capital markets groups, and assetsecuritization and sales units. The InteragencyGuidelines provide a comprehensive discussionof the Board’s expectations for a banking orga-nization’s appraisal and evaluation program aswell as background information on the technicalaspects of appraisals. (See SR-10-16 and itsattachment.)

The Board’s long-standing policy on real estateappraisals emphasizes the importance of soundappraisal policies and procedures in a bankingorganization’s real estate lending activity. Withthe passage of title XI of the Federal FinancialInstitutions Reform, Recovery, and Enforce-ment Act of 1989 (FIRREA), the Board and theother federal financial institutions regulatoryagencies adopted regulations in August 1990relating to the performance and use of apprais-als by federally regulated financial institutions,which were amended in June 1994. The Board’sappraisal standards regulation may be found inRegulation Y, subpart G, 12 C.F.R. 225.1

The Board’s appraisal regulation requires,1a

at a minimum, that real estate appraisals beperformed in accordance with generallyaccepted uniform appraisal standards as evi-denced by the appraisal standards promulgatedby the Appraisal Standards Board (ASB), andthat such appraisals be in writing.2 The regula-tion also sets forth additional appraisal stan-dards including that the appraisal and analysiscontain sufficient information to support thebanking organization’s decision to engage in thetransaction and provide the real property’s mar-ket value.

The intent of title XI and the Board’s regula-tion is to protect federal financial and publicpolicy interests in real estate–related financialtransactions that require the services of anappraiser in connection with federally relatedtransactions.3 Federally related transactions aredefined as those real estate–related financialtransactions that an agency engages in, contractsfor, or regulates and that require the services ofan appraiser.4 Each state has established a pro-gram for certifying and licensing real estateappraisers who are qualified to perform apprais-als in connection with federally related transac-tions. Additionally, title XI designated theAppraisal Qualifications Board and the ASB ofthe Appraisal Foundation, a nonprofit appraisalindustry group, as the authority for establishingqualifications criteria for appraiser certificationand standards for the performance of anappraisal. The statute established the AppraisalSubcommittee of the Federal Financial Institu-tions Examination Council (FFIEC). It was des-ignated the entity to monitor the requirementsestablished to meet the intent of title XI. If theAppraisal Subcommittee issues a finding thatthe policies, practices, or procedures of a stateare inconsistent with title XI, the services oflicensed or certified appraisers from that statemay not be used in connection with federallyrelated transactions. Further, several provisionsin title XI of FIRREA were amended by theDodd-Frank Wall Street Reform and ConsumerProtection Act of 2010 (Dodd-Frank Act), pro-viding additional authority to the Appraisal Sub-committee in its oversight of states’ appraiser

1. The appraisal standards for federally related transactionsare found in sections 225.61 to 225.67 of subpart G ofRegulation Y. Section 225.63 was amended, effective Decem-ber 28, 1998, to exclude from the Board’s appraisal require-ments transactions that involve underwriting or dealing inmortgage-backed securities. The amendment permits bankholding company subsidiaries engaged in underwriting anddealing in securities to underwrite and deal in mortgage-backed securities without demonstrating that the loans under-lying the securities are supported by appraisals that meet theBoard’s appraisal requirements. (See 1999 FRB 50.)

1a. A banking organization is required to use a certifiedappraiser for—

• all federally related transactions $1 million or more,• nonresidential federally related transactions $250,000 or

more, and• complex residential federally related transactions $250,000

or more.

A banking organization is requested to use either a state-certified or a state-licensed appraiser for noncomplex residen-tial federally related transactions that are under $1 million. A

complex one- to four-family residential property appraisalmeans that the properties to be appraised, the form of owner-ship, or market conditions are atypical (12 C.F.R. 225.63(d)).

2. See 12 USC 3339.3. See 12 USC 3339.4. See 12 USC 3350(4).

BHC Supervision Manual July 2011Page 1

regulatory programs. (See sections 1471-1473of Pub. L. 111-203, 124 Stat. 1376 (2010).)

Over the years, the Board and the other fed-eral banking regulatory agencies (the Office ofthe Comptroller of the Currency and the FederalDeposit Insurance Corporation (the agencies))have issued several appraisal-related guidancedocuments to assist institutions in implementingand complying with the appraisal regulation.5 InDecember 2010, the agencies issued the Inter-agency Appraisal and Evaluation Guidelines(Interagency Guidelines) to clarify theirappraisal regulations and to promote best prac-tices in institutions’ appraisal and evaluationprograms. (See SR-10-16.) The InteragencyGuidelines pertain to all real estate–relatedfinancial transactions originated or purchased bya regulated institution or its operating subsidiaryfor its own portfolio or as assets held for sale,including activities of commercial and residen-tial real estate mortgage operations, capital mar-kets groups, and asset securitization and salesunits. The Interagency Guidelines provide acomprehensive discussion of the Board’s expec-tations for a banking organization’s appraisaland evaluation program as well as backgroundinformation on the technical aspects ofappraisals.

A banking organization’s collateral-valuationprogram needs to consider when an appraisal orevaluation should be obtained to monitor collat-eral risk and to support credit analysis, includ-ing for purposes of rating or classifying thecredit. When a credit becomes troubled, theprimary source of repayment often shifts fromthe borrower’s cash flow and income to theexpected proceeds from the sale of the realestate collateral. Therefore, it is important thatbanking organizations have a sound and inde-pendent basis for determining the value of thereal estate collateral. (See SR-09-07.)

The expectations that an institution conductits appraisal and evaluation program for realestate lending in a safe and sound mannerremains unchanged with the issuance of theInteragency Guidelines. They reflect develop-ments concerning appraisals and evaluations, aswell as changes in appraisal standards andadvancements in regulated institutions’ collat-eral valuation methods. The Interagency Guide-

lines also promote consistency in the applicationand enforcement of the agencies’ appraisal regu-lations. (See SR-10-16.)

2231.0.1 INTERAGENCY APPRAISALAND EVALUATION GUIDELINES(INTERAGENCY GUIDELINES)

FIRREA requires each agency to prescribe ap-propriate standards for the performance of realestate appraisals in connection with ‘‘federallyrelated transactions,’’6 which are defined asthose real estate–related financial transactionsthat an agency engages in, contracts for, orregulates and that require the services of an ap-praiser.7 The agencies’ appraisal regulationsmust require, at a minimum, that real estate ap-praisals be performed in accordance with gener-ally accepted uniform appraisal standards asevidenced by the appraisal standardspromulgated by the ASB, and that such apprais-als be in writing.8 An agency may requirecompliance with additional appraisal standardsif it makes a determination that such addi-tional standards are required to properly carryout its statutory responsibilities.9 Each of theagencies has adopted additional appraisalstandards.10

The agencies’ real estate lending regulationsand guidelines,11 issued pursuant to section 304of the Federal Deposit Insurance CorporationImprovement Act of 1991 (FDICIA),12 requireeach institution to adopt and maintain writtenreal estate lending policies that are consistentwith principles of safety and soundness and thatreflect consideration of the real estate lendingguidelines issued as an appendix to the regula-tions. The real estate lending guidelines statethat an institution’s real estate lending programshould include an appropriate real estateappraisal and evaluation program.

5. The Board has issued several other guidance documentsrelated to appraisals and real estate lending that provideadditional information on the establishment of an effectivereal estate appraisal and evaluation program. (See SR-95-16,SR-95-27, SR-05-05, SR-05-11, and SR-05-14.)

6. See 12 USC 3339.7. See 12 USC 3350(4).8. See 12 USC 3339.9. See 12 USC 3339.10. See, e.g., 12 CFR 225, subpart G, and 12 CFR 208,

subpart E.11. The Federal Reserve did not adopt the real estate

lending standards for bank holding companies and their non-bank subsidiaries. However, bank holding companies andtheir nonbank subsidiaries are expected to conduct their realestate lending activities in a prudent manner consistent withsafe and sound lending standards. A bank subsidiary of aBHC should refer to 12 C.F.R. 208, subpart G.

12. See Pub. L. 102-242, section 304, 105 Stat. 2354(1991); 12 USC 1828(o).

Real Estate Appraisals and Evaluations 2231.0


2231.0.2 SUPERVISORY POLICY

An institution’s real estate appraisal and evalua-tion policies and procedures will be reviewed aspart of the inspection of the institution’s overallreal estate–related activities. Examiners willconsider the size and the nature of an institu-tion’s real estate–related activities when assess-ing the appropriateness of its program.

While borrowers’ ability to repay their realestate loans according to reasonable termsremains the primary consideration in the lendingdecision, an institution also must consider thevalue of the underlying real estate collateral inaccordance with the Board’s appraisal regula-tions. Institutions that fail to comply with theBoard’s appraisal regulations or to maintain asound appraisal and evaluation program consis-tent with supervisory guidance will be cited insupervisory letters or inspection reports and maybe criticized for unsafe and unsound bankingpractices. Deficiencies will require appropriatecorrective action.

When analyzing individual transactions,examiners will review an appraisal or evaluationto determine whether the methods, assumptions,and value conclusions are reasonable. Examin-ers also will determine whether the appraisal orevaluation complies with the Board’s appraisalregulations and is consistent with supervisoryguidance as well as the institution’s policies.Examiners will review the steps taken by aninstitution to ensure that the persons who per-form the institution’s appraisals and evaluationsare qualified, competent, and are not subject toconflicts of interest.

2231.0.3 APPRAISAL ANDEVALUATION PROGRAM

An institution’s board of directors or its desig-nated committee is responsible for adopting andreviewing policies and procedures that establishan effective real estate appraisal and evaluationprogram. The program should

• provide for the independence of the personsordering, performing, and reviewing apprais-als or evaluations;

• establish selection criteria and procedures toevaluate and monitor the ongoing perfor-mance of appraisers and persons who performevaluations;

• ensure that appraisals comply with theBoard’s appraisal regulations and are consis-tent with supervisory guidance;

• ensure that appraisals and evaluations contain

sufficient information to support the creditdecision;

• maintain criteria for the content and appropri-ate use of evaluations consistent with safe andsound banking practices;

• provide for the receipt and review of theappraisal or evaluation report in a timely man-ner to facilitate the credit decision;

• develop criteria to assess whether an existingappraisal or evaluation may be used to sup-port a subsequent transaction;

• implement internal controls that promotecompliance with these program standards,including those related to monitoring third-party arrangements;

• establish criteria for monitoring collateral val-ues; and

• establish criteria for obtaining appraisals orevaluations for transactions that are not other-wise covered by the appraisal requirements ofthe Board’s appraisal regulations.

2231.0.4 INDEPENDENCE OF THEAPPRAISAL AND EVALUATIONPROGRAM

For both appraisal and evaluation functions, aninstitution should maintain standards ofindependence as part of an effective collateral-valuation program for all of its real estate lend-ing activity. The collateral-valuation program isan integral component of the credit under-writing process and, therefore, should beisolated from influence by the institution’s loan-production staff. An institution should establishreporting lines independent of loan productionfor staff who administer the institution’scollateral-valuation program, including theordering, reviewing, and acceptance of apprais-als and evaluations. Appraisers must beindependent of the loan production and collec-tion processes and have no direct, indirect, orprospective interest, financial or otherwise, inthe property or transaction.13 These standards ofindependence also should apply to persons whoperform evaluations.

For a small or rural institution or branch, itmay not always be possible or practical to sepa-

13. The Board’s appraisal regulations set forth specificappraiser independence requirements that exceed those setforth in the Uniform Standards of Professional AppraisalPractice. Institutions also should be aware of separate require-ments on conflicts of interest under Regulation Z (Truth inLending), 12 CFR 226.42(d).



rate the collateral-valuation program from theloan-production process. If absolute lines ofindependence cannot be achieved, an institutionshould be able to demonstrate clearly that it hasprudent safeguards to isolate its collateral-valuation program from influence or interfer-ence from the loan-production process. In suchcases, another loan officer, official, or director ofthe institution may be the only person qualifiedto analyze the real estate collateral. To ensuretheir independence, such lending officials, offi-cers, or directors must abstain from any vote orapproval involving loans on which they ordered,performed, or reviewed the appraisal or evalua-tion.

Communication between the institution’scollateral-valuation staff and an appraiser or per-son performing an evaluation is essential for theexchange of appropriate information relative tothe valuation assignment. An institution’s poli-cies and procedures should specify methods forcommunication that ensure independence in thecollateral-valuation function. These policies andprocedures should foster timely and appropriatecommunications regarding the assignment andestablish a process for responding to questionsfrom the appraiser or person performing anevaluation.

An institution may exchange informationwith appraisers and persons who perform evalu-ations, which may include providing a copy ofthe sales contract14 for a purchase transaction.However, an institution should not directly orindirectly coerce, influence, or otherwiseencourage an appraiser or a person who per-forms an evaluation to misstate or misrepresentthe value of the property.15 Consistent with itspolicies and procedures, an institution also mayrequest the appraiser or person who performs anevaluation to

• consider additional information about the sub-ject property or about comparable properties;

• provide additional supporting informationabout the basis for a valuation; or

• correct factual errors in an appraisal.

An institution’s policies and proceduresshould ensure that it avoids inappropriateactions that would compromise theindependence of the collateral-valuation func-tion,16 including

• communicating a predetermined, expected, orqualifying estimate of value, or a loan amountor target loan-to-value ratio to an appraiser orperson performing an evaluation;

• specifying a minimum value requirement forthe property that is needed to approve the loanor as a condition of ordering the valuation;

• conditioning a person’s compensation on loanconsummation;

• failing to compensate a person because aproperty is not valued at a certain amount;17

• implying that current or future retention of aperson’s services depends on the amount atwhich the appraiser or person performing anevaluation values a property; or

• excluding a person from consideration forfuture engagement because a property’sreported market value does not meet a speci-fied threshold.

After obtaining an appraisal or evaluation, oras part of its business practice, an institutionmay find it necessary to obtain another appraisalor evaluation of a property and it would beexpected to adhere to a policy of selecting themost credible appraisal or evaluation, ratherthan the appraisal or evaluation that states thehighest value. (Refer to the ‘‘ReviewingAppraisals and Evaluations’’ subsection belowfor additional information on determining anddocumenting the credibility of an appraisal orevaluation.) Further, an institution’s reporting ofa person suspected of noncompliance with theUniform Standards of Professional AppraisalPractice (USPAP), and applicable federal orstate laws or regulations, or otherwise engagedin other unethical or unprofessional conduct tothe appropriate authorities would not be viewedby the Federal Reserve as coercion or undueinfluence. However, an institution should notuse the threat of reporting a false allegation inorder to influence or coerce an appraiser or aperson who performs an evaluation.

14. Refer to USPAP Standards Rule 1-5(a) and the EthicsRule.

15. For mortgage transactions secured by a consumer’sprincipal dwelling, refer to 12 CFR 226.42 under RegulationZ (Truth in Lending). Regulation Z also prohibits a creditorfrom extending credit when it knows that the appraiser inde-pendence standards have been violated, unless the creditordetermines that the value of the property is not materiallymisstated.

16. See 12 CFR 226.42(c).17. This provision does not preclude an institution from

withholding compensation from an appraiser or person whoprovided an evaluation based on a breach of contract orsubstandard performance of services under a contractual pro-vision.



2231.0.5 SELECTION OF APPRAISERSOR PERSONS WHO PERFORMEVALUATIONS

An institution’s collateral-valuation programshould establish criteria to select, evaluate, andmonitor the performance of appraisers and per-sons who perform evaluations. The criteriashould ensure that

• The person selected possesses the requisiteeducation, expertise, and experience to com-petently complete the assignment.

• The work performed by appraisers and per-sons providing evaluation services is periodi-cally reviewed by the institution.

• The person selected is capable of rendering anunbiased opinion.

• The person selected is independent and has nodirect, indirect, or prospective interest, finan-cial or otherwise, in the property ortransaction.

• The appraiser selected to perform an appraisalholds the appropriate state certification orlicense at the time of the assignment. Personswho perform evaluations should possess theappropriate appraisal or collateral-valuationeducation, expertise, and experience relevantto the type of property being valued. Suchpersons may include appraisers, real estatelending professionals, agricultural extensionagents, or foresters.18

An institution or its agent must directly selectand engage appraisers. The only exception tothis requirement is that the agencies’ appraisalregulations allow an institution to use anappraisal prepared for another financial servicesinstitution provided certain conditions are met.An institution or its agents also should directlyselect and engage persons who perform evalua-tions. Independence is compromised when aborrower recommends an appraiser or a personto perform an evaluation. Independence is alsocompromised when loan-production staff selectsa person to perform an appraisal or evaluationfor a specific transaction. For certain transac-tions, an institution also must comply with theprovisions addressing valuation independencein Regulation Z (Truth in Lending).19

An institution’s selection process shouldensure that a qualified, competent, and indepen-

dent person is selected to perform a valuationassignment. An institution should maintaindocumentation to demonstrate that the appraiseror person performing an evaluation is compe-tent, independent, and has the relevant experi-ence and knowledge for the market, location,and type of real property being valued. Further,the person who selects or oversees the selectionof appraisers or persons providing evaluationservices should be independent from the loanproduction area. An institution’s use of aborrower-ordered or borrower-providedappraisal violates the agencies’ appraisal regula-tions. However, a borrower can inform an insti-tution that a current appraisal exists, and theinstitution may request it directly from the otherfinancial services institution.

2231.0.5.1 Approved Appraiser List

If an institution establishes an approvedappraiser list for selecting an appraiser for aparticular assignment, the institution shouldhave appropriate procedures for the develop-ment and administration of the list. These proce-dures should include a process for qualifying anappraiser for initial placement on the list, aswell as periodic monitoring of the appraiser’sperformance and credentials to assess whetherto retain the appraiser on the list. Further, thereshould be periodic internal review of the use ofthe approved appraiser list to confirm thatappropriate procedures and controls exist toensure independence in the development,administration, and maintenance of the list. Forresidential transactions, loan-production staffcan use a revolving, preapproved appraiser list,provided the development and maintenance ofthe list is not under their control.

2231.0.5.2 Engagement Letters

An institution should use written engagementletters when ordering appraisals, particularly forlarge, complex, or out-of-area commercial realestate properties. An engagement letter facili-tates communication with the appraiser anddocuments the expectations of each party to theappraisal assignment. In addition to the otherinformation, the engagement letter will identifythe intended use and user(s), as defined inUSPAP. An engagement letter also may specifywhether there are any legal or contractualrestrictions on the sharing of the appraisal with

18. Although not required, an institution may use state-certified or state-licensed appraisers to perform evaluations.Institutions should refer to USPAP Advisory Opinion 13 forguidance on appraisers performing evaluations of real prop-erty collateral.

19. See 12 CFR 226.42.



other parties. An institution should include theengagement letter in its credit file. To avoid theappearance of any conflict of interest, appraisalor evaluation development work should notcommence until the institution has selected andengaged a person for the assignment.

2231.0.6 TRANSACTIONS THATREQUIRE APPRAISALS

Although the agencies’ appraisal regulationsexempt certain real estate–related financialtransactions from the appraisal requirement,most real estate–related financial transactionsover the appraisal threshold are considered fed-erally related transactions and, thus, requireappraisals.20 The agencies also reserve the rightto require an appraisal under their appraisalregulations to address safety and soundness con-cerns in a transaction. (See ‘‘AppendixA—Appraisal Exemptions.’’)

2231.0.7 MINIMUM APPRAISALSTANDARDS

The Board’s appraisal regulations include mini-mum standards for the preparation of anappraisal. (See ‘‘Appendix D—Glossary’’ forterminology used in these guidelines.) Theappraisal must

• Conform to generally accepted appraisalstandards as evidenced by the USPAP promul-gated by the ASB of the Appraisal Foundationunless principles of safe and sound bankingrequire compliance with stricter standards.Although allowed by USPAP, the agencies’appraisal regulations do not permit anappraiser to appraise any property in whichthe appraiser has an interest, direct or indirect,financial or otherwise in the property or trans-action. Further, the appraisal must contain anopinion of market value as defined in theagencies’ appraisal regulations. (See discus-sion on the definition of market value below.)Under USPAP, the appraisal must contain a

certification that the appraiser has compliedwith USPAP. An institution may refer to theappraiser’s USPAP certification in its assess-ment of the appraiser’s independence con-cerning the transaction and the property.Under the agencies’ appraisal regulations, theresult of an Automated Valuation Model(AVM), by itself or signed by an appraiser, isnot an appraisal, because a state-certified orstate-licensed appraiser must perform anappraisal in conformance with USPAP and theagencies’ minimum appraisal standards. Fur-ther, the Dodd-Frank Act21 provides ‘‘[i]nconjunction with the purchase of a consum-er’s principal dwelling, broker price opinionsmay not be used as the primary basis to deter-mine the value of a piece of property for thepurpose of loan origination of a residentialmortgage loan secured by such piece of prop-erty.’’22

• Be written and contain sufficient informationand analysis to support the institution’s deci-sion to engage in the transaction. An institu-tion should obtain an appraisal that is appro-priate for the particular federally relatedtransaction, considering the risk and complex-ity of the transaction. The level of detailshould be sufficient for the institution tounderstand the appraiser’s analysis and opin-ion of the property’s market value. As pro-vided by the USPAP Scope of Work Rule,appraisers are responsible for establishing thescope of work to be performed in rendering anopinion of the property’s market value. Aninstitution should ensure that the scope ofwork is appropriate for the assignment. Theappraiser’s scope of work should be consis-tent with the extent of the research and analy-ses employed for similar property types, mar-ket conditions, and transactions. Therefore, aninstitution should be cautious in limiting thescope of the appraiser’s inspection, research,or other information used to determine theproperty’s condition and relevant market fac-tors, which could affect the credibility of theappraisal.

According to USPAP, appraisal reportsmust contain sufficient information to enablethe intended user of the appraisal to under-stand the report properly. An institutionshould specify the use of an appraisal reportoption that is commensurate with the risk andcomplexity of the transaction. The appraisalreport should contain sufficient disclosure ofthe nature and extent of inspection and

20. In order to facilitate recovery in designated majordisaster areas, subject to safety and soundness considerations,the Depository Institutions Disaster Relief Act of 1992 pro-vides the Board with the authority to waive certain appraisalrequirements for up to three years after a presidential declara-tion of a natural disaster. Pub. L. 102-485, section 2, 106 Stat.2771 (October 23, 1992); 12 USC 3352.

21. Pub. L. 111-203, 124 Stat. 1376 (2010).22. Dodd-Frank Act, section 1473(r).



research performed by the appraiser to verifythe property’s condition and support theappraiser’s opinion of market value. (See‘‘Appendix D—Glossary’’ for the definitionof appraisal report options.)

Institutions should be aware that provisionsin the Dodd-Frank Act address appraisalrequirements for a higher-risk mortgage to aconsumer.23 To implement these provisions,the agencies recognize that future regulationswill address the requirement that the appraiserconduct a physical property visit of the inte-rior of the mortgaged property.24

• Analyze and report appropriate deductionsand discounts for proposed construction orrenovation, partially leased buildings, non-market lease terms, and tract developmentswith unsold units. Appraisers must analyze,apply, and report appropriate deductions anddiscounts when providing an estimate of mar-ket value based on demand for real estate inthe future. This standard is designed to avoidhaving appraisals prepared using unrealisticassumptions and inappropriate methods inarriving at the property’s market value. (See‘‘Appendix C—Deductions and Discounts’’for further explanation on deductions and dis-counts.)

• Be based upon the definition of market valueset forth in the appraisal regulation. Eachappraisal must contain an estimate of marketvalue, as defined by the agencies’ appraisalregulations. The definition of market valueassumes that the price is not affected by unduestimulus, which would allow the value of thereal property to be increased by favorablefinancing or seller concessions. Value opin-ions such as ‘‘going concern value,’’ ‘‘value inuse,’’ or a special value to a specific propertyuser may not be used as market value forfederally related transactions. An appraisalmay contain separate opinions of such valuesso long as they are clearly identified and dis-closed.

The estimate of market value should con-sider the real property’s actual physical condi-tion, use, and zoning as of the effective date ofthe appraiser’s opinion of value. For a transac-tion financing construction or renovation of abuilding, an institution would generallyrequest an appraiser to provide the property’scurrent market value in its ‘‘as is’’ condition,

and, as applicable, its prospective marketvalue upon completion and/or prospectivemarket value upon stabilization. Prospectivemarket value opinions should be based uponcurrent and reasonably expected market con-ditions. When an appraisal includes prospec-tive market value opinions, there should be apoint of reference to the market conditionsand time frame on which the appraiser basedthe analysis.25 An institution should under-stand the real property’s ‘‘as is’’ market valueand should consider the prospective marketvalue that corresponds to the credit decisionand the phase of the project being funded, ifapplicable.

• Be performed by state-certified or state-licensed appraisers in accordance withrequirements set forth in the appraisal regula-tion. In determining competency for a givenappraisal assignment, an institution must con-sider an appraiser’s education and experience.While an institution must confirm that theappraiser holds a valid credential from theappropriate state appraiser regulatory author-ity, a state certification or license is a mini-mum credentialing requirement. Appraisersare expected to be selected for individualassignments based on their competency toperform the appraisal, including knowledge ofthe property type and specific propertymarket.

As stated in the agencies’ appraisal regula-tions, a state-certified or state-licensedappraiser may not be considered competentsolely by virtue of being certified or licensed.In communicating an appraisal assignment, aninstitution should convey to the appraiser thatthe agencies’ minimum appraisal standardsmust be followed.

2231.0.8 APPRAISAL DEVELOPMENT

The Board’s appraisal regulations requireappraisals for federally related transactions tocomply with the requirements in USPAP, someof which are addressed below. Consistent withthe USPAP Scope of Work Rule,26 the appraisalmust reflect an appropriate scope of work thatprovides for ‘‘credible’’ assignment results. Theappraiser’s scope of work should reflect the

23. Under the law, the provisions are effective 12 monthsafter final regulations to implement the provisions are pub-lished. See Dodd-Frank Act, section 1400(c)(1) or 12 USC1601.

24. Section 1471 of the Dodd-Frank Act added new sec-tion 129H to the Truth in Lending Act (15 USC 1631 et seq.).

25. See USPAP, Statement 4 on Prospective Value Opin-ions, for further explanation.

26. See USPAP, Scope of Work Rule, Advisory Opinions28 and 29.



extent to which the property is identified andinspected, the type and extent of dataresearched, and the analyses applied to arrive atopinions or conclusions. Further, USPAPrequires the appraiser to disclose whether he orshe previously appraised the property.

While an appraiser must comply with USPAPand establish the scope of work in an appraisalassignment, an institution is responsible forobtaining an appraisal that contains sufficientinformation and analysis to support its deci-sion to engage in the transaction. Therefore, toensure that an appraisal is appropriate for theintended use, an institution should discuss itsneeds and expectations for the appraisal withthe appraiser. Such discussions should assist theappraiser in establishing the scope of work andform the basis of the institution’s engagementletter, as appropriate. These communicationsshould adhere to the institution’s policies andprocedures on independence of the appraiserand not unduly influence the appraiser. Aninstitution should not allow lower cost or thespeed of delivery time to inappropriately influ-ence its appraisal ordering procedures or the ap-praiser’s determination of the scope of work foran appraisal supporting a federally relatedtransaction.

As required by USPAP, the appraisal mustinclude any approach to value (that is, the cost,income, and sales comparison approaches) thatis applicable and necessary to the assignment.Further, the appraiser should disclose therationale for the omission of a valuationapproach. The appraiser must analyze andreconcile the information from the approachesto arrive at the estimated market value. Theappraisal also should include a discussion onmarket conditions, including relevant informa-tion on property value trends, demand and sup-ply factors, and exposure time. Other informa-tion might include the prevalence and effect ofsales and financing concessions, the list-to-saleprice ratio, and availability of financing. Inaddition, an appraisal should reflect an analysisof the property’s sales history and an opinion asto the highest and best use of the property.USPAP requires the appraiser to disclosewhether or not the subject property wasinspected and whether anyone providedsignificant assistance to the appraiser signingthe appraisal report.

2231.0.9 APPRAISAL REPORTS

An institution is responsible for identifying theappropriate appraisal report option to support itscredit decisions. The institution should considerthe risk, size, and complexity of the transac-tion and the real estate collateral whendetermining the appraisal report format to bespecified in its appraisal engagement instruc-tions to an appraiser.

USPAP provides various appraisal reportoptions that an appraiser may use to present theresults of appraisal assignments. The major dif-ference among these report options is the levelof detail presented in the report. A report optionthat merely states, rather than summarizes ordescribes the content and information requiredin an appraisal report, may lack sufficient sup-porting information and analysis to explain theappraiser’s opinions and conclusions.

Generally, a report option that is restricted toa single client and intended user will not beappropriate to support most federally relatedtransactions. These reports lack sufficient sup-porting information and analysis for underwrit-ing purposes. These less detailed reports may beappropriate for real estate portfolio monitoringpurposes. (See ‘‘Appendix D—Glossary’’ forthe definition of appraisal report options.)

Regardless of the report option, the appraisalreport should contain sufficient detail to allowthe institution to understand the scope of workperformed. Sufficient information shouldinclude the disclosure of research and analysisperformed, as well as disclosure of the researchand analysis typically warranted for the type ofappraisal, but omitted, along with the rationalefor its omission.

2231.0.10 TRANSACTIONS THATREQUIRE EVALUATIONS

The Board’s appraisal regulations permit aninstitution to obtain an appropriate evaluation ofreal property collateral in lieu of an appraisal fortransactions that qualify for certain exemptions.These exemptions include transactions that—

• Have a transaction value equal to or less thanthe appraisal threshold of $250,000.

• Constitute a business loan with a transactionvalue equal to or less than the business loanthreshold of $1 million, and is not dependenton the sale of, or rental income derived from,real estate as the primary source of repay-ment.

• Involve an existing extension of credit at the



lending institution, provided that— There has been no obvious and material

change in market conditions or physicalaspects of the property that threaten theadequacy of the institution’s real estatecollateral protection after the transaction,even with the advancement of new mon-ies; or

— There is no advancement of new moniesother than funds necessary to cover rea-sonable closing costs.

For more information on real estate–relatedfinancial transactions that are exempt from theappraisal requirement, see ‘‘AppendixA—Appraisal Exemptions.’’ For a discussion onchanges in market conditions, see the ‘‘Validityof Appraisals and Evaluations’’ subsectionbelow.

Although the Board’s appraisal regulationsallow an institution to use an evaluation forcertain transactions, an institution should estab-lish policies and procedures for determiningwhen to obtain an appraisal for such transac-tions. For example, an institution should con-sider obtaining an appraisal as an institution’sportfolio risk increases or for higher risk realestate–related financial transactions, such asthose involving

• loans with combined loan-to-value ratios inexcess of the supervisory loan-to-value limits,

• atypical properties,• properties outside the institution’s traditional

lending market,• transactions involving existing extensions of

credit with significant risk to the institution,or

• borrowers with high-risk characteristics.

2231.0.11 EVALUATIONDEVELOPMENT

An evaluation must be consistent with safe andsound banking practices and should support theinstitution’s decision to engage in the transac-tion. An institution should be able to demon-strate that an evaluation, whether prepared by anindividual or supported by an analytical methodor a technological tool, provides a reliable esti-mate of the collateral’s market value as of astated effective date prior to the decision toenter into a transaction. (Refer to AppendixB—Evaluations Based on Analytical Methodsor Technological Tools.)

A valuation method that does not provide aproperty’s market value or sufficient informa-

tion and analysis to support the value conclu-sion is not acceptable as an evaluation. Forexample, a valuation method that provides asales or list price, such as a broker price opin-ion, cannot be used as an evaluation because,among other things, it does not provide a prop-erty’s market value. Further, the Dodd-FrankAct provides ‘‘[i]n conjunction with the pur-chase of a consumer’s principal dwelling, bro-ker price opinions may not be used as the pri-mary basis to determine the value of a piece ofproperty for the purpose of loan origination of aresidential mortgage loan secured by such pieceof property.’’27 Likewise, information on localhousing conditions and trends, such as a com-petitive market analysis, does not contain suffi-cient information on a specific property that isneeded, and therefore, would not be acceptableas an evaluation. The information obtained fromsuch sources, while insufficient as an evalua-tion, may be useful to develop an evaluation orappraisal.

An institution should establish policies andprocedures for determining an appropriatecollateral-valuation method for a given transac-tion considering associated risks. These policiesand procedures should address the process forselecting the appropriate valuation method for atransaction rather than using the method thatrenders the highest value, lowest cost, or fastestturnaround time.

A valuation method should address the prop-erty’s actual physical condition and characteris-tics as well as the economic and market condi-tions that affect the estimate of the collateral’smarket value. It would not be acceptable for aninstitution to base an evaluation on unsupportedassumptions, such as a property is in ‘‘average’’condition, the zoning will change, or the prop-erty is not affected by adverse market condi-tions. Therefore, an institution should establishcriteria for determining the level and extent ofresearch or inspection necessary to ascertain theproperty’s actual physical condition, and theeconomic and market factors that should beconsidered in developing an evaluation. Aninstitution should consider performing aninspection to ascertain the actual physical condi-tion of the property and market factors thataffect its market value. When an inspection isnot performed, an institution should be able todemonstrate how these property and market fac-tors were determined.

27. Dodd-Frank Act, section 1473(r).



2231.0.12 EVALUATION CONTENT

An evaluation should contain sufficient informa-tion detailing the analysis, assumptions, andconclusions to support the credit decision. Anevaluation’s content should be documented inthe credit file or reproducible. The evaluationshould, at a minimum,

• Identify the location of the property.• Provide a description of the property and its

current and projected use.• Provide an estimate of the property’s market

value in its actual physical condition, use andzoning designation as of the effective date ofthe evaluation (that is, the date that the analy-sis was completed), with any limitingconditions.

• Describe the method(s) the institution used toconfirm the property’s actual physical condi-tion and the extent to which an inspection wasperformed.

• Describe the analysis that was performed andthe supporting information that was used invaluing the property.

• Describe the supplemental information thatwas considered when using an analyticalmethod or technological tool.

• Indicate all source(s) of information used inthe analysis, as applicable, to value the prop-erty, including:— External data sources (such as market

sales databases and public tax and landrecords);

— Property-specific data (such as previoussales data for the subject property, tax as-sessment data, and comparable salesinformation);

— Evidence of a property inspection;— Photos of the property;— Description of the neighborhood; or— Local market conditions.

• Include information on the preparer when anevaluation is performed by a person, such asthe name and contact information, and signa-ture (electronic or other legally permissiblesignature) of the preparer.

(See ‘‘Appendix B—Evaluations Based onAnalytical Methods or Technological Tools’’ forguidance on the appropriate use of analyticalmethods and technological tools for developingan evaluation.)

2231.0.13 VALIDITY OF APPRAISALSAND EVALUATIONS

The Board allows an institution to use an exist-ing appraisal or evaluation to support a subse-quent transaction in certain circumstances.Therefore, an institution should establish crite-ria for assessing whether an existing appraisalor evaluation continues to reflect the marketvalue of the property (that is, remains valid).Such criteria will vary depending upon the con-dition of the property and the marketplace, andthe nature of the transaction. The documentationin the credit file should provide the facts andanalysis to support the institution’s conclusionthat the existing appraisal or evaluation may beused in the subsequent transaction. A newappraisal or evaluation is necessary if the origi-nally reported market value has changed due tofactors such as

• passage of time;• volatility of the local market;• changes in terms and availability of financing;• natural disasters;• limited or over supply of competing

properties;• improvements to the subject property or com-

peting properties;• lack of maintenance of the subject or compet-

ing properties;• changes in underlying economic and market

assumptions, such as capitalization rates andlease terms;

• changes in zoning, building materials, or tech-nology; and

• environmental contamination.

2231.0.14 REVIEWING APPRAISALSAND EVALUATIONS

The Board’s appraisal regulations specify thatappraisals for federally related transactions mustcontain sufficient information and analysis tosupport an institution’s decision to engage in thecredit transaction. For certain transactions that donot require an appraisal, the Board’s regulationsrequire an institution to obtain an appropriateevaluation of real property collateral that isconsistent with safe and sound banking practices.

As part of the credit approval process andprior to a final credit decision, an institutionshould review appraisals and evaluations toensure that they comply with the Board’sappraisal regulations and are consistent withsupervisory guidance and its own internal poli-cies. This review also should ensure that an



appraisal or evaluation contains sufficient infor-mation and analysis to support the decision toengage in the transaction.

Through the review process, the institutionshould be able to assess the reasonableness ofthe appraisal or evaluation, including whetherthe valuation methods, assumptions, and datasources are appropriate and well supported. Aninstitution may use the review findings to moni-tor and evaluate the competency and ongoingperformance of appraisers and persons who per-form evaluations. (See the discussion in the‘‘Selection of Appraisers or Persons Who Per-form Evaluations’’ subsection above.)

When an institution identifies an appraisal orevaluation that is inconsistent with the Board’sappraisal regulations and the deficiencies cannotbe resolved with the appraiser or person whoperformed the evaluation, the institution mustobtain an appraisal or evaluation that meets theregulatory requirements prior to making a creditdecision. Though a reviewer cannot change thevalue conclusion in the original appraisal, anappraisal review performed by an appropriatelyqualified and competent state-certified or state-licensed appraiser in accordance with USPAPmay result in a second opinion of market value.An institution may rely on the second opinion ofmarket value obtained through an acceptableUSPAP-compliant appraisal review to supportits credit decision.

An institution’s policies and procedures forreviewing appraisals and evaluations, at a mini-mum, should

• address the independence, educational andtraining qualifications, and role of thereviewer;

• reflect a risk-focused approach for determin-ing the depth of the review;

• establish a process for resolving any deficien-cies in appraisals or evaluations; and

• set forth documentation standards for thereview and resolution of noted deficiencies.

2231.0.14.1 Reviewer Qualifications

An institution should establish qualification cri-teria for persons who are eligible to reviewappraisals and evaluations. Persons who reviewappraisals and evaluations should be indepen-dent of the transaction and have no direct orindirect interest, financial or otherwise, in theproperty or transaction, and be independent ofand insulated from any influence by loan-production staff. Reviewers also should possessthe requisite education, expertise, and compe-

tence to perform the review commensurate withthe complexity of the transaction, type of realproperty, and market. Further, reviewers shouldbe capable of assessing whether the appraisal orevaluation contains sufficient information andanalysis to support the institution’s decision toengage in the transaction.

A small or rural institution or branch withlimited staff should implement prudent safe-guards for reviewing appraisals and evaluationswhen absolute lines of independence cannot beachieved. Under these circumstances, the reviewmay be part of the originating loan officer’soverall credit analysis, as long as the originatingloan officer abstains from directly or indirectlyapproving or voting to approve the loan.

An institution should assess the level ofin-house expertise available to review appraisalsfor complex projects, high-risk transactions, andout-of-market properties. An institution mayfind it appropriate to employ additional person-nel or engage a third party to perform thereviews. When using a third party, an institutionremains responsible for the quality andadequacy of the review process, including thequalification standards for reviewers. (See thediscussion in the ‘‘Third-Party Arrangements’’subsection below.)

2231.0.14.2 Depth of Review

An institution should implement a risk-focusedapproach for determining the depth of thereview needed to ensure that appraisals andevaluations contain sufficient information andanalysis to support the institution’s decision toengage in the transaction. This process shoulddifferentiate between high- and low-risk transac-tions so that the review is commensurate withthe risk. The depth of the review should besufficient to ensure that the methods, assump-tions, data sources, and conclusions are reason-able, well supported, and appropriate for thetransaction, property, and market. The reviewalso should consider the process through whichthe appraisal or evaluation is obtained, eitherdirectly by the institution or from another finan-cial services institution. The review processshould be commensurate with the type of trans-action as discussed below:

• Commercial Real Estate. An institutionshould ensure that appraisals or evaluationsfor commercial real estate transactions are



subject to an appropriate level of review.Transactions involving complex properties orhigh-risk commercial loans should bereviewed more comprehensively to assess thetechnical quality of the appraiser’s analysis.For example, an institution should perform amore comprehensive review of transactionsinvolving large-dollar credits, loans securedby complex or specialized properties, andproperties outside the institution’s traditionallending market. Persons performing suchreviews should have the appropriate expertiseand knowledge relative to the type of propertyand its market.

The depth of the review of appraisals andevaluations completed for commercial proper-ties securing lower-risk transactions may beless technical in nature, but still should pro-vide meaningful results that are commensu-rate with the size, type, and complexity of theunderlying credit transaction. In addition, aninstitution should establish criteria for whento expand the depth of the review.

• One- to Four-Family Residential Real Estate.The reviews for residential real estate transac-tions should reflect a risk-focused approachthat is commensurate with the size, type, andcomplexity of the underlying credit transac-tion, as well as loan and portfolio risk charac-teristics. These risk factors could include debt-to-income ratios, loan-to-value ratios, level ofdocumentation, transaction dollar amount, orother relevant factors. With prior approvalfrom its primary federal regulator, an institu-tion may employ various techniques, such asautomated tools or sampling methods, for per-forming pre-funding reviews of appraisals orevaluations supporting lower risk residentialmortgages. When using such techniques, aninstitution should maintain sufficient data andemploy appropriate screening parameters toprovide adequate quality assurance and shouldensure that the work of all appraisers andpersons performing evaluations is periodicallyreviewed. In addition, an institution shouldestablish criteria for when to expand the depthof the review.

An institution may use sampling and auditprocedures to verify the seller’s representa-tions and warranties that the appraisals for theunderlying loans in a pool of residential loanssatisfy the Board’s appraisal regulations andare consistent with supervisory guidance andan institution’s internal policies. If an institu-tion is unable to confirm that the appraisal

meets the Board’s appraisal requirements,then the institution must obtain an appraisalprior to engaging in the transaction.

• Appraisals from Other Financial ServicesInstitutions.28 The Board’s appraisal regula-tions specify that an institution may use anappraisal that was prepared by an appraiserengaged directly by another financial servicesinstitution, provided the institution determinesthat the appraisal conforms to the Board’sappraisal regulations and is otherwise accept-able. An institution should assess whether touse the appraisal prior to making a creditdecision. An institution should subject suchappraisals to at least the same level of reviewthat the institution performs on appraisals itobtains directly for similar properties anddocument its review in the credit file. Thedocumentation of the review should supportthe institution’s reliance on the appraisal.Among other considerations, an institutionshould confirm that— the appraiser was engaged directly by the

other financial services institution;— the appraiser had no direct, indirect, or

prospective interest, financial or other-wise, in the property or transaction; and

— the financial services institution (not theborrower) ordered the appraisal. Forexample, an engagement letter shouldshow that the financial services institution,not the borrower, engaged the appraiser.

An institution must not accept an appraisalthat has been readdressed or altered by theappraiser with the intent to conceal the originalclient. Altering an appraisal report in a mannerthat conceals the original client or intendedusers of the appraisal is misleading, does notconform to USPAP, and violates the Board’sappraisal regulations.

2231.0.14.3 Resolution of Deficiencies

An institution should establish policies and pro-cedures for resolving any inaccuracies or weak-nesses in an appraisal or evaluation identifiedthrough the review process, including proce-dures for:

• Communicating the noted deficiencies to andrequesting correction of such deficiencies by

28. An institution generally should not rely on an evalua-tion prepared by or for another financial services institutionbecause it will not have sufficient information relative to theother institution’s risk-management practices for developingevaluations.



the appraiser or person who prepared theevaluation. An institution should implementadequate internal controls to ensure that suchcommunications do not result in any coercionor undue influence on the appraiser or personwho performed the evaluation.

• Addressing significant deficiencies in theappraisal that could not be resolved with theoriginal appraiser by obtaining a secondappraisal or relying on a review that complieswith Standards Rule 3 of USPAP and is per-formed by an appropriately qualified and com-petent state-certified or state-licensedappraiser prior to the final credit decision.

• Replacing evaluations prior to the credit deci-sion that do not provide credible results orlack sufficient information to support the finalcredit decision.

2231.0.14.4 Documentation of theReview

An institution should establish policies for docu-menting the review of appraisals and evalua-tions in the credit file. Such policies shouldaddress the level of documentation needed forthe review, given the type, risk, and complexityof the transaction. The documentation shoulddescribe the resolution of any appraisal or evalu-ation deficiencies, including reasons for obtain-ing and relying on a second appraisal or evalua-tion. The documentation also should provide anaudit trail that documents the resolution of noteddeficiencies or details the reasons for relying ona second opinion of market value.

2231.0.15 THIRD-PARTYARRANGEMENTS

An institution that engages a third party to per-form certain collateral-valuation functions on itsbehalf is responsible for understanding andmanaging the risks associated with the arrange-ment. An institution should use caution if itengages a third party to administer any part ofits appraisal and evaluation function, includingordering or reviewing appraisals and evalua-tions, selecting an appraiser or person to per-form evaluations, or providing access to analyti-cal methods or technological tools.

An institution is accountable for ensuring thatany services performed by a third party, bothaffiliated and unaffiliated entities, comply withapplicable laws and regulations and are consis-

tent with supervisory guidance.29 Therefore, aninstitution should have the resources and exper-tise necessary for performing ongoing oversightof third-party arrangements.

An institution should have internal controlsfor identifying, monitoring, and managing therisks associated with using a third-party arrange-ment for valuation services, including compli-ance, legal, reputational, and operational risks.While the arrangement may allow an institutionto achieve specific business objectives, such asgaining access to expertise not available inter-nally, the reduced operational control over out-sourced activities poses additional risk. Consis-tent with safe and sound practices, an institutionshould have a written contract that clearlydefines the expectations and obligations of boththe financial institution and the third party,including that the third party will perform itsservices in compliance with the Board’sappraisal regulations and consistent with super-visory guidance.

Prior to entering into any arrangement with athird party for valuation services, an institutionshould compare the risks, costs, and benefits ofthe proposed relationship to those associatedwith using another vendor or conducting theactivity in-house. The decision to outsource anypart of the collateral-valuation function shouldnot be unduly influenced by any short-term costsavings. An institution should take into accountall aspects of the long-term effect of the relation-ship, including the managerial expertise andassociated costs for effectively monitoring thearrangement on an ongoing basis.

If an institution outsources any part of thecollateral-valuation function, it should exerciseappropriate due diligence in the selection of athird party. This process should include suffi-cient analysis by the institution to assesswhether the third-party provider can perform theservices consistent with the institution’s perfor-mance standards and regulatory requirements.An institution should be able to demonstratethat its policies and procedures establish effec-tive internal controls to monitor and periodi-cally assess the collateral-valuation functionsperformed by a third party.

An institution also is responsible for ensuring

29. See, for example, FFIEC statement, Risk Managementof Outsourced Technology Service (November 28, 2000) forguidance on the assessment, selection, contract review, andmonitoring of a third party that provides services to a regu-lated institution. Refer to the institution’s primary federalregulator for additional guidance on third-party arrangements.



that a third party selects an appraiser or a personto perform an evaluation who is competent andindependent, has the requisite experience andtraining for the assignment, and thoroughknowledge of the subject property’s market.Appraisers must be appropriately certified orlicensed, but this minimum credentialingrequirement, although necessary, is not suffi-cient to determine that an appraiser is competentto perform an assignment for a particular prop-erty or geographic market.

An institution should ensure that when a thirdparty engages an appraiser or a person whoperforms an evaluation, the third party conveysto that person the intended use of the appraisalor evaluation and that the regulated institution isthe client. For example, an engagement letterfacilitates the communication of thisinformation.

An institution’s risk-management systemshould reflect the complexity of the outsourcedactivities and associated risk. An institutionshould document the results of ongoing moni-toring efforts and periodic assessments of thearrangement(s) with a third party for compli-ance with applicable regulations and consis-tency with supervisory guidance and its perfor-mance standards. If deficiencies are discovered,an institution should take remedial action in atimely manner.

2231.0.16 PROGRAM COMPLIANCE

Deficiencies in an institution’s appraisal andevaluation program that result in violations ofthe Board’s appraisal regulations or contraven-tions of the Board’s supervisory guidance reflectnegatively on management. An institution’sappraisal and evaluation policies should estab-lish internal controls to promote an effectiveappraisal and evaluation program. The compli-ance process should

• maintain a system of adequate controls, verifi-cation, and testing to ensure that appraisalsand evaluations provide credible marketvalues;

• insulate the persons responsible for ascertain-ing the compliance of the institution’sappraisal and evaluation function from anyinfluence by loan-production staff;

• ensure the institution’s practices result in theselection of appraisers and persons who per-form evaluations with the appropriate qualifi-

cations and demonstrated competency for theassignment;

• establish procedures to test the quality of theappraisal and evaluation review process;

• use, as appropriate, the results of the institu-tion’s review process and other relevant infor-mation as a basis for considering a person fora future appraisal or evaluation assignment;and

• report appraisal and evaluation deficiencies toappropriate internal parties and, if applicable,to external authorities in a timely manner.

2231.0.16.1 Monitoring Collateral Values

Consistent with the Board’s real estate lendingregulations and guidelines,30 an institutionshould monitor collateral risk on a portfolio andon an individual credit basis. Therefore, aninstitution should have policies and proceduresthat address the need for obtaining currentcollateral-valuation information to understandits collateral position over the life of a creditand effectively manage the risk in its real estatecredit portfolios. The policies and proceduresalso should address the need to obtain currentvaluation information for collateral supportingan existing credit that may be modified orconsidered for a loan workout.

Under their appraisal regulations, the Boardreserves the right to require an institution toobtain an appraisal or evaluation when there aresafety and soundness concerns on an existingreal estate secured credit. Therefore, an institu-tion should be able to demonstrate that sufficientinformation is available to support the currentmarket value of the collateral and the classifica-tion of a problem real estate credit. When suchinformation is not available, an examiner maydirect an institution to obtain a new appraisal orevaluation in order to have sufficient informa-tion to understand the current market value ofthe collateral. Examiners would be expected toprovide an institution with a reasonable amountof time to obtain a new appraisal or evaluation.

2231.0.16.2 Portfolio Collateral Risk

Prudent portfolio-monitoring practices include

30. The Federal Reserve did not adopt the real estatelending standards for bank holding companies and their non-bank subsidiaries. However, bank holding companies andtheir nonbank subsidiaries are expected to conduct their realestate lending activities in a prudent manner consistent withsafe and sound lending standards. A bank subsidiary of aBHC should refer to 12 C.F.R. 208, subpart G.



criteria for determining when to obtain a newappraisal or evaluation. Among other consider-ations, the criteria should address deteriorationin the credit since origination or changes inmarket conditions. Changes in market condi-tions could include material changes in currentand projected vacancy, absorption rates, leaseterms, rental rates, and sale prices, includingconcessions and overruns and delays in con-struction costs. Fluctuations in discount or directcapitalization rates also are indicators of chang-ing market conditions.

In assessing whether changes in market con-ditions are material, an institution should con-sider the individual and aggregate effect of thesechanges on its collateral protection and the riskin its real estate lending programs or creditportfolios. Moreover, as an institution’s relianceon collateral becomes more important, its poli-cies and procedures should

• ensure that timely information is available tomanagement for assessing collateral and asso-ciated risk;

• specify when new or updated collateral valua-tions are appropriate or desirable to under-stand collateral risk in the transaction(s); and

• delineate the valuation method to beemployed after considering the property type,current market conditions, current use of theproperty, and the relevance of the most recentappraisal or evaluation in the credit file.

Consistent with sound collateral-valuationmonitoring practices, an institution can use avariety of techniques for monitoring the effectof collateral-valuation trends on portfolio risk.Sources of relevant information may includeexternal market data, internal data, or reviews ofrecently obtained appraisals and evaluations. Aninstitution should be able to demonstrate that ithas sufficient, reliable, and timely informationon market trends to understand the risk associ-ated with its lending activity.

2231.0.16.3 Modifications and Workoutsof Existing Credits

An institution may find it appropriate to modifya loan or to engage in a workout with an exist-ing borrower. The Board expects an institutionto consider current collateral valuation informa-tion to assess its collateral risk and facilitate aninformed decision on whether to engage in amodification or workout of an existing realestate credit. (See the discussion above under‘‘Portfolio Collateral Risk.’’)

• Loan Modifications. A loan modification to anexisting credit that involves a limitedchange31 in the terms of the note or loanagreement and that does not adversely affectthe institution’s real estate collateral protec-tion after the modification does not rise to thelevel of a new real estate–related financialtransaction for purposes of the Board’sappraisal regulations. As a result, an institu-tion would not be required to obtain either anew appraisal or evaluation to comply withthe Board’s appraisal regulations, but shouldhave an understanding of its collateral risk.For example, institutions can use automatedvaluation models or other valuationtechniques when considering a modificationto a residential mortgage loan. An institutionshould have procedures for ensuring analternative collateral-valuation methodprovides reliable information. In addition, aninstitution should be able to demonstrate thata modification reflects prudent underwritingstandards and is consistent with safe andsound lending practices. Examiners willassess the adequacy of valuation informationan institution uses for loan modifications.

• Loan Workouts. As noted above under ‘‘Moni-toring Collateral Values,’’ an institution’s poli-cies and procedures should address the needfor current information on the value of realestate collateral supporting a loan workout. Aloan workout can take many forms, includinga modification that adversely affects the insti-tution’s real estate collateral protection afterthe modification, a renewal or extension ofloan terms, the advancement of new monies,or a restructuring with or without concessions.These types of loan workouts are new realestate–related financial transactions.

If the loan workout does not include theadvancement of new monies other than rea-sonable closing costs, the institution mayobtain an evaluation in lieu of an appraisal.For loan workouts that involve the advance-ment of new monies, an institution may obtainan evaluation in lieu of an appraisal providedthere has been no obvious and material change

31. A loan modification that entails a decrease in theinterest rate or a single extension of a limited or short-termnature would not be viewed as a subsequent transaction. Forexample, an extension arising from a short-term delay in thefull repayment of the loan when there is documented evidencethat payment from the borrower is forthcoming, or a briefdelay in the scheduled closing on the sale of a property whenthere is evidence that the closing will be completed in the nearterm.



in market conditions and no change in thephysical aspects of the property that threatensthe adequacy of the institution’s real estatecollateral protection after the workout.

In these cases, an institution should sup-port and document its rationale for using thisexemption. An institution must obtain anappraisal when a loan workout involves theadvancement of new monies and there is anobvious and material change in either marketconditions or physical aspects of the property,or both, that threatens the adequacy of theinstitution’s real estate collateral protectionafter the workout (unless another exemptionapplies).32 (See also ‘‘Appendix A—Appraisal Exemptions’’ for transactionswhere an evaluation would be allowed in lieuof an appraisal.)

• Collateral-Valuation Policies for Modifica-tions and Workouts. An institution’s policiesshould address the need for obtaining currentcollateral-valuation information for a loanmodification or workout. The policies shouldspecify the valuation method to be used andaddress the need to monitor collateral risk onan ongoing basis taking into considerationchanging market conditions and the bor-rower’s repayment performance. An institu-tion also should be able to demonstrate thatthe collateral-valuation method used is reli-able for a given credit or loan type.

Further, for loan workouts, an institution’spolicies should specify conditions underwhich an appraisal or evaluation will beobtained. As loan repayment becomes moredependent on the sale of collateral, an institu-tion’s policies should address the need toobtain an appraisal or evaluation for safetyand soundness reasons even though one is nototherwise required by the Board’s appraisalregulations.

2231.0.17 REFERRALS

An institution should file a complaint with theappropriate state appraiser regulatory officialswhen it suspects that a state-certified or state-licensed appraiser failed to comply with USPAP,applicable state laws, or engaged in otherunethical or unprofessional conduct. In addition,effective April 1, 2011, an institution must file a

complaint with the appropriate state appraisercertifying and licensing agency under certaincircumstances.33

An institution also must file a suspiciousactivity report (SAR) with the Financial CrimesEnforcement Network of the Department of theTreasury (FinCEN) when suspecting fraud oridentifying other transactions meeting the SARfiling criteria.34 Examiners finding evidence ofunethical or unprofessional conduct by apprais-ers should instruct the institution to file a com-plaint with state appraiser regulatory officialsand, when required, to file a SAR with FinCEN.If there is a concern regarding the institution’sability or willingness to file a complaint or makea referral, examiners should forward their find-ings and recommendations to their supervisoryoffice for appropriate disposition and referral tostate appraiser regulatory officials and FinCEN,as necessary.

2231.0.18 APPENDIXES ININTERAGENCY APPRAISAL ANDEVALUATION GUIDELINES

There are four appendixes included with theguidelines. They are summarized below and canbe found in section A. 4140.1 of the Commer-cial Bank Examination Manual.

Appendix A—Appraisal Exemptions: A com-mentary on the 12 exemptions from the agen-cies’ appraisal regulations. The appendix pro-vides an explanation of the agencies’ statutoryauthority to provide for appraisal regulatoryexemptions and the application of these exemp-tions.

Appendix B—Evaluations Based on AnalyticalMethods and Technological Tools: A discussionof the agencies’ expectations for evaluationsthat are based on analytical methods and techno-logical tools, including the use of automatedvaluation models and tax assessment valuations.

Appendix C—Deductions and Discounts Mini-mum: A discussion on appraisal standards fordetermining the market value of a residential

32. For example, if the transaction value is below theappraisal threshold of $250,000.

33. See 12 CFR 226.42(g).34. Refer to 12 CFR 208.62, 211.5(k), 211.24(f), and

225.4(f). Refer also to the Federal Financial InstitutionsExamination Council Bank Secrecy Act/Anti-Money Launder-ing Examination Manual (revised April 29, 2010) to reviewthe general criteria, but note that instructions on filing a SARthrough the Financial Crime Enforcement Network (FinCEN)of the Department of the Treasury are attached to the SARform. The SAR form is available on FinCEN’s website:www.fincen.gov/forms/bsa_forms/#SAR.



tract development, including an explanation ofthe requirement to analyze and report appropri-ate deductions and discounts for proposed con-struction or renovation, partially leased build-ings, nonmarket lease terms, and tractdevelopments with unsold units.

Appendix D—Glossary: Definitions of termsrelated to real estate lending, appraisals, andregulations to aid in the reading of theguidelines.

2231.0.19 BACKGROUNDINFORMATION ON APPRAISALVALUATION APPROACHES

An appraiser typically utilizes three market-value approaches to analyze the value ofproperty:

• cost approach• sales comparison approach• income approach

All three approaches have particular meritsdepending upon the type of real estate beingappraised. For single-family residential prop-erty, the cost and comparable sales approachesare most frequently used since the common useof the property is the personal residence of theowner. However, if a single-family residentialproperty is intended to be used as a rental prop-erty, the appraiser would have to consider theincome approach as well. For special-use com-mercial properties, the appraiser may have diffi-culty obtaining sales data on comparable proper-ties and may have to base the value estimate onthe cost and income approaches.

If an approach is not used in the appraisal, theappraiser should disclose the reason theapproach was not used and whether this affectsthe value estimate.

2231.0.19.1 Cost Approach

In the cost approach to value estimation, theappraiser obtains a preliminary indication ofvalue by adding the estimated depreciated repro-duction cost of the improvements to the esti-mated land value. This approach is based on theassumption that the reproduction cost is theupper limit of value and that a newly con-structed building would have functional andmechanical advantages over an existing build-ing. The appraiser would evaluate any func-tional depreciation (disadvantages or deficien-

cies) of the existing building in relation to a newstructure.

The cost approach consists of four basicsteps: (1) estimate the value of the land asthough vacant, (2) estimate the current cost ofreproducing the existing improvements, (3) esti-mate depreciation and deduct from the repro-duction cost estimate, and (4) add the estimateof land value and the depreciated reproductioncost of improvements to determine the valueestimate.

2231.0.19.2 Sales Comparison Approach

The essence of the sales comparison approach isto determine the price at which similar proper-ties have recently sold on the local market.Through an appropriate adjustment for differ-ences in the subject property and the selectedcomparable properties, the appraiser estimatesthe market value of the subject property basedon the sales price of the comparable properties.The process used in determining the degree ofcomparability of two or more propertiesinvolves judgment about their similarity withrespect to age, location, condition, construction,layout, and equipment. The sales price or listprice of those properties deemed most compa-rable tend to set the range for the value of thesubject property.

2231.0.19.3 Income Approach

The income approach estimates the project’sexpected income over time converted to an esti-mate of its present value. The income approachis typically used to determine the market valueof income-producing properties such as officebuildings, apartment complexes, hotels, andshopping centers. In the income approach, theappraiser can use several different capitalizationor discounted cash-flow techniques to arrive at amarket value. These techniques include theband-of-investments method, mortgage-equitymethod, annuity method, and land-residual tech-nique. Which technique is used depends onwhether there is project financing, whether thereare long-term leases with fixed-level payments,and whether the value is being rendered for acomponent of the project such as land or build-ings.

The accuracy of the income-approach methoddepends on the appraiser’s skill in estimating



the anticipated future net income of the propertyand in selecting the appropriate capitalizationrate and discounted cash flow. The followingdata are assembled and analyzed to determinepotential net income and value:

• Rent schedules and the percentage of occu-pancy for the subject property and for compa-rable properties for the current year and sev-eral preceding years. This provides grossrental data and shows the trend of rentals andoccupancy, which are then analyzed by theappraiser to estimate the gross income theproperty should produce.

• Expense data such as taxes, insurance, andoperating costs paid from revenues derivedfrom the subject property and by comparableproperties. Historical trends in these expenseitems are also determined.

• A time frame for achieving stabilized, or nor-mal, occupancy and rent levels (also referredto as a holding period).

Basically, the income approach converts allexpected future net operating income intopresent-value terms. When market conditionsare stable and no unusual patterns of future rentsand occupancy rates are expected, the directcapitalization method is used to value incomeproperties. This method calculates the value of aproperty by dividing an estimate of its stabilizedannual income by a factor called a cap rate.Stabilized income is generally defined as theyearly net operating income produced by theproperty at normal occupancy and rental rates; itmay be adjusted upward or downward fromtoday’s actual market conditions. The cap rate—usually defined for each property type in a mar-ket area—is viewed by some analysts as therequired rate of return stated as a percent ofcurrent income.

The use of this technique assumes that the useof either the stabilized income or the cap rateaccurately captures all relevant characteristicsof the property relating to its risk and incomepotential. If the same risk factors, required rateof return, financing arrangements, and incomeprojections are used, explicit discounting anddirect capitalization should yield the sameresults.

For special-use properties, new projects, ortroubled properties, the discounted cash flow(net present value) method is the more typicalapproach to analyzing a property’s value. In thismethod, a time frame for achieving a stabilized,

or normal, occupancy and rent level is pro-jected. Each year’s net operating income duringthat period is discounted to arrive at the presentvalue of expected future cash flows. The proper-ty’s anticipated sales value at the end of theperiod until stabilization (its terminal or rever-sion value) is then estimated. The reversionvalue represents the capitalization of all futureincome streams of the property after the pro-jected occupancy level is achieved. The termi-nal or reversion value is then discounted to itspresent value and added to the discountedincome stream to arrive at the total presentmarket value of the property.

Most importantly, the analysis should bebased on the ability of the project to generateincome over time based upon reasonable andsupportable assumptions. Additionally, the dis-count rate should reflect reasonable expectationsabout the rate of return that investors requireunder normal, orderly, and sustainable marketconditions.

2231.0.19.4 Value Correlation

The three value estimates—cost, sales compari-son, and income—must be evaluated by theappraiser and correlated into a final value esti-mate based on the appraiser’s judgment. Corre-lation does not imply averaging the value esti-mates obtained by using the three differentapproaches. Where these value estimates arerelatively close together, correlating them andsetting the final market value estimate presentsno special problem. It is in situations wherewidely divergent values are obtained by usingthe three appraisal approaches that the examinermust exercise judgment in analyzing the resultsand determining the estimate of market value.

2231.0.19.5 Other Definitions of Value

While the Board’s appraisal regulation requiresthat the appraisal contain the market value ofthe real estate collateral, there are other defini-tions of value that are encountered in appraisingand evaluating real estate transactions. Theseinclude the following:

Fair Value. This is an accounting term that isgenerally defined as the amount in cash orcash-equivalent value of other considerationthat a real estate parcel would yield in a currentsale between a willing buyer and a willingseller (the selling price), that is, other than in a



forced or liquidation sale.35 According toaccounting literature, fair value is generallyused in valuing assets in nonmonetary transac-tions, troubled debt restructuring, quasi-reorganizations, and business combinationsaccounted for by the purchase method. Anaccountant generally defines fair value as mar-ket value; however, depending on the circum-stances, these values may not be the same for aparticular property.

Investment Value. This is based on the data andassumptions that meet the criteria and objectivesof a particular investor for a specific property orproject. The investor’s criteria and objectivesare often substantially different from partici-pants’ criteria and objectives in a broader mar-ket. Thus, investment value can be significantlyhigher than market value in certain circum-stances and should not be used in credit analysisdecisions.

Liquidation Value. This assumes that there islittle or no current demand for the property butthe property needs to be disposed of quickly,resulting in the owner sacrificing potential prop-erty appreciation for an immediate sale.

Going-Concern Value. This is based on thevalue of a business entity rather than the valueof just the real estate. The valuation is based onthe existing operations of the business that has aproven operating record, with the assumptionthat the business will continue to operate.

Assessed Value. This represents the value onwhich a taxing authority bases its assessment.The assessed value and market value may differconsiderably due to tax assessment laws, timingof reassessments, and tax exemptions allowedon properties or portions of a property.

Net Realizable Value (NRV). This is recognizedunder generally accepted accounting principles

as the estimated selling price in the ordinarycourse of business less estimated costs ofcompletion (to the stage of completion assumedin determining the selling price), holding, anddisposal. The NRV is generally used to evaluatethe carrying amount of assets being held fordisposition and properties representing collat-eral. While the market value or future sellingprice are generally used as the basis for theNRV calculation, the NRV also reflects the cur-rent owner’s costs to complete the project and tohold and dispose of the property. For this rea-son, the NRV will generally be less than themarket value.

2231.0.20 SUPERVISORYEXPECTATIONS AND FINDINGS

In conjunction with assessing overall adequacyof a banking organization’s appraisal and evalu-ation function to support safe and sound realestate lending, examiners should review thebanking organization for compliance with theBoard’s appraisal regulation and related guide-lines. The following summarizes possibleinspection findings and references to the appli-cable provisions in the Board’s regulations orrelevant section in the Interagency Guidelines.

• Banking organization’s appraisal function isweak:— The banking organization has failed to

satisfy supervisory expectations as indi-cated in the Interagency Appraisal andEvaluation Guidelines. See the ‘‘Appraisaland Evaluation Program’’ subsectionabove.

• Banking organization does not have adequateprocedures for monitoring market conditionsfor its CRE lending:— A bank subsidiary of a bank holding com-

pany must monitor real estate market con-ditions in its lending area and have creditadministration policies that address thetype and frequency of collateral valua-tions. Violation of 12 CFR 225, subpart G(real estate lending standards regulationand guidelines).

— The banking organization has failed tocomply with the Interagency Guidelines.See the ‘‘Monitoring Collateral Values’’subsection above.

• Appraisal fails to comply with regulation:— Violation of 12 CFR 225.64 (minimum

35. See Accounting Standards Codification (ASC) Topic820, ‘‘Fair Value Measurements and Disclosures’’ (formerlyFASB Statement No. 157, ‘‘Fair Value Measurements’’). Itdefines fair value and establishes a framework for measuringfair value. ASC Topic 820 should be applied when otheraccounting topics require or permit fair value measurements.Fair value is defined as the price that would be received to sellan asset or paid to transfer a liability in an orderly transactionbetween market participants in the asset’s or liability’s princi-pal (or most advantageous) market at the measurement date.This value is often referred to as an ‘‘exit’’ price. An orderlytransaction is a transaction that assumes exposure to themarket for a period prior to the measurement date to allow formarketing activities that are usual and customary for transac-tions involving such assets or liabilities; it is not a forcedliquidation or distressed sale.



appraisal standards) or 12 CFR 225.65(appraiser independence).

— Examiners may require the banking orga-nization to obtain a new appraisal forsafety-and-soundness reasons (12 CFR225.63(c)).

• The banking organization fails to obtain anappraisal as required by the regulation:— Violation of 12 CFR 225.63(a).— The banking organization must obtain an

appraisal.— For further background, refer to the Inter-

agency Guidelines, the ‘‘Transactions ThatRequire Appraisals’’ subsection, andAppendix A—Appraisal Exemptions.

• The banking organization fails to obtain anevaluation for certain exempted transactions:— Violation of 12 CFR 225.63(b) (see the

provision on evaluations required).— For further background, refer to the Inter-

agency Guidelines and the section on‘‘Transactions That Require Evaluations’’as well as Appendix A—AppraisalExemptions.

— The banking organization must obtain anevaluation.

• The evaluation is inadequate:— The banking organization has failed to

satisfy supervisory expectations as indi-cated in the Interagency Appraisal andEvaluation Guidelines.

— For further background, refer to theInteragency Guidelines, the ‘‘EvaluationDevelopment’’ and ‘‘Evaluation Content’’subsections, and Appendix B—EvaluationsBased on Analytical Methods or Techno-logical Tools.

— Depending upon the noted deficiencies,examiners should require the bankingorganization to perform a new evaluation.


1. To determine whether policies, practices,procedures, and internal controls regardingreal estate appraisals and evaluations forreal estate–related financial transactions areadequate.

2. To determine whether the banking organiza-tion’s officers and employees are operatingin conformance with the board of director’sappraisal policies and that such policies pro-mote compliance with the appraisal regula-tions and related-supervisory guidance and

independence between the appraisal andevaluation process and the loan productionfunction (i.e., the credit decision).

3. To determine whether the banking organiza-tion’s policies and procedures address therequirement to monitor real estate collateralvalues and market conditions on a portfoliobasis and over the life of the credit.

4. To determine that appraisals performed inconnection with federally related transac-tions comply with the minimum standardsof the Board’s regulation and the UniformStandards of Professional Appraisal Prac-tice.

5. To determine that the banking organiza-tion’s policies and practices for performingevaluations comply with supervisory guid-ance and ensure that qualified individualsperform evaluations.

6. To determine whether the banking organiza-tion has effective policies and proceduresfor the review of appraisals and evaluations,including procedures for addressingdeficiencies.

7. To determine that appraisers used in con-nection with federally related transactionshold a valid state license or certification asapplicable for the property being appraised.

8. To determine that appraisers are competentto render appraisals in federally relatedtransactions, and are independent of thetransaction, or other lending, investment, orcollection functions as appropriate.

9. To determine that the banking organizationhas appropriate oversight over any thirdparty providing appraisal managementservices.

10. To determine that the banking organizationhas appropriate policies and proceduresgoverning the use of analytical methods andtechnological tools in the preparation ofevaluations.

11. To initiate corrective action when policies,practices, procedures, or internal controlsare deficient, or when violations of laws orregulations or noncompliance with provi-sions of supervisory guidelines have beennoted.


1. On the basis of the evaluation of internalcontrols and the work performed by internalor external auditors, or inspection findingsfrom the institution’s real estate lendingactivity, determine the scope of theinspection.



2. Test for compliance with policies, practices,procedures, and internal controls in conjunc-tion with performing the remaining inspec-tion procedures. Obtain a listing of anydeficiencies noted in the latest reviewperformed by internal or external auditors ora previous inspection report and determine ifappropriate corrections have been made.a. Provide copies of the banking organiza-

tion’s appraisal and evaluation policiesand procedures to examiners assigned tofunctional areas in which real estate–related transactions may require the ser-vices of an appraiser or evaluator.

b. When individual real estate–related trans-actions such as loan D.P.C. assets or otherreal estate owned (OREO) transactionsare examined, appraisals and evaluationsshould be reviewed for compliance withthe Board’s appraisal regulation, supervi-sory guidance, and the banking organiza-tion’s appraisal and evaluation programs.

c. When real estate–related transactions areexamined on a portfolio basis, theappraisal and evaluation processes for theactivity should be examined. Examinersshould determine whether these processesensure that appraisals and evaluationscomply with the Board’s appraisal regula-tion, supervisory guidance, and the bank-ing organization’s appraisal and evalua-tion programs.

3. Review the appraisal and evaluation programand determine the following:a. The board of directors has adopted poli-

cies and procedures that—• establish and maintain an effective,

independent appraisal and evaluationprogram for all of the institution’s lend-ing functions;

• are sufficiently comprehensive;• require an appropriate level of review

of appraisals and evaluations to pro-mote compliance with the Board’sappraisal regulation and supervisoryguidance as well as safe and soundlending; and

• are applied uniformly to all unitsengaged in real estate–related activity.

b. The appraisal and evaluation programestablishes criteria which the bankingorganization uses to select, evaluate,monitor, and ensure the independence ofappraisers and the individuals who per-form evaluations as well as those indi-viduals who perform and oversee thereview of appraisals and evaluations.

c. The program considers the independent

appraiser’s qualifications, experience, andeducational background; confirms theappraiser’s independence; ensures thatappraisals are not used if they were pre-pared by an individual recommended orselected by the borrower (including thoseindividuals listed by the banking organi-zation as approved appraisers); andensures that appraisals conform to theBoard’s appraisal regulation and are con-sistent with supervisory guidance.

d. The program ensures that evaluationsconform to the Board’s guidance onevaluations.

e. The program is adequate for the bankingorganization’s size and location and forthe nature and complexity of its real estatelending and other real estate–relatedactivities.

f. The policies and procedures require thatappraisals and evaluations be written andcontain sufficient information on the realestate collateral’s market value to supportthe banking organization’s decision toenter into the transaction.

g. The program includes policies and proce-dures concerning the need for current col-lateral valuation information to under-stand the banking organization’s collateralposition over the life of the credit and tomanage risk in its real estate credit port-folio.

h. The policies and procedures address theneed for current collateral valuation infor-mation for loans that the banking organi-zation is considering for modification or aworkout.

i. If the program utilizes an approvedappraiser list, the banking organizationhas appropriate procedures for the devel-opment and administration of the list.

j. The program addresses appraisal andevaluation review procedures, includingthe communications with the appraiser orthe individual who performed the evalua-tion, resolution of deficiencies, and thedecision to obtain a second appraisal orevaluation.

k. The board or senior management reviewsannually its appraisal and evaluationrelated policies and procedures andrecords such review in its minutes.

4. Evaluate the banking organization’sappraisal and evaluation program withrespect to the following:



a. the adequacy of written appraisals andevaluations

b. the manner in which officers are operatingin conformance with establishedpolicy

c. internal control deficiencies or exceptions,including lack of independence of theappraisal and evaluation process from theloan-production function

d. the integrity of the appraisal and evalua-tion process, including appraisal andevaluation compliance procedures

e. the integrity of individual appraisals andevaluations, including the adequacy, rea-sonableness, and appropriateness of themethods, assumptions, and techniquesused and whether the appraisals andevaluations comply with the Board’sappraisal regulation and supervisoryguidance

f. the adequacy of the appraisal and evalua-tion review practices, including the depthand content of the review, documentationsupport for the review, and the resolutionof deficiencies

g. the adequacy of policies and internal con-trols for managing and monitoring thirdparties that provide appraisal managementservices to the banking organization

h. the integrity of policies and proceduresgoverning the use of automated valuationmodels in the development of evaluations

i. the eligibility of the banking organizationto assign a 50 percent risk weight to cer-tain one- to four-family residential mort-gage loans for risk-based capital purposes(See section 4060.3, ‘‘Assessment ofCapital Adequacy.’’)

j. recommended corrective action whenpolicies, practices, or procedures arefound to be deficient

k. the degree of violations, if any, of theBoard’s appraisal regulation and theextent of noncompliance with supervisoryguidance, if noted

l. other matters of significance:• misrepresentation of data, such as the

omission of information on favorablefinancing, seller concessions, sales his-tory, market conditions, property’s cur-rent performance (i.e., occupancy andrental rate), project feasibility (i.e., leaseor sale absorption rate), zoning, ease-ments, or deed restrictions

• inadequate techniques of analysis, that

is, failure to use the cost, comparable-sales, or income approach in anappraisal when the approach is appro-priate for the type of property

• use of dissimilar comparables in thecomparable-sales approach to valuation,for example, the age, size, quality, orlocation of the comparable is signifi-cantly different from the subject prop-erty, making reconciliation of valuedifficult

• underestimation of factors such asconstruction cost, construction period,lease-up period, and rent concessions

• use of best-case assumptions for theincome approach to valuation withoutperforming a sensitivity analysis on thefactors that would identify the lender’sdownside risk

• overly optimistic assumptions such as ahigh absorption rate in an overbuilt mar-ket or assumptions on discount andcapitalization rates that do not reflectmarket conditions and investor’sexpected rate of return

• failure to analyze and report appropriatedeductions and discounts when theappraisal provides a market value esti-mate based on the future demand of thereal estate (such as proposed construc-tion, partially leased buildings, non-market lease terms, and unsold units ina residential tract development)

• the nonreconcilement of demographicfactors (such as existing housing inven-tory, projected completions, andexpected market share to the value ren-dered) and the discussion of demo-graphic factors as backgroundinformation

• the opinion of market value includes thevalue of both real property and non-realproperty (e.g., furnishings or an intan-gible asset)

• lack of documentation on the reasonsthat an alternative market value wasused in the credit decision from theopinion of market value provided in theappraisal or evaluation

5. Report any instances of questionable conductby appraisers, along with the supportingdocumentation, to the Reserve Bank for pos-sible referral to the appropriate stateappraisal authorities.

6. Update workpapers with any information thatwill facilitate future inspections.



2231.0.23 INTERNAL CONTROLQUESTIONNAIRE

Review the banking organization’s internalcontrols, policies, practices, and procedures forreal estate appraisals and evaluations. The bank-ing organization’s system should be accuratelyand fully documented and should include,where appropriate, narrative descriptions, flowcharts, copies of forms used, and other pertinentinformation. Items marked with an asteriskrequire substantiation by observation or testing.

2231.0.23.1 Policies

1. Has the board of directors, consistent withits duties and responsibilities, adoptedwritten appraisal and evaluation policiesthat define the following:a. management’s responsibility for select-

ing, evaluating, monitoring, and ensur-ing the independence of the individualwho is performing the appraisal orevaluation?

b. the basis for selecting staff appraisersand engaging fee appraisers for aparticular appraisal assignment and forensuring that the individual isindependent of the transaction; pos-sesses the requisite qualifications,expertise, and educational background;demonstrates competency for themarket and property type; and has therequired state certification or license ifapplicable?

c. procedures for when to obtain apprais-als and evaluations?

d. procedures for prohibiting the use of aborrower-ordered or borrower-providedappraisal?

e. procedures for monitoring collateralrisk on a loan and portfolio basis as towhen to obtain a new appraisal or newevaluation, including the frequency,triggering events, scope of appraisalwork, valuation methods, and reportoption?

f. appraisal and evaluation complianceprocedures to determine that appraisalsand evaluations are reviewed by quali-fied and adequately trained individualswho are not involved in the loan-production process?

g. appraisal and evaluation review proce-dures to ensure that the banking organi-zation’s appraisals and evaluations areconsistent with the standards of the

Uniform Standards of ProfessionalAppraisal Practice (USPAP) and theBoard’s regulation and guidelines?

h. appraisal and evaluation review proce-dures that require the performance ofthe review prior to the credit decision,resolution of noted deficiencies, anddocumentation of the review in thecredit file, and, if necessary, obtaining asecond appraisal or relying on USPAP’sstandard rule 3 in performing a reviewor performing another evaluation?

i. an appropriate level of review forappraisals and evaluations ordered bythe banking organization’s agents orobtained from another financial ser-vices institution?

j. adequate level of oversight when thebanking organization uses a third partyfor appraisal management services?

k. use of analytical methods and techno-logical tools (such as automated valua-tion models or tax assessment valua-tions) in the development ofevaluations that is appropriate for therisk and type of transaction andproperty?

l. internal controls to prevent officers,loan officers, or directors who order orreview appraisals and evaluations fromhaving the sole authority for approvingthe requested loans?

m. procedures for promoting compliancewith the appraisal independence provi-sions of Regulation Z (Truth in Lend-ing) for open- and closed-end consumercredit transactions secured by a con-sumer’s principal dwelling?

2. Does the board of directors annuallyreview these policies and procedures toensure that the appraisal and evaluationpolicies and procedures meet the needs ofthe banking organization’s real estate lend-ing activity and remains compliant withthe Board’s regulation and supervisoryguidance?

2231.0.23.2 Appraisals

*1. Are appraisals in writing, dated, andsigned by the appraiser?

*2. Does the appraisal meet the minimumstandards of the Board’s regulation and



USPAP, and supervisory guidance, con-taining sufficient information and analysisto support the banking organization’s deci-sion to engage in the transaction? Does theappraisal—a. reflect an appropriate scope of work

that will provide for credible results,including the extent to which the prop-erty is identified and inspected, the typeand extent of data research performed,and the analyses applied to arrive at anopinion of market value?

b. disclose the purpose and use of theappraisal?

c. provide an opinion of the collateralmarket value as defined in the Board’sappraisal regulation and further clari-fied in supervisory guidance?

d. provide an effective date for the opin-ion of market value?

e. provide the sales history of the subjectproperty for the prior three years?

f. reflect valuation approaches (that is,cost, income, and sales comparisonapproaches) that are applicable for theproperty type and market?

g. include an analysis and reporting ofappropriate deductions and discountswhen the appraisal provides a marketvalue estimate based on the futuredemand of the real estate (such as pro-posed construction, partially leasedbuildings, non-market lease terms, andunsold units in a residential tractdevelopment)?

h. evaluate and reconcile the threeapproaches into an opinion of marketvalue estimate based on the appraiser’sjudgment?

i. explain why an approach is inappropri-ate and not used in the appraisal?

j. fully support the assumptions and thevalue rendered through adequatedocumentation and information on mar-ket conditions and trends?

k. evaluate key assumptions and potentialramifications to the opinion of marketvalue if these assumptions are notrealized?

l. present an opinion of the collateral’smarket value in an appraisal reportoption that addresses the property type,market, risk, and type of transaction?

m. disclose and define other value opin-ions (such as disposal value of the prop-

erty or the value of non-real property),if the banking organization requestssuch information?

*3. Are appraisals received before the bankingorganization makes its final credit or othercredit decision (for example, is the datethe loan committee approved the creditlater than the date of the appraisal)?

*4. If the banking organization is dependingon an appraisal obtained for another finan-cial services institution as support for itstransaction, does the banking organizationhave appraisal review procedures to ensurethat the appraisal meets the standards ofthe appraisal regulation, including inde-pendence? (These types of transactionswould include loan participations, loanpurchases, and mortgage-backedsecurities.)

*5. If an appraisal for one transaction is usedfor a subsequent transaction, does thebanking organization sufficiently docu-ment its determination that the appraiser isindependent, the appraisal complies withthe appraisal regulations, and the appraisalis still valid?

2231.0.23.3 Appraisers

1. Are appraisers fairly considered forassignments regardless of their member-ship or lack of membership in a particularappraisal organization?

2. Before the banking organization selects anappraiser for an assignment, does thebanking organization confirm that theappraiser has the requisite qualifications,education, experience, and competency forboth the property type and market to com-plete the appraisal?

3. If a banking organization pre-screensappraisers and uses an approved appraiserlist, does it have procedures for assessingan appraiser’s qualifications, selecting anappraiser for a particular assignment, andevaluating the appraiser’s work for reten-tion on the list?

4. The following items apply for large, com-plex, or out-of-area commercial real estateproperties:a. Are written engagement letters used

when ordering appraisals, and are cop-ies of the letters retained or included inthe appraisal report?

b. Does the banking organization haveprocedures for determining when suchappraisals should be reviewed by



another appraiser (that is, a USPAPstandard rule 3 appraisal review)?

5. Are appraisers independent of thetransaction?a. Are staff appraisers independent of the

lending, investment, and collectionfunctions and not involved, except asan appraiser, in the federally relatedtransaction? Has a determination beenmade that they have no direct or indi-rect interest, financial or otherwise, inthe property?

b. Are fee appraisers engaged directly bythe banking organization or its agent?Has a determination been made thatthey have no direct or indirect interest,financial or otherwise, in the propertyor transaction?

c. Are any appraisers recommended orselected by the borrower (applicant)?

6. If the banking organization has staffappraisers to perform appraisals orappraisal reviews, does the banking orga-nization periodically have independentappraisers evaluate their work for qualityand confirm that they have the knowledgeand competency to perform their work andcontinue to hold the appropriate statelicense or certification?

7. If fee appraisers are used by the bankingorganization, does the banking organiza-tion investigate their qualifications,experience, education, background, andreputations?

8. Is the status of an appraiser’s state certi-fication or license verified with the stateappraiser regulatory authority to ensurethat the appraiser is in good standing?

9. Does the banking organization have proce-dures for filing complaints with the appro-priate state appraiser regulatory officialswhen it suspects the fee appraiser failed tocomply with USPAP, applicable state laws,or engaged in other unethical or unprofes-sional conduct?

10. Are fee appraisers paid the same feewhether or not the loan is granted?

11. Does the banking organization pay a cus-tomary and reasonable fee for appraisalservices in the market where the propertyis located when the appraisal is for anopen- and closed-end consumer credittransaction secured by a consumer’s prin-cipal dwelling as required under Regula-tion Z?

2231.0.23.4 Evaluations

1. Are the individuals performing evalua-tions independent of the transaction?

*2. Are the evaluations required to be in writ-ing, dated, and signed?

*3. Does the banking organization require suf-ficient information and documentation tosupport the estimate of value and the indi-vidual’s analysis?

*4. Are the development and content of theevaluation reflective of transaction riskand appropriate for the property type?

*5. Are the valuation methods used, and doesthe supporting information in the evalua-tion provide a reliable estimate of theproperty’s market value as of a statedeffective date prior to the credit decision?

*6. If analytical methods or technologicaltools are used in the development of anevaluation, is the use of the method or toolconsistent with safe and sound bankingpractices and supervisory guidance?

*7. If an evaluation obtained for one transac-tion is used for a subsequent transaction,does the banking organization sufficientlydocument its determination that the evalu-ation is still valid?

*8. Are evaluations received before the bank-ing organization enters into a loan commit-ment?

*9. Does the banking organization have evalu-ation review procedures to ensure that theevaluation meets the Board’s regulationand guidance?

*10. If a tax assessment valuation is used in thedevelopment of an evaluation, has thebanking organization demonstrated thatthere is a valid correlation between the taxassessment data and the property’s marketvalue?

2231.0.23.5 Evaluators

1. Are individuals who perform evaluationscompetent to complete the assignment?

2. Do the individuals who perform evalua-tions possess the appropriate collateralvaluation training, expertise, and experi-ence relevant to the type of property beingvalued?

3. Are evaluations prepared by individualswho are independent of the transaction?



2231.0.23.6 Monitoring Collateral Values

1. Does the banking organization have poli-cies to monitor collateral risk on a port-folio and on an individual credit basis?

2. Does the policy address the need to obtaincurrent valuation information for collat-eral supporting an existing credit that maybe modified or considered for a loanworkout?

3. Does the criteria for determining when toobtain a new appraisal or new evaluationaddress deterioration in the credit; mate-rial changes in market conditions; andrevisions to, or delays in, the project’sdevelopment and construction?

4. Does the banking organization sufficientlydocument and follow its criteria for obtain-ing reappraisals or reevaluations?

2231.0.23.7 Third Party Arrangements

1. Did the banking organization exerciseappropriate due diligence in the selectionof a third party to perform appraisal man-agement services for the banking organiza-tion?

2. Does the banking organization have theresources and expertise necessary for per-forming ongoing oversight of such thirdparty arrangements?

3. Does the banking organization have theinternal controls for identifying, monitor-ing, and managing the risks associatedwith the use of the third party?

4. Does the banking organization adequatelydocument the results of its ongoing moni-toring and periodic assessments of thethird party’s compliance with applicableregulations and consistency with supervi-sory guidance?

5. Does the banking organization take timelyremedial actions when deficiencies are dis-covered?

6. Does the banking organization ensure thatthe third party selects an appraiser or aperson to perform an evaluation who iscompetent, qualified, independent, andappropriately licensed or certified for agiven assignment?

7. Does the banking organization ensure thatthe third party conveys to the appraiser orthe person who performs the evaluationthat the banking organization is the client?

2231.0.23.8 Analytical Methods AndTechnological Tools

1. Does the banking organization have staff,or if necessary engage a third party, withthe requisite expertise and training to man-age the selection, use, and validation of ananalytical method or technological tool?

2. Does the banking organization haveadequate policies, procedures, and internalcontrols governing the selection, use, andvalidation of the valuation method or toolfor the development of an evaluation?

3. Does the banking organization have appro-priate policies and procedures governingthe selection of automated valuation model(AVM)? For instance, did the bankingorganization:• Perform the necessary level of due dili-

gence in selecting an AVM vendor andits models, considering how modeldevelopers conducted performance test-ing as well as the sample size used andthe geographic level tested (such ascounty level or zip code).

• Establish acceptable minimum perfor-mance criteria for a model prior to, andindependent of, the validation process.

• Perform validation of the model(s) dur-ing the selection process and documentthe validation process.

• Evaluate underlying data used in themodel(s), including the data sources andtypes, frequency of updates, quality con-trol performed on the data, and thesources of the data in states where pub-lic real estate sales data are not dis-closed.

• Assess modeling techniques and theinherent strengths and weaknesses ofdifferent model types as well as how amodel(s) performs for different propertytypes.

• Evaluate the AVM vendor’s scoring sys-tem and methodology for the model(s).

• Determine whether the scoring systemprovides an appropriate indicator ofmodel reliability by property types andgeographic locations.

4. Does the banking organization have proce-dures for monitoring the use of anAVM(s), including an ongoing validationprocess?

5. Does the banking organization maintainAVM performance criteria for accuracyand reliability in a given transaction, lend-ing activity, and geographic location?

6. Has the banking organization established a



criteria for determining whether a particu-lar valuation method or tool is appropriatefor a given transaction or lending activity,considering associated risks, includingtransaction size and purpose, credit qual-ity, and leverage tolerance (loan-to-value)?

7. Does the criteria consider when marketevents or risk factors would preclude theuse of a particular method or tool?

8. Does the banking organization have inter-nal controls to preclude ‘‘value shopping’’when more than one AVM is used for thesame property?

9. Do the banking organization’s policiesinclude standards governing the use ofmultiple methods or tools, if applicable,for valuing the same property or to supporta particular lending activity?

10. Does the banking organization have appro-priate controls to ensure that the selectedmethod or tool produces a reliable esti-mate of market value that supports thebanking organization’s decision to engagein a transaction?

11. Do the banking organization’s policies andprocedures adequately address the extentto which• An inspection or research should be per-

formed to ascertain the property’s actualphysical condition, and

• Supplemental information should beobtained to assess the effect of marketconditions or other factors on the esti-mate of market value.


Subject Laws 1 Regulations 2 Interpretations 3 Orders

Appraisal standards forfederally relatedtransactions

3310,3331,3351

Subpart G,225.61–67

4-053–4-054.4

Interagency Appraisal andEvalutation Guidelines,December 2010

3-1577

The Uniform Standards ofProfessional AppraisalPractice

1. 12 U.S.C., unless specifically stated otherwise.2. 12 C.F.R., unless specifically stated otherwise.3. Federal Reserve Regulatory Service reference.



Guidelines for the Review and Classificationof Troubled Real Estate Loans Section 2240.0

These guidelines are designed to in ensure thattroubled real estate loans receive consistenttreatment nationwide. The guidelines are notintended to be a substitute for the examiner’sjudgment or for careful analysis of applicablecredit and collateral factors. Use of the word‘‘institution’’ in these guidelines refers to anylending source within the bank holding com-pany organization, whether the lender is theparent company, a bank, thrift, or nonbankingsubsidiary.

2240.0.1 EXAMINER REVIEW OFCOMMERCIAL REAL ESTATELOANS

2240.0.1.1 Loan Policy andAdministration Review

As part of the analysis of an institution’s com-mercial real estate loan portfolio, examinersreview lending policies, loan administration pro-cedures, and credit risk control procedures. Themaintenance of prudent written lending policies,effective internal systems and controls, andthorough loan documentation are essential tothe institution’s management of the lendingfunction.The policies governing an institution’s real

estate lending activities must include prudentunderwriting standards that are periodicallyreviewed by the board of directors and clearlycommunicated to the institution’s managementand lending staff. The institution must also havecredit risk control procedures that include, forexample, prudent internal limits on exposure, aneffective credit review and classification pro-cess, and a methodology for ensuring that theallowance for loan and lease losses is main-tained at an adequate level. The complexity andscope of these policies and procedures shouldbe appropriate to the size of the institution andthe nature of the institution’s activities, andshould be consistent with prudent banking prac-tices and relevant regulatory requirements.

2240.0.1.2 Indicators of Troubled RealEstate Markets and Projects, and RelatedIndebtedness

In order to evaluate the collectibility of an insti-tution’s commercial real estate portfolio, exam-iners should be alert for indicators of weaknessin the real estate markets served by the institu-tion. They should also be alert for indicators of

actual or potential problems in the individualcommercial real estate projects or transactionsfinanced by the institution.There are several warning signs that real

estate markets or projects are experiencing prob-lems that may result in real estate valuesdecreasing from original appraisals or projec-tions. Adverse economic developments and/oran overbuilt market can affect a project’s eco-nomic feasibility and may cause a real estateproject and the loan to become troubled. Avail-able indicators, such as permits for—and thevalue of—new construction, absorption rates,employment trends, and vacancy rates, are use-ful in evaluating the condition of commercialreal estate markets. Weaknesses disclosed bythese types of statistics may indicate that a realestate market is experiencing difficulties thatmay result in cash flow problems for individualreal estate projects, declining real estate values,and ultimately, in troubled commercial realestate loans.Indicators of potential or actual difficulties in

commercial real estate projects may include:

• An excess of similar projects underconstruction.

• Construction delays or other unplannedadverse events resulting in cost overruns thatmay require renegotiation of loan terms.

• Lack of a sound feasibility study or analysisthat reflects current and reasonably antici-pated market conditions.

• Changes in concept or plan (for example, acondominium project converted to an apart-ment project because of unfavorable marketconditions).

• Rent concessions or sales discounts resultingin cash flow below the level projected in theoriginal feasibility study or appraisal.

• Concessions on finishing tenant space, mov-ing expenses, and lease buyouts.

• Slow leasing or lack of sustained sales activ-ity and increasing sales cancellations that mayreduce the project’s income potential, result-ing in protracted repayment or default on theloan.

• Delinquent lease payments from majortenants.

• Land values that assume future rezoning.• Tax arrearages.

As the problems associated with a commer-


cial real estate project become more pro-nounced, problems with the related indebted-ness may also arise. Such problems includediminished cash flow to service the debt anddelinquent interest and principal payments.While some commercial real estate loans

become troubled because of a general downturnin the market, others become troubled becausethey were originated on an unsound or a liberalbasis. Common examples of these types of prob-lems include:

• Loans with no or minimal borrower equity.• Loans on speculative undeveloped propertywhere the borrowers’ only source of repay-ment is the sale of the property.

• Loans based on land values that have beendriven up by rapid turnover of ownership, butwithout any corresponding improvements tothe property or supportable income projec-tions to justify an increase in value.

• Additional advances to service an existingloan that lacks credible support for full repay-ment from reliable sources.

• Loans to borrowers with no developmentplans or noncurrent development plans.

• Renewals, extensions and refinancings thatlack credible support for full repayment fromreliable sources and that do not have a reason-able repayment schedule.1

2240.0.1.3 Examiner Review ofIndividual Loans, Including the Analysisof Collateral Value

The focus of an examiner’s review of a commer-cial real estate loan, including binding commit-ments, is the ability of the loan to be repaid. Theprincipal factors that bear on this analysis arethe income-producing potential of the under-lying collateral and the borrower’s willingnessand capacity to repay under the existing loanterms from the borrower’s other resources ifnecessary. In evaluating the overall risk associ-ated with a commercial real estate loan, examin-ers consider a number of factors, including thecharacter, overall financial condition and

resources, and payment record of the borrower;the prospects for support from any financiallyresponsible guarantors; and the nature anddegree of protection provided by the cash flowand value of the underlying collateral.2 How-ever, as other sources of repayment for atroubled commercial real estate loan becomeinadequate over time, the importance of thecollateral’s value in the analysis of the loannecessarily increases.The appraisal regulations of the federal bank

and thrift regulatory agencies require institu-tions to obtain appraisals when certain criteriaare met.3 Management is responsible for review-ing each appraisal’s assumptions and conclu-sions for reasonableness. Appraisal assumptionsshould not be based solely on current conditionsthat ignore the stabilized income-producingcapacity of the property.4 Management shouldadjust any assumptions used by an appraiser indetermining value that are overly optimistic orpessimistic.An examiner analyzes the collateral’s value

as determined by the institution’s most recentappraisal (or internal evaluation, as applicable).An examiner reviews the major facts, assump-tions, and approaches used by the appraiser(including any comments made by managementon the value rendered by the appraiser). Underthe circumstances described below, the exam-iner may make adjustments to this assessmentof value. This review and any resulting adjust-ments to value are solely for purposes of anexaminer’s analysis and classification of a creditand do not involve actual adjustments to anappraisal.A discounted cash flow analysis is an appro-

priate method for estimating the value ofincome-producing real estate collateral.5 Thisanalysis should not be based solely on the cur-rent performance of the collateral or similar

1. As discussed more fully in Manual section 2240.0.2, therefinancing or renewing of loans to sound borrowers wouldnot result in a supervisory classification or criticism unlesswell-defined weaknesses exist that jeopardize repayment ofthe loans. Consistent with sound banking practices, institu-tions should work in an appropriate and constructive mannerwith borrowers who may be experiencing temporarydifficulties.

2. The treatment of guarantees in the classification processis discussed in subsection 2240.0.3.3. Department of the Treasury, Office of the Comptroller

of the Currency, 12 CFR Part 34 (Docket No. 90–16); Boardof Governors of the Federal Reserve System, 12 CFR Parts208 and 225 (Regulation H and Y; Docket No. R–0685);Federal Deposit Insurance Corporation, 12 CFR 323 (RIN3064–AB05); Department of the Treasury; Office of ThriftSupervision, 12 CFR Part 564 (Docket No. 90–1495).4. Stabilized income generally is defined as the yearly net

operating income produced by the property at normal occu-pancy and rental rates; it may be adjusted upward or down-ward from today’s actual market conditions.5. The real estate appraisal regulations of the federal bank

and thrift regulatory agencies include a requirement that anappraisal (a) follow a reasonable valuation method thataddresses the direct sales comparison, income, and costapproaches to market value; (b) reconcile these approaches;and (c) explain the elimination of each approach not used. Adiscounted cash flow analysis is recognized as a valuationmethod for the income approach.

Guidelines for the Review and Classification of Troubled Real Estate Loans 2240.0


properties; rather, it should take into account, ona discounted basis, the ability of the real estateto generate income over time based upon rea-sonable and supportable assumptions.When reviewing the reasonableness of the

facts and assumptions associated with the valueof the collateral, examiners may evaluate:

• Current and projected vacancy and absorptionrates;

• Lease renewal trends and anticipated rents;• Volume and trends in past due leases;• Effective rental rates or sale prices (takinginto account all concessions);

• Net operating income of the property as com-pared with budget projections; and

• Discount rates and direct capitalization(‘‘cap’’) rates.

The capacity of a property to generate cashflow to service a loan is evaluated based uponrents (or sales), expenses, and rates of occu-pancy that are reasonably estimated to beachieved over time. The determination of thelevel of stabilized occupancy and rental ratesshould be based upon an analysis of current andreasonably expected market conditions, takinginto consideration historical levels when appro-priate. The analysis of collateral values shouldnot be based upon a simple projection of currentlevels of net operating income if markets aredepressed or reflect speculative pressures butcan be expected over a reasonable period oftime to return to normal (stabilized) conditions.Judgment is involved in determining the timethat it will take for a property to achieve stabi-lized occupancy and rental rates.Examiners do not make adjustments to ap-

praisal assumptions for credit analysis purposesbased on worst case scenarios that are unlikelyto occur. For example, an examiner would notnecessarily assume that a building will becomevacant just because an existing tenant who isrenting at a rate above today’s market rate mayvacate the property when the current leaseexpires. On the other hand, an adjustment tovalue may be appropriate for credit analysispurposes when the valuation assumes renewal atthe above-market rate, unless that rate is a rea-sonable estimate of the expected market rate atthe time of renewal.When estimating the value of income-

producing real estate, discount rates and ‘‘cap’’rates should reflect reasonable expectationsabout the rate of return that investors requireunder normal, orderly and sustainable marketconditions. Exaggerated, imprudent, or unsus-tainably high or low discount rates, ‘‘cap’’ rates,

and income projections should not be used.Direct capitalization of nonstabilized incomeflows should also not be used.Assumptions, when recently made by quali-

fied appraisers (and, as appropriate, by institu-tion management) and when consistent with thediscussion above, should be given a reasonableamount of deference. Examiners should notchallenge the underlying assumptions, includingdiscount rates and ‘‘cap’’ rates used in apprais-als, that differ only in a limited way from normsthat would generally be associated with theproperty under review. The estimated value ofthe underlying collateral may be adjusted forcredit analysis purposes when the examiner canestablish that any underlying facts or assump-tions are inappropriate and can support alterna-tive assumptions.

2240.0.2 CLASSIFICATIONGUIDELINES

As with other types of loans, commercial realestate loans that are adequately protected by thecurrent sound worth and debt service capacityof the borrower, guarantor, or the underlyingcollateral generally are not classified. Similarly,loans to sound borrowers that are refinanced orrenewed in accordance with prudent underwrit-ing standards, including loans to creditworthycommercial or residential real estate developers,should not be classified or criticized unless well-defined weaknesses exist that jeopardize repay-ment. An institution will not be criticized forcontinuing to carry loans having weaknessesthat result in classification or criticism as longas the institution has a well-conceived and effec-tive workout plan for such borrowers, and effec-tive internal controls to manage the level ofthese loans.In evaluating commercial real estate credits

for possible classification, examiners apply stan-dard classification definitions. In determiningthe appropriate classification, considerationshould be given to all important information onrepayment prospects, including information onthe borrower’s creditworthiness, the value of,and cash flow provided by, all collateral support-ing the loan, and any support provided by finan-cially responsible guarantors.The loan’s record of performance to date is

important and must be taken into consideration.As a general principle, a performing commer-cial real estate loan should not automatically be



classified or charged-off solely because thevalue of the underlying collateral has declinedto an amount that is less than the loan balance.However, it would be appropriate to classify aperforming loan when well-defined weaknessesexist that jeopardize repayment, such as the lackof credible support for full repayment from reli-able sources.These principles hold for individual credits,

even if portions or segments of the industry towhich the borrower belongs are experiencingfinancial difficulties. The evaluation of eachcredit should be based upon the fundamentalcharacteristics affecting the collectibility of theparticular credit. The problems broadly associ-ated with some sectors or segments of an indus-try, such as certain commercial real estate mar-kets, should not lead to overly pessimisticassessments of particular credits that are notaffected by the problems of the troubled sectors.

2240.0.2.1 Classification of TroubledProject-Dependent Commercial RealEstate Loans6

The following guidelines for classifying a trou-bled commercial real estate loan apply when therepayment of the debt will be provided solely bythe underlying real estate collateral, and thereare no other available and reliable sources ofrepayment. The guidelines are not intended toaddress loans that must be treated as ‘‘OtherReal Estate Owned’’ for bank and BHC report-ing purposes.As a general principle, for a troubled project-

dependent commercial real estate loan, any por-tion of the loan balance that exceeds the amountthat is adequately secured by the value of thecollateral, and that can clearly be identified asuncollectible, should be classified ‘‘loss.’’7 Theportion of the loan balance that is adequatelysecured by the value of the collateral shouldgenerally be classified no worse than ‘‘substan-dard.’’ The amount of the loan balance in excessof the value of the collateral, or portions thereof,

should be classified ‘‘doubtful’’ when the poten-tial for full loss may be mitigated by the out-comes of certain pending events, or when loss isexpected but the amount of the loss cannot bereasonably determined.If warranted by the underlying circumstances,

an examiner may use a ‘‘doubtful’’ classifica-tion on the entire loan balance. However, thiswould occur infrequently.

2240.0.2.2 Guidelines for ClassifyingPartially Charged-off Loans

Based upon consideration of all relevant factors,an evaluation may indicate that a credit haswell-defined weaknesses that jeopardize collec-tion in full, but that a portion of the loan may bereasonably assured of collection. When an insti-tution has taken a charge-off in an amount suffi-cient that the remaining recorded balance of theloan (a) is being serviced (based upon reliablesources) and (b) is reasonably assured of collec-tion, classification of the remaining recordedbalance may not be appropriate. Classificationwould be appropriate when well-defined weak-nesses continue to be present in the remainingrecorded balance. In such cases, the remainingrecorded balance would generally be classifiedno more severely than ‘‘substandard.’’A more severe classification than ‘‘substan-

dard’’ for the remaining recorded balance wouldbe appropriate if the loss exposure cannot bereasonably determined, e.g., where significantrisk exposures are perceived, such as might bethe case for bankruptcy situations or for loanscollateralized by properties subject to environ-mental hazards. In addition, classification of theremaining recorded balance would be appropri-ate when sources of repayment are consideredunreliable.

2240.0.2.3 Guidelines for ClassifyingFormally Restructured Loans

The classification treatment previously dis-cussed for a partially charged off loan wouldalso generally be appropriate for a formallyrestructured loan when partial charge-offs havebeen taken. For a formally restructured loan, thefocus of the examiner’s analysis is on the abilityof the borrower to repay the loan in accordancewith its modified terms. Classification of a for-mally restructured loan would be appropriate, if,after the restructuring, well-defined weaknessesexist that jeopardize the orderly repayment ofthe loan in accordance with reasonable modified

6. The discussion in this section is not intended to addressloans that must be treated as ‘‘other real estate owned’’ forbank regulatory reporting purposes or ‘‘real estate owned’’ forthrift regulatory reporting purposes. Guidance on these assetsis presented in supervisory and reporting guidance of theagencies.7. For purposes of this discussion, the ‘‘value of the collat-

eral’’ is the value used by the examiner for credit analysispurposes, as discussed in a previous section of this policystatement.



terms.8 Troubled commercial real estate loanswhose terms have been restructured shouldbe identified in the institution’s internal creditreview system, and closely monitored bymanagement.

2240.0.3 TREATMENT OFGUARANTEES IN THECLASSIFICATION PROCESS

Initially, the original source of repayment andthe borrower’s intent and ability to fulfill theobligation without reliance on third party guar-antors will be the primary basis for the reviewand classification of assets.9 The federal bankand thrift regulatory agencies will, however,consider the support provided by guarantees inthe determination of the appropriate classifica-tion treatment for troubled loans. The presenceof a guarantee from a ‘‘financially responsibleguarantor,’’ as described below, may be suffi-cient to preclude classification or reduce theseverity of classification.For purposes of this discussion, a guarantee

from a ‘‘financially responsible guarantor’’ hasthe following attributes:

• The guarantor must have both the financialcapacity and willingness to provide supportfor the credit;

• The nature of the guarantee is such that it canprovide support for repayment of the indebt-edness, in whole or in part, during the remain-ing loan term; and10

• The guarantee should be legally enforceable.

The above characteristics generally indicatethat a guarantee may improve the prospects forrepayment of the debt obligation.

2240.0.3.1 Considerations Relating to aGuarantor’s Financial Capacity

The lending institution must have sufficient

information on the guarantor’s financial condi-tion, income, liquidity, cash flow, contingentliabilities, and other relevant factors (includingcredit ratings, when available) to demonstratethe guarantor’s financial capacity to fulfill theobligation. Also, it is important to consider thenumber and amount of guarantees currentlyextended by a guarantor, in order to determinethat the guarantor has the financial capacity tofulfill the contingent claims that exist.

2240.0.3.2 Considerations Relating to aGuarantor’s Willingness to Repay

Examiners normally rely on their analysis of theguarantor’s financial strength and assume a will-ingness to perform unless there is evidence tothe contrary. This assumption may be modifiedbased on the ‘‘track record’’ of the guarantor,including payments made to date on the assetunder review or other obligations.Examiners give due consideration to those

guarantors that have demonstrated their abilityand willingness to fulfill previous obligations intheir evaluation of current guarantees on similarassets. An important consideration will bewhether previously required performance underguarantees was voluntary or the result of legalor other actions by the lender to enforce theguarantee. However, examiners give limited cre-dence, if any, to guarantees from obligors whohave reneged on obligations in the past, unlessthere is clear evidence that the guarantor has theability and intent to honor the specific guaranteeobligation under review.Examiners also consider the economic incen-

tives for performance from guarantors:

• Who have already partially performed underthe guarantee or who have other significantinvestments in the project;

• Whose other sound projects are cross-collateralized or otherwise intertwined withthe credit; or

• Where the guarantees are collateralized byreadily marketable assets that are under thecontrol of a third party.

2240.0.3.3 Other Considerations as to theTreatment of Guarantees in theClassification Process

In general, only guarantees that are legally

8. An example of a restructured commercial real estateloan that doesnothave reasonable modified terms would be a‘‘cash flow’’ mortgage which requires interest paymentsonlywhen the underlying collateral generates cash flow but pro-vides no substantive benefits to the lending institution.9. Some loans are originated based primarily upon the

financial strength of the guarantor, who is, in substance, theprimary source of repayment. In such circumstances, examin-ers generally assess the collectibility of the loan based uponthe guarantor’s ability to repay the loan.10. Some guarantees may only provide for support for

certain phases of a real estate project. It would not be appro-priate to rely upon these guarantees to support a troubled loanafter the completion of these phases.



enforceable will be relied upon. However, alllegally enforceable guarantees may not beacceptable. In addition to the guarantor’s finan-cial capacity and willingness to perform, it isexpected that the guarantee will not be subjectto significant delays in collection, or undue com-plexities or uncertainties about the guarantee.The nature of the guarantee is also considered

by examiners. For example, some guarantees forreal estate projects only pertain to the develop-ment and construction phases of the project. As

such, these limited guarantees would not berelied upon to support a troubled loan after thecompletion of those phases.Examiners also consider the institution’s

intent to enforce the guarantee and whetherthere are valid reasons to preclude an institutionfrom pursuing the guarantee. A history of timelyenforcement and successful collection of the fullamount of guarantees will be a positive consid-eration in the classification process.



Retail-Credit ClassificationSection 2241.0

During the early 1980s, open-end credit prima-rily consisted of credit card accounts with smalllines of credit to the most creditworthy borrow-ers. Currently, open-end credit consists of muchlarger lines of credit that have been extended todiverse borrowers with a variety of risk profiles.In 1980, the Federal Financial InstitutionsExamination Council (FFIEC) (the FederalReserve Board, Federal Deposit Insurance Cor-poration, Office of the Comptroller of the Cur-rency, and, in 1987, the Federal Home LoanBank Board (now the Office of Thrift Supervi-sion)) adopted a uniform policy for the classifi-cation of installment credit based on delin-quency status. The 1980 policy also providedfor different charge-off time frames for open-end and closed-end credit.

Because open-ended borrowing practices hadchanged and institutional practices for chargingoff open-end accounts based on their past-duestatus were inconsistent, the agencies (the FRB,FDIC, OTS, and OCC) undertook a review ofthe 1980 FFIEC classification policy in concertwith a review of all written policies, as man-dated by section 303(a) of the Riegle Commu-nity Development and Regulatory ImprovementAct of 1994 (RCDRIA). In February 1999, anupdated policy was issued, effective for use onFFIEC bank call reports beginning December31, 2000. This new policy was revised againand reissued in June 2000, with the same effec-tive date. (The June 2000 policy supersedesboth the 1980 policy and the updated February1999 policy.) The June policy provides supervi-sory guidance for residential and home equityloans; fraudulent loans; loans to deceased per-sons; loans to borrowers in bankruptcy; treat-ment of partial payments involving past-dueloans; and re-aging, deferrals, renewals, orrewrites of open-end and closed-end credit. Theagencies are to use this expanded supervisoryguidance when applying the uniform classifica-tions to retail-credit loans extended by deposi-tory institutions. See SR-00-8.

While the terms of the revised policy applyonly to federally insured depository institutions,the Federal Reserve believes the guidance isbroadly applicable to bank holding companies(BHCs) and their nonbank lending subsidiaries.Accordingly, examiners should apply therevised policy, as appropriate, in the inspectionof consumer finance subsidiaries of BHCs.

When reviewing consumer finance subsidi-aries of banking organizations, examinersshould consider the methodology used for agingretail loans. In accordance with the FFIEC bank

call report instructions, banks and their con-sumer finance subsidiaries are required to usethe contractual method, which ages loans basedon the status of contractual payments. BHCs, inpreparing their financial statements, are permit-ted to use the range of options available underGAAP. This, in effect, allows uninsured, non-bank consumer finance subsidiaries of BHCs toemploy the recency method, which ages loansaccording to the date of the most recent pay-ment, regardless of the contractual terms of theloan.

In general, the contractual method provides amore accurate reflection of loan performanceand, therefore, is the preferred methodology,especially from the standpoint of financial-statement transparency and public disclosure.Examiners should encourage BHCs and theirconsumer finance subsidiaries to use the con-tractual method. However, BHCs should notchange their aging methodology from contrac-tual to recency without the prior concurrence ofthe Federal Reserve. A BHC subsidiary may notchange its methodology if the intent or effect ofsuch a change is to mask asset quality or finan-cial weaknesses. Moreover, in the event thatconsumer receivables are transferred from abank to its BHC or the BHC’s nonbankingsubsidiaries, the BHC or the nonbanking subsid-iaries should continue to age the receivablesaccording to the contractual method.

When a BHC uses the recency method, itshould have adequate controls in place to accu-rately track the performance of loans within theretail portfolio and to demonstrate sound andcompelling business reasons for the use of therecency method. Examiners should see section3100.0 for further guidance on the review ofconsumer finance operations.

2241.0.1 UNIFORM RETAIL-CREDITCLASSIFICATION ANDACCOUNT-MANAGEMENT POLICY

The uniform retail-credit classification andaccount-management policy issued by theFFIEC (and approved by the Federal ReserveBoard) is reproduced below. The Board hasclarified certain provisions of this policy. In thistext, the Board’s revisions are in brackets. Sec-tion numbers have also been added to the sub-titles of the text.


The Uniform Retail-Credit Classification andAccount-Management Policy1 establishes stan-dards for the classification and treatment ofretail credit in financial institutions. Retail creditconsists of open- and closed-end credit extendedto individuals for household, family, and otherpersonal expenditures, and includes consumerloans and credit cards. For purposes of thispolicy, retail credit also includes loans to indi-viduals secured by their personal residence,including first mortgage, home equity, andhome-improvement loans. Because a retail-credit portfolio generally consists of a largenumber of relatively small-balance loans, evalu-ating the quality of the retail-credit portfolio ona loan-by-loan basis is inefficient and burden-some for the institution being examined and forexaminers.

Actual credit losses on individual retail cred-its should be recorded when the institutionbecomes aware of the loss, but in no case shouldthe charge-off exceed the time frames stated inthis policy. This policy does not preclude aninstitution from adopting a more conservativeinternal policy. Based on collection experience,when a portfolio’s history reflects high lossesand low recoveries, more conservative stan-dards are appropriate and necessary.

The quality of retail credit is best indicated bythe repayment performance of individual bor-rowers. Therefore, in general, retail creditshould be classified based on the followingcriteria:

1. Open- and closed-end retail loans past due90 cumulative days from the contractual duedate should be classified substandard.

2. Closed-end retail loans that become past due120 cumulative days and open-end retailloans that become past due 180 cumulativedays from the contractual due date should beclassified loss and charged off.2 In lieu of

charging off the entire loan balance, loanswith non–real estate collateral may be writ-ten down to the value of the collateral, lesscost to sell, if repossession of collateral isassured and in process.

3. One- to four-family residential real estateloans and home equity loans that are past due90 days or more with loan-to-value ratiosgreater than 60 percent should be classifiedsubstandard. Properly secured residential realestate loans with loan-to-value ratios equal toor less than 60 percent are generally notclassified based solely on delinquency status.Home equity loans to the same borrower atthe same institution as the senior mortgageloan with a combined loan-to-value ratioequal to or less than 60 percent need not beclassified. However, home equity loanswhere the institution does not hold the seniormortgage, that are past due 90 days or moreshould be classified substandard, even if theloan-to-value ratio is equal to, or less than,60 percent.

For open- and closed-end loans secured byresidential real estate, a current assessmentof value should be made no later than 180days past due. Any outstanding loan balancein excess of the value of the property, lesscost to sell, should be classified loss andcharged off.

4. Loans in bankruptcy should be classified lossand charged off within 60 days of receipt ofnotification of filing from the bankruptcycourt or within the time frames specified inthis classification policy, whichever isshorter, unless the institution can clearlydemonstrate and document that repayment islikely to occur. Loans with collateral may bewritten down to the value of the collateral,less cost to sell. Any loan balance notcharged off should be classified substandarduntil the borrower re-establishes the abilityand willingness to repay for a period of atleast six months.

5. Fraudulent loans should be classified lossand charged off no later than 90 days ofdiscovery or within the time frames adoptedin this classification policy, whichever isshorter.

6. Loans of deceased persons should be classi-fied loss and charged off when the loss isdetermined or within the time frames adoptedin this classification policy, whichever isshorter.

1. [For the Federal Reserve’s depository institution classi-fication guidelines, see section 2060.1, ‘‘Classification ofCredits,’’ in the Commercial Bank Examination Manual.]

2. For operational purposes, whenever a charge-off is nec-essary under this policy, it should be taken no later than theend of the month in which the applicable time period elapses.Any full payment received after the 120- or 180-day charge-off threshold, but before month-end charge-off, may be con-sidered in determining whether the charge-off remainsappropriate.

OTS regulation 12 CFR 560.160(b) allows savings institu-tions to establish adequate (specific) valuation allowances forassets classified loss in lieu of charge-offs.

Open-end retail accounts that are placed on a fixed repay-ment schedule should follow the charge-off time frame forclosed-end loans.

Retail-Credit Classification 2241.0


2241.0.1.1 Other Considerations forClassification

If an institution can clearly document that apast-due loan is well secured and in the processof collection, such that collection will occurregardless of delinquency status, then the loanneed not be classified. A well-secured loan iscollateralized by a perfected security interest in,or pledges of, real or personal property, includ-ing securities with an estimable value, less costto sell, sufficient to recover the recorded invest-ment in the loan, as well as a reasonable returnon that amount. ‘‘In the process of collection’’means that either a collection effort or legalaction is proceeding and is reasonably expectedto result in recovery of the loan balance or itsrestoration to a current status, generally withinthe next 90 days.

2241.0.1.2 Partial Payments on Open-and Closed-End Credit

Institutions should use one of two methods torecognize partial payments. A payment equiva-lent to 90 percent or more of the contractualpayment may be considered a full payment incomputing past-due status. Alternatively, theinstitution may aggregate payments and givecredit for any partial payment received. Forexample, if a regular installment payment is$300 and the borrower makes payments of only$150 per month for a six-month period, [theinstitution could aggregate the paymentsreceived ($150 × six payments, or $900). Itcould then give credit for three full months($300 x three payments) and thus treat the loanas] three full months past due. An institutionmay use either or both methods in its portfolio,but may not use both methods simultaneouslywith a single loan.

2241.0.1.3 Re-aging, Extensions,Deferrals, Renewals, and Rewrites

Re-aging of open-end accounts, and extensions,deferrals, renewals, and rewrites of closed-endloans3 can be used to help borrowers overcome

temporary financial difficulties, such as loss ofjob, medical emergency, or change in familycircumstances like loss of a family member. Apermissive policy on re-agings, extensions,deferrals, renewals, or rewrites can cloud thetrue performance and delinquency status of theportfolio. However, prudent use is acceptablewhen it is based on a renewed willingness andability to repay the loan, and when it is struc-tured and controlled in accordance with soundinternal policies.

Management should ensure that comprehen-sive and effective risk management and internalcontrols are established and maintained so thatre-ages, extensions, deferrals, renewals, andrewrites can be adequately controlled and moni-tored by management and verified by examin-ers. The decision to re-age, extend, defer, renew,or rewrite a loan, like any other modification ofcontractual terms, should be supported in theinstitution’s management information systems.Adequate management information systemsusually identify and document any loan that isre-aged, extended, deferred, renewed, or rewrit-ten, including the number of times such actionhas been taken. Documentation normally showsthat the institution’s personnel communicatedwith the borrower, the borrower agreed to paythe loan in full, and the borrower has the abilityto repay the loan. To be effective, managementinformation systems should also monitor andtrack the volume and performance of loans thathave been re-aged, extended, deferred, renewed,or rewritten and/or placed in a workout program.

2241.0.1.4 Open-End Accounts

Institutions that re-age open-end accountsshould establish a reasonable written policy andadhere to it. To be considered for re-aging, anaccount should exhibit the following:

1. The borrower has demonstrated a renewedwillingness and ability to repay the loan.

3. These terms are defined as follows. Re-age: Returning adelinquent, open-end account to current status without collect-ing (at the time of aging) the total amount of principal,interest, and fees that are contractually due. Extension:Extending monthly payments on a closed-end loan and rollingback the maturity by the number of months extended. Theaccount is shown current upon granting the extension. Ifextension fees are assessed, they should be collected at the

time of the extension and not added to the balance of the loan.Deferral: Deferring a contractually due payment on a closed-end loan without affecting the other terms, including maturity,(or the due date for subsequently scheduled payments,) of theloan. The account is shown current upon granting the deferral.Renewal: Underwriting a matured, closed-end loan generallyat its outstanding principal amount and on similar terms.Rewrite: Underwriting an existing loan by significantly chang-ing its terms, including payment amounts, interest rates, amor-tization schedules, or its final maturity.



2. The account has existed for at least ninemonths.

3. The borrower has made at least three con-secutive minimum monthly payments or theequivalent cumulative amount. Funds maynot be advanced by the institution for thispurpose.

Open-end accounts should not be re-agedmore than once within any twelve-month periodand no more than twice within any five-yearperiod. Institutions may adopt a more conserva-tive re-aging standard; for example, some insti-tutions allow only one re-aging in the lifetime ofan open-end account. Additionally, an over-limit account may be re-aged at its outstandingbalance (including the over-limit balance, inter-est, and fees), provided that no new credit isextended to the borrower until the balance fallsbelow the predelinquency credit limit.

Institutions may re-age an account after itenters a workout program, including internaland third-party debt-counseling services, butonly after receipt of at least three consecutiveminimum monthly payments or the equivalentcumulative amount, as agreed upon under theworkout or debt-management program.Re-aging for workout purposes is limited toonce in a five-year period and is in addition tothe once-in-twelve-months/twice-in-five-yearslimitation described above. To be effective,management information systems should trackthe principal reductions and charge-off historyof loans in workout programs by type ofprogram.

2241.0.1.5 Closed-End Loans

Institutions should adopt and adhere to explicitstandards that control the use of extensions,deferrals, renewals, and rewrites of closed-endloans. The standards should exhibit thefollowing:

1. The borrower should show a renewed will-ingness and ability to repay the loan.

2. The standards should limit the number andfrequency of extensions, deferrals, renewals,and rewrites.

3. Additional advances to finance unpaid inter-est and fees should be prohibited.

Management should ensure that comprehen-sive and effective risk management, reporting,and internal controls are established and main-tained to support the collection process and toensure timely recognition of losses. To be effec-tive, management information systems shouldtrack the subsequent principal reductions andcharge-off history of loans that have beengranted an extension, deferral, renewal, orrewrite.

2241.0.1.6 Examination Considerations

Examiners should ensure that institutions adhereto this policy. Nevertheless, there may beinstances that warrant exceptions to the generalclassification policy. Loans need not be classi-fied if the institution can document clearly thatrepayment will occur irrespective of delin-quency status. Examples might include loanswell secured by marketable collateral and in theprocess of collection, loans for which claims arefiled against solvent estates, and loans supportedby valid insurance claims.

The Uniform Retail-Credit Classification andAccount-Management Policy does not precludeexaminers from classifying individual retail-credit loans that exhibit signs of credit weaknessregardless of delinquency status. Similarly, anexaminer may also classify retail portfolios, orsegments thereof, where underwriting standardsare weak and present unreasonable credit risk,and may criticize account-management prac-tices that are deficient.

In addition to reviewing loan classifications,the examiner should ensure that the institution’sallowance for loan and lease losses providesadequate coverage for probable losses inherentin the portfolio. Sound risk- and account-management systems, including a prudent retail-credit lending policy, measures to ensure andmonitor adherence to stated policy, and detailedoperating procedures, should also be imple-mented. Internal controls should be in place toensure that the policy is followed. Institutionsthat lack sound policies or fail to implement oreffectively adhere to established policies will besubject to criticism.

Issued by the Federal Financial InstitutionsExamination Council on June 6, 2000.



Domestic and Other Reports to Be Submittedto the Federal Reserve Section 2250.0

In carrying out its regulatory and supervisoryresponsibilities, the Board requires the submis-sion of various reports from bank holding com-panies. These reports are an integral part of theBoard’s supervision, monitoring, and surveil-lance functions. Information from these reportsis used to evaluate the performance of bankholding companies, appraise their financial con-dition, and determine their compliance withapplicable laws and regulations. The examinermust review the reports (submitted to the Fed-eral Reserve System) for accuracy and timeli-ness and insist on their being amended if mate-rial errors are found. If inaccurate data aresubmitted, the resulting ratios could concealdeteriorating trends in the company’s financialcondition and performance. Bank holding com-panies should maintain sufficient internal sys-tems and procedures to ensure that reporting isaccomplished according to appropriate regula-tory requirements. Clear, concise, and orderlyworkpapers should support the data presentedand provide a logical tie between report dataand the financial records. For detailed currentinformation on who must submit reports andwhat the reporting requirements are, seethe Board’s public site on the Internet at thefollowing address: www.federalreserve.gov/boarddocs/reportforms.

2250.0.1 PENALTIES FOR ERRORS INREPORTS

Section 8 of the Bank Holding Company Act(the act) was amended to provide for the assess-ment of civil money penalties for the submis-sion of late, false, or misleading reports filed bybank holding companies that are required by theact and Regulation Y and for the failure to filethe required regulatory reports. Financial institu-tions that have adequate procedures to avoidany inadvertent errors but that unintentionallysubmit incorrect information or are minimallylate in publishing or transmitting the reports canbe fined up to $2,000 per day. The financialinstitution has the burden of proving that theerror was inadvertent. If the error was not inad-vertent, a penalty of up to $20,000 per day canbe assessed. If the submission was done in aknowing manner or with reckless disregard forthe law, a fine of up to $1 million or 1 percent ofthe institution’s assets can be assessed for eachday of the violation. Institution-affiliated partieswho participate in any manner in the filing of aninstitution’s false or misleading required regula-

tory report, or who cause the failure to file or alate filing of a required regulatory report, maybe assessed a civil money penalty of up to$25,000 per day.

2250.0.2 APPROVAL OF DIRECTORSAND SENIOR OFFICERS OFDEPOSITORY INSTITUTIONS

The Federal Deposit Insurance Act (12 U.S.C.1811) was amended to require each insureddepository institution and depository institutionholding company to give 30 days’ prior notifica-tion to the federal banking authority of (1) theproposed addition of any individual to its boardof directors or (2) the employment of any indi-vidual as a senior executive officer. This require-ment applies to the following institutions:

1. institutions that have been chartered less thantwo years

2. institutions that have undergone a change incontrol within the preceding two years

3. institutions that are in a troubled condition orwhose capital is below minimum standards

The agencies have the authority to issue a noticeof disapproval to stop the appointment oremployment of an individual if they feel thatappointing or employing the person would notbe in the interests of the public, taking intoaccount that individual’s competence, experi-ence, character, and integrity.


1. To determine that required reports are beingfiled on time.

2. To determine that the contents of reports areaccurate and complete.

3. To recommend corrective and, if needed, for-mal enforcement action when official report-ing practices, policies, or procedures aredeficient.


1. A bank holding company’s historical recordconcerning the timely submission of reportsshould be ascertained by reviewing relevant


Reserve Bank files. The examiner shoulddetermine, from documentation in the files,which reports should have been filed becauseof the passage of time or the occurrence of anevent. If a report is delinquent, the bankholding company should be instructed to pre-pare and submit the report expeditiously.

2. Copies of regulatory reports filed since theprior inspection should be reviewed andcompared with company records on a ran-dom, line-by-line basis, using a significancetest. In some cases, the review will necessar-ily extend to supporting schedules and work-papers that substantiate the data reflected inthe reports. If the initial reports reviewed arefound to be substantially correct, then thescope of subsequent reviews may be cur-tailed. If the reports are found to be incorrect,the overall review procedures should beintensified. When an error or misstatement isconsidered significant, the matter should bebrought to management’s attention and thebank holding company should be required tosubmit adjusted data. Improper methods usedin preparing reports should be called to man-agement’s attention. The examiner shouldexplain all changes carefully and assist bankholding company personnel in whatever waypossible to ensure proper reporting in futurereports.

3. At the conclusion of the review process, theexaminer should discuss the following withmanagement, when applicable:a. inaccuracies found in reports and the need

for submission of amended pages orreports

b. violations of law, rulings, or regulationsc. recommended corrective action when

policies or procedures have contributed todeficiencies noted in the reports or theuntimely submission of report(s)

4. Details concerning the late or inaccuratepreparation of reports should be listed in theinspection report on the Other SupervisoryIssues report page. If the matter is consideredsignificant, it should be noted on the Examin-er’s Comments and Matters Requiring Spe-cial Board Attention report page, as well.When the exceptions are considered minorand have been discussed with managementand corrected, it will suffice to state this onthe Other Supervisory Issues workpaper sup-porting page.

5. When it is determined that false, misleading,or inaccurate information is contained infinancial statements or reports, considerwhether formal enforcement action is neededto ensure that the offending bank holdingcompany, financial institution, or other entityunder the holding company structure willcorrect the statements and reports.

Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0




Submission of reports concerningcompliance with the act, orregulations or orders under it

1844(c)

Annual reports 1844(c) 225.5(b)

Report on intercompanytransactions

1844(c) 225.5(b)

Reports emanating frominspection reportrecommendations

1844(c) 225.5(b)

Reports emanating from cease-and-desist orders

1818(b), (c)

Civil money penalties for errorson bank call and BHC Reports

3241847



Domestic and Other Reports to Be Submitted to the Federal Reserve 2250.0


Venture CapitalSection 2260.0


Venture capital activities are usually conductedthrough one or more of the following types ofentities: Small Business Investment Companies(SBIC); Minority Enterprise Small BusinessInvestment Companies (MESBIC); Non-licensed Venture Capital Companies; and Part-nerships or Venture Capital Funds. SBIC’s andMESBIC’s are licensed and regulated by theSmall Business Administration (SBA); the othertypes are not. Both SBIC’s and MESBIC’s arelimited by regulation to investing in and lendingto small businesses; whereas, non-licensed ven-ture capital companies and partnerships havegreater latitude. The activities of MESBIC’s(section 103d companies) are specifically lim-ited to small firms owned by socially or eco-nomically disadvantaged persons. Most banksand bank holding companies engage in venturecapital activities through an SBIC because of itsbroad ability to take equity positions in othercompanies. SBIC’s are permitted to own up to49.9 percent of the voting shares of a company.By contrast, a non-licensed venture capital com-pany that is a subsidiary of a bank holdingcompany may not own more than 4.9 percent ofthe voting shares of a business. To escape fromthis limitation some bank holding companieshave formed partnerships or venture capitalfunds. However, a bank holding company canonly participate as a limited partner with anownership interest not to exceed 24.9 percent.Limited partnerships are preferred by those bankholding companies who do not possess theexpertise for this type of activity but seek thepotential opportunity for high returns.Through the use of private capital and, in

some cases, borrowed money, venture capitalcompanies invest in and lend to new and grow-ing business enterprises. They prefer to invest inand lend to companies that exhibit strong man-agement talent and clearly defined strategies.Many of the companies are yet unknown to thepublic. Their products either have been intro-duced to the market or are due to arrive in thenext few years. Venture capital companies donot favor pioneering research. Instead, they areinterested in financing innovative products, i.e.,

those next in generation to existing ones, thathave a wide market appeal and the potential forstrong growth. Such products are preferredbecause of their shorter development time andpossible faster realization of profits. One of theways a venture capital company makes moneyis by purchasing the common stock of an emerg-ing company and selling it when the companyhas grown and the stock has appreciated invalue. It also generates earnings by making con-vertible preferred stock investments and bylending money in the form of subordinated de-bentures and term loans. Usually lending agree-ments contain provisions which enable a ven-ture capital company to acquire shares orincrease existing holdings through the exerciseof warrants or stock options at a later date.Although in most cases some equity interest istaken, venture capital companies, generally, donot acquire a controlling interest in a businessthey finance.Once financing commences, venture capital

companies typically take an active role in themanagement of the companies. They usuallyreceive representation on the company’s boardof directors, which enables them to review bud-gets and assist in structuring the company’slong-range strategic plan. Guiding a companythrough its developing stages is consideredessential for the achievement of equity apprecia-tion and realization of the high returns soughtby venture capital companies.

2260.0.2 LOANS AND INVESTMENTS

Investments and lending philosophy may differamong venture capital companies. Some chooseto be equity-oriented; that is, they look forhigher returns on investments through capitalappreciation, while others favor lending in theform of loans or convertible debt securitieswhich provide cash flow to fund operations andservice debt. However, most companies willstrive for a diversified portfolio in terms of thetype of investment and industry mix. The rangeof financing possibilities associated with lend-ing and/or investing is as follows:


First Step Financing Funds needed for seed capital to help develop an idea.

Start-up Financing Funds needed to cover the cost of preparing a business plan,conducting market studies and opening a business.

First Stage Financing Funds needed to start manufacturing and selling the product(s).

Second Stage Financing Funds needed for working capital to expand production and buildinventories. Company is operating but not yet profitable.

Third Stage Financing Funds needed to improve the product, build working capital andexpand marketing and production facilities. At this point, the com-pany should be generating a profit.

Fourth Stage Financing Additional working capital funds needed prior to initial publicoffering which may be as much as a year later.

In addition to the above, venture capital com-panies will consider financing leveraged buy-outs and turnaround situations.The degree of risk assumed varies according

to the stage of financing, i.e., lower stages con-tain greater risk because of the requirement forlonger-term investment discipline than higherstages. Investments in start-up companies typi-cally take five to seven years or more to mature.Because of the high risk involved, most bank-affiliated venture capital companies will avoidthe earlier or lower stages of financing. Newlyestablished venture capital companies and espe-cially those that use leverage tend to focus onthe intermediate and latter stages of financing.These stages are represented primarily bydebenture financing, preferred stock invest-ments, and straight term loans. In structuring aportfolio, a venture capitalist should considerboth liquidity and capital protection. The idealfinancing mix might entail a limited amount ofmoney invested in common stock with theremainder distributed between debentures,loans, and preferred stock. These instrumentswill provide income to cover operating expensesand service debt as well as give some protectionshould the business start to decline. Limitedholdings of common stock give the companythe opportunity to enhance earnings throughcapital gains without adversely effecting cashflow. Regardless of the type of financingoffered, the ability to exist from an investmentor loan through either the issuance of publicstock or a cash buyout by a larger company isthe goal of a venture capital company.

2260.0.3 FUNDING

A venture capital company may use privatecapital, leverage, or a combination of both tofund its portfolio of loans and investments. Ven-ture capital companies obtain private capitalfrom their parent organization, either banks orbank holding companies. Generally, private cap-ital is used to fund high-risk, lower-stage invest-ments, although some companies may diversifytheir portfolio and deploy a portion of capital inloans, debentures and preferred stock. Leveragemay be derived from internal and external bor-rowings. SBIC’s that are banking subsidiariesmay receive funding in the form of loans fromtheir parent bank. For those companies that are asubsidiary of a bank holding company, internalfunding may be provided by the bank holdingcompany from internal cash flow or its externalborrowing sources. A bank holding companymight borrow from its available bank lines orother borrowing sources to fund venture capitaloperations. There is, however, one exception;that is, the use of commercial paper proceeds tofund venture capital investments and loans doesnot appear to qualify under the exemptive provi-sions of section 3(a)(3) of the Securities Act of1933. SBIC’s and MESBIC’s can obtain exter-nal financing from the U.S. government and theprivate sector, while, non-licensed venture capi-tal companies are limited to only private sourcesfor their external financing. Under current SBAregulations, an SBIC can borrow up to $35 mil-lion from the federal financing bank with nolimit as to the aggregate amount of private debt.Because of the investment restrictions onMESBIC’s, the SBA allows them to incurhigher leverage. MESBIC’s are permitted to

Venture Capital 2260.0


borrow up to four times their capital base andissue preferred stock to the SBA up to two timestheir capital base. MESBIC’s also have no limiton the aggregate amount of private debt. Allgovernment borrowings ings are through thefederal financing bank and carry the guaranteeof the SBA. Such borrowings are classified assenior debt.

2260.0.4 PROFITABILITY

Earnings of venture capital companies can fluc-tuate widely depending on the nature of theiractivities. Those companies that blend theirportfolios with loans, debentures and preferredstock investments tend to be more predictableand less erratic in earnings performance thancompanies that are strictly equity-oriented. Thedifference being that loans, debentures and pre-ferred stock provide income to cover operatingexpenses and debt service requirements, whilecommon stock investments may not yield posi-tive returns for several years. Portfolio diversifi-cation tends to smooth out earnings, althoughthe potential for major fluctuations in earningsexists in the future should capital gains be real-ized on equity investments. In measuring earn-ings performance, one should consider the com-bination of net realized earnings (net investmentincome plus net realized gains (losses) on saleof investments) and net unrealized appreciationor depreciation on investment holdings found inthe capital structure of the balance sheet. It isnot uncommon to see aggregate returns on capi-tal reach 50or more. Typically, returns of this magnitude

are influenced by either large gains realized onthe sale of investments or a substantial amountof unrealized appreciation on investments heldor a combination of both. Appreciation or depre-ciation in portfolio investments representspotential realized gains or losses and, therefore,should be considered in evaluating the compa-ny’s earnings performance. Specifically, thechange in year-to-year net unrealized apprecia-tion or depreciation is a factor that should beconsidered in analyzing results. When measur-ing the company’s contribution to consolidatedearnings, net unrealized appreciation or depreci-ation should be ignored.

2260.0.5 CAPITALIZATION

In addition to the usual equity components ofcapital stock, surplus and retained earnings, thecapital structure of a venture capital company

includes a separate category for net unrealizedappreciation (depreciation) on equity interests.Net unrealized appreciation (depreciation) onequity interests represents the gross amountreported under loans and investments less anappropriate provision for taxes. Since unreal-ized appreciation (depreciation) on equity inter-ests represents future profits (losses) they aremeasured separately in the equity account ratherthan in earnings.There are no industry norms with which to

measure capital adequacy. What is known, how-ever, is that the SBA requires a minimum capitalinvestment of $1,000,000 to establish an SBIC.Moreover, regulations governing SBIC’s limitthe dollar amount of investments and/or loans toa single customer to 20 percent of an SBIC’scapital base. Although banks are limited bystatute to a maximum capital investment in anSBIC of 4.9 percent of their primary capital,statistics show that SBIC’s have substantiallyless than this limit. By contrast, there are norestrictions as to the amount of capital that abank holding company may invest in a nonbankaffiliated venture capital company. Dependenceon capital to fund portfolio loans and invest-ments seems to be preferred as the cost ofleverage, at present, cannot provide meaningfulspreads. It can be assumed that the larger thecapital position the higher the dollar amountavailable for investing and/or lending to a singlecustomer.Sustained profitability and satisfactory asset

quality are required to maintain financial sound-ness and capital adequacy. The SBA will con-sider an SBIC’s capital as impaired if net unreal-ized depreciation and/or operating losses equal50 percent or more of its capital base. It wouldseem appropriate to use this guideline for mea-suring the adequacy of capital of non-licensedventure capital companies that are affiliated witha bank holding company.


1. To determine whether the company isoperating within the scope of its approved activ-ities and within the provisions of the Act andRegulation Y.2. To determine whether transactions with

affiliates, especially banks, are in accordancewith applicable statutes and regulations.3. To determine the quality of the asset port-

folios and whether the allowance for losses is



adequate in relation to portfolio risk andwhether the nonaccrual policy is appropriate.4. To determine the viability of the company

as a going concern, and whether its affiliatestatus represents a potential or actual adverseinfluence upon the parent holding company andits affiliated bank and nonbank subsidiaries andthe condition of the consolidated corporation.5. To determine whether the company has

formal written policies and procedures relatingto lending and investing.6. To determine if such policies and proce-

dures are adequate and that management isoperating in conformance with the establishedpolicies.7. To assess management’s ability to operate

the company in a safe and sound manner.8. To suggest corrective action when poli-

cies, practices or procedures are deficient, orwhen asset quality is weak, or when violationsof laws or regulations have been noted.


2260.0.7.1 Pre-Inspection

All SBIC’s and MESBIC’s are subject to com-prehensive regulations and annual examinationsadministered by the SBA. Therefore, it is notnecessary to conduct a full scope inspection ofthese subsidiaries. The bank holding companyinspection should focus on the quality of assets,as disclosed in the annual director’s valuationand financial statements submitted to the SBAon an annual basis, transactions with affiliatesand an overall financial evaluation.The decision whether the operations of a

non-licensed venture capital company will beinspected ‘‘on-site’’ is based on the availabilityand adequacy of data from either the parentholding company or that which is obtained uponrequest from the subsidiary. The followinginformation should be obtained and thoroughlyreviewed prior to making a decision to go ‘‘on-site’’:1. Minutes of the board and executive com-

mittee meetings since inception of company orthe date of the previous inspection;2. Comparative interim and fiscal financial

statements containing value accounting adjust-ments, including the year-end filing with theSBA;3. Listing of contingent liabilities, including

any pending material litigation;

4. Latest director’s valuation of loans andinvestments and results of latest internal loan orcredit review;5. Copies of the most recent internal and

external audit reports;6. Trial balance of all loans and investments,

indicating the percent ownership of a companyinvolving an equity interest;7. Listing of loans, debentures and preferred

stock on which scheduled payments are in ar-rears 30 days or more or on which payments areotherwise not being made according to originalterms;8. Details of internal and external borrowing

arrangements; and9. Any agreements, guarantees or pledges be-

tween the subsidiary and its parent holding com-pany or affiliates.After reviewing the above information, a

decision whether or not to conduct an on-siteinspection must be made. Some of the determi-nants of this decision would include: relativesize; current level and trend of earnings; assetquality as indicated in the director’s valuation ofloans and investments; and the condition of thecompany when last inspected. From the infor-mation provided, it might be determined that thecompany is operating properly and is in soundcondition. In such a case, an on-site inspectionmay not be warranted. Conversely, a deteriorat-ing condition might be detected which wouldwarrant a visit even though a satisfactory condi-tion had been determined during the previousinspection. All non-licensed venture capitalcompanies should be inspected on-site at leastonce every three years.

2260.0.7.2 On-Site Inspection

If the decision was made to conduct an ‘‘on-site’’ inspection of the subsidiary, the examinershould expand the scope of the review to includethese additional procedures:1. Hold a brief meeting with the chief execu-

tive officer of the company to establish contactand present a brief indication of the scope of theinspection;2. Review the company’s policy statements

for loans, investments, nonaccruals, and charge-offs;3. Review the latest internal review by the

company’s directors or the loan review depart-ment of the bank affiliate or bank holdingcompany;4. Conduct an independent review of the

portfolio;a. Establish the minimum dollar of loans



and investments to be reviewed to achieve atleast 70 percent coverage of the portfolio;

b. Review loans and investments in sam-ple, giving consideration to the following:

• Latest balance sheet and income data;• Profitability projections;• Product(s) being produced by customerand their market acceptance;

• Business plan;• Extent of relationship with customer;• Funding sources; and• Ultimate source of repayment.

c. Discuss the more serious problem loansand investments with management;

d. Classify, if necessary, those loans andinvestments that exhibit serious weaknesseswhere collectibility is problematical or worse.Lower classification criteria must accompanythese assets, which possess a higher degree ofcredit risk than found in other types of nonbanklending;

e. Determine the diversification of riskwithin the portfolio, i.e., the mix of loans andinvestments and the type of industries financed;

f. Review the adequacy of the allowancefor loan losses and determine the reasonablenessof the amount of unrealized appreciation or de-preciation reported on the balance sheet in con-junction with the asset evaluation; and

g. Determine whether the board of direc-tors or parent holding company has establishedcredit limits for the maximum amount of loansand investments to be extended to a single cus-tomer. Verify adherence to the limits.5. Review equity investments for compliance

with the 4.9 percent maximum limitation to anyone customer;6. Verify office locations and activities with

system approvals;

7. Compare company’s general ledger withstatements prepared for the latest FR Y–6;8. Review the quality and liquidity of other

investment holdings;9. Review and classify, if necessary, assets

acquired in liquidation of a customer’s businessdue to default. Determine compliance of divesti-ture period with section 4(c)(2) of The BankHolding Company Act;10. Review the manner and frequency in

which subsidiary management reports to theparent holding company;11. Follow-up on matters criticized in the

most recent audit reports and the previousinspection report on the subsidiary; and12. Assess the expertise of subsidiary man-

agement and awareness of subsidiary directors.

2260.0.7.3 Matters WarrantingRecommendation in Inspection Report

Deficiencies or concerns that warrant citation inthe inspection report for the attention of man-agement are:1. Lack of policies and/or controls in the

lending and investing functions;2. Improper diversification of risk in the loan

and investment portfolio;3. Adverse tie-in arrangements with the affil-

iate bank(s):4. Lack of management expertise;5. Impairment of capital as a result of operat-

ing losses or high unrealized depreciation onequity interests or a combination of both; and6. Lack of adequate reporting procedures to

parent holding company management.



2260.0.8 LAWS, REGULATIONS, INTERPRETATIONS AND ORDERS


Acquisition of SBIC by abank holding company

1843(c)(8)1843(c)(5)

225.111 4–1734–1754–174

Limitations of an SBIC’scontrol over businessenterprises

13 C.F.R. 107.901(a)

Criteria for various types ofbusiness investments of anSBIC

13 C.F.R. 121.3–1013 C.F.R. 121.3–11

Acquisition of a non-licensedventure capital company by abank holding company

1843(c)(8) 225.112

Formation of joint ventures(limited partnerships) forpurpose of conductingventure capital activities

1843(c)(6)

Limitation on equity interestsof a non-licensed venturecapital company affiliatedwith a bank holding company

1843(c)(6)

Loans to affiliates—Section 23A of FR Act

371c

Restrictions ontransactions with affiliates

371c

Acquisition of sharesacquired DPC

1843(c)(2)

Acquisition of assetsacquired DPC

1843(c)(2) 225.132 4–175.1





2260.0.9 APPENDIX 1—VENTURE CAPITAL COMPANY SAMPLE BALANCESHEET

December 31, 19XX

ASSETS

Cash XXXXMoney Market investments XXXXLoans and investments XXXXLoans XXXXDebt securities XXXXEquity interests XXXXTotal loans and investments XXXX

Less: Allowance for losses on loans and investments XXXXPlus: Unrealized appreciation (depreciation) on equity interests XXXX

Net loans and investments XXXXInterest and dividends receivable XXXXAssets acquired in liquidation of loans and investments XXXXOther assets XXXX

Total assets XXXX

LIABILITIES

Notes payable—affiliates XXXXNotes payable—others XXXXAccrued taxes payable XXXXDeferred tax credits XXXXOther liabilities XXXX

Total liabilities XXXX

STOCKHOLDER’S EQUITY

Common stock (par value XXX) XXXXSurplus XXXXRetained earnings XXXXNet unrealized appreciation (depreciation) of equity interests XXXX

Total stockholder’s equity XXXX

Total liabilities and stockholder’s equity XXXX



2260.0.10 APPENDIX 2—VENTURE CAPITAL COMPANY—SAMPLE INCOMESTATEMENT

For Fiscal Year EndedDecember 31, 19XX

INTEREST INCOME

Interest on loans and debt securities XXXDividends on equity interests XXXInterest on money market investments XXX

Total interest income XXX

INTEREST EXPENSE

Interest on notes payable to affiliates XXXInterest on notes payable to others XXX

Total interest expense XXX

NET INTEREST INCOME XXX

PROVISION FOR LOAN LOSSES XXX

Net interest after provision for loan losses XXX

OTHER REVENUEIncome from assets acquired in liquidation of loans and investments XXXManagement Fees XXX

Total other revenue XXX

Net interest and other revenue XXX

NONINTEREST EXPENSE

Salaries and benefits XXXManagement and service fees XXXOther expenses XXX

Total noninterest expense XXX

Income before taxes XXXApplicable taxes XXXNet investment income XXXRealized gain (loss) on sale of securities, net of tax XXX

Net income XXX



Supervision of Savings and Loan Holding CompaniesSection 2500.0

WHAT’S NEW IN THIS REVISEDSECTION

Effective January 2016, this section is revised todelete a reference to SR letter 02-1, “Revisionsto Bank Holding Company Supervision Proce-dures for Organizations with Total ConsolidatedAssets of $5 Billion or Less.” The letter is nolonger active. Effective July 2015, this sectionwas also revised to include a reference to SRletter 14-9, ″Incorporation of Federal ReservePolicies into the Savings and Loan HoldingCompany Supervision Program,″ which pro-vides a listing of supervisory guidance docu-ments (SR letters) that were issued prior to July21, 2011. The Federal Reserve has determinedthat these SR letters are applicable to savingsand loan holding companies.

Title III of the Dodd-Frank Wall Street Reformand Consumer Protection Act1 (Dodd-Frank Act)transferred to the Board of Governors of theFederal Reserve System (Board) the supervisoryfunctions of the Office of Thrift Supervision(OTS) related to savings and loan holdingcompanies (SLHCs) and their nondepositorysubsidiaries beginning on July 21, 2011. TheDodd-Frank Act also provides that all regula-tions, guidelines, and other advisory materialsissued by the OTS on or before the transfer datewith respect to SLHCs and their nondepositorysubsidiaries will be enforceable until modified,terminated, set aside, or superseded by the Board.

The Board intends, to the greatest extentpossible, taking into account any uniquecharacteristics of SLHCs and the requirements ofthe Home Owner’s Loan Act (HOLA), to assessthe condition, performance, and activities ofSLHCs on a consolidated basis in a manner thatis consistent with the Board’s establishedrisk-based approach regarding bank holdingcompany (BHC) supervision. As with BHCs, theBoard’s supervisory objective will be to ensurethat an SLHC and its nondepository subsidiariesare effectively supervised and can serve as asource of strength for, and do not threaten thesoundness of, its subsidiary depository institu-tion(s). The frequency and scope of supervisoryactivities for holding companies is discussed indetail in section 5000 of this manual.

The Board understands that it will take timeto acquaint SLHCs with the Board’s supervi-sory policies and approach. To help facilitate

this transition, examiners will be using the firstsupervisory cycle2 to inform SLHCs how theiroperations compare to the Board’s supervisoryexpectations and assign indicative ratings. Forspecific information about the supervisoryapproach during the first supervisory cycle forholding companies of varying size and complex-ity, see attachments A and B to SR-11-11,‘‘Supervision of Savings and Loan HoldingCompanies (SLHCs).’’ Once the indicative rat-ing has been assigned, the SLHCs will be super-vised and assigned ratings consistent with theBHC supervisory program and cycle.

Federal Reserve supervisory staff shouldassess whether an SLHC conducts its operationsin a safe and sound manner and in compliancewith applicable laws and regulations. Staffshould also determine whether an SLHC, itssubsidiary depository institution(s), and nonde-pository subsidiaries are in compliance with anyenforcement actions, applications commitments,or other supervisory directives (including cita-tions in previous examinations or inspections).If Federal Reserve supervisory staff concludesthat an SLHC is not conducting its operations ina safe and sound manner; is in violation ofapplicable law or regulations; or is not comply-ing with any outstanding enforcement action,commitment, or supervisory directive, or if theprimary regulator of a subsidiary savings asso-ciation has determined that it is not in satisfac-tory condition, appropriate action should betaken against the SLHC, including possible for-mal or informal enforcement actions.

When communicating inspection findings,examiners should use standard Federal Reserveterminology to differentiate among mattersrequiring immediate attention (MRIAs) andmatters requiring attention (MRAs).3 Examinersshould discuss with management those practicesthat are not consistent with the safety-and-soundness principles. When MRIAs and/orMRAs have been identified and communicatedto the SLHC in a report of inspection, examinersshould work with the SLHC to establish a planand appropriate timetable for SLHC manage-ment to address these matters within a reason-

1. Pub. L. 111-203, July 21, 2010; 124 Stat. 1376. SeeSection 312, Powers and Duties Transferred.

2. The first supervisory cycle for an SLHC is the period oftime between July 21, 2011, and the close of the first requiredinspections.

3. See SR-13-13/CA-13-10, ‘‘Supervisory Considerationsfor the Communication of Supervisory Findings’’ and itsattachment, and section 5000.0.9.3 of this manual.

BHC Supervision Manual January 2016Page 1

able period. In determining the appropriate time-table for addressing deficiencies, examinersshould consider the nature, scope, complexity,and risk of the deficiency. Supervision staff atthe Board will review MRIAs and MRAs peri-odically to ensure appropriate prioritization andconsistent treatment across SLHCs.

2500.0.1 APPLICABLE LAW,REGULATIONS, AND GUIDANCE

The main governing statute for SLHCs isHOLA. Other statutes apply to both SLHCs andBHCs, such as the Change in Bank Control Actand the Management Interlocks Act. On August12, 2011, the Board issued an interim final rulecodifying all the rules that apply to SLHCs.4

Although the Board anticipates conformingcertain portions of the OTS rules to those

currently found in the Board’s Regulation Y,Regulation Y will not apply to SLHCs. AlthoughSLHCs are similar to BHCs, SLHCs are notsubject to the Bank Holding Company Act. Inparticular, SLHCs may engage in a wider arrayof activities than those permissible for BHCs andmay have concentrations in real estate lendingthat are not typical for BHCs.

The Federal Reserve has identified supervi-sory guidance documents (SR letters) that itdetermined to be applicable to SLHCs. Theletters were issued prior to July 21, 2011 (thedate of transfer of supervision and regulation ofSLHCs from the former Office of Thrift Super-vision (OTS) to the Federal Reserve Board).Refer to SR-14-9, “Incorporation of FederalReserve Policies into the Savings and LoanHolding Company Supervision Program,” andits attached listing of the SR letters.

4. See 76 Fed. Reg. 56508, September 13, 2011. (See alsothe Board’s press release issued on August 12, 2011.)

Supervision of Savings and Loan Holding Companies 2500.0

BHC Supervision Manual January 2016Page 2

futures, forward, and option contracts section 2130 · futures, forward, and option contracts...

Documents